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UNIT 1: Overview of Performance Management

1.1 Performance Management
(a) Concept of Enterprise performance Management (EPM)
 Performance management includes process which effectively communicate company
goals to employees, evaluate their performance with reference to these goals &
reward them fairly based on performance. It covers all the operations carried out
throughout the organization
 EPM should cover following areas:
(i) Strategy Formulation
Strategy is based on mission & vision of the business. Different strategies
require different parameters of EPM e.g. for airline company effective &
efficient maintenance & scheduling services are essential
Once the direction is established organization monitors its achievement with
reference to goals set & takes corrective action to reach a particular target.
(ii) Planning & Forecasting
This involves activities to be performed with reference to strategy & forecasting
expected results from operational execution during a particular period of time.
Company which excels in these two activities produce better results as
compared to its competitors
(iii) Financial Management
Financial management deals with three important decision making areas:
(a) Financing decision involves deciding on various sources of funds for financing
business. This decision must be in line with strategies of business & plans to
achieve the strategic objectives of the business. In particular any source selected
must be cost effective, convenient to business & minimize the risk of business e.g.
issuing equity capital may reduce business risk but it may dilute the control of
promoters on the other hand if debentures are issued control may not be diluted but
risk of the business may increase. Proper blend of equity & debt is essential to
minimize business risk & increase the value of shareholders
(b) Investment decision deals with investing the funds procured in right projects which
are useful for achieving desired objectives of business. Performance of the business
can be assessed on the basis of ROI & EVA which highlight efficiency of
management to invest available funds in projects which increase value of the
shareholders
(c) Dividend decision highlights profits distributed to shareholders as well as reserves
created for future business growth & expansion. Higher reserves indicate better
enterprise performance & are useful for achieving strategic plans of the business.
Constant dividend year after year shows consistency in management performance &
useful for building brand equity

(iv) Supply Chain Effectiveness

Supply chain is a network of facilities & distribution options which perform the
functions of procurement of materials, transformation of these materials into
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intermediate & finished products & distribution of these products to the customers.
The objectives of supply chain management are to ensure that the right product
reaches the right place at the right time for the right price & brings profit for the
business. Effective supply chain management links demand management, resource
management & supply management to ensure that product in desired quantity & at
desired time is available to customer all the time.
At strategic level business has to focus on service levels required to support strategic
planning developed by business. Based on the support achieved from supplier
business can build appropriate channels & networks to ensure efficient supply chain
At structural level company has to identify: suppliers, inventory levels to be
maintained, and appropriate transport models to be applied. At this level extent of
outsourcing is determined.
At functional level operational details are worked out which involves developing
appropriate policies & procedures, equipments to be employed, IT systems to be
introduced & training to be imparted
 EPM helps organization to focus on key value drivers which relate to corporate
strategy & specific business processes. Thus with EPM value based decision making
process becomes easy
 EPM ensures that day-to-day work performed by various employees translates into
strategic value. It is a philosophy & approach which helps business to achieve success
for years to come
 For implementing EPM effectively following steps are necessary:

Develop an enterprise strategy.

Enterprise performance management builds on the framework of a good strategic
plan.
EPM takes the elements of the strategic plan and deploys the plan throughout the
organization.
Objectively map the organization.
This step requires creating or revising the blueprint of how work is accomplished
within the organization (process flow), identifying resources required to accomplish
the work, and identifying the outputs resulting from the work.
Identify improvement opportunities and key performance indicators (KPIs).
KPIs describe critical organization metrics like a compass indicates direction. Well
conceived KPIs are of vital importance and linked to outputs and process
Develop an objective and relevant scorecard.
Well designed and relevant business scorecards can provide decision makers with
critical information at right timely.
Implement outcome based change management.
For developing a change management plan addressing following questions is
important
(a) What needs to happen and why?
(b) Is people, process, or outcome change involved?
(c) What about our customers?
(d) When will change occur?
(e) What does the timeline look like?
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(f) Who is responsible for the change?

(g) What is the prediction or impact of the change?
(h) How will it affect people processes, or outcome?
(i) What are the measures of change success or failure?
(j) What is the measurement mechanism?
(k) What is the feedback mechanism?
(l) What is the plan to deal with failure?
(m) Have rewards and accountabilities been developed and communicated?
Measure the Results and Continue to refine the methodology
This is the final step & should be a continuous process. The effects of change need to
be objectively measured and then evaluated
 Effective EPM
Based on its experience as a leader in EPM, Avanade has identified seven keys to an
effective EPM implementation:
 Treat EPM as an integrated approach across all departments. EPM must focus on
more than the financial performance; it must also include strong operational
monitoring and reporting and tie performance to strategic goals.

 Make sure that all decision makers are involved in performance management

 Education and training to support a results-oriented culture

 Create an enterprise data model. Executives need to understand the process by

which data travels and its origins. Data used must be credible, and that credibility
must be verified back to the source. If the source is suspect, all resulting data are
also suspect. Establishing the integrity of the data sources is a key step.

 Identify parameters which reflect true drivers of the business

 Company must also establish a consistent way of modeling their data and
propagating it throughout the organization.

 Make easy for users to get access to the information they need, using familiar
applications. EPM should integrate seamlessly into existing environments, such as
Microsoft Office applications and intranet portals.

(b)EPM & Strategic Planning

 Strategic planning is to business what GPS is to car driver. It is an organizational process

of defining strategy for the organization & making decisions on allocating resources to
pursue this strategy
 Strategic planning defines route from present position of the business to destination
where stakeholders want organization to reach
 Strategic planning must follow mission & vision of the enterprise & is driven from top to
bottom after analyzing internal & external environment of the business
 Linkage of EPM & strategic planning has following dimensions:
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(a) First step in strategic planning is analysis of current situation which is considered as
foundation of strategic planning. This analysis is useful to prepare valuable strategic
plan required to gain competitive advantage to the business. Enterprise performance
depends on how effectively this analysis is carried out by organization
(b) Market segmentation analysis is very much essential in strategic planning process.
Before deciding the products & services that company should produce market
segments must be identified with reference to customers’ needs. There is no defined
way to segment a market. It is a combination of science & art of understanding
buying behavior of current & potential customers. Higher the skill of enterprise for
segmentation better would be strategic plan
(c) SWOT analysis is the essential ingredient of any strategic plan. It is a valuable &
effective tool for strategic planning to be useful to achieve sustainable competitive
advantage. Enterprise performance depends on how accurately & efficiently SWOT
analysis is carried out by organization considering all internal & external factors
affecting the business
(d) Another important step in strategic planning process is to assess core competencies of
the firm. In each company or industry there are different sets of core competencies
which are vital for the success of the business in the existing as well as new markets.
Analysis of core competencies gives realistic view of skill sets, processes & systems
in which company has to excel & helps focus on value added activities. Better the
core competencies higher is the performance of the organization
(e) Strategic planning requires focus on Key Success Factors (KSFs) which are functions,
activities or business practices required to outperform competitors & success in the
market. KSFs revolve around skills, processes & systems. Superior performance of
organization in these areas result in winning orders.
(f) Business unit strategies & functional strategies are essential ingredients of strategic
planning. These strategies must be aligned to each other & finally to overall corporate
strategy. Performance of the organization can be evaluated on the basis of its ability
to integrate these strategies to achieve strategic objective of the organization.
(g) Performance of the organization cannot be judged merely on financial parameters, but
should cover both financial & non financial areas. Kaplan & Norton have defined
four distinct perspectives as
- How do we look at our shareholders? ( Financial results)
- How do we satisfy customers, suppliers & outsiders (Satisfaction results)
- What must we excel at ( Internal business processes results)
- Can we continue to improve & create value (Innovation & learning results)
Thus EPM depends upon strategic planning of the business. If organization is
considering all above four perspectives then it has to excel in all four
in balanced way

(c) EPM & Management Control

 Performance of the organization depends upon management control over various
activities performed by business & hence must be linked to each other.
 As per traditional concept control refers to process of
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- Establishing standards
- Evaluating actual performance against such standards
- Implementing corrective actions to achieve goals of organization
 However modern organizations are operating in competitive environment. In dynamic
& complex business environment most carefully crafted plans can go wrong.
Management control in such case requires to monitor developments in external
environment & adapt to them
 Efficient & effective management control system is necessary for EPM & is useful to
tackle one or all of the following situations
- Managers & employees do not have clear idea of what is expected of them
- Conditions in the organization do not provide impetus for the performance
- In spite of knowing about expectations for performance managers & employees
are unable to perform
 With reference to EPM , management control can be viewed as process by which
managers influence behavior & actions of members of organization to implement
strategies formulated by top management
 In the context of EPM management control refers to the process of establishing &
revising standards of performance in response to dynamics of the market against
which actual performance is evaluated & corrective actions are taken to carry out &
control activities required to achieve organizational goals
 Control ensures that there is no performance deviation & involves following functions:
a. Plan i.e. deciding how to achieve desired target
a. Coordinating activities throughout organization
b. Measure actual performance
c. Evaluate performance with reference to planned performance
d. Communicate relevant information throughout organization
e. Influence people to change their behavior
 Management Control process has following elements:
(a) Detector or sensor is an agent who helps to measure the actual performance of activity
under control e.g. production supervisor who submits daily production report
could be a detector
(b) Assessor Is an evaluator who decides significance of deviation between desired & actual
performance e.g. production foreman who receives & analyses production reports
(c) Effecter initiates alternative course of action if such deviation calls for his intervention in
performance of an activity e.g. production manager who modifies production process
(d) Communication network (MIS) through which information is transmitted to all entities
involved in control process

 There are two types of control

a. Feedback control
 This means controlling business activity to maintain that activity within predetermined
level of performance
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 It is a closed loop control i.e. control is initiated after completing loop

Input – Process –Output which are three essential ingredients of any control system
 Input & output are not coupled together
 Rely on output to initiate control
 Response time is prohibitively long
 Reacts to deviation between expected & actual results
 May introduce system instability
 Output cannot be manipulated as per inputs
 Rarely useful in managerial tasks
 Examples: Material price & quantity variances, Budgetary control system
b. Feed Forward Control
 This means controlling business activity anticipating deviation in output & accordingly
correcting input & process
 It is an open loop control i.e. control is initiated before completing
Input – process – output
 Input & output are coupled together
 Relies on input & process to initiate control
 Response time is very less
 Reacts to factors causing deviations
 Not likely to introduce system instability
 Output can be manipulated on the basis of inputs
 Very much useful in managerial tasks
 Examples: Output of chemical system depends on input & process similarly quantity &
quality of automobile product depends on inputs & technology

(e) EPM & Operational Control

 In the context of business, operation is a set of activities carried out to achieve a
specific purpose e.g. procurement, production, distribution & sales are business
operations. Each of these operations has specific target to be achieved within given
framework of time
 Various operations can be classified as internal & external.
Internal operations are carried out within the organization & have no linkages with
external world. Control elements with reference to such operations are to large extent
defined by organization & can be controlled easily. Quality Control, Production
Control & Inventory Control are important control areas in internal operations.
External operations are also carried out within the organization, but they have the
interface with external world e.g. purchase has to interact with suppliers whereas
warehousing, distribution & sales have linkages with dealers & customers
 Operational control systems are designed to ensure that day- to- day actions are
consistent with established plans & objectives. They are derived from requirements of
management control system
 In operational control standards are set & corrective actions are taken if performance
does not meet these standards. These actions may be motivation, training or
termination
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 Following are some of the techniques used by EPM to establish operational control
(a) Value chain analysis to ensure that value is created at each stage of value chain
(b) Quantitative performance reports such as sales growth, profit improvement,
increase in market share etc. are reviewed & analyzed at regular intervals. This
helps the management to judge whether firm is doing what it is expected to do.
(c) Benchmarking involves comparing performance of products & processes with
that of competitors. This helps the firm to stay abreast of its competitors’
improvements & changes
(d) Key factor rating involves close scrutiny of key factors affecting performance of
the firm
(e) Ratio analysis involves analyzing various ratios to assess financial performance of
the firm. Intra firm comparison can be done between different units of the same
firm. Inter firm comparison is done between firm & other firms of the same
industry. This is useful to assess performance of the firm as compared to
performance of the competitors

(f) Framework for management performance & control

 The objective of performance measurement systems is to implement

strategies effectively and efficiently.
 Managers do not work or control costs personally, but they influence people
who are responsible to do the work or for incurring costs. Their function is to
ensure that work is done efficiently, effectively & at desired cost levels.
 Thus management control involves following activities.
 Selecting right employees
 Making sure that employees are properly & adequately trained
 Deciding where employees can be best fitted in organization
 Empowering employees
 Providing advice and suggestions
 Solving problems
 Ensuring satisfactory work environment
 Discipline
 Resolving disputes
 Approving actions of employees wherever required
 Interacting with other managers for cooperation & coordination
 Creating climate that induces employees to work efficiently and effectively
 To carry out these activities managers need following types of information :
i) Informal information through observations, face to face conversation,
meetings, grapevine & so on.
ii) Most of the formal information that flows throughout on organization
in its day-to-day operations is task control information. Summary of
this information is management control information
iii) Budget reports : The approved budget is the principal financial device
for controlling activities of responsibility centres and report that
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compares actual revenues and expenses with budgeted amounts is the

principal financial report
iv) Certain nonfinancial informations are key indicators of how well
strategies have been implemented. They include :
- Key variables
- Key Success Factors
- Critical Success Factors
- Key Performance Indicators
 Following types of targets can be set to judge management performance :
 Model targets based on historical data & sound relationship among the
factors influencing targets e.g. E.O.Q.
 Historical targets derived from historical data of performance e.g. target
for ROI this year would be 2% over last year’s achieved ROI
 Negotiated targets

When there is no consensus on target set between target setter & target
achiever negotiation takes place between them & target mutually
acceptable is set e.g. top management desires to have target ROI as 20%
but responsibility centre manager does not agree to this due to
completion & market constraints. Then there is negotiation between
corporate office & business unit and target may be set as 16%
 Externally derived targets are those set on the basis external inputs e.g.
targets for promotional expenses, target price under target costing or
bench marking with industry average or competitors’ achievements
 Internally derived targets are solely based on organizational inputs taken
from employees. These targets provide motivational force to employees.
 Fixed & flexible targets :

Certain targets are fixed for specific period of time

e.g. budgets or ROI may be fixed for month, quarter or year.
Sales targets may be flexible depending upon no. of competitors
& position in the market

1.2 & 1.3 Performance Evaluation parameters

(a) Financial Parameters

[1] RESPONSIBILITY CENTERS

(i) Meaning of Responsibility Center

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 Responsibility center is an unit in organization headed by manager who is responsible

for its activities & performance
 Company is a collection of responsibility centers each of which is part of organization
structure
 There are three levels of responsibility centers
 Lowest level - Sections or shifts
 Middle level - Departments or business units
 Top level - B.O.D. & senior management
 Responsibility center requires material, labour, services, fixed assets & working capital
to convert input to output. Input can be procured from other responsibility center or
from market. Output can either be sold to other unit or to the market
 Performance of responsibility center can be judged on any of the following bases
 Expense
 Revenue
 Profit
 ROI

(ii) Significance of Responsibility Center

 Responsibility center exists to accomplish one or more objectives which are useful to
implement strategies required to achieve organizational goals
 As a general rule output is directly related to input & manager heading responsibility
center is responsible to obtain optimum relationship between input & output
 Focus of control is on making products/services available in right quantity, right quality,
with right specifications using minimum input
 Inputs are consumed in quantity but for MCS these quantities are translated into
monetary terms. Cost is a monetary measure of the amount of resources used by
responsibility center
 Performance of responsibility centre can be measured on the basis of two criteria :

Efficiency is the ratio of output to input or amount of output per unit of input. Thus
responsibility centre is more efficient that others if it gives same output for less input
or gives more output for same input.

Effectiveness is the relationship between output of responsibility centre and its

objectives. More the contribution of output to objectives more effective is the
responsibility centre.

Responsibility centre should be both efficient & effective and when all responsibility
centres are efficient and effective organization can achieve its goals by optimum
Utilization of available resources.
In short, responsibility centre is efficient if it does things right and it is effective if it
does right things. e.g. if credit department handles paper work connected to
defaulting accounts at low cost per account it is efficient but if it is unsuccessful in
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making collections or in the process of collection it antagonises customers, it is

ineffective.
 Profit is the difference between revenue which is a measure of output & expense
which is measure of input. Hence profit measures both efficiency and effectiveness.

