Answrs the following.. 1.

elements of management control system

Characteristics of Control
• • • • • •

Control is a continuous process Control is a management process Control is embedded in each level of organizational hierarchy Control is forward looking Control is closely linked with planning Control is a tool for achieving organizational activities

The elements of control
The four basic elements in a control system — (1) the characteristic or condition to be controlled, (2) the sensor, (3) the comparator , and (4) the activator — occur in the same sequence and maintain a consistent relationship to each other in every system.[3] The first element is the characteristic or condition of the operating system which is to be measured. We select a specific characteristic because a correlation exists between it and how the system is performing. The characteristic may be the output of the system during any stage of processing or it may be a condition that has resulted from the output of the system. For example, it may be the heat energy produced by the furnace or the temperature in the room which has changed because of the heat generated by the furnace. In an elementary school system, the hours a teacher works or the gain in knowledge demonstrated by the students on a national examination are examples of characteristics that may be selected for measurement, or control. The second element of control, the sensor, is a means for measuring the characteristic or condition. The control subsystem must be designed to include a sensory device or method of measurement. In a home heating system this device would be the thermostat, and in a quality-control system this measurement might be performed by a visual inspection of the product. The third element of control, the comparator, determines the need for correction by comparing what is occurring with what has been planned. Some deviation from plan is usual and expected, but when variations are beyond those considered acceptable, corrective action is required. It is often possible to identify trends in performance and to take action before an unacceptable variation from the norm occurs. This sort of preventative action indicates that good control is being achieved. The fourth element of control, the activator, is the corrective action taken to return the system to expected output. The actual person, device, or method used to direct corrective inputs into the operating system may take a variety of forms. It may be a hydraulic controller positioned by a solenoid or electric motor in response to an electronic error signal, an employee directed to rework the parts that failed to pass quality inspection, or a school principal who decides to buy additional books to provide for an increased number of students. As long as a plan is performed

within allowable limits, corrective action is not necessary; this seldom occurs in practice, however. Information is the medium of control, because the flow of sensory data and later the flow of corrective information allow a characteristic or condition of the system to be controlled. To illustrate how information flow facilitates control, let us review the elements of control in the context of information
2.Explain corporate level strategy in terms of diversification..?


2. Explain Business level strategy in accordance with BCG matrix

Business-level strategy is - applicable in those organizations, which have different businesses-and each business is treated as strategic business unit (SBU). The fundamental concept in SBU is to identify the discrete

independent product/market segments served by an organization. Since each product/market segment has a distinct environment, a SBU is created for each such segment. For example, Reliance Industries Limited operates in textile fabrics, yarns, fibers, and a variety of petrochemical products. For each product group, the nature of market in terms of customers, competition, and marketing channel differs. Therefore, it requires different strategies for its different product groups. Thus, where SBU concept is applied, each SBU sets its own strategies to make the best use of its resources (its strategic advantages) given the environment it faces. At such a level, strategy is a comprehensive plan providing objectives for SBUs, allocation of re-sources among functional areas and coordination between them for making optimal contribution to the achievement of corporate-level objectives. Such strategies operate within the overall strategies of the organization. The corporate strategy sets the long-term objectives of the firm and the broad constraints and policies within which a SBU operates. The corporate level will help the SBU define its scope of operations and also limit or enhance the SBUs operations by the resources the corporate level assigns to it. There is a difference between corporate-level and business level strategies. For example, Andrews says that in an organization of any size or diversity, corporate strategy usually applies to the whole enterprise, while business strategy, less comprehensive, defines the choice of product or service and market of individual business within the firm. In other words, business strategy relates to the ‘how’ and corporate strategy to the ‘what’. Corporate strategy defines the business in which a company will compete preferably in a way that focuses resources to convert distinctive competence into competitive advantage.’ Corporate strategy is not the sum total of business strategies of the corporation but it deals with different subject matter. While the corporation is concerned with and has impact on business strategy, the former is concerned with the shape and balancing of growth and renewal rather than in market execution.


3. Wtr the formal and informal factors that influence the goal congruence.?

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Author – Sarbesh Mishra, Ph.D Organization – National Institute of Construction Management and Research (NICMAR) Address – NICMAR’s CISC, NAC Campus, P.O – Kondapur, At – Hyderabad, PIN – 500 084. INDIA. Tel - +91 – 40 – 23111 286 (Telefax), +91 – 40 – 64510 763 (DID), +91 – 93968 44687 (Mob) E.mail –,

The present paper is a part of larger research on a quantitative expression of plan of action prepared in advance of the period to which it relates and a means of translating the overall objectives of the organization into detailed plans of action. The macro theme requires details of changes in law, economy and business in different fields. Towards creating a new area of strategic risk management, its micro details, this paper takes up the goals of individuals and groups should coincide with the goals and objectives of the organisation as a whole which is the behavioral aspects of budgeting.

