Submitted to professor M.A.Ganachari

Group No- 4 Rakshit Shetty Razak Shaikh Reena Gupta Rishikant JakhotiyaRizwana Kagzi75 76 77 78 79


Q1. How a profit centre is differs from investment centre? What are the different methods of judging their performance? Which is the better method?
Profit Center A profit center is any business segment whose manager has control over both cost and revenue. A profit center generally does not have control over investment funds. Profit center managers are often evaluated by comparing actual profit to targeted or budgeted profit. Segmented income statements should be used to evaluate the performance of profit center managers.

Profit centre includes marketing, production and service functions. Examples include a manufacturing plant or product line. Evaluation of their performance is done by Gross profit or contribution margin, operating income and net income plus the variances for sales and cost. A responsibility centre is called a profit centre when the manager is held responsible for both costs (inputs) and revenues (outputs) and thus for profit. Despite the name, a profit centre can exist in nonprofits organizations (though it might not be referred to as such) when a responsibility centre receives revenues for its services. A centre, whose performance is measured in terms of both - the expense it incurs and revenue it earns, is termed as a profit centre. The output of a responsibility centre may either be meant for internal consumption or for outside customers. In the latter case, the revenue is realized when the sales are made. That is, when the output is meant for outsiders, then the revenue will be measured from the price charged from customers. If the output is meant for other Responsibility centre, then management takes a decision whether to treat the centre as profit centre or not. In fact, any responsibility centre can be turned into a profit centre by determining a selling price for its outputs.


A profit centre is like a separate company with its own profit and loss account and the manager¶s decisions relate to the revenue and costs that make up the divisions profit statement. From a management accounting perspective, key performance appraisal measures used would be cost and revenue variances to budget, as well as the preparation of key profit ratios such as gross profit percentage, operating profit percentage and expenses to sales percentages. Divisional profit statements are commonly used in profit centre and mainly distinguish between costs that are controlled by the division and costs that are controlled by head-office.

In addition to the authority to acquire short term assets, to hire temporary or contract personnel, and to manage inventories, profit center managers are usually given the authority to make long term hires, set salary and promotion schedules (subject to organization wide standards), organize their units, and acquire long lived assets costing less than some specified amount. Note, however, real revenue can be earned only on sales outside the organization -AFMC's sales of services to foreign governments and private firms earns revenue, for example; services performed for other elements of the Air Force would merely earn notational revenues or transfer prices.

Investment center An investment center is any segment of an organization whose manager has control over cost, revenue and investments in operating assets. Investment centers are usually evaluated using return on investment or residual income measures. Investment Centers - segments such as divisions of a company where the managers control the acquisition and utilization of assets, as well as revenue and costs. Investment center includes all the functions above plus the manager¶s control what to produce and how to produce, i.e., have autonomy or more


Thus. its ROA would have been 5. investment centers are divisions of large companies. the logistics center described earlier had assets of $7. If. just as a profit center involves more than a cost center. In recent years many have turned to economic value added (EVA).5 billion ($5 billion in fixed assets and $2. Investment center managers are responsible for both profit and the assets used in generating profit. its quasi-EVA would have been $50 million ($425 million . an investment center adds more to a manager's scope of responsibility than does a profit center. but also the assets that generate these costs and revenues and the investment decisions relating to disposal and acquisition of assets. where the former is expressed as a percentage of the latter. revenues and net assets for capital investment.$375 million). Investment center managers are typically evaluated in terms of return on assets (ROA). 4 . primarily work-in-progress and parts inventories) and the federal government's cost of capital were 5 percent. Return on Investment: = (Return on Sales)(Capital Turnover) = (Net income ÷ Sales)(Sales ÷ Total assets) = Net income ÷ Total assets also Residual Income. An investment centre is where the manager has responsibility for not just the revenues and costs relating to the centre. net operating "profit" less an appropriate capital charge. Investment centre are profit centre that are accountable for cost. which is the ratio of profit to assets employed. which is a dollar amount rather than a ratio. for example.autonomy than profit center managers. Managers in an investment centre are responsible for purchasing capital or non-current assets and making investment decisions with capital. Typically.7 percent. This unit is assessed by return on investment and is a cost centre.5 in current assets. This is essentially the same as economic value added (EVA).

e. On account of these difficulties. is a difficult question. Presumably. It is defined as a responsibility centre in which inputs are measured in terms of cost / expenses and outputs are measured in terms of revenues and in which assets employed are also measured. the term investment centre is not widely used. Measurement of assets employed poses many problems. both manufacturing and marketing. investment centers are generally used only for relatively large units. In practice. the term profit centre is used indiscriminately to describe centers those are always assigned responsibility for revenues and expenses. senior management wants the 5 . Its success is measured not only by its income but also by relating that income to its invested capital. but may or may not be assigned responsibility for the capital investment. Some of the assets are in the physical possession of the responsibility centre while for some assets it may depend upon other responsibility centers or the Head Office of the company. however. they can be changed at the discretion of the profit center manager. He is expected to earn a satisfactory return on the assets employed in his responsibility centre. The problem with this argument is that its premises are inaccurate. have been allocated to the profit center). as in a ratio of income to the value of the capital employed. The principal argument in favor of using it to measure the performance of profit center managers is that since fixed expenses are beyond their control. Many expense items are discretionary. managers should focus their attention on maximizing contribution. Whether such assets should be included in the figure of assets employed of the responsibility centre and if included. including a fair share of the corporate overhead. which have independent divisions. the manager in charge is held responsible for the proper utilization of assets. Different Methods of judging the performance of Profit Center and Investment center A profit center's economic performance is always measured by net income (i. The Vice President (Investments) of a mutual funds company may be in charge of an Investment Centre. and some are entirely controllable. The performance of the profit center manager. In the Investment Centre..An investment centre goes a step further than a profit centre does. that is. This is particularly true of cash or heavy plant and equipment. almost all fixed expenses are at least partially controllable by the manager. at how much value. for their individual products. Instead. in fact. It becomes difficult to determine the amount of assets employed in a particular responsibility centre. the income remaining after all costs. may be evaluated by five different measures of profitability: (1) Contribution Margin: Contribution margin reflects the spread between revenue and variable expenses.