(iii) Types of Responsibility Centers

There are four types of responsibility centers classified according to responsibility
assigned to them
(A) Revenue Center
 Revenue centre is a responsibility centre in which outputs are measured in monetary
terms but there is no attempt to relate inputs to outputs.
 Marketing division of a company is a revenue centre.
 It has a responsibility of achieving budgeted sales target.
 It has no responsibility of profit.
 Responsibility of making trade off between cost and revenue for optimum marketing
decisions is not delegated to this centre.
 Each revenue centre is also an expense centre. Its manager is accountable for expenses
incurred directly within his unit.
(B) Expense Center
 This center is responsible for expenses
 Input is measured in monetary terms & output is measured in quantitative terms
 Performance is assessed on the basis of expenses incurred with reference to budgeted
expenses
 Expense center is different from cost center. While expense center has identifiable
manager, cost center does not have e.g. maintenance is an expense center whereas
electrical maintenance, mechanical maintenance, civil maintenance are cost centers
 There are two types of expense centers:
(a) Engineered Expense Center
 It relates to engineered costs which are based on technical specifications &
engineering estimates
 Optimum amount of input required to produce one unit of output can be
established & Standard cost = [ output units x std. cost per unit]
 Efficiency = [Standard cost] – [Actual cost]
When actual cost > standard cost efficiency is decreasing
When actual cost < standard cost efficiency is increasing
 Center manager is responsible for
- Quantity of product
- Quality of product
- Efficiency of cost
He has to achieve trade-off between these parameters
 This expense center is found in manufacturing, warehousing, distribution &
similar units
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(b) Discretionary Expense Center

 It is an expense center in which costs are incurred on the discretion of
management
 Discretionary costs cannot be estimated on the basis of engineering estimates
& technical calculations
 Discretion of the management depends on
- Strategies to be implemented
- Competitive advantage required
- Customer satisfaction levels expected
 Efficiency of center = [Budgeted input cost] – [Actual input cost]
 Important discretionary expense centers are:
(i) Administrative & support centers
They include administrative set up which provide service to other
responsibility centers e.g. internal audit department, tax advisory cell,
cash support center, intranet communication system,
training & development
(ii) Research & development center
R & D expense depends upon product & process innovation strategies
adopted by management, tax benefits available to company & technology
leadership expected by management
Benefits from R & D are long term & controlling expenses is difficult
R & D projects continue over long period & many times expenses may not
give desired results
R & D budget many times is aligned to the budget of competitors &
depends upon market leadership expected by management e.g R & D
budgets of automobile or pharmaceutical companies
(iii) Marketing & sales promotion
Expenses on these activities depend upon management’s desire to
increase market share, maintain market leadership & increasing &
maintaining brand equity
Output of this center can be measured, but it is difficult to evaluate its
effectiveness
Expense target has less significance & sales target is main criteria for
performance evaluation

(C) Profit Center

 This center is responsible for achieving targeted profit
 Profit = [Revenue] - [Expenses]
Hence profit center head has been given autonomy to take decisions relating to
revenue & expenses. Following decisions are taken by him:
- Sales price
- Sales volume
- Sales mix
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- Marketing strategies
- Controlling expenses
- Cost management
 Profit center manager is a senior management position & he generally reports to BOD
 Targets are set in terms of profit with reference to sales
 Business unit or functional unit can be a profit center
 To introduce profit center concept in organization following conditions must be
satisfied:
 Business unit to be considered as profit center must be headed by competent
manager capable of taking decisions relating to revenue & expenses
 Transfer pricing mechanism must be set in
 Performance appraisal system based on profitability must be well established
 Function or activity must have highest influence on bottom line i.e. net profit with
reference to sales
 Profit center manager must be given autonomy for resource allocation, sales
revenue & asset acquisition. He should be given powers to take decisions relating
to input mix, product mix & selling price
 Accounting system must be uniform & consistent
 Appropriate & consistent revenue recognition method must be followed
 A well developed arbitration procedure must be in place. This is useful to resolve
disputes among the centers
 Rational management at corporate & divisional level
 Uniform corporate policy relating to profit centers
 Rationally timed services to all centers at uniform cost
 Ensuring goal congruence by taking care of center’s interest without disturbing
goal of organization
 Well designated organization chart which clearly specifies authority delegated &
responsibilities assigned
 Proper & effective communication channel
 Advantages of profit centre
 Speed of operating decisions increase as they are not referred to H.O.
 Quality of decision improves as they have been made by managers closely related
to point of decision.
 H.O. management is relieved of day to day decisions and can concentrate on more
important issues concerning entire organization.
 Profit consciousness of managers increase.
 Measurement of performance is broadened.
 Effects of management actions on both revenue & expenses is measured.
 With less restrictions & controls by corporate office, centre managers are free to
use their imagination and initiative.
 Profit centre is similar to an independent company. Hence it provides excellent
training ground for general management.
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 It provides excellent means of evaluating managers’ potential for higher

management jobs.
 It facilitates use of different specialists & experts in different types of business
when company adopts strategy of diversification.
 Profit centres are under pressure to improve their competitive performance.

 Disadvantages of profit centre

 As decisions are decentralized, top management may lose some control.
 Managers heading profit centres may not be effective as many times they may not
have developed general management competence.
 An increase in one manager’ profit may decrease profit of other. This may lead to
reduction in cooperation amongst them. Eventually costs of both centres may
increase revenue may go down & profits reduce.
 There may be too much emphasis on short run profitability at the expense of long-
run profitability. In desire to report high current profits, profit centre manager
may skip R & D, training programs or maintenance. This tendency is relatively high
when turnover of profit centre manages is high.
 There is no completely satisfactory system for ensuring that each profit centre by
optimising its own profits will optimise company profits.
 Due to lack of superior information and lack of capability of centre manager,
quality of some of the decisions may be reduced.
 It may increase costs due to additional staff, assets and record keeping many tasks
may be duplicated at each profit centre.
 Conflicts among centres, relating to the following issues:
- Sharing of resources& costs
- Credit for revenue earned
- Setting transfer price
 Many times unwanted competition may be set in among different centres.
 Overall cost control, cost reduction or cost management may not be possible due
to lack in cooperation, coordination and distance barrier
 Methods of measuring profit of profit center
(a) Contribution Margin
 Contribution = [Sales] – [Variable Cost]
 Profit center manager is responsible for controlling only variable costs while
increasing sales
 Fixed costs must be properly identified & should not be included in MIS relating
to profit center
 Semi-variable costs must be properly segregated into fixed & variable
components
 Behaviour of variable costs with reference to output must be properly
understood by profit center manager
 Many fixed cost may be incurred due to specific actions of profit center
manager but he may not be made accountable for them under this method
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(b) Direct Profit

 Direct Profit = [Contribution] – [Fixed Cost]
 Fixed cost must be allocated to profit centers on rational & consistent basis
 Fixed costs due to specific actions of center manager must be properly
identified to that center
 This profit considers all the costs which can be traced to profit center
(c) Controllable Profit
 Controllable Profit = [Direct Profit]-[corporate charges controllable by profit
center]
 This profit is arrived after deducting all expenses that may be influenced by
profit center manager
 H. O. expenses which may be controlled by unit manager are only reduced from
direct profit e.g. expenses relating to corporate governance, public relation,
shareholders’ communication are not controllable by unit manager & hence
cannot be considered
(d) Income Before Tax (EBT)
 EBT = [Controllable profit] - [Other corporate charges]
 This profit takes into account all the expenses traceable to specific profit center
 It highlights how expenses relating to center have been controlled by center
manager
 It shows real efficiency & effectiveness of profit center
(e) Net Income(EAT)
 EAT = [EBT] - [Tax]
 Income tax is constant percentage of pre-tax income, hence there is no
advantage of incorporating tax
 Many decisions having impact on tax are made at headquarters & profit center
manager cannot be judged by consequences of these decisions
 However if units are located in different countries tax rates may vary & must be
considered
 If income tax liability is incurred due to decisions of profit center managers it
must be considered

(D) Investment Center

 It is a responsibility center in which profit with reference to assets employed by center is
used as performance measure
 Investment center manager has two objectives:
(a) To generate maximum profits from assets & resources available to him within policy
framework of the company
(b) To invest in additional assets & resources only when he can justify returns from such
investment more than company’s cost of capital i.e. WACC
 There are two methods of relating profit to investment
(a) ROI = Profit/Investment
(b) EVA = EBIT (1-t) – [capital employed x WACC] or = Capital employed (ROI – WACC)
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 Following problems are faced while implementing investment center

(a) Selection of appropriate asset base
(b) Should only tangible assets be considered or intangible assets should also be added
(c) Which assets are controllable & uncontrollable by the center
(d) Allocation of assets when used by two or more centers
(e) How assets should be valued
 Investment center head is a senior management position & is responsible for asset
acquisition, asset disposal & involved in major decisions such as mergers & acquisition
 Two types of assets are employed by investment center - fixed & current. Their
valuation is a policy decision & may differ from company to company. Following are
some general norms followed by different companies
(i) Cash :
- Most of the companies control cash centrally. Consequently actual cash
balance at business unit level tends to be very small.
- Many companies calculate cash to be included in investment base by means
of a formula e.g. General motors’ use cash as 4.5% of annual sales.
DU Pont Chemicals use two months cost of sales less depreciation
- Some companies omit cash from investment base. The reason is that
amount of cash approximates current liabilities.
(ii) Receivables :
- Business unit managers are in a position to influence level of receivables
through credit policy, credit terms & efficiency of collecting dues.
- Receivables are considered at book value excluding allowance for bad
debts.
- If business unit does not control credits & collection, then receivables may
be calculated on formula basis.
(iii) Inventories :
- They are recorded at end of period amount. However conceptually intra
period averages would be preferred.
- If company is using L. I. F. O. method, inventory balance would be shown at
lower levels during inflationary period. In this case standard cost or
weighed average cost method should be used for inventory valuation.
- If W.I.P. is financed by advance payments or by progress payments from
customer, which is the case with goods requiring longer production period,
these payments should either be subtracted from gross inventory amount
or can be reported as liabilities
- Some companies subtract accounts payable from inventory on the grounds
that they represent financing part of inventory by vendors & hence zero
cost to business unit.
- If business unit can influence the payment period allowed by vendors, the
inclusion of accounts payable in calculation encourages manager to seek
most favorable terms.
- Credit period availed from vendors should give benefit in terms of financing
cost but it should not hurt credit rating of company.
 16

(iv) Working Capital :

- At one extreme companies include only current assets.
This method is logical if business units have no control on accounts payable
& other current liabilities.
- At another extreme companies deduct current liabilities from current
assets. This method is sound only when business units have control on
accounts payable & other current liabilities.
- Ex : Quaker Oats used controllable working capital which included items
such as inventory but not those over which unit manager has no control.
(v) Fixed Assets :
Following are various aspects relating to valuation of fixed assets
(i) Most of the companies value fixed assets at net book value i.e. purchase
cost less accumulated depreciation
(ii) When assets are overvalued ROI drops & when assets are undervalued
ROI increase. It is therefore essential to value fixed assets accurately
(iii) There must be uniformity across the organization for valuation methods
of fixed assets, method of depreciation & rates of depreciation
(iv) When new assts are to be purchased by investment centre, it may be
beneficial to centre but may not be profitable to organization. Purchase
of such assets is not approved by corporate management
(v) On the other hand centre may not favor purchase of new asset as it drops
ROI of unit but it may be beneficial to organization. Purchase of such
assets is insisted by corporate management even though declined by
centre manager
(vi) When assets are worn out their value goes down & ROI of centre goes
up. However for strategic reasons purchase of new assets becomes
necessary. With increase in investment ROI of unit goes down, hence
many times investment centre is reluctant to replace assts.
(vii) Idle assets can be transferred to other units. This is useful to improve ROI
of both the units
(viii) ROI/EVA should be calculated on basis of tangible & intangible assts
(ix) For leased assets investment base goes down & ROI/EVA goes up.
Therefore unit managers prefer leased assets over owned assets
(x) Some companies do not use accounting records to value fixed assets &
use the methods like cost inflation index or approximate current value
 Capital Charge
- Rate of capital charge is set by corporate head office.
- It should be higher than rate for debt financing because funds employed are a
mix of debt & equity which has cost higher than debt.
- Different rates can be used for different units based on their risk
characteristics.
- Some companies use lower rate for working capital than for fixed assets because
working capital is less risky as funds are committed for shorter time period.
 17

[2] RETURN ON INVESTMENT ( ROI )

- It is also called as Return on capital employed ( ROCE)
- Strategic aim of business is to earn a return on capital which will satisfy those
who have supplied capital.
- Measuring historical performance of an investment centre calls for profit
earned in relation to capital employed by centre.
- R O I can be calculated by two ways :
ROI = EBIT ( I – t ) x 100 [operating ROI]

Capital Employed

- Logic of using this formula is that out of EBIT interest is to be paid to loan
providers. On this payment company gets tax shield e.g. if interest paid by
company is Rs. 50 Crs. & tax rate is 40% then effective interest payment is
50 ( 1-0.4 ) = Rs. 30 Crs.

The capital employed should earn sufficient EAT for its shareholders
( equity & preference ) after making interest payment with tax shield.

ROI = EAT x 100 [Owners’ ROI]

CAPITAL EMPLOYED

ROI = E A T x SALES
SALES CAPITAL EMPLOYED

= [Net Profit Ratio ] x [ Capital turnover Ratio ]

- Thus R O I is affected by :

i) Sales
ii) Capital Employed
iii) Net profit earned
- Hence R O I can be increased by :
i) Increasing sales
ii) Reducing costs
iii) Reducing capital employed
- Capital Employed = [ Equity capital + Reserves + Preference Capital ]
+ [ Debentures + Loans ]
= [ Owner’s capital ] + [ Loans Capital ]
Or
= [ Fixed Assets ] + [ Working Capital ]
- ROI analysis provides a strong incentive for optimum utilization of resources
& assets of company
 18

- This encourages investment centre mangers to obtain assets providing

satisfactory ROI & dispose off assets not providing acceptable returns.
- ROI provides suitable measure for selecting long term investment
proposals.
- ROI is useful in measuring managerial performance in following
ways :
i) Measuring profitability of business units & entire company
ii) Actual ROI can be compared with target ROI
iii) Indicates how effectively operating assets have been
utilized
iv) Divisional performance can be easily measured
v) Useful in inter-divisional & inter-firm comparison
vi) It shows financial power of company.
- ROI suffers from following operational limitations :
i) Operating managers many times do not understand ROI & may not be
able to interpret it properly.
ii) Divisional investment base requires precise definition of all elements
to be included & value to be assigned to them.
iii) In calculating earnings of division which corporate expenses should be
included & by how much remains a problem.
iv) It may not be possible to apply general accounting principles to
measure divisional earnings.

v) Use of ROI may distort allocation of resources in the firm e.g. company
has two divisions with Investment opportunity of Rs. 30 lakhs to both
Division A B Overall Co.
Present ROI ( Before investment ) 15% 10% 12%
Expected ROI ( After investment ) 14% 11%
Division A will reject opportunity but it is profitable to company.
Division B will accept opportunity but is not desirable for company.
Du Pont Chart
Factors which affect ROI can be represented by a chart known as Du Pont Chart.
This chart was first introduced by Du Pont company of U.S.A. in annual report.

ROI = Net Profit

Capital
= Net Profit x Sales
Sales Capital
= [N/P Ratio] x [Capital Turnover Ratio]

N/P = [Sales] - [C.O.G.S. + Admin. Exp. + Selling Exp. + Income Tax ]

 19

Capital = Shareholders Equity + Long Term Funds or

= Fixed Assets + Current Assets – Current Liabilities

First bracket shows Income Statement of company while second bracket shows

Balance Sheet of company. Hence chart is a snapshot of company’s financial performance

[3] RETURN ON ASSETS ( ROA)

- It is defined as

E. A. T x 100 = E. A. T. X 100
Total assets Net fixed assets + Current Assets
Net fixed assets = [Gross fixed assets] – [Depreciation]
- Assets purchased by company are allocated to different investment centres as
per their needs and objectives to be achieved.
- Efficiency of using these assets can be judged by calculating ROA.
- When ROI goes down, means fund providers to buy these assets are
Unsatisfied & management is inefficient to use available assets
- ROA can be improved by :
 Selecting right kind of assets
 Maximum capacity utilization
 Proper maintenance of assets
 Effective asset accounting & control system
 Replacing old assets by new technology

[4] ECONOMIC VALUE ADDED (EVA)

→Originally proposed by U.S.A. consulting firm Stern Stewart & Co. EVA is currently a very
popular technique used by many blue chip companies like Coca Cola, General Electric, TCS

→EVA is defined as surplus left after making appropriate charge for the capital
employed in the business.

→EVA can be calculated by any of the following formulas

EVA = [ EBIT(I-t) ] – [ WACC x TCE ]

EVA = [ NOPAT ] – [ WACC x TCE ]

EVA = [ EAT + INTEREST (I-t)] – [ WACC x TCE ]

EVA = TCE [ ROCE – WACC ]

EVA = [ EAT – Ke x EQUITY], Where,

EBIT = Earnings Before Interest & Tax
t = Tax Rate
NOPAT = Net Operating Profit after Tax = EBIT(I-t )
 20

WACC = Weighted Average Cost of Capital

TCE = Total Capital Employed
ROCE = Return on Capital Employed = NOPAT/CAPITAL
EAT = Earnings After Tax
Ke = Cost of Equity

Illustration :
Income statement for year ending 31-3-2013 (Rs.in Crs.)
Net sales 600
Less operating Expenses 350
( Excluding interest )
EBIT 250
Less Interest 50
EBT 200
Less Tax ( 35% ) 70
EAT 130
Balance sheet as on 31-3-2012 (Rs.in Crs.)
Equity 100
Debt 500
Total 600
Net Fixed Asset 450
Net Current Assets 150
Cost of equity = 20%, Cost of debt ( pre-tax) = 10 %
Decide EVA of company
EBIT = 250 Crs.
t = 35% = 0.35
NOPAT =250 ( 1-0.35 ) = 162.5
WACC = 100 x 20% + 500 x 10% ( 1 – 0.35 ) = 8.75%
600 600
TCE = 100 + 500 = 600 Crs.
ROCE = 250 ( 1 – 0.35 ) x 100 = 27.08%
600

i)EVA =[EBIT(I-t)-[TCE x WACC]=[162.5]-[600x8.75%]= 110 Crs

ii)EVA =[NOPAT]-[TCE x WACC]=[162.5]-[600x 8.75%]=110Crs
iii)EVA =[EAT+INT(I-t)]-[TCE x WACC]=[130+50(1-0.35)]-[600x 8.75%]=110Crs
iv)EVA =TCE[ROCE-WACC]=600[27.08%-8.75%]= 110 Crs
v)EVA =[EAT-Ke x EQUITY]=130-20%x100]=110 Crs.
→EVA has three components :
(i) Net operating Profit After Tax ( NOPAT ) = EBIT(I-t)
This definition is based on two principles:
EBIT shows operating profits of company. It highlights how funds of the company have
been invested & how efficiently resources of company have been utilized
(ii) Cost of Capital
 21

Providers of capital i.e. shareholders & lenders want to be suitably compensated for
investing capital in the firm. Cost of capital reflects what they expect.