Tunnel vision, planning, cost accounting, management, efficient working, control system, goals, goal congruence, internal factors, external factors, informal factors, formal factors. There are different models of organizational styles of management exists. Among the possible style of management, the ones most likely to create problems are the “fire fighting” and “tunnel vision” approaches. Fire fighting consists of reacting to the events and crises when they appear; tunnel vision is a selective perception of what constitutes the organization’s concern. Planning is an effective mechanism to counter both the fire fighting and tunnel vision management styles. It allows the organisation to define its relationship with the environment and is “a method of guiding managers so that their decisions and actions are set to the future of the organization in a consistent and rational manner and in a way desired by the top management”. Planning has also been defined as a process which begins with objectives; defines

strategies, policies and detailed plan to achieve them; which establishes an organization to implement decisions and feedback to introduce new planning cycle.” The above definitions describe planning as the process of collecting information on objectives and making decisions on the way to achieve them. Planning is vital to an organization’s future success. Stanley Thune and Robert House analyzed the planning function in 36 similar firms in six industries. This has led to the conclusion that (i) those firms that rely on formal planning department were more successful than those rely on informal planning, (ii) those firms that rely on a formal planning department perform more successfully after the system is instituted than previously. Planning prepares firm to operate in dynamic world and to adapt to the ensuing changes in the technology, finance, resource availability, economic conditions, and so forth. Because of the benefits of planning, it is not surprising that most firms of all sizes and industries rely on some formal planning system Cost accounting, also known as management control systems or control systems, consist of rules and procedures aimed at accumulation and communication of relevant cost information for internal decision making. These control systems formalize the objective of the organization and express them operationally as performance criteria to be met by the individuals in the organization. Central to the efficient working of the control systems is goal congruence, that is, the harmonization of individual and group objectives within the organization and the

objectives of the organization as a whole. Robert N. Anthony was perhaps the first to stress the importance of goal congruence. 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 to express their own aspirations within the structure of the firm.

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. While profit maximization has long been considered the single goal of the firm, in reality, corporations pursue range of goals. For example a reputed firm may emphasize multiple goals by stressing that organizational performance be measured in the following areas i.e. (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. The goals of the firm may also conflict with one another, with individuals and group objectives. A bargaining process may be necessary to reduce these conflicts in the goal setting process. In fact the budget may be considered as the key mechanism for stabilization of that process, that is, a bargaining medium through which individuals and groups try to further their own goals. Individuals work in different hierarchies and handle different responsibilities & may have different goals. But they must come together as far as Company’s Goal is concerned, (the action must speak Company’s language). This term is 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. 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.
Significance of Goal Congruence

Ensures frictionless working.

Ensures achievement of organization’s goal/strategic objective

Ensures coordination & motivation of all concerned

Ensures consistency in the working of all concerned.

Gives fair chance to its employees to achieve their personal goals.

Enhances the loyalty towards the company.

Satisfies prime requirement ofManagement Control System (MCS) Factors those influence the Goal Congruence
Informal Factors

External factors – set of attitudes of the society, work ethics of the society

Internal factors (Factors within the organization)


Culture- “Common beliefs, shared values, norms of behavior & assumptions” implicitly

accepted and explicitly built into.

Mgt. Style – Informal/Formal

The Communication Channels Perception and Communication – e.g. Budget (meaning): A strict profit control plan,Budget: A tentative guiding profit plan Formal Factors Management Control System –A Strategy itself Rules –Instructions, manuals and circulars, Physical controls, system safeguards, task control system.

4. What do you mean by responsibility centers.?

4. DECENTRALIZATION AND RESPONSIBILITY CENTERS Responsibility accounting is an underlying concept of accounting performance measurement systems. The basic idea is that large diversified organizations are difficult, if not impossible to manage as a single segment, therefore they must be decentralized or separated into manageable parts. These parts, or segments are referred to as responsibility centers and include: 1) revenue centers, 2) cost centers, 3) profit centers and 4) investment centers. This approach allows responsibility to be assigned (not delegated*) to the segment managers that have the greatest amount of influence over the key elements to be managed. These elements include revenue for a revenue center (a segment that mainly generates revenue with relatively little costs), costs for a cost center (a segment that generates costs, but no revenue), a measure of profitability for a profit center (a segment that generates both revenue and costs) and return on investment (ROI) for an investment center (a segment such as a division of a company where the manager

controls the acquisition and utilization of assets, as well as revenue and costs). These concepts are summarized by ABKY in Exhibit 12-15 and in a similar exhibit below.
Types of Responsibility Centers Sales: Sales Variances Sale price variances Sales volume variances Costs: Cost Variances: For purchasing & production departments Material price variances Material quantity variances Direct labor rate variances Direct labor efficiency variances Variable overhead budget variances Fixed overhead budget variances Production volume variances For service departments Spending variances Traditional Evaluation (Control) Methods

) Revenue Centers - segments that mainly generate evenue with relatively little costs.

ncludes marketing functions only with very little costs elative to the revenue produced.

) Cost Centers - segments that generate costs, but no evenue.

ncludes production and service functions or departments.

) Profit Centers - segments that generate both revenue and Gross profit or contribution margin, operating income and net osts. income plus the variances for sales and cost such as the ones above. ncludes both marketing, production and service unctions. Examples include a manufacturing plant or product line. Return on Investment: = (Return on Sales)(Capital Turnover) = (Net income ÷ Sales)(Sales ÷ Total assets) = Net income ÷ Total assets

) Investment Centers - segments such as divisions of a ompany where the managers control the acquisition and tilization of assets, as well as revenue and costs.

ncludes all the functions above plus the managers ontrol what to produce and how to produce, i.e., have utonomy or more autonomy than profit center managers.

Typically, investment centers are divisions of large ompanies.

Also Residual Income. This is essentially the same as economic value added (EVA).