Cost of capital must have following features:

 It should represent weighted average of costs of all sources of capital.

 It must be calculated in post-tax terms.
 It reflects risks borne by various providers of capital.
Cost of capital i.e. weighted Average Cost of Capital ( WACC)
It is calculated by following formula:
WACC = [E/x]Ke + [P/x]Kp + [D/x]Kd(1-t) + [L/x]KL(1-t )

Where, E = Equity Capital

P = Preference Capital
D = Debenture Capital
L = Loan Capital
X = Total Capital = E+P+D+L
Ke = Cost of equity capital
Kp = Cost of Pref. Capital
Kd = Cost of Debentures
KL = Cost of Loan
t = Tax Rate
 For debt or loan use average interest rate paid by company
 Cost of equity is found using CAPM
 Cost of preference shares is fixed rate of dividend
(iii) Total Capital Employed(TCE)
TCE = [Net Fixed Assets] + [Working Capital] or
= [Equity + Reserves + Preference + Debentures + Short & long term loans]
Use capital employed at the beginning as this capital is available for whole year
It is prudent to use book values because this is the amount available to management
 To calculate EVA many adjustments are necessary to accounting figures. Stern & Stewart
have identified more than 160 potential adjustments
 When EVA is positive wealth of shareholders increase & when it is negative wealth is
destroyed
→ Actions to improve EVA

i) Improvement in operating performance

ii) Investing capital in projects which earn rate of return more than cost of capital.
iii) Capital is withdrawn from activities which earn inadequate returns
iv) Alter financing strategy to reduce WACC
 Advantages of EVA
i) EVA combines profit centre & investment centre concept. With EVA
management establishes target for profit or rate of return for business
segment. Any income in excess of target level is EVA.
 22

e.g. Target ROA for ABC Ltd. = 30%

Total Assets = Rs. 200 Cr.

Actual Net Income = Rs. 70 Cr.

Target Net Income = Rs. 60 Cr. [ 200 x 30% )

EVA = Rs. 10 Cr.

ii) With EVA all business units have same profit objective for comparable
investments.
iii) EVA has a stronger positive correlation with changes in company’s market
share.
iv) EVA is most directly linked to the creation of shareholder’s wealth over time.
Maximising value in the EVA context means maximising long term yield on
shareholder’s investment and not just absolute amount of profits.
v) Mechanism of EVA forces management to consider its WACC in all its
decisions. This results in goal congruence of managers and owners.
vi) EVA framework provides clear perception of underlying economies of
business and enables managers to take better decisions.
vii) Regular monitoring of EVA emphasizes on problem areas of company & helps
managers to take corrective actions.
viii) It is used to assess likely impact of competing strategies on shareholder’s
wealth & thus helps managers to select those strategies which will best serve
shareholders.
ix) EVA compensation system ties interests of management and shareholders.
x) It fits well in corporate governance. EVA bonus system involves awarding
ownership stake to managers in improving EVA of their divisions or activities.
Thus management becomes more accountable to shareholders.
xi) EVA helps in brand valuation. The brand equity or value created by a
particular business unit can be equated with value of wealth that the brand
has generated over a period of time.

→Limitations of EVA analysis

i) EVA analysis does not necessarily eliminate problem of comparing the performance
of large & small divisions

Division A B C

Net income ( Rs ) 25,000 1,25,000 2,50,000

ROI 25% 25% 25%

Total assets 1,00,000 5,00,000 10,00,000

Target Net income ( 15% of 15,000 75,000 1,50,000

 23

Assets)

EVA=[ NET Income- target 10,000 50,000 1,00,000

Net Income]

Though all divisions have same rate of return on net assets & have same
target net income requirement still EVA measures dramatically different
among the divisions. Units generating larger rupee profits show higher EVA

ii) Many adjustments are required to NOPAT

iii) Deciding division wise investment is a matter of debate & ambiguity.
iv) Selecting fair and equitable WACC may not be possible & risky.
v) Many firms prefer ROI over EVA as performance indicator

→ EVA Vs Return on Investment (ROI)

 More of the companies employing investment centres evaluate business units on

the basis of ROI rather than on EVA due to following three benefits:
(a) It is a comprehensive measure. Anything that affects financial statements is
reflected in ROI
(b) ROI is easy to calculate & understand
(c) It is a common denominator that may be applied to any organizational unit
responsible for profitability irrespective of its business & its size. Performance
of business & that of competitors can be compared on the basis of ROI

However there are three compelling reasons to use EVA over ROI
(a) Decisions taken by business units may not be in the interest of organization

Unit ROI WACC Returns expected Decision Effect on

of business on new investment by unit business
A 25% 15% 20% Reject Beneficial

B 10% 15% 12% Accept Not beneficial

In above situation EVA is better measure for decision making

(b) Decision which increases ROI of centre may decrease its overall profits.
This may not happen if EVA is performance indictor e.g. business unit has
following investments.

Investment in Asset ROI

Rs. 40 Cr. 32%

Rs. 10 Cr. 22%

 24

Rs. 50 Cr. 30% [ 40 x 32% + 10 x 22%]

50
Cost of capital WACC = 20%

Profit expected [30% of 50] 15 Crs.

In order to improve his performance centre manager disposes off assets

giving 22% returns. No doubt his ROI is now 32% but absolute profit would
come down from 15 Cr. To 12.8 Cr. & its EVA would come down.

( EVA ) before = 50[30% - 20%] = 5 Cr.

( EVA ) after = 40[ 32% - 20%] = 4.8 Cr.

(c) While for ROI same interest rate is to be applied, for EVA different interest rates
may be used for different type of assets e.g. for inventory rate may be low
whereas for fixed assets it is high. By this measurement system can be made
consistent with decision rules that affect acquisition of assets. Thus business unit
managers act consistently in decisions involving investments in new assets.

→ Implementing EVA system

This involves following steps:
Step I : Developing commitment of top management
To build this commitment top management should be thoroughly grounded in
theory & practice of EVA
Step II : Customise definitions of EVA
NOPAT, Capital Employed & WACC should be properly defined considering
accounting system & MIS
Step III : Identify EVA centres
A firm may be divided into EVA centres. These are the responsibility centers for
which EVA will be calculated on continuous basis
Create system which would facilitate proper allocation of resources & assets
to these centres. Establish proper transfer price system & set appropriate target
EVA for each centre
Step IV: Analyse drivers of EVA
EVA must be linked to various financial & non-financial variables which drive it.
An understanding of these drivers help managers to appreciate how their
actions influence value
Step V : Design appropriate EVA based incentive system
Compensation system must align interests of managers & shareholders & induce
managers to act like owners
Step VI: Provide EVA based management system
This involves
- Ensure that only value added projects are undertaken
 25

- Identifying operating measures to implement EVA

- Introducing EVA reporting on regular basis
- Aligning Management Control System to EVA process
- Relating strategy choice, resource allocation, corporate restructuring &
goal setting to EVA
Step VII : Motivation & Mindset
Effective implementation of EVA requires change in culture, mindset & motivation
of workforce, for which following actions are necessary
- Train people for EVA & value building process
- Teach them to focus on one objective i.e. maximising EVA
- Ensure that incentive system encourages managers to maximise EVA of his
responsibility centre & also of entire organization

→EVA Vs MVA

 Term closely related to EVA is Market Value Added ( M V A ) It is defined as :

MV=[Market Value of Capital employed by firm]-[Book Value of Capital

employed]

 MVA is a cumulative measure of corporate performance. It measures how

much company’s stock has added to or taken out of investor’s pocket over its
life.
 Continuous improvement in EVA year after year leads to increase in MVA.

 Thus if market value of company’s equity & debt is Rs. 500 Cr. and book value
of equity & debt is Rs. 300 Cr. then MVA =( 500 – 300 ) = Rs. 200 Cr.

 MVA is the present value of all future EVAs

MVA = ( EVA )1 + (EVA)2 + (EVA)3 +----

(I + WACC )1 ( I + WACC )2 ( I + WACC )3

 MVA is positive means market value of company exceeds its capital employed
 MVA is negative means market value of company is less than its capital
employed.

 Value of the Company may be expressed as :

V = NOPAT + I ( R – WACC ) T
WACC WACC (1 + WACC )
Where I = Amount of new investment projected every year
 26

R = Expected rate of return from new investment

T = Period over which new investment will take place.
First term in above formula represents value of investments in place
Second term in above formula represents value of forward plan. It is the present value
of EVA added by new investments which are available for period of T years.
It is expected that after T years new entrants & substitutes will compete away the
potential for superior returns.
[5] Limitations of financial measures
 While setting financial measures to measure performance following issues
need consideration.

 Accounting profit do not exactly & usually indicate firm’s value creation
due to following reasons :
 Difference in changes in economic value and accounting rules to
record them.
 Accounting results depend on method of accounting used
 Conservative accounting concept leads to delayed revenue recognition
but quick recognition of expenses and losses.
 It ignores investment in intangible assets e.g. physical assets of
Microsoft Corporation are only approximately 10% of its market value.
 Profit ignores cost of investment in working capital
 Profit reflects costs of debts but not cost of equity
 Accounting profit ignores the risk & changes in risk
 Profit focuses on past whereas economic value is derived from
potential cash flows.
 Financial measures alone are insufficient to ensure that strategy will be
executed successfully
 Financial measures such as revenue, profit, ROI, EVA etc. pose following
difficulties to the company in implementation of its strategy :
 It may encourage short term actions such as supplying low quality
goods to achieve sales & profit targets. This may be harmful to long
term strategy.
 Business unit manager may not take up any new investment project in
order to keep certainty of his performance
 It may lead to distortion of communication between corporate and
business unit management in terms of setting low targets or non
communication of not achieving targets
 It motivates manipulations such as low bad debt provision or warranty
claims.
- Many non financial activities in organization have financial impact
- Usually organizations use non financial measures to control activities of
lower management and rely on financial measures for senior management
control. Therefore proper blend of financial & non financial measures is
necessary. Financial measures indicate past while non financial measures
 27

indicate about future performance.

 Non financial measures ( Key Success Factors )
They can be grouped under three heads.

(A ) Customer related:

- Order booking signals efforts of marketing

- Back orders indicate dissatisfaction of customers
- Market share indicates company’s competitive position
- Key Account Orders are bulk orders received from most valued
customers of the firm. Their composition in total sales helps to
understand future market strategy
- Customer satisfaction helps in getting future orders
- Customer retention displays his long term association towards
company’s product.
- Customer loyalty is measured by counting repeat purchase orders,
referrals, & % of purchases with respect to his total requirements.

(B) Business Related:

- Capacity utilization, Higher utilization means lower fixed cost per

unit which leads to higher profitability.
- On time delivery reflects efficiency of production and distribution.
It results in increasing customer satisfaction level.
- Inventory Turnover indicates efficiency with which inventory has
been used.
- Quality. It is related to customer satisfaction and brand equity.
- Lower production cycle time results in cost savings and reduction
in working capital requirements
(C) Employee Related :

- Turnover: Lower the turnover more is the effective HR

department & better is the productivity.
- Employee attitude: Efficiency and productivity are influenced by
their attitude towards company & job. Better HR policies result in
more commitment by employees which is required for
improvement in performance.
- Employee loyalty –

Thus performance of responsibility centre manager should be

evaluated on financial as well as non financial parameters. Proper
weight age needs to be given to each parameter for rational
evaluation of performance.

(b) Non financial measures

 28

(I) Balanced Scorecard (B.S.C.)

Concept of Balanced Scorecard:

 It was first developed in early 1990s by Robert Kaplan and David Norton at
Hardward Business School.
 Most of the companies manage their business based solely on financial
measures. Though financial measures are necessary they can report about
the past but cannot point out where business is heading
 It is therefore necessary to include financial & non-financial measures in
performance management system of a company
 Financial measures can be used by top management to monitor & control
performance of entire organization & its business units or divisions
 Non-financial measures can be used by operating managers to monitor &
control operational activities
 Balanced Score Card is an integrated performance measurement system
which combines financial & non-financial measures
 Balanced Score Card measures performance of the organization on
following four perspectives

FINANCIAL

To succeed financially what kind

of financial performance should
company provide to its
 29

investors

CUSTOMER INTERNAL
BUSINESS
To achieve VISION PROCESS
our vision,
MISSION To satisfy
How shareholders
company will & & customers
be seen by at what
customer. ST R A T EGY
company
must excel
internally.

LEARNING & GROWTH

To achieve vision-

How company will sustain its

ability to change & improve

(a) Financial Perspective

This perspective covers financial aspects of business & highlights following

measures to reflect financial performance

 30

- Net Profit Ratio [N.P./Sales]

This is the bottom line of business & minimum expected N/P ratio must be
achieved by business or its unit
- Return on Investment [ROI= profit/Investment]
- Return on Assets [ROA= Profit/Total Assets]
- Return on Equity [ROE = Profit/Net Worth]
- Economic Value Added [EVA = Capital Employed(ROI – WACC)
- Market Value Added [ M.V. of equity & debt (-) B.V. of equity & debt]
- EBITDA
- E.P.S.
- CFROI [Cash Flow Return On Investment]
CFROI = [EBIT(1-t) + Depreciation – Economic Depreciation]
Economic depreciation is the amount to be set aside every year
considering life of an asset & WACC of business
Economic Depreciation = Cost of Asset/F.V. annuity factor
If CFROI is positive it shows improving performance of assets utilized
- CVA [Cash Value Added]
CVA = [EBIT(1-t) + Depreciation]-[Economic Depreciation]
-[Capital charge on gross investment]

(b) Customer perspective

This perspective captures ability of the organization to provide quality goods &
services, delivering goods in time, & overall customer satisfaction & service.
Needs & desires of customers have to be attended properly because he pays
for cost & profit of the organization. It covers following measures:
- Customer satisfaction & loyalty levels
- Length of customer relationships
- Repeat customer rate
- No. Of customer complaints
- Warranty rates
- Number of complaints resolved first time
- Customer response time
- Customer loss & retention rates
- New customer acquisition numbers
- Total number of customers
- Price of products/services vis- a- vis competitors’ price
- Revenue per customer
- Revenue from new customers
- Sales Volume
- Sales per product/service line
- Sales per employee
- Market share
 31

(c) Internal business processes perspective

This perspective focuses on internal business results. To meet organizational
objectives & customer’s expectations organization must identify key business
processes in which they must excel.

Measures relating to this perspective are:

Relating to speed
- On time delivery
- Lead time
- Process cycle time
- Machine or process down time
- New product/process development time
- Time to market products/services
- Customer response time
- Break even time
- Project closeout cycle
Relating to quality
- Continuous improvement
- Warranty returns
- Sales returns
- Field service representative calls & visits
- Defect rate: rework, repair, scrap
- Process capability
- Sigma level
- First pass yield
- Project performance index
Relating to cost
- Cost of waste
- Cost per transaction
- Research & development cost
- Labour cost
- Cost of rework, repair & scrap
- Break even cost
- Appraisal cost(inspection, compliance)
- Environmental compliance cost
- Inventory cost
- Marketing, advertising & distribution cost
Relating to other aspects
- Floor space utilization
- Inventory turnover rate
- Material stock-outs & shortages
- Forecasting & planning accuracy
- Tender success rate
- Safety index
 32

(d) Learning & growth perspective

The focus of this perspective is to establish & maintain metrics that will tell
management how well company is doing towards achieving growth & learning
goals. Company needs people with new capabilities, knowledge & abilities to
achieve desired growth rate in competitive market
Managers have to understand first current skills & capabilities in company, industry &
market
Next they have to understand company’s growth & development goals
Finally they need to communicate effectively with those who will be involved in the
process of growth & development
Thus perspective looks to the ability of employees & quality of information system.
Processes will be successful only if adequately skilled & motivated employees
supplied with accurate & timely information are driving them
Measures covered by this perspective are:
- Initiatives related to growth & development
- Sustainability of growth
- Rate of corporate restructuring
- Success rate of restructuring
- Market leadership index
- Number of innovations
- New patents/Copyrights
- % of revenue from new products/services
- Rate of improvement index
- Increase in employee productivity
- Increase in employee skills
- Training & its effectiveness
 In creating balanced scorecard set of measurements must be selected that:
 Accurately reflect critical success factors of company’s strategy.
 Show relationships among individual measures in cause-effect manner
indicating how non financial measures affect long term
financial results.
 Provide a broad based view of current status of company
Balanced scorecard tries to create a blend of:
 Outcome & driver measures
 Financial & non financial measures.
 Internal & external measures.
(a) outcome & driver measures :
Outcome measures indicate result of strategy.
It tells management what has happened.
 33

Driver measures show progress of key areas in implementing a strategy. They indicate
incremental changes that will ultimately affect outcome. By focussing
management attention on key aspects of business they affect behaviour in the
organization.
e.g. business cycle time is driver measure
Delivery to market is outcome measure.
(b) Financial & non financial measures :
Financial measures are measured in terms of profitability, ROI, EPS, market price of
company’s share & so on
Non financial measures are quality, customer satisfaction & so on.
e.g. Pam Air lines, U.S. Steel, Xerox & IBM dominated their markets were displaced as
market leaders by competitors who achieved quality and better customer
satisfaction.
Many corporate have failed to incorporate non financial measures in executive
performance appraisal.

(c) Internal & External measures :

Company must strike balance between external measures such as customer
satisfaction & internal business processes such as manufacturing technology.
 Significance of Balanced Score Card
(a) It is a performance measurement system & means to set and achieve
strategic goals & objectives of the organization.
(a) Balanced scorecard creates the balance between unbalanced strategic
measures in order to achieve goal congruence & thus encourages employees to
act in the best interest of the organization.
(b) Balanced scorecard is a tool for focussing on:
 Setting organizational objectives
 Improving communication
→ Providing feedback on strategy
(c) Dividing measures into various categories provide balance between needs of
different stakeholders of the organization. Together they give a focussed
picture on what needs to be done to improve so as to successfully implement
its strategy.
(d) The most important aspect of balanced scorecard is its ability to measure
outcomes & drivers in such a way that organization is prepared to act in
accordance with its strategies.
(e) The balanced scorecard measures are linked from top to bottom & tied to
specific targets throughout the organization.
 34

(f) Balanced scorecard emphasizes on cause & effect relationships between

financial & non financial measures & shows how non financial measures such
as product quality, drive financial measures such as revenue. Individual
measures & four perspectives in the scorecard are linked together explicitly in
cause & effect way to act as a tool to translate strategy into action.

Better these relationships are understand more each individual will be able to directly
& clearly contribute to the success of organization’s strategies.

(g) Balanced scorecard covers all the aspects of management control system to
effectively implement organizational strategies.

Implementing balanced scorecard

Step I: Define strategy

Balanced scorecard builds a link between strategy & operational action; hence it is
necessary to define strategy of the organization. For a single industry firm
scoreboard should be developed at corporate level & then percolated down to
functional level. In multi business firms such as G.E., DU PONT, WIPRO, TATA,
BIRLA business unit should be a starting point for developing scorecard.
Functional departments within a business unit should have their own
scorecards & these must be aligned with business unit scorecard. Finally
corporate level scorecard needs to be developed to achieve synergies across
business units.

Step II: Define measures of strategy

To decide critical measures on which organization should focus. Individual measures

be linked with each other in a cause - effect manner e.g.

Perspective Measures
Financial Sales growth
Customer Customer satisfaction level
Internal business processes Order cycle time
Innovation & learning Manufacturing skills

Step III: Integrate measures into management system

Balanced scorecard must be integrated with organization’s formal & informal

structure, its culture & its H.R. practices. While balanced scorecard gives some means
for balancing measures, they may still be unbalancing by other systems in the
 35

organization e.g. compensation policies that compensate managers strictly based on

financial performance.

Step IV: Review measures and results frequently

Once balanced scorecard is in operation, it must be consistently reviewed by senior

management. The organization should look for:

 How organization is doing as per outcome measures

 How organization is doing as per driver measures
 How organization’s strategy has changed since last review
 How scorecard measures have changed

This review gives idea about –

 Whether strategy is being implemented

 How successfully strategy is working
 Whether management is serious about importance of these measures
 Whether management maintains alignment of measures to ever changing
strategies.
 Whether measures improve measurement.

Problems of balanced scorecard

Following problems unless suitably dealt could limit the

usefulness of balanced scorecard :

i) There is poor correlation between nonfinancial measures and results. There is

no guarantee that future profitability will follow target achievements in any
non financial area.
ii) Managers are often compensated for financial performance. This can disrupt
goal congruence causing managers to be more concerned about the financials
than any of the other measures.
iii) In order to achieve stretch goals mechanism required for improvement is not
in place. For achieving many of the goals shift in business processes culture &
attitude of employees is necessary which is not possible in many cases.
iv) Many companies do not have formal mechanism for updating measures to
align with changes & shifts in strategy. The result is that the company is still
producing measures based on yesterday’s strategy.
v) Many times managers are loaded with many critical measures. He may not be
able to track all of them by focusing on all of them.
 36

vi) Establishing tradeoffs between financial & non financial measures is many
times difficult. To achieve this trade off proper weight age must be given to
each measure

[2] Malcom Baldridge Model

 In 1980s industry & government in USA felt the need for renewed emphasis on
quality of doing business in ever expanding & more demanding competitive
market & Malcom Baldridge National Quality award was evolved as a standard
of excellence that would help U.S. companies to achieve world class quality
 Malcolm Baldridge criteria for performance excellence are widely accepted not
only in USA but also round the world as standards for performance excellence
 Baldridge criteria for performance excellence are a framework that any
organization can use to improve overall performance. They are designed to
help organizations to use an integrated approach to organizational
performance that result in:
(a) Delivering ever improving value to customers which is required for success
in the market
(b) Improvement of overall organizational effectiveness & capabilities
(c) Organizational & personal improvement
 The core concepts of the Baldridge criteria for performance excellence
are:
(a) Visionary leadership
(b) Customer driven excellence
(c) Organization & personal learning
(d) Valuing employees & partners
(e) Agility
(f) Focus on future
(g) Managing for innovation
(h) Management by fact
(i) Social responsibility
(j) Focus on results & creating value
(k) Systems perspective
 Organizations are judged on following seven categories:
(a) Leadership is judged by examining how senior executives guide & sustain
the organization & how organization addresses governance, ethical issues,
legal responsibilities & social responsibility
(b) Strategic planning is examined to know how organization sets strategic
directions & how key action plans are executed
(c) Customer focus is examined to see how organization determines & fulfills
expectations of the customers & markets; how organization builds
relationship with customers; how customers are acquired, satisfied &
retained
 37

(d) Measurement, analysis & knowledge management examines how analysis

& improvement of data are used by management to support key
organization processes as well as how organization reviews its performance
(e) Workforce focus examines how organization engages, manages & develops
its workforce to utilize full potential of each employee & how workforce is
aligned with organizational objectives
(f) Process management examines how key production, delivery & support
processes are designed, managed & improved
(g) Results examines performance of the organization & improvement in key
business areas & how organization performs as compared to competitors
 Baldridge is the most comprehensive management framework available. It
enables leaders to understand all of the internal & external forces that drive
business to success & select course of action that achieve, increase & sustain
the best possible overall performance. Thus implementing Baldridge guide
organizations to do right things at right time & in right way
 Baldridge works if leadership & organization have willingness & ability to
develop an organization culture based on core values of high performing
organizations defined by criteria. Both leaders & organization must be willing
to commit a long term journey of continuous learning & improvement
 Baldridge has true systems perspective as it looks at all components of
organization with equal emphasis & focuses on how each part impacts & links
with the others. It helps leaders align & integrate their leadership, strategy,
customer & market focus, data analysis, knowledge management, workforce &
process management systems to produce the best overall results

1.4 Measuring SBU level performance

[A] Concept of SBU

 SBU means strategic Business Unit which is a part of organization having distinct
external market for goods or services that is different from another SBU

 A strategic business unit is a fully functional and distinct unit of the business
that develops their own strategic vision and direction. Within large companies
there are smaller specialized divisions that work towards specific projects and
goals, and we see this organizational setup frequently in global companies. The
SBU, remains an important component of the company and must report back
through headquarters about their operational status. Typically they will operate
as an independent organization with a specific focus on target markets and are
large enough to maintain internal divisions such as finance, HR, and so forth.

 There are many great examples of SBU's . For instance, AP Moller has a lengthy
list of SBU's, such as marine shipping, marine terminals, trucking, 3rd party
logistics, energy, and oil exploration. Another widely recognized company is
 38

General Electric, which has 49 SBU's in such markets as appliances, aerospace,

electronics, and so on. LG operates along the same lines with SBU's competing
in electronics and appliances among others. So why do each of these SBU's
differentiate from each other and still belong to the same organization? The
answer is that profitability of your company and appeal within the industry are
directly tied together. In the case of AP Moller, the company has separated each
industry into a strategic business unit to maximize potential.

 When company initiates SBUs which have their own separate ability to craft
strategy which relates to their function and may be industry specific each SBU is
allowed to perform competitive analysis on its market position, develop goods
and services that meet the needs of the target customer and understand SBU level
performance.

 SBU set up becomes essential when company is operating in diversified sectors

e.g. Tata Group is an Indian multinational conglomerate company
headquartered in Mumbai, India. It encompasses seven business sectors:
communications and information technology, engineering, materials, services,
energy, consumer products and chemicals. Tata Group was founded in 1868 by
Jamsetji Tata as a trading company. It has operations in more than 80 countries
across six continents. Tata Group has over 100 operating companies with each of
them operating independently. Out of them 32 are publicly listed. The major Tata
companies are Tata Steel, Tata Motors, Tata Consultancy Services (TCS), Tata
Power, Tata Chemicals, Tata Global Beverages, Tata Teleservices, Titan
Industries, Tata Communications and Taj Hotels. The combined market
capitalisation of all the 32 listed Tata companies was INR 6.8 Trillion ($ 109
billion) as of March 2014. Tata receives more than 58% of its revenue from
outside India. Each of these companies operate as separate SBU with separate
markets, competitors & management set up

 SBUs are classified in terms of their profit, sales growth & cash flow prospects
using BCG classification

(a) Cash cows: High market share & low market growth. A large net cash flow
generator. Such cash flows may be used to finance development of other
divisions
(b) Dogs: Low market share & low market growth. A declining market with
declining sales, cash flows & profits
(c) Stars: High market share & high market growth. A successful business unit
in an industry with rapidly growing sales & profitability
(d) Question marks: Low market share & high market growth. There are serious
doubts about the division to exploit potential
 39

 Depending on way SBU is classified manager is given guidelines on how to

manage the division, what capital expenditure would be sanctioned, balance
required between sales growth & ROI. In relation to the guidelines laid down by
central management the SBU manager identifies environmental variables,
resources available with him & develops strategies for SBU

 Concept of SBU is closely related to EPM.

 Financial performance of each SBU is separately highlighted

 Each SBU is treated as profit center & its efficiency is highlighted in
terms of ROI or EVA
 Contribution of each SBU to overall profitability of business can be
highlighted
 Reports are generated on how resources available with SBU have been
utilized
 Transfer price mechanism is applied for any transactions between two or
more SBUs
 Effectiveness of HR & marketing strategies by different SBUs can be
assessed
 As each unit formulates its own strategies top management can assess
whether business unit strategies are in line with corporate strategies &
whether these strategies are bringing results as desired by top
management
 Whether SBU is giving due weightage to financial & non financial
parameters
 Performance of the organization depends on performance of the SBUs
 Assessment whether SBUs are achieving goal congruence or not

[B] Goal Congruence

 In an organization different people follow different goals. An individual

simultaneously pursues his own goal as well as goal assigned to him by his company.
 Divergence of goal can be expressed as :

Individual goal - Monetary goal career growth etc.

Functional goal - Production cost, Delivery performance, Profit margin, ROI
Organizational goal – Enhance market share, Enter fortune 500 list
Goal conflict may occur due to following reasons:
 An individual may strive hard for monetary gains, which may be against company’s goal
offering better profits.
 40

 Different functional goals lead to goal conflict. Production manger may strive hard to cut
production cost whereas quality control manager may increase cost of production by
implementing highly sophisticated quality control technology.
 Different hierarchical goals also lead to goal conflict. e.g. Senior Marketing Manager
may concentrate on enhancing customer satisfaction whereas branch manager may
pursue higher sales target irrespective of CRM factor expected by his seniors.
 Employee needs to pursue organisational goal irrespective of his immediate goal which
gives rise to goal conflict.
 Problem of conflicting goal arises when mission of company is broken down into

functional activities, hierarchical activities & individual activities.

 Goal conflict starts affecting execution of strategic performance. & need for
Management Control System arises which influences behavior of the people such that
while pursuing their individual goal they also act in the best interest of company’s goal.
 Act of ensuring consistency among the goals of an organization and goals of its people is
referred to as goal congruence.
 Goal congruence ensures that organization & its people march towards a common goal.
 Its ties together performance of two or more entities to a common path.
 In goal congruence process Management Control System ensures that the actions of
individuals are in the best interest of organization. Hence Management Control System
should emphasize on :
 Locating actions which would motivate people for their self interest.
 Ensuring that these actions are in the best interest of organization
 Management Control System induces individuals to pursue his personal goals in a way
that it automatically takes care of organization goal.
 Goal congruence does not mean common or same goal. When different people having
different hierarchical positions & handle different functional responsibilities they will
follow their individual, functional, & role specific goals simultaneously. These goals
cannot be one & the same e.g. finance manager has goal of increasing ROI, whereas
marketing manager has goal of increasing market share. Thus one cannot expect
managers to follow a single goal. Management Control System aims at bringing
maximum possible consistency among the goals followed by managers.
 Deviation in the performance depends upon the degree of inconsistency of goals.
 Performance of individual is the result of his behavioural response to organizational
efforts. Controller therefore should influence behaviour of its people so that they
pursue desired course of action. This would bring consistency of goals & deviation of
performance under control.
 Goals of an individual, function, division, business unit & company should be properly
meshed with each other.
 The prime task of controller is to induce change in the behaviour of employees so that
while they act in their own interest, their actions are also in the best interest of the
organization.
 41

Illustration :

TVS has introduced new model WEGO which will be competing with Honda Activa &
pleasure by Here Honda.

Company Goal: To increase market share in this segment.

Advertising Management Goal: To exhibit advertise which will attract both – male-
female.

Production Manager Goal – Increase production rate with quality comparable to

competing model.

R & D Goal: To introduce product innovation e.g. arrangement of filing petrol from
outside without opening dickey. Thus there is goal congruence requirement to
achieve strategic or competitive advantage.

 Advantages of goal congruence :

a) It leads to frictionless working of the company.

b) Integration of efforts throughout company

c) Enhances professional approach to accomplish given task.
a) It ensures that goal of the organization is being sincerely followed by its employees &
also they are given fair chance to achieve their goal simultaneously.
b) It satisfies prime motive of Management Control System that organization moves
towards its strategic objective.
c) By implementing appropriate reward program it ensures that while targets of the
company are achieved, individuals also make progress towards their personal goal.
 Factors which influence goal congruence :

Formal & informal behavior factors decide degree of congruence that can be attained.
a) Informal factors :

Factors such as ethics, work culture & management style determine response of
employees to the appeal made by organization. These factors explain why two
organizations with identical formal Management Control System wary in terms of actual
performance.
These factors can be divided as:

External Factors
 Attitudes of society
 Work ethics of society
 Customs in particular area
 Cultural values of society
 Social honesty & discipline
 42

They influence employee loyalty & commitment to organizational task.

e.g. German person has pride of discipline & perfection that is why cars like Mercedes
Benz are designed & manufactured in this country.
Internal factors :
 Organizational culture
 Management style
 Informal communication & relationships
 Perception & communication of goal

b) Formal factors :
 These factors define specific framework for doing a particular task. Management Control
System is a part of this formal system. They bring clarity of purpose & help in focussing
behaviour.
 Rules & regulations as important part of formal Management Control System act as
guideline for employee behaviour.
 Rules define path & boundaries to be followed. They act as restrictive aspects of control.

Rules may involve formal instructions to perform tasks or process manuals etc.
Rules may act like guidelines or may be in the form of strict control.
 Guiding rules would not restrict actions of employees if the interests of the organization are
not disturbed while following an exception. They act as positive force behind the action &
specify what is expected from an employee.
 Strict control rules specify punitive actions, impose restrictions & are negative in nature.
 Rules could be in the form of –
 Physical controls ( Computer password, card swiping for restricted areas )
 Manuals ( documented directives for uniformity in working )
 System safeguards ( In- built control mechanism e.g. internal audit )
 Task control systems ( finacle software in banking )

[C] Transfer Pricing

Transfer Pricing
(I) Meaning & Significance
 Transfer price is the price at which goods & services are transferred between business
units of decentralized organization
 Transfer prices are set for intermediate products. Buying division purchases them &
after further processing final product is sold either to other division or to external
customers
 When business is diversified each unit handling different business is treated as profit
center. Many times output of one unit may be input for other unit e.g. output of TATA
Steel is required by TATA Motors. When goods are transferred from one profit center
to other profit center transfer price decided within policy norms of the company is
applied & accordingly funds are transferred from one center to other center
 43

 Transfer price must be rationally set & should not benefit one unit loss to other.
General rule for setting transfer price is: price should be such that buying & selling
divisions make economic decision which is optimal for the total company. This would
make selling division indifferent whether output is sold externally or internally &
buying division indifferent whether input is purchased externally or internally
 Following are the benefits of transfer pricing
 Performance evaluation of divisions becomes easy
 Develops healthy competition among the divisions
 Helps in coordination of divisional objectives in achieving organizational goals
 Provides useful information to the top management in making policy decisions
like expansion, sub-contracting, make or buy, closing down of division
 Acts as check on suppliers’ prices
 Improves productivity of organization, prepares managers to meet competitive
economy & optimizes financial resources of the company
(c) Methods of Transfer Pricing
 Cost Based
1. Price based on production cost
 Production cost = [Prime cost] + [Production Overheads]
Prime cost = Direct Material + Direct Labour + Direct Expenses
Units are transferred at this cost
 Any efficiency & reduction in prime cost or production expenses reduces
transfer price & this increases profitability of buying division. In the reverse
situation transfer price increases & profitability of buying division goes down
 This method cannot achieve goal congruence & cannot motivate either buying
or selling division
2. Price based on standard cost
 Selling & buying unit negotiate & settle price based on standard material, labour
& other costs e.g. if standard costs are:
Direct Material = Rs. 120/unit
Direct Labour = Rs.50 /unit
Direct Expenses = Rs. 30 /unit
Production overheads = 50% of prime cost, then
Transfer Price = [120+ 50 + 30] + 50% [ 120 +50 +30] = Rs. 300/unit
 Any efficiency improvement & cost reduction gives benefit to selling unit. Its
profit increases & performance is elevated
 Any inefficiency is not transferred to buying unit
3. Price based on full cost
 Full cost =[Prime cost] + [prodn. Cost] + [Admin. Cost] + [Selling cost]
 Any operational inefficiency of selling unit is loaded to buying unit. This reduces
profit of buying unit & overall company
 While calculating total cost marketing & sales promotion cost is not considered
because these costs are not incurred for interdivisional transfer
 44