Responsibility accounting is based on the controllability principle. The idea is that managers should only be evaluated based on what they can control. One problem with this approach is that there is a great deal of interdependence within any organization. This interdependence creates joint responsibility across segments that is difficult to separate. In addition, since the parts of an organization cannot be entirely independent, they tend to affect each other in ways that influence the performance measurements in the exhibit above. Evaluating the various segments of an organization separately tends to create competition between them and prevent the company from optimizing the performance of the whole. For example, the segment reporting illustration in ABKY Exhibit 12-16 shows the allocation of some common, or joint costs to the segments of an automobile dealership. A problem that frequently arises involves disputes between responsibility center managers related to how those costs are allocated. Another problem involves transfer pricing disputes.
5. What is profitability centers.? Advantages and disadvantages

What is the advantages and disadvantages of profitability index?"
Profitability Index Advantages Tells whether an investment increases the firm's value Considers all cash flows of the project Considers the time value of money Considers the risk of future cash flows (through the cost of capital) Useful in ranking and selecting projects when capital is rationed Disadvantages Requires an estimate of the cost of capital in order to calculate the profitability index May not give the correct decision when used to compare mutually exclusive projects OR
A profit centre is a responsibility unit that measures the performance of a division, product line, geographic area, or other measurable unit. Divisional profit figures are best obtained by subtracting from revenue only the costs the division manager can

control (direct division costs) and eliminating allocated costs common to all divisions (e.g., an allocated share of company image advertising that benefits all divisions but is not controlled by division managers). Profit is a very often used method to evaluate a division's financial success as well as the performance of its manager. In determining divisional profit, a Transfer Price may have to be derived. The divisional profit center allows for decentralization. As each division is treated as a separate business entity with responsibility for making its own profit. Or A profit center is nothing more than an accounting and operating structure which allows you to track revenue, costs and expenses unique to each product or service offered. The real advantage is that you know which segments of your business are profitable and which are not

7. What is transfer pricing? Methods of transfer pricing?
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. OECD Transfer Pricing Guidelines state, “Transfer prices are significant for both taxpayers and tax administrations because they determine in large part the income and expenses, and therefore taxable profits, of associated enterprises in different tax jurisdictions.”

Transfer Pricing Methods
Best Method Rule of Transfer Pricing

The best method rule is intended to avoid the rigidity of the priority of methods that formerly had been required. The rule guides taxpayers and the IRS as to which method is most appropriate in a particular case. The temporary regulations no longer provided for an ordering rule to select the method that provides for an arm’s-length result. Rather, in choosing a method, the arm’s-length result must be determined under the method which provides “the most accurate measure of an arm’s-length result.” The best method rule appears to be somewhat subjective and, because of its technical nature, may require special expertise. Certainly, the rule does not appear to eliminate the potential for controversy between the IRS and taxpayers. The rule will likely require taxpayers to expend more energy developing intercompany transfer prices and reviewing data. The best method rule had three limitations:

1. Tangible property rules normally do not adequately consider the effect of nonroutine intangibles in determining which method is the best method. In these cases, adjustments may be required under the intangible property rules.7 2. Tangible property comparable methods may be superseded, especially as they effect significant nonroutine intangibles that are not defined. 3. A taxpayer can request an “advance pricing agreement” to determine its best method. Multiple Methods of Transfer Pricing

The temporary regulations encouraged the taxpayer to use more than one transfer pricing method. When two or more methods produce inconsistent results, the best method rule should be applied to determine which method produces the most accurate measure. Presumably, if the results are consistent, it may not be necessary to invoke the best method rule. If the best method rule does not clearly indicate the most accurate method, consistency between results should be considered as an additional factor. Using this approach, the taxpayer should ascertain whether any of the methods, or separate applications of a method, yields a result consistent with any other method.
Comparable Uncontrolled Price Method

The CUP method provides the best evidence of an arm's length price. A CUP may arise where:

the taxpayer or another member of the group sells the particular product, in similar quantities and under similar terms to arm's length parties in similar markets (an internal comparable); an arm's length party sells the particular product, in similar quantities and under similar terms to another arm's length party in similar markets (an external comparable); the taxpayer or another member of the group buys the particular product, in similar quantities and under similar terms from arm's length parties in similar markets (an internal comparable); or an arm's length party buys the particular product, in similar quantities and under similar terms from another arm's length party in similar markets (an external comparable).

Incidental sales of a product by a taxpayer to arm's length parties may not be indicative of an arm's length price for the same product transferred between non-arm's length parties, unless the non-arm's length sales are also incidental. Transactions may serve as comparables despite the existence of differences between those transactions and non-arm's length transactions, if:
• •

the differences can be measured on a reasonable basis; and appropriate adjustments can be made to eliminate the effects of those differences.

Where differences exist between controlled and uncontrolled transactions, it may be difficult to determine the adjustments necessary to eliminate the effect on transfer prices. However, the difficulties that arise in making adjustments should not routinely preclude the potential application of the CUP method. Therefore, taxpayers should make reasonable efforts to adjust for differences.
The use of the CUP method precludes an additional allocation of related product development costs or overhead unless such charges are also made to arm's length parties. This prevents the double deduction of those costs-once as an element of the transfer price and once as an allocation. Resale price method of Transfer Pricing

The resale price method begins with the resale price to arm's length parties (of a product purchased from an non-arm's length enterprise), reduced by a comparable gross margin. This comparable gross margin is determined by reference to either:
• •

the resale price margin earned by a member of the group in comparable uncontrolled transactions (internal comparable); or the resale price margin earned by an arm's length enterprise in comparable uncontrolled transactions (external comparable).