 Distribution cost depends on geographical location e.g. if units are in the same
premises this cost is negligible, but if units are in different cities or countries it
may be substantial
4. Price based on full cost + Mark –up
 Mark-up is % on full cost or % on capital employed
e.g. full cost Rs. 500/unit & mark –up is 20% then,
Transfer price = 500 + 20% (500) = Rs. 600/unit
OR
Full cost = Rs.40,00,000
Fixed assets = Rs.20,00,000
Current assets = Rs.15,00,000
Return on fixed assets = 15%
Return on current assets = 6%
Units transferred = 10,000
T.P./unit = 40,00,000 + 15%(20,00,000) + 6%(15,00,000)
10,000
= Rs. 439/unit
Efficiencies & inefficiencies of selling unit are transferred to buying unit. This
affects profitability of buying unit & overall company
5. Price based on standard variable cost
 T.P = [Std. variable cost] + [Lump sum charge for fixed cost] + [Profit]
All the three components of transfer price are calculated considering:
(a) Items of variable costs to be included
(b) Fixed cost portion to be allocated
(c) Profit negotiated between two units
 Excess variable cost by selling unit is not passed on to buying unit
Variable cost is generally controlled by operating managers. This brings better
operational efficiency
Fixed cost per unit is calculated considering fixed cost to be allocated & no. of
units to be sold. This gives assurance to both centers of quantity to be sold &
purchased. In case of any reduction in quantity to be purchased, increases
purchasing cost per unit & pulls down profit of buying unit
e.g. T.P. is based on following terms:
Variable cost/unit = Rs. 150 + fixed cost Rs. 5,00,000
Profit per unit = 10% on cost
Units sold = 10,000
T.P.(for buying unit) = [150x10,000 + 5,00,000] 10%[150x10,000 +5,00,000]
10,000
= Rs. 220/unit
If buying unit decides to buy only 8,000 units
T.P.(for buying unit) = [150x8,000 + 5,00,000] 10%[150x8,000 +5,00,000]
8,000
= Rs. 233.75/unit
 45

 Price based on Market Price

 Transfer price is determined based on market price prevailing in
competitive market.
 Competitive market price provides reliable measure of divisional income
because this price is set independently
 It acts as incentive to selling unit to achieve efficiency in its operations.
Excessive cost is not passed to buyer unit.
 It is a right price for decision making by buying division
 In relation to goal congruence, use of open market price ensures
maximisation of profit of divisions as well as for organization provided
 Selling division has option of selling externally
 Buying division has option of buying externally
 Price lower than market price for internal transactions can be justified
on following reasons.
(i) Selling division will not incur some marketing and administrative
cost which would be necessary for the achievement of sales to
external customers.
(ii) Bad debts would not occur on internal sales.
(iii) Production cost per unit can be kept low when there is high
guaranteed units to be bought by buying division.
(iv) Lower delivery costs with dependable delivery schedule.
 Many times identifying market price is difficult because price will vary
among various customers due to :
(i) Quantity discounts
(ii) Special discounts for special customers.
(iii) The extent of after sales service provided.
(iv) The extent to which delivery charges are included.
(v) Deliberate dumping at lower price by supplier who has built up
excess inventories.
 Advantages of market price method :
(i) It truly represents opportunity cost
(ii) Actual historical costs fluctuate from time to time & are not
readily available, whereas market price are easily available.
(iii) Current performance of buying & selling units can be assessed on
basis of current market price which reflects existing market
conditions.
(iv) Variance between current & predicted prices provide useful data
for control.
 Limitations of market price method
(i) Market price fails to become opportunity cost when company is
the price leader or a monopolist.
(ii) Intermediate products are many times not available in market
 46

(iii) Cost prices are available in internal records whereas market price
fluctuates depending upon market forces.
(iv) There may be difficulties in interpreting term “market price “ as
this price to wholesaler or dealer or customer or
(v) Ex-Factory price.
(vi) Cost may be involved in obtaining information of market price
(vii) Accounting principles do not allow inclusion of profit in stock
(viii) Market price includes selling & distribution cost which is not
involved in transfer price and as such market price is not proper
guide.

 Negotiated Prices

 Divisional manager has freedom to negotiate competitive price.

 He can buy from outside if internal prices are not acceptable to him.
 Both the divisions will negotiate for determination of transfer price
such that there will not be any undue advantage to either division &
overall profitability of company is kept in mind.
 47

UNIT 2 CAPITAL EXPENDITURE

2.1 Capital Expenditure Control

(A) Concept of capital expenditure
 Every business requires two types of assets. Current assets are required for
day-to-day functioning of the business & generate sales. Benefits from these
assets are available within a period of one year. Fixed assets are required for
creating productive capacity & benefits from these assets are available for a
period of more than one year
 Capital budgeting is the process of making investment decisions in fixed
assets. Thus any decision of buying fixed assets or modifying fixed assets to
increase operating capacity of business is a capital budgeting decision
 Following are some of the examples of capital expenditure
- Buying of a plant
- Buying machinery
- Constructing building for business
- Buying vehicles for distribution of goods
- Constructing service stations
 Following are important features of capital budgeting
 They involve exchange of current funds for the future benefits
 Future benefits are expected to be realized over series of years
 Huge commitment of funds is involved
 Funds are invested in non-flexible & long term activities
 They increase capacity of business

(B) Need of capital expenditure

 In competitive environment company wants to achieve sustainable competitive
advantage which calls for better asset base as compared to competitors
management has to purchase new capital assets
 When demand for the product increases company needs to have more capacity.
Expansion becomes inevitable & capital assets are required to be purchased
e.g. with increase in demand in Honda Activa company had to increase its
capacity
 Many times company wants to diversify in new product lines for which
purchase of new plant, machinery & equipments becomes necessary
 48

 In order to strengthen supply chain business requires more vehicles,

warehouses & material handling equipments & management has to buy these
capital equipments & assets
 For many strategic decisions such as product innovation, product flexibility or
enhanced service facilities new set up of machinery & equipments is required
& need for capital budgeting decision arises
 For upgrading technology new improved machinery & plant needs to be
purchased
 To improve productivity, quality & delivery performance company requires to
buy new assets
 In case of mergers & acquisitions company acquires another company which is
a capital budgeting decision
 When some components purchased by company are to be manufactured
internally for financial & strategic reasons buying of new assets becomes
necessary for manufacturing
 Capital budgeting decisions are of national importance as they determine
employment, economic activities & economic growth of the country

(C) Process of capital budgeting

Capital budgeting is an exhaustive & complex exercise wherein series of steps
are involved:
Step 1:

To identify investment opportunities. potential sources of opportunities are:

 Study of supply/ demand conditions of different industries

 Study of end & by-products
 Analysis of input requirements
 Import substitutes
 Social & economic trends
 Sick unit to be turned into profitable unit
 Backward & forward integration
 Government policy

Step 2 :

Available opportunities should be screened with reference to:

 Compatibility with promoters

 Compatibility with government priorities
 Availability of raw materials & utilities
 Size of potential market
 Costs & risks involved

Step 3:
 49

Appraisal of screened opportunities

(a) Market appraisal

 Market size
 Company’s share expected
 Composition of market
 Demand & supply analysis
 Consumer requirements
 Production constraints

(b) Technical appraisal

 Proposed Vs available technology

 Availability of raw material & other inputs
 Optimization
 Plant layout & design

(c) Economic appraisal

 Impact on savings & investment in society

 Job potential
 Contribution to social objectives
 Impact on foreign exchange reserves.

(d) Financial appraisal

This involves two steps

Step I : Assessing cash flows during life of a project

Three cash flows are involved

INITIAL CASH FLOWS (AT THE TIME OF BUYING NEW ASSET)

= Cost of new asset

(+) Installation Expenses
(+) Other capital expenditure
(+) Additional working capital
(+) Tax burden on sale of old asset
(- ) Salvage value of old asset
 50

SUBSEQUENT CASH FLOWS (EVERY YEAR DURING LIFE OF ASSET )

= EBIT ( 1-t) + Depreciation – Additional capital expenditure

Where t = Tax Rate

TERMINAL CASH FLOWS (IN THE LAST YEAR OF LIFE OF ASSET)

Yearly cash flows i.e. EBIT ( 1 – t) + Depreciation

(+) Working capital released

(+) Scrap value of new asset

While ascertaining cash flows of a proposal financial cash inflows and outflows such
as issue of capital or debt or repayment of debt, interest & dividend are ignored
because interest & dividend are considered in calculating W.A.C.C. which is used to
discount future cash inflows.
Step II: Expected cash flows estimated as above are used for deciding whether proposal /s
under consideration should be accepted or not. Following methods are used

1 Payback Period (PB) Method

(i) Payback period (PB) is the no. of years required to cover initial investment
(ii) PB less than PB expected by management then project is accepted
PB more than PB expected by management then project is rejected
(iii)When two or more projects are having accepted payback period then project with
minimum payback gets top priority if they are mutually exclusive.
If they are independent then all are accepted
(iv)Yearly cash flows are considered & not the profits
(v) Merits :
 Easy to understand &compute
 Inexpensive
 Uses cash flow information
 Easy but crude way to cope with risk
(vi) Demerits :

 Ignores time value of money

 Ignores cash flows after payback period
 Standard payback period cannot be determined
 Not in line with wealth maximization principle

2 Accounting Rate of Return (ARR) Method

(i) ARR is calculated by formula:

ARR = AV. EBIT ( 1 - t) x 100 [ or ] Av. P.A.T. x 100
AV. INVESTMENT Av. Investment
 51

AV. EBIT (1– t) = (EBIT)1 (1- t) + (EBIT)2 (1 – t ) + -----(EBIT)n (1- t)

N
N = No. of years.
t = Corporate tax rate

AV. Investment = Original Investment + Scrap Value

2
(ii) If ARR more than expected by management Project is accepted
If ARR less than expected by management Project is rejected
(iii) If two or more projects are having accepted ARR then project with highest ARR gets top
priority if they are mutually exclusive but if they are independent all are accepted
(iv) Yearly profits are considered & not the cash flows
(v) Merits:
 Uses accounting data
 Gives more weight age to future receipts
(vi) Demerits:
 Ignores the time value of money
 Do not use cash flows
 Minimum ARR required cannot be decided

3 Net Present Value (NPV) method

(i) (NPV) = ( ∑ P.V. of all cash inflows ) – ( ∑P.V. of all cash outflow )

(ii) If N.P.V. > 0 ( accept project)

If N.P.V < 0 ( reject project )

(iii) When two or more projects are having positive NPV then project with maximum NPV
gets priority if they are mutually exclusive but if they are independent all are accepted

(iv) Features of Net Present Value (NPV) Method :

 NPV of an investment proposal may be defined as sum of present values of cash

inflow-less sum of present values of all cash outflows associated with a proposal.
 A rate of discount must be specified and applied to both inflows & outflows in
order to find out their present values (PVs)
 When present value of all inflows & outflows are added, the resultant figure is
denoted as net present value (NPV). NPV is positive or negative.
 When NPV is positive project is acceptable because cash inflows are more than
cash outflows on the other hand if cash outflows are more than cash inflows then
NPV is negative & project is rejected.
 From economic point of view rate of discount is the overall cost of capital which
takes into account expectations of shareholders, business risk & leverage used.
 52

 In case of mutually exclusive proposals the project with highest NPV ranks first
& that with lowest NPV ranks last.
(v) Merits:

 It recognizes time value of money

 Considers the entire cash flow streams during life of project
 Based on cash flow & thus helps in analyzing the effect of the proposal on the
wealth on shareholders in a better way
 Discount rate can be adjusted to take care of risk involved in the project
 NPV represents the net contribution on a proposal towards wealth of the firm &
is therefore is in full conformity with the objective of wealth maximization of
shareholders.
 NPVs of different projects can be added
 Cash flows accruing between initial & end of project get reinvested at discount
rate.
(vi) Demerits:

 Calculations are difficult

 There may be uncertainty with cash flow occurring or there may be errors in cash
flow estimates.
 In practical life deciding correct rate of discounting is not easy
 Does not provide a measure of project’s own rate of return. It evaluates proposal
on minimum required rate of return.
 It ignores difference in initial outflows, size of different proposals while
evaluating mutually exclusive proposals.

4) Profitability Index Method. ( P.I. Method)

i) PI = [ ∑P.V. of all cash inflows ]

[∑ P.V. of all cash outflows]

ii) If PI > 1 Project Accepted

PI < 1 Project Rejected.

iii) When two or more projects are having PI > 1 then project with highest PI gets
priority if they are mutually exclusive but if they are independent all are accepted

iv) Merits & Demerits : Same as for N.P.V. method.

5) Internal Rate Of Return (IRR) Method .

i) IRR of a proposal is the discount rate which produces zero NPV

ii) Also know as marginal or break even rate or return
iii) Future cash inflows are discounted in such a way the their PV is just equal to PV of
cash outflows
 53

iv) Discounting rate is arrived at by trial & error method.

v) Decision rule:
First firm has to decide its own required rate of return known as “cut off rate” (k)
If IRR > k – Accept proposal
If IRR < k – Reject proposal
In case of mutually exclusive proposals proposal with highest IRR ranks first
& Proposal with lowest IRR ranks last. If there are two or more proposals with IRR
more than accepted IRR & they are mutually exclusive project with highest IRR is
accepted, but if they are independent all are accepted
vi) Method of calculating IRR :
Step I :
Decide N.P.V. by any given rate of discounting
Step II:
Find NPV of project using IRR as decided in Step I
If NPV = 0 Then selected rate is correct IRR
If NPV is + Ve then try higher rate for discounting
If NPV is - Ve then try lower rate for discounting.
(Generally choose next higher rate by 2% )
Step III :
To find IRR
Let, b = NPV at lower rate
c = NPV at higher rate
Actual IRR = [ Lower rate of discount ] + [ (b) x Diff. in rate ]
(b-c)
Step 4
After evaluating various proposals unprofitable or uneconomical proposals are rejected. It
may not be possible to invest immediately in all proposals due to limitation of funds. Hence
it is essential to rank various proposals & to establish priorities after considering urgency,
risk & profitability involved in the projects
Step 5
Proposals meeting various criteria are finally approved & included in Capital Expenditure
Budget which lays down the amount of estimated expenditure to be incurred on fixed assets
during budget period

(D) Types of capital expenditure proposals

Following types of proposals are undertaken by company
1. Replacement decisions
When economic life of fixed asset is over its efficiency is reduced & operating cost of
the machine starts increasing and needs to be replaced by new machine. While buying
new machine its cost, efficiency, maintenance cost & operating cost is considered
2. Modernization decisions
If the plant or machine becomes obsolete, it has to be replaced by new one having latest
technology, which improves productivity & quality. Huge amount of funds are required
for this & selecting right technology & machine is the skill of management
3. Expansion decisions
When there is increase in demand, present output is inadequate to meet delivery
schedule as required by customers. To increase production capacity additional
 54

machinery needs to be purchased

4. Diversification decisions
When firm wants to diversify in product lines, plant & machinery required for new
Plants becomes essential e.g. still manufacturer wants to diversify for refinery entire
new plant is to be installed for oil extraction & its refining
5. Mutually exclusive decisions
Decisions are said to be mutually exclusive when two or more alternative proposals are
such that if one proposal is accepted other needs to be rejected e.g. buying automatic or
semi- automatic machine
6. Independent decisions
These decisions are independent of each other & all can be accepted at one & the
same time if all of them are feasible & profitable e.g. buying lathe machine for production
& buying milling machine for production
7. Contingent decisions
Decisions are such that when one is accepted another all needs to be accepted e.g. when
Machinery for additional production is to be purchased material handling equipments to
distribute this production must also be purchased

(E) Control of Capital Expenditure

(i) Pre - sanction control
Capital budgeting is vital decision for any firm. Success or failure of the organization
depends on intelligence of management in taking this decision. Detailed study of
several aspects of a decision is necessary before recommendation is made to B.O.D.
for the purchase of capital asset. Following aspects must be thoroughly studied to
ensure feasibility of the project to be undertaken
(a) Technical aspects
 Company must select appropriate technology by addressing following issues:
 Can locally available raw material & manpower is possible to be used
 Is technology in tune with local, social & cultural conditions
 Will the ecological balance be maintained
 Agreement of collaboration must incorporate terms & conditions which are
convenient to company & are in the interest of the company. Terms should be
useful for future business success & growth
 Proper plant location to ensure adequacy of power, water & other facilities
(b) Commercial aspects should cover:
 Supply/demand pattern
 Government policies
 Product pricing
 Distribution system
(c) Economic aspects cover
 Employment generation
 Use of foreign exchange
 Contribution to GDP
(d) Financial aspects are
 Debt-Equity ratio
 55

 Operating expenses
 Net cash inflow
 Payback period, NPV, IRR
(e) Risk analysis on following aspects
 Technology risk
 Political risk
 Interest rate risk
 Exchange rate risk
(f) Other aspects
 Management capabilities
 Social benefits & hazards
 Licenses & permissions
 Delays in starting of project

(ii) Operational Control

 Funds must be available in time
 No project time overruns
 No project cost overruns
 In time supply of material & manpower
 Services of experts & consultants whenever necessary
 Continuous supervision & control on various activities & their scheduled
dates
 Minimising mismatch between availability of resources &
requirement of resources
 Quality standards are maintained
 Managing unexpected problem areas
 Ensuring that project objectives are met
 Organization’s commitment to the project

(iii) Post-sanction control

(a) Technical Control
 Evaluation of quality, quantity & delivery
 Comparing feasibility report & actual achievement
 Evaluation of utilities consumed
 Comparing actual against standards & specifications
 Delays in erection & commissioning
(b) Financial Control
 Project cost control under various heads
 Operating cost
 Maintenance cost
 Profitability estimates
 Cash flow estimates
 Sources & applications of funds
(c) Economic Control
 56

 Whether project is contributing to economic growth of the country

 How much employment is generated by project
 Whether it is useful to enhance standard of living of people
 How much foreign exchange is saved

2.2 Tools & Techniques of Capital Expenditure Control

(a) Performance Index
 Effective control over capital expenditure requires that following questions
are answered satisfactorily by the management team involved in purchase &
use of capital asset
 Whether asset is commissioned as per, ahead or behind schedule, why did
it occur, who is responsible for it & what are its implications
 Whether expenditure is as per, more than or less than budget estimates. If
there is variation where did it occur, why did it occur, who is responsible
for it & what would be its implications
 What is the trend of performance & what would be final cash outflow for
the capital asset
 For simple & small capital projects performance analysis is done for the
project as whole or for its major components, but for complex & large
projects performance analysis needs to be done for individual segments of
the project which are referred to as ‘cost accounts’
 Performance analysis of cost accounts or at higher levels of the work method
of analysis takes into account the value of work that has been done & seeks
to remove subjectivity by employing framework based on following terms
 BCWS (Budgeted Cost for Work Schedule): It represents the total of three
components:
 Budgets for all work packages scheduled to be completed
 Budgets for the portion of in- process work
 Budgets for the overheads for the period
 BCWP (Budgeted Cost for Work Performed): This is equal to the sum of
three components:
 Budgets for the work packages actually completed
 Budgets applicable to the completed in- process work
 Overheads Budgets for the period
 ACWP (Actual cost of Work Performed ): This represents actual cost
incurred for accomplishing work performed during particular period of time
 BCTW (Budgeted Cost for Total Work ): This is simply the total budgeted
cost for the entire project work
 ACC (Additional Cost for Completion ): This represents the estimates for the
additional cost required for completing the project
 With above terms following performance indices can be calculated
Cost Variance : [BCWP] - [ACWP]
Cost Variance in cost terms : [BCWP] - [BCWS]
Cost Performance Index : [BCWP]/[ACWP]
 57

Schedule Performance Index : [BCWP]/[BCWS]

Estimated Cost Performance Index : [BCWT]/[ACWP + ACC]

(b) Technical Performance Measurement (TPM)

 Technical performance measurements compare actual versus planned technical
development and design parameters required for the given business situations. They also
report the degree to which system requirements are met in terms of performance, cost,
schedule, and speed
 Systems Engineers use Technical Performance Measurement (TPM) to:

 Provide early visibility of actual versus planned systems-level performance

 Provide early detection of systems-level performance problems

 Support proposed changes to the system's technical baseline

 TPM is a disciplined approach to monitoring the status of critical technical elements
throughout the business process. The process begins by selecting key measurable and
quantifiable parameters such as: Accuracy, Cooling capacity, Fuel consumption, Power
consumption, Reliability, Resource utilization, useful life, weight of the machine
 These parameters reflect product-level characteristics that directly impact critical
performance requirements of the business systems

 If these critical systems-level parameters are not met, the overall capability provided by
the system to the end users is in jeopardy. Therefore TPMs are measured and formally
evaluated at key points across the lifecycle of the equipments. If projections indicate a
potential performance problem, early corrective action is taken.