Under this method, the arm's length price of goods acquired by a taxpayer in a non-arm's length transaction is determined by reducing the price realized on the resale of the goods by the taxpayer to an arm's length party, by an appropriate gross margin. This gross margin, the resale margin, should allow the seller to:
• •

recover its operating costs; and earn an arm's length profit based on the functions performed, assets used, and the risks assumed.

Where the transactions are not comparable in all ways and the differences have a material effect on price, the taxpayer must make adjustments to eliminate the effect of those differences. The more comparable the functions, risks and assets, the more likely that the resale price method will produce an appropriate estimate of an arm's length result. An exclusive right to resell goods will usually be reflected in the resale margin. The resale price method is most appropriate in a situation where the seller adds relatively little value to the goods. The greater the value-added to the goods by the functions performed by the seller, the more difficult it will be to determine an appropriate resale margin. This is especially true in a situation where the seller contributes to the creation or maintenance of an intangible property, such as a marketing intangible, in its activities.

Cost plus method of Transfer Pricing

The cost plus method begins with the costs incurred by a supplier of a product or service provided to an non-arm's length enterprise, and a comparable gross mark-up is then added to those costs. This comparable gross mark-up is determined in two ways, by reference to:
• •

the cost plus mark-up earned by a member of the group in comparable uncontrolled transactions (internal comparable); or the cost plus mark-up earned by an arm's length enterprise in comparable uncontrolled transactions (external comparable).

In either case, the returns used to determine an arm's length mark-up must be those earned by persons performing similar functions and preferably selling similar goods to arm's length parties. Where the transactions are not comparable in all ways and the differences have a material effect on price, taxpayers must make adjustments to eliminate the effect of those differences, such as differences in:
• •

the relative efficiency of the supplier; and any advantage that the activity creates for the group.

The more comparable the functions, risks and assets, the more likely it is that the cost plus method will produce an appropriate estimate of an arm's length result. In general, for purposes of applying a cost-based method, costs are divided into three categories: (1) direct costs such as raw materials; (2) indirect costs such as repair and maintenance which may be allocated among several products; and (3) operating expenses such as selling, general, and administrative expenses. The cost plus method uses margins calculated after direct and indirect costs of production. In comparison, net margin methods-such as the transactional net margin method (TNMM) discussed in Section B of this Part-use margins calculated after direct, indirect, and operating expenses. For purposes of calculating the cost base for the net margin methods, operating expenses usually exclude interest expense and taxes. Properly determining cost under the cost plus method is important. Cost is usually calculated in accordance with accounting principles that are generally accepted for that particular industry in the country where the goods are produced. However, it is most important that the cost base of the transaction of the tested party to which a mark-up is to be applied be calculated in the same manner as-and reflects similar functions, risks, and assets as-the cost base of the comparable transactions. Where cost is not accurately

determined in the same manner, both the mark-up (which is a percentage of cost) and the transfer price (which is the total of the cost and the mark-up) will be misstated. For example, if the comparable party includes a particular item as an operating expense, while the tested party includes the item in its cost of goods sold, the cost base of the comparable must be adjusted to include the item.

Transactional Profit Methods of Transfer Pricing
Traditional transaction methods are the most reliable means of establishing arm's length prices or allocations. However, the complexity of modern business situations may make it difficult to apply these methods. Where the information available on comparable transactions is not detailed enough to allow for adjustments necessary to achieve comparability in the application of a traditional transaction method, taxpayers may have to consider transactional profit methods. However, the transactional profit methods should not be applied simply because of the difficulties in obtaining or adjusting information on comparable transactions, for purposes of applying the traditional transaction methods. The same factors that led to the conclusion that it is not possible to apply a traditional transaction method must be considered when evaluating the reliability of a transactional profit method. The OECD Guidelines endorse the use of two transactional profit methods:
• •

the profit split method; and transactional net margin method (TNMM).

The key difference between the profit split method and the TNMM is that the profit split method is applied to all members involved in the controlled transaction, whereas the TNMM is applied to only one member. The more uncertainty associated with the comparability analysis, the more likely it is that a onesided analysis, such as the TNMM, will produce an inappropriate result. As with the cost plus and resale price methods, the TNMM is less likely to produce reliable results where the tested party contributes to valuable or unique intangible assets. Where uncertainty exists with comparability, it may be appropriate to use a profit split method to confirm the results obtained.
Profit split method of Transfer Pricing

Under the profit split method:

The first step is to determine the total profit earned by the parties from a controlled transaction. The profit split method allocates the total integrated profits related to a controlled transaction, not the total profits of the group as a whole. The profit to be split is generally the operating profit, before the deduction of interest and taxes. In some cases, it may be appropriate to split the gross profit.

The second step is to split the profit between the parties based on the relative value of their contributions to the non-arm's length transactions, considering the functions performed, the assets used, and the risks assumed by each non-arm's length party, in relation to what arm's length parties would have received.

The profit split method may be applied where:
• •

the operations of two or more non-arm's length parties are highly integrated, making it difficult to evaluate their transactions on an individual basis; and the existence of valuable and unique intangibles makes it impossible to establish the proper level of comparability with uncontrolled transactions to apply a one-sided method.

Due to the complexity of multinational operations, one member of the multinational group is seldom entitled to the total return attributable to the valuable or unique assets, such as intangibles. Also, arm's length parties would not usually incur additional costs and risks to obtain the rights to use intangible properties unless they expected to share in the potential profits. When intangibles are present and no quality comparable data are available to apply the one-sided methods (i.e., cost plus method, resale price method, the TNMM), taxpayers should consider the use of a profit split method. The second step of the profit split method can be applied in numerous ways, including:
• •

splitting profits based on a residual analysis; and relying entirely on a contribution analysis.

Following the determination of the total profit to be split in the first step of the profit split, a residual profit split is performed in two stages. The stages can be applied in numerous ways, for example:

Stage 1: The allocation of a return to each party for the readily identifiable functions (e.g., manufacturing or distribution) is based on routine returns established from comparable data. The returns to these functions will, generally, not account for the return attributable to valuable or unique intangible property used or developed by the parties. The calculation of these routine returns is usually calculated by applying the traditional transaction methods, although it may also involve the application of the TNMM. Stage 2: The return attributable to the intangible property is established by allocating the residual profit (or loss) between the parties based on the relative contributions of the parties, giving consideration to any information available that indicates how arm's length parties would divide the profit or loss in similar circumstances.

Transactional net margin method (TNMM) of Transfer Pricing


compares the net profit margin of a taxpayer arising from a non-arm's length transaction with the net profit margins realized by arm's length parties from similar transactions; and examines the net profit margin relative to an appropriate base such as costs, sales or assets.

This differs from the cost plus and resale price methods that compare gross profit margins. However, the TNMM requires a level of comparability similar to that required for the application of the cost plus and resale price methods. Where the relevant information exists at the gross margin level, taxpayers should apply the cost plus or resale price method. Because the TNMM is a one-sided method, it is usually applied to the least complex party that does not contribute to valuable or unique intangible assets. Since TNMM measures the relationship between net profit and an appropriate base such as sales, costs, or assets employed, it is important to choose the appropriate base taking into account the nature of the business activity. The appropriate base that profits should be measured against will depend on the facts and circumstances of each case.

8. what is EVA and ROI.?

The purpose of a business is to make profits, and the purpose of a shareholder is to create shareholder wealth. There are various measures to determine the profitability of a business, and the extent to which it is enhancing shareholder value. The measures include Return on Investment, Economic Value Added and Market Value Added. Each of them is significant in their own right, and is interconnected with the other measures. Any business must be evaluated based on all the three measures, as each shows a different aspect of the company. Return on Investment Profits are the acid test of the existence of a company, the all-important indicator of the fortunes of a company from the investor’s point of view.

Profit is the residual amount that is retained by the business after subtracting all expenses from the revenues earned during that accounting period. Profits = (Income during the period) – (Expenses incurred to earn such income) Profit is a measure of how much of the revenue received from customers for goods and services is available for reinvestment in the business or distribution to owners. However, profit as a stand-alone measure does not take into account the level of investment needed to generate that profit. ROI = Profit / Investment The ROI can also be evaluated as ROE, ROCE or ROTA, all of which indicate the amount earned as against the amount invested to create such income. What is important in calculating the ROI or the ROTA measures in the consistency between the aim of the measure and the constituents of the denominator and the numerator. For example, the finance manager must decide that if he/she were measuring the ROTA, would the total assets include Net Book Value or Gross book value or the replacement cost of the Fixed Assets. If the ROCE was being measured, then only the productive assets should be taken into account. Hence, the manager must take two important decisions – what constituents the assets/ investment in the above measure what is the valuation to be used for fixed assets on which depreciation is charged The consistency of the numerator and the denominator becomes a major issue when measuring the performance of a company, as otherwise it may present a distorted picture. An example of this can be wrongly taking PBIT/Equity as a measure of ROI. Here the PBIT accrues to both debt holders and shareholders, while the denominator presents only the equity shareholders. Since PBIT is not the income earned by the shareholders, it cannot be used to show the ROI on their investment (share capital).

The main constraint of ROI as a measure of performance of a company is that it does not indicate whether the company is adding any value or not. This means that even though the business may be earning an positive ROI, it may be possible that the cost of capital is more than that, indicating value erosion rather than value creation. Economic Value Added The fact whether the company is creating value can be verified using the EVA as a measure. It computes the value created or destroyed each year by deducting a charge for capital from the NOPAT of the companies. EVA = NOPAT - Capital Charge (Capital * CoC) EVA implementation improves overall capital efficiency and ensures that the company is moving forward in the right direction. It also integrates financial measurement with business imperatives in a comprehensible form. EVA makes adjustments for many items that are treated differently from the GAAP practices. The off balance sheet items, Research & Development expenditure, interest expenditure, deferred tax expenses, amortization of goodwill etc. This is the greatest advantage of EVA, since it helps to generate a profit number that more closely represents economic cash flows and restates the balance sheet to reflect the true value of resources used to generate income. The EVA is based on the same concept of choosing those projects that have a positive NPV, since they add to the value of the firm. Similarly, companies are evaluated based on whether they add to shareholder value or not. EVA also makes the managers accountable for those factors that are within his/her control, like the return on capital or the cost of capital (provided these decisions are actually vested with each investment centre). He is not taken to task for the factors out of his control like the market sentiments regarding the stocks. Further, it tests all aspects of the functioning of the manager, with the feasibility of his/her investment, and financing decisions.