 TPM involves following steps:

 Critical system parameters are selected. These parameters are based on user
specific requirements and & are called Key Performance Parameters (KPPs).
Most KPPs are system-specific, but some, are mandated for all systems.
Parameters are tracked over time.
 Actual values are measured and compared to planned values to determine
variances.
 Extrapolations are performed to predict future technical variance.
 Analyses are conducted to determine the impact of current and future variances on
process performance, schedule, and cost.
 Recommendations for resolving variance are provided to the management.

(c) Post Completion Audit

 It is an evaluation of the capital expenditure project after its completion
 At the time of project appraisal, estimates are made for project cost & project completion
time. After the project is completed project audit is carried out to assess the actual project
cost & actual time taken for project completion
 While project appraisal is an estimate for future post project evaluation is an assessment
of the past
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 Project is considered successful if it gets completed on time within the budgeted cost &
gives expected level of performance
 In case of public projects apart from studying variations in project cost & project
completion time, post project evaluation also makes an assessment of the actual
social - cost benefit factors & the extent up to which project’s objectives are achieved.

 Objectives of post completion audit:

 By carrying out post completion audit financial institution which has funded the
expenditure can identify pitfalls if any in its project appraisal & control mechanism
that should have been followed for effective project monitoring e.g. based on
project completion time repayment of loan schedule is prepared which may not be
followed by the organization due to project completion delay. Financial institution
can correct in subsequent disbursements & change terms & conditions considering
these delays
 Contractor who has executed a project & completed in delayed time period may
incur additional expenditure. This will make him cautious while quoting bid for
subsequent projects.
 Information built during post completion audit is useful for proper estimation of
cost & time for next capital expenditure proposals
 It is useful for educating project management team
 Correct time-cost relationship can be established
 Appropriate work standards can be established
 Sharing of audit information among all concerned in order to build up better
understanding & better comprehension of the project & its problem areas so that
lapses could be avoided in future
 Post audit is carried out immediately after completion of capital expenditure to
achieve following objectives:
 Studying differences between actual & estimated project cost
 Studying difference between estimated completion & actual completion time
 Locating areas contributing to the variances in project cost & time
 Identifying reasons for such variances, classifying them into avoidable &
unavoidable
 Analyzing steps that could have been taken to avoid avoidable variances
 Studying possibility of removing unavoidable variances by taking appropriate
policy decisions
 Post audit carried out after lapse of 2 to 3 years is done with a wider perspective.
Objectives of this audit are to:
 Study whether project objectives are achieved
 Know whether capital expenditure is giving desired quantity & quality of
products
 Whether is achieving desired level of market share
 Following types post completion audit are carried out:
(i) Technical audit is the evaluation of quality & quantity of production & cost of
production. Comparison is made between estimates & actual
(ii) Financial audit is carried out to highlight differences between estimated project cost,
operating cost, maintenance cost, cash flows & actual
 59

(iii) Economic audit is carried out to assess social costs & benefits
UNIT 3
3.1 Performance Evaluation Parameters for Banks
(a) Customer base of banks
 Customer base of the bank depends on:
 No of branches opened in different parts of the world e.g. SBI is
having largest no. of branches in India & also outside India, hence its
customer base is also large
 Variety of services provided by bank to different type of customers
 Quality of service provided by bank
 Use of technology by bank
 Risk taking ability of the bank. Higher the ability larger is the
customer base
 Benefits provided to customers such as higher rate of interest on
deposit & on savings bank account
 Higher the brand equity more is the customer base
 Additional benefits such as health insurance at low cost given to its
customers
 Long term relationship maintained with customers
 Consistent good financial performance
 More contribution to economic growth
 Customer is a person or entity who maintains account &/or has business
relationship with bank or one on whose behalf account is maintained.
 Bank can have following types of relationship with customer on the basis
of which customer base is dependent
 When customer deposits money with bank he becomes lender & bank
becomes borrower. If the terms of deposit are lucrative & convenient
to customers more customers are attracted to bank & customer base
increases
 If customer keeps certain valuables or securities with bank for safe
keeping or deposits certain amount of money for a specific purpose
banker becomes trustee & also becomes bailee & customer becomes
bailor. Bailee is liable for any loss caused to the bailor due to
negligence. By providing this service bank attracts more corporate &
individual customers
 Bank provides services such as remittance, collection of cheques bills
etc. In such cases bank acts as an agent & customer being his
principal. It is because of this service amounts are credited at faster
rate to the accounts of bank’s customers. Faster this service more are
the customers of bank
 Bank gives safe deposit lockers on rent. In this case bank is a lessor &
customer is lessee. Bank which provides lockers can attract more
customers
 60

 In case of demand drafts or fixed deposit receipts, if these instruments

are lost bank issues another draft or fixed deposit receipt against
indemnity bond. Bank is indemnity holder & customer is indemnifier.
This service restores faith of the customers in bank & with improved
relationship bank can attract more customers
 Customer base of the bank can be classified on the basis of risk involved
e.g. industrial customer may carry high risk whereas individual customers
carry low risk for the bank
 For all practical purposes customers of the bank are classified into
following categories:
 Individual minor
 Individual major
 HUF
 Partnership firm
 Private Limited companies
 Public Limited Companies
 Trusts
 Co-operative Societies
 Government & public departments
Specific rules are framed by each bank to open account, operate account
& to carry out commercial transactions with the bank for each of the
above categories of customers
 Customer base of nationalized banks is very large . They cater to all types
of customers across the globe. Most of them are having overseas branches
in different parts of the world
 In order to increase customer base banks are attracting techno savvy new
generation by upgrading their technology. SBI has launched six digital
branches branded as ‘sbiINTOUCH’ across the country to provide high
tech services to its large customer base
 Administration, management & profitability of the bank depends on
customer base & services provided to various types of customers

(b) Non Performing Assets (NPAs)

 An asset including leased asset becomes NPA when it ceases to generate
income for the bank
 NPA is a loan or advance where
(a) Interest &/or principal remains overdue for more than 90 days in
case of term loans
(b) In case of overdraft or cash credit accounts if account remains ‘out
of order’ i.e. continuous negative balance in excess of sanctioned
limits for more than 90 days
(c) Bills purchased & discounted remains overdue for more than 90
days
(d) Principal &/or interest thereon remains overdue for two crop
seasons for short duration crops
 61

(e) Principal &/or interest thereon remains overdue for one crop season
for long duration crops
 Internationally income is not recognized from NPA unless it is actually
received. Therefore banks cannot take interest on NPA to their income
account
 Banks are required to furnish report on NPAs on global basis as on March
31 every year after completion of audit. NPAs are also to RBI
 NPAs are classified into following three categories based on period for
which asset remains non performing
(a) Substandard Assets
Which have remained NPA for a period less than or equal to 12
Months
(b) Doubtful Assets
Which have remained NPA for a period of 12 months
(c) Loss Assets
Assets in case of which bank, internal auditor, external auditor or
RBI auditor has identified loss, but the amount has not been
written off wholly
 Advances against: term deposits, NSCs eligible for surrender, IVPs, KVPs
& life policies are not treated as NPAs
 Bank should make provisions against NPAs as below:
 Loss assets should be written off
 Doubtful assets
Period of NPA Asset Provision
Up to one year 25%
1 to 3 years 40%
More than 3 years 100%
 Substandard assets: 15% on total outstanding
 NPAs is one of the important parameters for bank performance. Lower the
NPAs better is the performance

(c) Deposits accepted by Bank

 The major function of the bank is to accept deposit from entities having
excess funds &invest &/or lend these deposits to individuals, firms &
corporate
 Deposits are divided in two categories:
(a) Demand Deposits
Following are the features of demand deposits:
 They are payable on demand
 Carry low interest or no interest
 They include current, savings, overdue & unclaimed deposits
 Interest is paid on half yearly basis on savings account
Demand deposits are further classified as:
(i) Current deposits
- Allowed only to trade & business entities
 62

- No interest paid by bank

- Any number of withdrawals per day are allowed
- Customer can carry negative balance up to a limit sanctioned
by bank known as overdraft limit or cash credit limit
 Interest charged by bank on negative balance on daily basis
(ii) Savings Deposits
 Allowed only to non business entities like individual or trust
 Interest is paid on balance on daily basis
 No. of withdrawals per day are restricted
 Cannot carry negative balance
 Certain minimum balance must be maintained
(b) Time or Term Deposits
Performance of the bank is assessed on the basis of deposits
collected. It is an important performance indicator. Higher the
collection of deposits better is the performance
Following are the features of term deposits:
 Amount can be deposited for fixed period of time which ranges
from 7 days to 120 months
 Deposits can be made by individuals, firms, corporates or by
designated institutions
 Interest rate varies from bank to bank & depends on duration of
deposit
 Deposits can be withdrawn before maturity but interest rate is
reduced by bank
 Interest is cumulative on quarterly basis
 If interest paid in a year is Rs. 10,000 or more tax is deducted
as per Income Tax Act provisions
 They are non transferrable
 Term deposits are classified under various schemes such as
 Fixed Deposits (Interest payable six monthly)
 Monthly Income Scheme ( Interest paid monthly)
 Quarterly Income Scheme (Quarterly interest)
 Short term Deposits (period less than a year)
 Recurring Deposit Scheme (Monthly basis)
(d) ROI
 This is another important performance indicator of bank
 This means Return on Investment or Return on capital Employed
 In case of a bank it is calculated in two components
Return on Assets (ROA)
ROA = [Net income] / [Average Total Assets]

- Interest is calculated over a period of time whereas assets as

balance sheet component are determined at a particular time.
Therefore average assets are used
- Interest income on assets
 63

(-) Interest Expenses on liabilities

= Net Interest income
(+) Non interest income
(=) TOTAL REVENUE (a)
Provision for loan losses
(+) Non interest expense
(=) TOTAL EXPENSES (b)
Income Before Tax (a-b)
(-) Income Tax Expenses
(=) NET INCOME
- Following are the assets of bank
(a) Cash
- Cash in hand
- Cash with RBI
- Cash with other banks
(b) Money at short notice
When bank makes money available at short notice to other
banks & Financial Institutions (FIs) for a short period of 1 to
14 days it is treated as asset
(c) Investments made by bank in various securities
(d) Loans & Advances: Money given to various entities
as loans & advances
(e) Other assets not covered above
- Following are the liabilities of bank
(a) Share Capital is the contribution of shareholders for starting
a bank
(b) Reserves are accumulated funds from undistributed profits
(c) Deposits are the money owned by customers & therefore it
is a liability of a bank
* Current Deposits
* Savings Deposits
* Time Deposits
* Other Deposits
(d) Borrowings are money borrowed from RBI & other banks
(e) Other liabilities not included above

Return on Equity (ROE)

ROE = [ROA] x [Leverage Ratio]

= [ROA] x [ Bank Assets / Bank Capital ]

ROA can be improved by:

(i) Employing optimum level of assets
(ii) Getting maximum interest on loans & advances
(iii) Investing in securities which give more yield
(iv) Minimising other assets such as buildings, furniture, ATM
 64

machines & other infrastructure facilities

(v) Keeping NPAs to minimum level
(vi) Borrowings should be at minimum cost
(vii) Minimising operating expenses
ROE is improved when ROA improves & at the same time leverage is kept
to maximum i.e. minimizing capital & maximizing assets
Bank must ensure that while increasing ROA & ROE business is not
exposed to higher risk. There should be proper balance between risk & return
(e) Spread
 It is the difference between average yield a bank receives from loans, advances & other
interest accruing activities & average rate it pays on the deposits taken from its customers
& its borrowings.
 Spread = [Av. Interest rate received on assets – Av. Interest rate paid on liabilities]
 The net interest rate spread is a key determinant of profitability of a bank. Greater the
spread more is the profit to bank
 Thus spread is the most important performance indicator of bank
(f) Financial Inclusion
 Financial inclusion or inclusive financing is the delivery of financial services at
affordable costs to sections of disadvantaged and low-income segments of society, where
those services are not available or affordable.
 Banking services are in the nature of public goods; the availability of banking and
payment services to the entire population without discrimination is the prime objective of
financial inclusion public policy.
 The United Nations defines the goals of financial inclusion as follows:
 access at a reasonable cost for all households to a full range of financial services,
including savings or deposit services, payment and transfer services, credit and
insurance;
 sound and safe institutions governed by clear regulation and industry
performance standards;
 financial and institutional sustainability, to ensure continuity and certainty of
investment;
 competition to ensure choice and affordability for clients
 In India, RBI has initiated several measures to achieve greater financial inclusion, Some
of these steps are:

 Opening of no-frills accounts: Basic banking no-frills account is with nil or

very low minimum balance as well as charges that make such accounts
accessible to vast sections of the population. Banks have been advised to provide
small overdrafts in such accounts.
 Relaxation on know-your-customer (KYC) norms: KYC requirements for opening
bank accounts were relaxed for small accounts in August 2005, thereby simplifying
procedures by stipulating that introduction by an account holder who has been subjected
to the full KYC drill would suffice for opening such accounts. The banks were also
permitted to take any evidence as to the identity and address of the customer to their
satisfaction. It has now been further relaxed to include the letters issued by the Unique
 65

Identification Authority of India containing details of name, address and Aadhaar

number.
 Engaging business correspondents (BCs):In January 2006, RBI permitted banks to
engage business facilitators (BFs) and business correspondents ( BCs ) as intermediaries
for providing financial and banking services. The BC model allows banks to provide
doorstep delivery of services, especially cash in-cash out transactions, thus addressing the
last-mile problem. The list of eligible individuals and entities that can be engaged as BCs
is being widened from time to time. BFs may include following intermediaries:
 NGOs
 Farmers’ co. op. societies
 Community based organizations
 IT enabled rural outlets of corporate entities
 Post offices
 Insurance agents
 Well functioning Panchayats
 Village knowledge centers
 Agri. Business centers
 Krishi Vigyan Kendras
Services of these intermediaries can be used by banks for
 Identification of borrowers
 Preliminary processing of loan applications
 Creating awareness about savings & other banking products

 Money management & debt counseling

 Processing & submission of applications to bank

 Post sanction monitoring

 Follow up for recovery

For above services bank do not require permission of RBI
BCs may include following intermediaries
 NGOs
 Microfinance Institutions
 Societies
 NBFCs not accepting public deposits
 Post offices
Services of BCs can be used for
 Disbursal of small value credit
 Recovery of principal & interest
 Collection of small value deposits
 Sale of insurance, mutual fund & pension products
 Receipt & delivery of small value remittances & other payment
instruments
Activities undertaken by BCs should be within normal course of banking business but
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should be at place other than bank premises

Bank may pay reasonable amount of commission /fees to BFs & BCs for services
provided by them
 Use of technology: Recognizing that technology has the potential to address the issues of
outreach and credit delivery in rural and remote areas in a viable manner, banks have
been advised to make effective use of information and communications technology
(ICT), to provide doorstep banking services through the BCs
 Adoption of EBT: Banks have been advised to implement Electronics Benefit Transfer
(EBT) by leveraging ICT-based banking through BCs to transfer social benefits
electronically to the bank account of the beneficiary and deliver government benefits to
the doorstep of the beneficiary, thus reducing dependence on cash and lowering
transaction costs.
 GCC: With a view to helping the poor and the disadvantaged with access to easy credit,
banks have been asked to consider introduction of a general purpose credit card (GCC)
facility up to Rs.25,000 at their rural and semi-urban branches. The objective of the
scheme is to provide hassle-free credit to banks’ customers based on the assessment of
cash flow without insistence on security, purpose or end use of the credit. This is in the
nature of revolving credit entitling the holder to withdraw up to the limit sanctioned.
 Simplified branch authorization: To address the issue of uneven spread of bank
branches, in December 2009, domestic scheduled commercial banks were permitted to
freely open branches in tier III to tier VI centers with a population of less than 50,000
under general permission, subject to reporting. In the north-eastern states and Sikkim,
domestic scheduled commercial banks can now open branches in rural, semi-urban and
urban centers without the need to take permission from RBI in each case, subject to
reporting.
 Opening of branches in unbanked rural centers: To further step up the opening of
branches in rural areas so as to improve banking penetration and financial inclusion
rapidly, banks have been mandated to allocate at least 25% of the total number of
branches to be opened during a year to unbanked rural centers.