Market Value Added MVA, or market value added, is the differential in the book value of a firm’s equity and the market value of its equity. It is the difference between the market value of a company (both equity and debt) and the capital contributed by investors. MVA is the difference between what investors have contributed and what they could get by selling at today's prices. If MVA is positive, it means that the company has increased the value of the capital entrusted to it and thus created shareholder wealth. If MVA is negative, the company has destroyed wealth. MVA = Total Market Value - Total Invested Capital Hence, the primary objective of the firm is to maximize the value added as perceived in the market. MVA is essentially the premium over book value of equity. MVA and EVA EVA is a function of the relationship between a firm’s earnings and its cost of capital, and MVA is a function of that firm’s expected future EVA. So market value added is clearly a function of a firm’s earnings. The current year MVA is approximately the discounted present values of future expected EVAs. MVA = Firm Value - Total Capital MVA = [Debt plus Equity Value] - Total Capital MVA = PV of Expected Future EVA EVA and ROI EVA is a function of a firm’s net income less its cost of equity capital (KE*BVE). This would suggest that EVA is maximized by maximizing the differential between earnings and the cost of equity capital. MVA, EVA and ROI MVA is the surplus of the market’s valuation of a firm’s equity over the book value of that equity. In other words, MVA is the value premium over the shareholders’ historical investment in a firm. If a firm is adding economic value by maximizing its return on equity (and its EVA), the market may reward it with a large MVA.

Thus we can see that the MVA in percentage terms is as follows: %MVA = ((Price/Earnings) x ROE) – 1 Since %MVA is a function of both the price/earnings multiple and ROE, it is clear that a firm’s value is related to things that management can influence, and things that management cannot influence. Management can influence the aspects of a business that ultimately are reflected in a firm’s ROE. However, management cannot influence overall market or industry trends and the impact that those trends may have on prevailing price/earnings multiples or the pricing of individual securities. It is seen that MVA, EVA and ROI are interconnected in a very intricate pattern, one reflecting in the other. The measures must be used in conjunction with each other, as analysing the performance of a company would be incomplete without assessing its performance on all 3 fronts. Hence, for purposes such as performance evaluation of the employees and such, the measure must be fixed as preferably EVA. But for valuing the company, it is essential to test performance on the market perceptions, the actual shareholder value created and the earnings made as compared to the investment required to create that income.



Economic Value Added and its characteristics
This chapter presents the main theory about EVA and shows some empirical findings around the concept in financial literature. The last section 2.3 tries to present what the theory of EVA means in practice for companies.


The main theory behind EVA

EVA measures whether the operating profit is enough compared to the total costs of capital employed. Stewart defined EVA (1990, p.137) as Net operating profit after taxes (NOPAT) subtracted with a capital charge: EVA = NOPAT – CAPITAL COST ⇔

EVA = NOPAT – COST OF CAPITAL x CAPITAL employed (1) Or equivalently, if rate or return is defined as NOPAT/CAPITAL, this turns into a perhaps more revealing formula: EVA = (RATE OF RETURN – COST OF CAPITAL) x CAPITAL (2) Where: 1. 2. Rate of return = Nopat/Capital Capital = Total balance sheet minus non-interest bearing debt in the beginning of the year 3. Cost of capital = Cost of Equity x Proportion of equity from capital + Cost of debt x Proportion of debt from capital x (1-tax rate). Cost of capital or Weighted average cost of capital (WACC) is the average cost of both equity capital and interest bearing debt. Cost of equity capital is the opportunity return from an investment with same risk as the company has. Cost of equity is usually defined with Capital asset pricing model (CAPM). The estimation of cost of debt is naturally more straightforward, since its cost is explicit. Cost of debt includes also the tax shield due to tax allowance on interest expenses. This derivation of equity cost and WACC is explained later in detail with chapter 4.2 (Company B’s EVA).

1. How to improve EVA There are countless individual operational things that create shareholder value and increase EVA. Often EVA does not directly help in finding ways to improve operational efficiency except when improving capital turnover. Nor does EVA help directly in finding strategic advantages that enable a company to earn abnormal returns and thus create shareholder value. It is however often helpful to understand the basic ways in which EVA and thus the wealth of shareholders can be improved. Increasing EVA falls always into one of the following three categories: 1. Rate of return increases with the existing capital base. It means that more operating profits are generated without tying any more capital in the business. 2. Additional capital is invested in business earning more than the cost of capital. (Making NPV positive investments.) 3. Capital is withdrawn or liquidated from businesses that fail to earn return greater than the cost of capital. The first method includes all the countless ways to improve operating efficiency or increase revenues. Of course increasing rate of return with current operations and new investments (that is categories 1 and 2) are often linked; in order to improve the efficiency of ongoing operations, companies often do investments which enhance also the return on current capital base. The fact that the wealth of shareholders increase with investments returning more that the cost of capital (category 2) is probably known in organizations if they also use some kind of weighted average cost of capital (WACC) and Net present value (NPV) methodology in investment calculations. This rule is actually completely same as accepting only NPV-positive investments. The third category, withdrawing capital, is probably not so widely understood and applied as the previous ones. It is however also very important to realize that shareholder value can also be increased if capital is withdrawn from businesses earning less than the cost of capital. Even if an operation has positive net income, it might pay to withdraw capital from that activity. It is also

kind of withdrawal when access inventories and receivables and thus the capital costs caused by them are reduced without corresponding decreases in revenues. These categories and ways to improve EVA might appear to be quite simple. They are certainly not new ways to improve the position of shareholders. Decreasing cost of capital is not included in this list of methods. That is because it can not normally be done without changing line of business and in that way changing business risk. Changing financial leverage affects WACC only slightly via increased tax shield. The effects of leverage on capital costs are discussed more thoroughly in chapter 3 Answers the following 1. Types of organizations/

Formal and informal organization
Formal organization A formal organization refers to the structure of well defined jobs, each bearing a definite measure of authority, responsibility and accountability. Thus, a formal organization is created through the co-ordination of efforts of various individuals. Every member is responsible for the performance of a specified task assigned to him on the basis of authority responsibility relationship in an organization. Informal organization Informal organization refers to the relationship between people in an organization based on personal attitudes, emotion, prejudices, likes and dislikes, etc. These relations are not developed according to procedures and regulations laid down in the formal organization. Benefits of Informal organization 1. To employees (i) Sense of belonging: In a formal organization, there is lack of sense of belongingness and personal satisfaction. Value for emotional problems: In the daily work routine there are many opportunities for tension and frustration. Aid on the job: In case of accidents or illness, members of an informal group help one another.