 Following are the challenges around financial inclusion

 Difficulty for banks to expand their business to remote areas due to lack
of infrastructure & low competitive market
 Lack of quality staff in remote areas
 Working in remote areas & reaching poor people is a tough & costly
 Lack of awareness of banking in remote area
 Technological backwardness
 One of the performance indicator of bank is initiative & success of financial inclusion.
No. of branches opened & reach in remote areas are important parameters in this
direction

(g) Credit appraisal

 A credit appraisal is an important part of determining the eligibility for a loan & quantum
of loan. A prospective borrower has to go through various stages of the credit appraisal
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process of the bank. Each bank has its own criteria to satisfy itself on the credit
worthiness of the borrower
 The eligibility for the loan that a person can get depends on borrower’s creditworthiness,
determined as per norms & standards of the bank. Creditworthiness assures repayment
capacity of borrower i.e. repayment of principal & payment of interest & other dues
within stipulated time period
 The norms differ from bank to bank & based on these parameters maximum amount
eligible is worked out

 Norms also differ for different type of loans e.g. for housing loan norms are different
from norms for vehicle loan.
 Norms are different for individuals & corporate
 For individuals information is collected on following aspects
- Income
- Age
- Qualifications
- Family details
- Nature of job
- Whether employed or having business
- Employer details
- Additional sources of income
- Investments
- Liabilities
 Loan amount for individual is arrived using following three important ratio
- Installment – to income ratio
- Fixed obligation – to income ratio
- Loan amount to cost of the asset to be purchased
 In case of corporate viability of project is assessed from point of: Technical,
Commercial, Economical, Financial & social parameters
 Two types of loans are required by corporate. Short term loan is required for working
capital whereas long term loan is required to acquire capital assets or for undertaking
huge projects. Different credit appraisal techniques are used by bank for assessing
creditworthiness of company for two types of loan
 For assessing amount of working capital loan bank generally uses either Tandon
committee norms or uses comprehensive risk rating & scoring model prescribed by RBI.
This model takes into account parameters relating to financial, market & managerial
risk. Based on the score rating is given to borrower & amount of loan is related to rating
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 In case of long term loans detailed information relating to: General information of
company relating to management & legal status & major financial ratios affecting
company’s loan servicing capability are analysed for credit appraisal
 For processing loan bank requires following documents:
- Loan application
- Copy of Memorandum & Articles of Association
- Copy of incorporation & commencement of business
- Copy of resolution of board regarding requirement of credit facilities
- Brief history of company
- Directors’ profile & experience
- Information about suppliers, customers & orders in hand
- Financial statements of company & its associate companies for last 3 years
- Copy of PAN/TAN
- Copy of Excise registration number
- Photo ID of all directors
- Address proof of all directors
- Copy of property details
 Proper credit appraisal helps bank to assess amount of loan to be sanctioned & is useful
for risk management & this decides NPA level of bank. Thus credit appraisal is an
important indicator of bank’s performance

(h) Investments by Bank

 Deposits collected from public are to be given as loans & advances to corporate & other
trading activities. When funds are in surplus with bank they are to be invested in
appropriate securities to increase revenue of bank
 As per regulatory norms bank must invest some % of deposits received with RBI &
approved government securities. This is known as CRR & SLR
 CRR, or cash reserve ratio, is the portion of deposits that the banks have to maintain with
RBI to reduce liquidity in banking system.

 SLR or Statutory Liquid Ratio is the portion of deposits that bank must invest in specified
government securities only & keep in the form of cash & gold
 At present CRR is 4% & SLR is 22.5%. This means if bank collects Rs.100 from customers
it must deposit Rs.4 with RBI on which RBI does not any pay interest to bank.
Bank must invest Rs. 22.5 in:
(i) Cash maintained with RBI in excess of CRR & in current accounts with other banks
(ii) Gold at market rate
(iii) Government treasury bills issued by central government
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(iv) Central & state Government bonds or dated securities

 Other than SLR investments bank can also invest in shares or debentures
 Investments by bank are shown under following 5 heads
(a) Government Securities
(b) Shares
(c) Debentures & Bonds
(d) Investment in subsidiaries & Joint Ventures
(e) Others (CP, MF etc.)

3.2 Performance Evaluation Parameters for Retail

 Essence of retail is merchandising which is the process of making products available to
end customer
 Merchandising is the planning involved in marketing the right merchandise at the right
place at the right time in the right quantities at the right price
 Achieving these “Five Rights” becomes increasingly difficult because in competitive
environment merchandise are to be distributed & sold through thousands of outlets
including on line selling
 Merchandising is the day-to-day business of all retailers. As inventory is sold, new stock
needs to be purchased, displayed & sold. Hence merchandising is said to be the core of
retail
 Measuring the performance of merchandise is necessary in order to gain an
understanding of the products which have performed well & which have not performed
as per the target
 There are following methods of analyzing merchandise performance
(a) ABC Analysis
This analysis classifies merchandise into three categories on the basis of some
performance measure such as demand pattern, type of customers or profitability
of different products etc.
A items are those which can never be out of stock
B items can be occasionally out of stock
C items can be deleted from stock
ABC analysis can be done from any level of merchandise i.e. from Stock Keeping
Unit (SKU) to department
The most important performance measure used is contribution margin.
Contribution can be calculated as:
[Contribution] = [Net Sales] – [Cost of goods sold]-[ Other variable expenses]
On this basis analysis can be done as:
A items are 5% in quantity but give 80% of contribution
B items are 15% in quantity & contribute 15% of contribution
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C items are 80 % in quantity but contribute only 5% of contribution

On the basis of sales analysis can be done as
A items are 5% in quantity but give 70% of sales
B items are 10% in quantity & give 20% of sales
C items are 85 % in quantity but contribute only 10% of contribution
Above percentages are not standard & may change from business to business &
company to company & may be based on situation in each different case
ABC analysis allows management to concentrate on those products which bring
more profitability & utilize minimum efforts on products which have insignificant
contribution to profit

(b) Sell through Analysis

 A sell through analysis is a comparison between actual and planned sales to

determine whether early markdowns are required or whether more merchandise is
needed to satisfy demand.

 There is no rule which can determine when a mark down is necessary. It depends
on experience with the merchandise in the past, whether the merchandise is
schedule to be featured in advertising or whether the vendor can be reduced, the
buyers risk by providing markdown ,money etc.

 If actual sales stay significantly ahead of planned sales, a reorder should be made.

(c) Multiple Attribute Method

This method uses a weighted average score for each vendor. The following steps
are followed:
1) Develop a list of issues to consider for decision making, like vendor reputation,
service merchandise quality, selling history etc.
2) Give importance weights to each attribute
3) Make judgments about each individuals brand’s performance on each issue.
4) Combine the importance and performance scores
5) Add all to arrive at the brand scores.

(d) Gross Margin Return On Investment (GMROI)

 An inventory profitability evaluation ratio that analyzes a firm's ability to turn
inventory into cash above the cost of the inventory. It is calculated by dividing
the gross margin by the average inventory cost and is used often in the retail
industry.

 Gross margin return on investment is also known as the "gross margin return on
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inventory investment" (GMROII).

 This is a useful measure as it helps the investor, or management, see the average
amount that the inventory returns above its cost. A ratio higher than 1 means the
firm is selling the merchandise for more than what it costs the firm to acquire it.
The opposite is true for a ratio below 1.
For example, say a firm has a gross margin of Rs.4,94,000 and an average
inventory cost of Rs.3,80,000. This firm's GMROI is 1.3 , which means it earns
revenues of 130% of costs.
 GMROI is a merchandising planning & decision making tool that assists the
retailer in identifying & evaluating whether adequate gross margin is being
earned by the products purchased as compared to the investment in the inventory
required to generate the gross margin. It focuses attention on ROI rather than on
sales as a basis for merchandise decisions.
 The focus is on SKUs ( Stock Keeping Units) of each individual product rather
than department totals & it helps to identify product “winners” & core products
 Product winners are those products which perform well, which boost profitability
& the best ROI products
 Core products on the other hand are the buyer’s list of existing winners that can
never be out of stock. They are the most valuable products in terms of their high
profitability & their excellent ROI
 Gross margin is the value of sales less cost of goods sold. It can be increased by
increasing sales & reducing cost of merchandise
 Merchandise managers who can effectively inter relate gross merchandise
management & inventory turnover management are able to achieve high
performance results

UNIT 4
4.1 Performance Evaluation Parameters for Projects
Project Control Process
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 Project control is a project management function that involves comparing actual

performance of project with planned performance of project and taking appropriate
corrective action to achieve desired outcome of the project
 In managing projects three aspects to be controlled are:
- Cost of project
- Scheduled time of project
- Quality or technical performance of project
 For effective controlling of project following three actions are necessary:
- Formulating suitable control plans in advance
- Developing suitable standards for project work packages
- Setting up suitable information system
 Project can be controlled by gathering required information from project information
system & comparing actual performance with planned performance
 Immediate actions are required to be taken when deviation between actual performance
& planned performance is noticed
 Project control systems are designed to monitor cost, time & quality parameters
 Accuracy of project control system depends on nature & complexity of projects & also
on the ability of project team to administer it
 Setting baseline plan : Any project plan is finalized after lot of deliberations,
corrections, modifications & revisions. Once the project is finalized it is to be stored as
reference. A baseline is a project plan containing original estimates for tasks, resources,
assignments & costs. Data as per plan like start & finish dates of tasks, duration of
tasks, costs of tasks etc. are captured in a baseline. Once the baseline is formed &
stored it is used as a reference for comparing actual progress with planned progress.
Comparison can be made either in terms of cost or in terms of time
 Measuring project progress & performance : Project progress & performance is to
be measured with reference to baseline of project to ensure that:
(a) Project stages are being completed as per projected schedule
(b) Project costs as per budgets
(c) Technical parameters are properly maintained
(d) There are no technical problems at any stage of project
(e) All performance indices are as per target
(f) Additional budgets wherever required are sanctioned
(g) Whether project is giving desired results at each stage of completion
(h) Appropriate manpower, material & equipments are available for undertaking
further stages of project

Following are the steps in the progress and performance measurement process.

 Plan for Progress and Performance Measurement

   Planning ensures that the measures captured in and reported by various systems are
useful to achieve desired project objectives

 Measure Physical Progress

  This is carried out to ensure project deliverables (i.e., the schedule), proper use of
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resources and the commitment and expenditure of funds (i.e., the cost budget). Progress
against each of these plan elements is measured which is useful to assess whether project
earns value to organization
 Track Resources
In addition to the physical progress measures that support earned value performance
assessment, the status of resource procurements and resource usage need to be tracked to
support productivity analysis to support forecasting and change management and to track
resource risk factors identified in the risk management process
 Status of the Schedule
As with tracking labor and material resources, the resource of time must be tracked. As
activities in the project schedule are started and completed, or when milestones are
achieved, the actual start, finish, or milestone date will be captured in the project schedule
database called as project management information system (PMIS). During the
assessment process the effect of project progress on the scheduled work remaining can be
evaluated.
 Measure Work Process Performance (i.e., "how" work is being done)
This highlights:
- Specific causes of performance problems
- Performance of specific areas such as material, labour, quality of work, safety aspects
of the project

 Project schedule variance & cost variance (Time & Cost overruns)
 Execution of project is delayed due to various reasons. Difference between estimated time
of completion of project & actual time for completion of project is known as schedule
variance. When actual time is more than estimated time it is called as time overrun.
Similarly when actual cost is more than estimated time it is called as cost overrun. In
general time overrun results in cost overrun
 Following are the reasons for time & cost overruns
Pre – feasibility stage
 Bureaucratic delays in obtaining clearances e.g. pollution clearance
 Approvals from regulatory bodies & financial institutions are delayed
 Inadequate infrastructure facilities such as power, roads etc.
 Resources & facilities required are not available in time
 Delay in preparing drawings & designs
Evaluation stage
 Cost & time evaluation of project is based on inadequate & wrong data
 Evaluation is based on inadequate study resulting in wrong estimation of
resources & incorrect specifications
 Selection of incompetent consultants
 Selecting wrong location of project site
 Wrong estimation of fund requirements
Choice of Technology
 Mismatch between technology selected & resources available
 Delays in finalizing drawings, designs & specifications
 Too much time wasted in finalizing technical collaboration agreement
Contracting & procurement
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 Delay in finalization of suppliers & tenders

 Selection of wrong suppliers & contractors
 Time consuming process of importing materials
 Poor purchase planning
Implementation & commissioning of project
 Starting construction activities with improper planning & resources
 Improper monitoring & coordination of various activities carried out by
contractors & third parties
 Delay in receiving manpower, services & special equipments
 Frequent changes in designs & specifications
 Untrained & unskilled manpower for erection & commissioning
 Increase in cost of material & other inputs due to fluctuation in foreign
exchange rates
Estimation flaws
Under estimation of various components of project cost. These components are:
 Land development cost
 Cost of administrative set up
 Cost of effluent treatment plant
 Cost of spares for plant & machinery
 Pre-operative expenses
Following methods are used to avoid cost & time overrun
Work Breakdown Structure (WBS): Purpose of WBS is to break down the whole
project in smaller work packages which can be defined, planned, budgeted, scheduled
& controlled accurately.
For each work package in WBS
Budgeted project cost =[ Budgeted direct cost of all packages] + [ Project overheads ]
Budgeted direct cost, time to be taken for its completion, time schedule i.e. start & end
dates & man power required form the basis for project control against which actual
figures are compared to take necessary actions. Each person heading WBS & his team
are responsible for time & cost overrun for WBS
Bar Chart is a pictorial representation showing various activities involved in a
project. Chart has two axes. One axis shows activities while other axis shows time
required for completion of individual activities
This chart was developed by Henry Gantt hence also known as Gantt Chart
Activities are shown in the form of bars & time taken for completion of each activity
is represented by length of bar
Programme – progress chart is also a bar chart but apart from showing activities
estimated & actual time taken for completion of different activities are incorporated
in this chart which helps in knowing the time lag between estimated & actual
progress of work & also helps in controlling the progress of work during
implementation of the project
Monthly status report covers all important areas of operations of projects. Major
status reports are:
(a) Financial Reports
- Planned Vs actual expenditure report
- Planned Vs actual cash flow report
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- Report on outstanding payments to creditors

(b) Procurement Reports
- Orders placed during the month
- Orders executed/pending
- Status of processing of bids
- Stock position of materials
- Forecast of delivery of materials/equipments
(c) Engineering Reports
- Adherence to specifications
- Preparation & release of construction & erection drawings
- Technical scrutiny of bids
(d) Inspection Progress Reports
- Works executed
- Facilities of vendors & premises
- Technical constraints & suggestions to overcome them
(e) Construction & Erection Reports
- Job wise progress of construction
- Erection of equipments planned Vs. achieved
- Modifications done in construction/erection
(f) Over all review Reports
- Reports covering all major issues
- Exception reports
- Suggestions & recommendations
Line of Balance (LOB) Chart is the chart for ascertaining the progress of various
activities of project on any particular date. It is an extension of bar chart. It provides
management the facility of applying the concept of “ Management by Exception.
Using LOB activities on schedule, lagging behind & ahead of schedule can be located
Earned Value Analysis is useful to exercise control over project by carrying out
periodic performance analysis. It provides an analytical framework for project control
by estimating factors like cost variance, schedule variance, cost & schedule
performance index

4.2 Performance Evaluation parameters for Non-Profit Organizations

(a)Features of Non – profit organizations (NPOs)
1. Passion for mission
Every non- profit organization has a mission statement which one sentence
statement which describes why an organization or program exists is useful to
decisions about priorities, actions & responsibilities
Following are some examples of mission statement
- To inspire and empower people affected by cancer
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- To honor and empower wounded warriors.

- To create lasting solutions to poverty, hunger, and social injustice
- To serve individuals and families in the poorest communities in the world
Everyone in the organization strives hard to achieve mission & woks relentlessly
to achieve the desired goal of the organization
2. Scarcity of resources
Many organizations are run with inadequate resources such as competent
manpower, insufficient infrastructure & paucity of funds
3. Lack of well defined organization structure
In many organizations there is absence of proper hierarchy & decision making
becomes informal & with participation of inappropriate people
4. Conflict between mission & financial results
Non-profit organizations have importance of mission in relation to return on
investment. Profit is not the motive of organization
5. Program outcomes are difficult to assess
Most of the organizations have limited program evaluation capacity & also
outcome of many programs cannot be measured in tangible terms. It is also very
difficult to get market feedback to know how well organization is fulfilling the
requirements of mission. Assessing cost effectiveness of programs & comparing
alternative actions is difficult in many cases
6. Governing board has dual role
Governing body is responsible for ensuring that public interest is served by
organization also expected to help the organization to be successful
7. Individuals have mixed skill levels
With limited financial resources & inadequate manpower non-profit organizations
often hire managers with limited management talent & experience of social
programs. This lowers the mission achievement capacity of the organization
8. Participation of volunteers
Many non-profit organizations rely on the active participation of volunteers.
Members of the board are normally not paid for their work & individuals
contribute considerable time & efforts in delivering services & providing
administrative support. Contribution that volunteers make is significant. However
volunteers usually have multiple commitments & they have to balance the job of
non-profit organization with their paid job, family responsibilities & other
engagements their commitment may not be at desired level
(b)Fund Accounting of Non-profit organization
In India accounting framework for NPOs comprises the following:
(a) Elements of financial statements are income, expenses, assets and liabilities
(b) Principles for recognition of items of income, expenses, assets and liabilities
lay down when an item should be recognized in financial statements
(c) Principles of measurement of items of income, expenses, assets and liabilities
lay down at what amount the aforesaid items should be recognized in the
financial statements.
(d) Presentation and disclosure principles lay down the manner in which
financial statements are to be presented by NPOs and the disclosures to be made therein.
(e) The elements of financial statements remain the same in NPOs as in business entities.
(f) There is no difference in the application of the recognition principles & measurement
 77

principles to business entities and NPOs.

(g) NPOs generally follow what is known as ‘fund based accounting’ whereas the business
entities do not follow this system for presentation of financial statements This is because
NPOs may be funded by numerous grants, donations or similar contributions, which may or
may not impose conditions on their usage. In other words, the use of some funds may be
restricted by an outside agency such as a donor or self-imposed by the organization.
(h) Financial statements of NPOs should reflect income, expenses, assets and liabilities in
respect of such funds separately so as to enable the users of financial statements such as
the contributors, to assess the usage of the funds contributed by them.
(i) Fund based accounting is relevant primarily for the purpose of presentation of financial
statements and not for the purpose of identification, recognition and measurement of various
items of income, expenses, assets and liabilities.
(j) While the identification, recognition and measurement of elements of financial statements
are same for both - business entities & NPOs, the disclosure & presentation of financial
statements may differ among the two Similarly, disclosure principles may also differ.
(k)The accounting framework discussed above would apply to all categories and types of
NPOs. However, the books of account to be maintained by various NPOs may depend upon
the nature of activities and/or programs carried out by them.
(l) Basis of Accounting refers to the timing of recognition of revenue, expenses, assets and
liabilities in accounts. The commonly prevailing bases of accounting are:
- cash basis of accounting; and
- accrual basis of accounting.
Under the cash basis of accounting, transactions are recorded when the related cash
receipts or cash payments take place. Thus, the revenue of NPOs, such as donations,
grants, etc. are recognized when funds are actually received. Similarly, expense on
acquisition and maintenance of assets used for rendering services as well for employee
remuneration and other items are recorded when the related payments are made.
(m) Accounting Standards
All NPOs, irrespective of the fact that no part of the activities is commercial, industrial or
business in nature, should follow Accounting Standards. This is because following the
Accounting Standards laid down by ICAI would help NPOs to maintain uniformity in
presentation of financial statements, proper disclosure and transparency. However, while
applying the Accounting Standards certain terms used in the Accounting
Standards may need to be modified in the context of the corresponding appropriate terms
for NPOs. For instance, where an Accounting Standard refers to the term ‘statement of
profit and loss’, in the context of NPOs, this Technical Guide uses the term
‘income and expenditure account’
(c) Governance of Non-profit organizations
 Governance is the process of providing strategic leadership to NPO. It
involves functions of setting direction, making policy & strategy decisions,
overseeing & monitoring organizational performance & ensure overall
accountability. NPO governance involves multiple functions & engage
multiple stakeholders
 Public sector governance refers to the political process of policy & decision
making for communities & political jurisdictions, whereas NPO governance
refers to the process of providing leadership, direction, & accountability for
a specific NPO
 Most of the NPOs have governing board or board of trustees which is
accountable for all acts undertaken by NPO
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 Effective governance is integral to the success of NPO. To succeed NPOs

must continuously renew the link between what they do & needs &
interests of the community they serve. They must ensure that they are
providing the services needed & valued by their clients & constituents &
are consistent with core values & principles of NPO they serve
 From legal perspective NPO board have three fundamental duties:
1. Duty of Care which is taking care & exercising judgement that any
reasonable & prudent person would exhibit in the process of
making informed decisions. Active preparation for & participation in
board meetings where important decisions are to be made is an
integral element of duty of care
2. Duty of loyalty which calls board members to consider & act in good
faith to protect the interests of NPO
3. Duty of Obedience requires obedience to the mission of
organization, bylaws & policies & honor the terms & conditions of
other standards of appropriate behavior such as laws, rules
regulations
 Core responsibilities of NPO board are
 Determine & articulate organization’s mission, vision & core
values
 Select & recruit chief executive for NPO
 Support & assess performance of chief executive
 Future organizational planning
 Determine set of programs required to implement strategies,
accomplish goals & monitor performance of these programs to
assess their value
 Ensure that organization has sufficient financial & other
resources to implement its plans
 Effective management & use of organizational resources
 Enhance organization’s credibility & image
 Ensure organizational integrity & accountability
 Assess & develop board’s own effectiveness
 Board & members of board have fiduciary responsibility to
the organization & to the larger community within which they serve. At the
core fiduciary responsibility is the responsibility to treat resources of
organization as a trust & responsible board ensures that these resources
are utilized in a reasonable, appropriate & legally accountable manner. In
general appropriate exercise of fiduciary responsibility includes:
(a) Formulating policies to govern acquisition & use of financial & other
resources
(b) Establish budgets on regular basis to allocate financial resources to
programs & activities required to fulfill organizational mission, vision
& goals
(c) Establishing system of accountability for everyone in the
organization
(d) Establish ongoing system to monitor, assess & report on overall
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financial performance of the organization

(e) Set up independent external review process such as independent
audit on regular basis to assess fiscal condition & effectiveness of
its systems & policies
 In India statutory framework provides governance for NPO. Following are
some of the main laws for governing various types of registered NPOs
(a) The Societies Registration Act 1860
(b) The Indian Trust Act 1882
(c) The Co-operative Societies Act 1904
(d) The Trade Unions Act, 1926
(e) Section 25 of the Indian Companies Act 1956
(f) The Charitable & Religious Trust Act 1920
 The Societies Registration Act 1860, The Indian Trust Act 1882 and Section
25 of the Indian Companies Act 1956 are the three enactments which seem
to fulfill requirements of NPOs created for larger public good
 The co-operative Societies Act 1904 & Indian Trade Unions Act 1926 are
created for the sole benefit of their members & not for larger public benefit,
yet they too are non-profit entities in their spirit & operations
 NPOs in India may be registered under any of the following five forms
1. The Societies Registration Act 1860
2. Public Charitable Trust Acts of various States
3. The Co-operative Societies Act 1904
4. The Trade Unions Act, 1926
5. Section 25 of the Indian Companies Act 1956
 Various Acts specify eligibility, position , applicability of act, scope &
purpose for which NPO can registered & operated

(d) Product Pricing of NPOs

 Product pricing in NPO may take the form of
 Voluntary pricing
This can be applied to NPO which provides free services & then asks for
donation from the public or clients to sustain those programs e.g. goods
or services with ‘suggested price’ for refreshment at school concert.
Based on this suggested price & no of students donations can be
collected
 Ability to pay
Pricing will depend on ability to pay by the receivers of goods or services
e.g. in a school fees will be charged based on the ability of parents to pay
i.e. annual income of parents
 Versioning
Pricing is different for different versions of services provided depending
on location, duration, date & time of performing service, value addition
service or incremental services
 Bundled services
Organizations that provide a range of services or programs might provide
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several different packages or bundles & price them depending on no. &
type of services included in bundle
 Since NPOs generally aim to serve as many customers as possible their
pricing must encourage growth. Low pricing must be balanced by need to
produce revenue to improve cervices
 For selecting proper pricing strategy following aspects need consideration:
 Charge high price to some customers & use extra revenue to
subsidize others
 Avoid marking up cost
 Set the price that creates value to customers
 Create value statement which clearly articulates why customers
should purchase the product from them over the rivals
 Understand that customers have different pricing needs
 Implement differential pricing through discounts, off peak times,
affiliations to particular organization & so on
 Offer different product versions such as ordinary, moderate,
excellent
 Provide no. of options to choose

(e)Strategic Planning for NPOs

 Strategic planning has been used as a tool for transforming & revitalizing
corporations, Government organizations & NPOs
 Strategic planning must have clear end result in mind, realistic goals,
explicit steps of action plan & must consider views of all the shareholders
 Successful strategic planning process examines & makes realistic
projections about environmental realties which is useful to articulate its
mission & goals, estimate realistic budgets for spending, reshape its
programs & plan other operational aspects
 NPO must take following steps to make strategic planning successful:
 A clear & comprehensive grasp of external opportunities
 Realistic assessment of strengths & weaknesses of organization
 All important stakeholders should have voice in strategic planning
 Strategic planning should be participatory proposition. Core jobs
should be entrusted to small planning committee with sufficient
decision making authority to keep project moving forward
 Commitment & involvement of senior management
 Sharing of responsibility by all the members of organization
 Learn for best practices in industry
 Set clear priorities & implementation plan
 Strategic planning is time consuming & requires patience
 There must be commitment by management to change

(f) Budget preparation for NPO

 Preparing budget for NPO can be on a small or much bigger scale & the
complexity is affected by the size & nature of programs, size of budget, no.
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of fund providers & no. of employees

 Budget is the financial plan of action based on the board’s decision for the
future specific period of time. It is a document which reflects joint planning
efforts of many people
 NPOs are continuously under pressure of maintaining & improving their
operations for which proper budgeting of receipts & payments is necessary
 NPO must follow normal budget process which involves following steps:
Step 1
To define budget period which is generally one year, however for cash
flows budget can be prepared for smaller duration
Step2
Gather budget information which must be in line with requirements of
strategic plan of NPO. Information must be as per financial & budgeting
policies of the organization
Step 3
Based on information gathered prepare various budgets. Following
budgets can be prepared by NPO
1. Revenue Budget
Components of this budget are:
- Contributions & donations from public
- Grants received (restricted) on which there are restrictions by
the entities given the grant
- Grants received (unrestricted) on which there are no restrictions
by entities given grant
- Other incomes through sale of goods & services
2. Expense Budget
This budget highlights various expense heads of NPO & may differ
from organization to organization, but in general may include items
such as: Employee Cost, Administrative Expenses, Telephone &
internet, Purchase of goods,

3 Capital Budget
This budget usually relates to acquisition of buildings, equipments
& other capital assets. It shows the costs of purchase & source of
funding to cover the cost
4. Program Budget
Budget is prepared for each program or service provided by NPO.
Most of the NPOs have more than one program
5. Cash Budget
This is based on expected cash inflows & cash out flows & generally
prepared on monthly basis
Step 4
Receive Approval
Once the budgets are prepared, they are presented to Board of NPO to
get final approval. Once budget is finalized it is communicated throughout
the organization
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(g)Social Audit

 Organizations in addition to focusing on profitability & growth should also be

concerned about the impact of their operations on the society. This need has given
rise to the concept of social audit

 Blake, Fredrick & Myres define social audit as “ a systematic attempt to identify,
analyze, measure, evaluate & monitor the effect of an organization’s operations on
society”

 Following are the features of social audit

- This audit assesses whether organizations are adhering to the norms of
social performance specified by either government, organization itself or
by some outside agencies
- The aim of conducting social audit is to influence the objectives, policies
& actions of concerned organization to improve its social responsibility
performance
- Social audits are conducted by professionals having knowledge about
social area to be audited
 Following are the approaches to social audit
(a) Inventory approach
It involves simple listing & short description of programs which
organization has developed to deal with social problems
(b) Program management approach
More systematic effort to measure costs, benefits & achievements of
organization in terms of money
(c) Cost –Benefit approach
This approach attempts to list all costs & benefits incurred by an
organization in terms of money
(d) Social Indicator approach
It pertains to utilizing social criteria such as suitable housing, good health,,
job opportunities & so on to clarify community needs & then evaluating
corporate activities in light of these indicators
 Fredrick, Myers & Blake have identified six types of social audits
1. Social Balance Sheet & Income Statement
This involves quantification of social costs & income. The objective of this
audit is to assess social costs in monetary terms with the objective of
reducing such social costs
2. Social Performance Audit
Conducted to assess performance of organizations with respect to some
area of social or public concern such as impact of pollution on society
3. Macro-micro social indicator audit
This audit is conducted to evaluate performance of organization in terms
of social indicators that signify public interest. It evaluates the
contribution of the organization to well being of the local community
4. Constituency Group Attitudes Audit
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It is conducted to ascertain how corporate actions affect employees or

general public in different ways. Depending on findings of audit policies
or actions of the organization are modified
5. Government Mandated Audits
This audit is conducted by authorized government agencies to study
performance of organization in areas of social concern
6. Social Process or Program Audit
This audit is limited to specific processes & programs of organization that
may have social implications

UNIT 5
Audit Function as Performance Measurement Tool
(a) Concept of audit
- Audit is an independent examination of financial & non financial information of any
entity with a view to ensure proper management and financial control.
- The person who prepares & submits audit report to management and regulatory
authorities is known as auditor.
- Statutory financial audit, Internal financial audit & cost audit are conducted to ensure
financial control and management audit is conducted to ensure that various
management functions are performed as desired by board & are producing desired
results.
- To make management of business efficient & effective it is essential, that control
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measures are sound enough for success of the business.

- The failures of business in certain or all areas calls for in depth study, analyses & review
of business situations to evolve & strengthen management control systems. This makes
need for audit quite essential.
(b) Types of Audit
i) Financial Audit
- It is compulsory for every private & public limited company.
- Auditor is appointed by shareholders of company.
- Objectives of financial audit are :
 Whether books of accounts have been maintained as per provisions of
Companies Act or any other applicable Act
 To ensure that applicable accounting standards have been followed in
preparing books of accounts.
 To detect frauds, wastages & errors.
 To ensure that books of accounts give true & fair view of affairs of business.
- Auditor must be an independent chartered accountant not connected
financially or otherwise to company.
- Auditor is appointed & removed by shareholders i.e. owners of company.
He submits his report to Shareholders at A.G.M.
- Thus financial audit gives assurance to owners & other fund providers that their funds
have been properly used by management, there is proper financial control & there is
no misuse of their funds.
- This audit is the most power tool of financial control.
- Companies Act has imposed certain duties & given certain rights to
auditor which are useful to give fair & useful results for financial
control of the company.
(i) Internal Audit
- It is not compulsory to any company.
- Internal auditor is appointed by Board of Directors.
- Following are basic principles of this audit.
 Integrity, objectivity & Independence
 Confidentiality
 Skill & competence through education & experience
 Documentation
 Planning
 Evidence
 System & internal control
 Conclusion & reporting
- Following are the objectives of internal audit :
 To ensure adequate & reliability of management information and control
system. Role of internal auditor is to evaluate whether various types & levels of
communication are effective & motivating force for all the people in
organization.
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 To check accuracy adequacy & effectiveness of internal control systems

related to various operations.
 To evaluate adequacy of timely financial recording & reporting.
 To assess whether management objectives are achieved or not.
 To check proper account, utilization & safeguarding of assets.
 To ascertain compliance of management plans, policies, systems and
procedures.
 Appraisal of internal systems & procedures.
 To ensure compliance of statutory lows & rules.
 Prevention &detection of fraud & misappropriations.
(ii) Cost Audit
- It is audit of specified costing records of company.
- It is carried out by independent cost accountant as per provisions of Companies Act.
- Two important principles of cost audit are :
i) It is the audit of executive action & plans which has bearing on finance and
expenditure of company. In this respect cost auditor has to make his own
judgment whether :
 Planned expenditure would give optimum results.

 Size & channels of expenditure are designed to give best results.

 Returns on capital employed could have been better by some alternative

plan of action .

ii) To ensure that resources have been allocated in most profitable

activities or projects.
- Following are the objectives of cost audit :
 Verification of costing records with reference to cost accounting
plans of company.
 To highlight abnormal costs
 To develop cost conscious attitude.
 Examining variances and their correct interpretation to management.
 To check operating efficiencies.
 To check optimum utilization of resources.
 To check appropriateness of overhead allocation.

 To examine system of stock valuation

 Infra firm & inter firm comparison of cost.

 Fixation of selling price of goods of national importance.

 Investigate cost structure of industries approaching for tariff protection etc.

- Financial Audit Vs Cost Audit

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Parameter Financial Audit Cost Audit

Statutory As per sec. 224 of Co.’s As per 233 of Co.’s

compulsion Act Act

Applicability Applicable to all Applicable only to

companies public limited
companies
Public & Private

Compulsion Compulsory to all Compulsory only to

companies those companies
who have been
directed by Central
Govt.

Scope of audit All financial i.e. Only costing records

accounting & costing
records

Qualifications to Conducted by Conducted by

conduct audit independent practicing independent
Chartered Accountant practicing cost
Accountant

Method of By shareholders of By Board of Directors

Appointment company at A.G.M. with prior approval of
Central Govt.

Reporting Submitted to Submitted to Central

shareholders of company Govt. With copy to
Board of company

Iv ) Management Audit
- Management audit is the audit of various functions performed by management viz.
Objectives, planning, organizing, policy formulation, strategy formulation, decision
making, controlling and various management systems.
- It has following objectives :
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 Too locate wastages & deficiencies.

 To search for better & improved methods.
 To suggest better system of control.
 To find out more efficient operations.
 To help using human & physical assets in a better manner.
- Management control is vital for efficient & effective running of an organization. Hence
one of the main objectives of management audit is to evaluate control measures.
Following aspects related to management control are dealt by management auditor:
 Nature of control process
 Necessity of introducing additional or changed control measures.
 Establishing standards of performance.
 Design measures to restore effective controls.
 Identify measurable & non-measurable control factors.
 Identify any special problems of controls.
 Ensure that all vital control systems, internal accounting systems, management
information and control systems remain effective throughout the organization.
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