Innovation and originality: By enabling members to modify the job situation more to their liking, the informal organization creates the necessary environment for individual innovation and originality. The individual can experiment with his ideas. Important channel of communication: News travels quickly via informal groups. They are the clandestine transmitters and receivers of information before it is officially released. Social control: Informal groups provide all its members a set of norms or guides to correct behaviour. Members are expected to conform to those norms. Check on authority: Informal group forces the manager to plan and act more carefully than he would otherwise. Informal organization is a check and balance on unlimited use of authority by a manager.





To management (i) Less supervision: Informal group is self-policing. This relieves the management of much of the burden of supervision. An aid to management: The information gives the manager much feedback about employees and their work experiences thereby increasing his understanding of what he needs to do.


Disadvantages of an Informal organization (i) Resistance to change: An informal organization is bound by customs, conventions and culture. Role conflict and sub-optimization: In an informal organization, everyone works towards the same objectives. Members put their own group objectives ahead of organization’s objectives. Hence, the organization suffers. Rumour: An informal organization sometimes functions as a carrier of rumour.



(iv) OR

Group think philosophy: Workers become loyal to their groups.

Organizations are basically clasified on the basis of relationships. There are two types of

organizations formed on the basis of relationships in an organization
1. Formal Organization - This is one which refers to a structure of well defined jobs each bearing a measure of authority and responsibility. It is a conscious determination by which people accomplish goals by adhering to the norms laid down by the structure. This kind of organization is an arbitrary set up in which each person is responsible for his performance. Formal organization has a formal set up to achieve pre- determined goals. 2. Informal Organization - It refers to a network of personal and social relationships which spontaneously originates within the formal set up. Informal organizations develop relationships which are built on likes, dislikes, feelings and emotions. Therefore, the network of social groups based on friendships can be called as informal organizations. There is no conscious effort made to have informal organization. It emerges from the formal organization and it is not based on any rules and regulations as in case of formal organization. Relationship between formal and informal organizations

For a concerns working both formal and informal organization are important. Formal organization originates from the set organizational structure and informal organization originates from formal organization. For an efficient organization, both formal and informal organizations are required. They are the two phase of a same concern. Formal organization can work independently. But informal organization depends totally upon the formal organization. Formal and informal organization helps in bringing efficient working organization and smoothness in a concern. Within the formal organization, the members undertake the assigned duties in cooperation with each other. They interact and communicate amongst themselves. Therefore, both formal and informal organizations are important. When several people work together for achievement of organizational goals, social tie ups tends to built and therefore informal organization helps to secure co-operation by which goals can be achieved smooth. Therefore, we can say that informal organization emerges from formal organization. 3. goal cognuence 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.

Consistency or agreement of actions with organizational goals. It identifies the managerial principle that all of a firm's subgoals must be congruent to achieve one central set of objectives.

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. 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. OR

Goal Congruence

Integration of goals and effectiveness when team building
The extent that individuals and groups perceive their own goals as being satisfied by the accomplishment of organizational goals is the degree of integration of goals. When organizational goals are shared by all, the term goal congruence can be used. (Read this case study.) To illustrate this concept, we can divide an organization into two groups, management and subordinates. The respective goals of these two groups and the resultant attainment of the goals of the organization to which they belong are illustrated in Figure 1.

In this instance, the goals of management are somewhat compatible with the goals of the organization but are not exactly the same. On the other hand, the goals of the subordinates are almost at odds with those of the organization.

The result of the interaction between the goals of management and the goals of subordinates is a compromise, and actual performance is a combination of both. It is at this approximate point that the degree of attainment of the goals of the organization can be pictured. This situation can be much worse when there is little accomplishment of organizational goals, as illustrated in Figure 2.

In this situation, there seems to be a general disregard for the welfare of the organization. Both managers and workers see their own goals conflicting with those of the organization. Consequently, both morale and performance will tend to be low and organizational accomplishment will be negligible. In some cases, the organizational goals can be so opposed that no positive progress is obtained. The result often is substantial losses, or draining off of assets (see Figure 3). In fact, organizations are going out of business every day for these very reasons.

The hope in an organization is to create a climate in which one of two things occurs. The individuals in the organization (both managers and subordinates) either perceive their goals as being the same as the goals of the organization or, although different, see their own goals being satisfied as a direct result of working for the goals of the organization. Consequently, the closer we can get the individual's goals and objectives to the organization's goals, the greater will be the organizational performance, as illustrated in Figure 4.

One of the ways in which effective leaders bridge the gap between the individual's and the organization's goals is by creating a loyalty to themselves among their followers. They do this by being an influential spokesperson for followers with higher management. These leaders have no difficulty in communicating organizational goals to followers and these people do not find it

difficult to associate the acceptance of these goals with accomplishment of their own need satisfaction. 3.expense centers Alternative term for cost center. An Expense Center is a cost center with an output that cannot be easily measured. Managers of these units typically have fixed budgets and should maximize service or output within that budget. Because the cost per output is difficult to measure, the users of an EC are generally not charged directly for its services. Rather these entities are paid via the overhead costs. As a result, the users of an EC tend to over consume its services. This then leads the manager of the EC to request additional budget.

4. Revenue centers A revenue center is a division or unit within a hospital or other institution (e.g., emergency room, pathology). A list of revenue centers codes can be found in the Revenue Center Table. In the MedPAR File, the revenue centers are combined into more generalized cost centers.

revenue center
a responsibility center for which a manager is accountable only for the generation of revenues and has no control over setting selling prices, or budgeting or incurring costs 5. Administrative and support system
1.1 Administrative systems and operation support systems Today’s administrative IT systems incorporate diverse functions for accounting, financial reporting, financial asset management, and payroll management. One of the most commonly used administrative systems is the Enterprise Resource Planning (ERP) system. This system has emerged from integrating and replacing the multitude of existing applications, formerly connected via a stovepipe architecture. ERP systems commonly consist of small, packaged modules that are designed for integration suppleness. [6][7] A typical operation support system is the Supervisory Control And Data Acquisition (SCADA) system, used for supervision and control of industrial processes. Operation support systems have traditionally used their own hardware and software architecture to realize the

real-time requirements imposed by the industrial processes. The hardware is typically of mainframe or workstation type. In order to achieve sufficient system performance, proprietary operating systems and software solutions for distributed access is frequently employed.

6. Administration of transfer prices Transfer pricing refers to the allocation of profits for tax and other purposes between parts of a multinational corporate group.mConsider a profitable UK computer group that buys micro-chips from its own subsidiary in Korea: how much the UK parent pays its subsidiary – the transfer price – will determine how much profit the Korean unit reports and how much local tax it pays. If the parent pays below normal local market prices, the Korean unit may appear to be in financial difficulty, even if the group as a whole shows a decent profit margin when the completed computer is sold. UK tax administrators might not grumble as the profit will be reported at their end, but their Korean counterparts will be disappointed not to have much profit to tax on their side of the operation. This problem only arises inside corporations with subsidiaries in more than one country; if the UK company bought its microchips from an independent company in Korea it would pay the market price, and the supplier would pay taxes on its own profits in the normal way. It is the fact that the various parts of the organisation are under some form of common control that is important for the tax authority as this may mean that transfers are not subject to the full play of market forces. Transfer prices are useful in several ways. They can help an MNE identify those parts of the enterprise that are performing well and not so well. And an MNE could suffer double taxation on the same profits without proper transfer pricing. Take the example of a French bicycle manufacturer that distributes its bikes through a subsidiary in the Netherlands. The bicycle costs €900 to make and it costs the Dutch company €100 to distribute it. The company sets a transfer price of €1000 and the Dutch unit retails the bike at €1100 in the Netherlands. Overall, the company has thus made €100 in profit, on which it expects to pay tax. But when the Dutch company is audited by the Dutch tax administration they notice that the distributor itself is not showing any profit: the €1000 transfer price plus the Dutch unit’s €100 distribution costs are exactly equal to the €1100 retail price. The Dutch tax administration wants the transfer price to be shown as €900 so that the Dutch unit shows the group’s €100 profit that would be liable for tax. But this poses a problem for the French company, as it is already paying tax in France on the €100 profit per bicycle shown in its accounts. Since it is a group it is liable for tax in the countries where it operates and in dealing with two different tax authorities it cannot just cancel one out against the other. Nor should it pay the tax twice. ORR

A large share of world trade consists of transfer of goods, intangibles and services within multinational enterprises. To determine tax liability in each jurisdiction, the right arm's length principle has to be applied. The OECD has issued Transfer Pricing Guidelines on this principle to avoid double taxation.

Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations The Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations provide guidance on the application of the "arm's length principle" for the valuation, for tax purposes, of cross-border transactions between associated enterprises. In a global economy where multinational enterprises (MNEs) play a prominent role, governments need to ensure that the taxable profits of MNEs are not artificially shifted out of their jurisdiction and that the tax base reported by MNEs in their country reflects the economic activity undertaken therein. For taxpayers, it is essential to limit the risks of economic double taxation that may result from a dispute between two countries on the determination of the arm’s length remuneration for their cross-border transactions with associated enterprises.

New material The Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations were originally approved by the OECD Council in 1995. They were completed with additional guidance on cross-border services, intangibles, costs contribution arrangements and advance pricing arrangements in 1996-1999. In the 2009 edition, some amendments were made to Chapter IV, primarily to reflect the latest developments on dispute resolution.

In 2010, Chapters I-III were substantially revised with the addition of new guidance on the selection of the most appropriate transfer pricing method to the circumstances of the case, on how to apply transactional profit methods (the transactional net margin method and the profit split method) and on how to perform a comparability analysis. Furthermore, a new Chapter IX was added, dealing with the transfer pricing aspects of business restructuring 7. Task control vs management control Task control is distinguished from management control in the following ways:
• •

The management control system is basically of similar throughout the organization. Each type task requires a different task control system. In management control, managers interact with other managers; in task control either humans are not involved at all, or the interaction is between a manager and a nonmanager. In management control the focus is on organizational units called responsibility centers; in task control the focus is on specific tasks.

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