it may be difficult to allocate corporate staff services in a manner that would properly reflect the amount of costs incurred by each profit center. First. the profit center manager is still responsible for controlling employees' efficiency and productivity. If these costs are included in the measurement system. Further. Expenses incurred at headquarters. three arguments in favor of incorporating a portion of corporate overhead into the profit centers' performance reports. There are two arguments against such allocations. A focus on the contribution margin tends to direct attention away from this responsibility. Second. A major disadvantage of this measure is that because it excludes non controllable headquarters expenses it cannot be directly compared with either published data or trade association data reporting the profits of other companies in the industry. these managers should not be held accountable for them. and human resource management are not controllable by profit center managers. (2) Direct Profit: This measure reflects a profit center's contribution to the general overhead and profit of the corporation. even if an expense. accounting. all corporate overhead is allocated to profit centers based on the relative amount of expense each profit center incurs. for example. since the costs incurred by corporate staff departments such as finance. (3) Controllable Profit: Headquarters expenses can be divided into two categories: controllable and non controllable. regardless of whether or not these items are within the profit center manager's control. corporate service units have a tendency to increase their power base and to enhance their own 6 . however. however.profit center to keep these discretionary expenses in line with amounts agreed on in the budget formulation process. (4) Income before Taxes: In this measure. First. profit will be what remains after the deduction of all expenses that may be influenced by the profit center manager. by the business unit manager-information technology services. such as administrative salaries. There are. A weakness of the direct profit measure is that it does not recognize the motivational benefit of charging headquarters costs. at least to a degree. The former category includes expenses that are controllable. are not included in this calculation. It incorporates all expenses either incurred by or directly traceable to the profit center. cannot be changed in the short run.

companies measure the performance of domestic profit centers according to the bottom line. the performance of each profit center will become more realistic and more readily comparable to the performance of competitors who pay for similar services. Allocating corporate overhead costs to profit centers increases the likelihood that profit center manager§ will question these costs. Finally. In other cases. product mix. In these situations. such variances would appear in the reports of the responsibility center that actually incurred these costs. If profit centers are to be charged for a portion of corporate overhead. they are motivated to make optimum long-term marketing decisions as to pricing. (5) Net Income: Here. and their use of other generally accepted accounting procedures to distinguish gross income from taxable income. however. in which case there would be no advantage in incorporating income taxes (2) Since many of the decisions that affect income taxes are made at headquarters. (Some companies have actually been known to sell their corporate jets because of complaints from profit center managers about the cost of these expensive items. profit centers may influence income taxes through their installment credit policies.) Second. foreign subsidiaries or business units with foreign operations may have different effective income tax rates. the amount of net income after income tax.excellence without regard to their effect on the company as a whole. are recovered. their decisions on acquiring or disposing of equipment. that will ultimately benefit (and even ensure the viability of) the company as a whole. it may be desirable to allocate income 7 . This ensures that profit center managers will not complain about either the arbitrariness of the allocation or their lack of control over these costs. since their performance reports will show no variance in the overhead allocation. in which the effective income tax rate does vary among profit centers. when managers know that their respective centers will not show a profit unless all-costs. costs. it is not appropriate to judge profit center managers on the consequences of these decisions. including the allocated share of corporate overhead. thus serving to keep head office spending in check. Instead. There are two principal arguments against using this measure: (1) After tax income is often a constant percentage of the pretax income. and so forth. in which case the "budget" and "actual" columns in the profit center's performance report will show identical amounts for this particular item. For example. There are situations. rather than actual. this item should be calculated on the basis of budgeted.

profit arising out of the normal activities of the company should only be taken. Debit balance of P & L A/c xxx xxx ROI = (Capital turnover ratio)(Profit Margin on Sales) = (Sales ÷ Investment)(Net Income ÷ Sales) The Capital Turnover Ratio reflects management's ability to generate sales from a given investment base and reflects the overall productivity of the segment. debt or stockholders equity) is usually considered irrelevant. Investment outside the business xxx b. ROI = Profit / Invested capital * 100 ROI = Net profit / Investment = (Net profit / Sales) * (Sales / Investment in assets) It will be seen from the above formula that ROI can be improved by increasing one or both of its components the profit margin and the investment turnover in any of the following ways: y y y Increasing the profit margin Increasing the investment turnover Increasing both profit margin and investment turnover Capital employed is taken to be the total of shareholders funds. Preliminary expenses xxx c. In the ROI measurement.. 8 .tax expenses to profit centers not only to measure their economic profitability but also to motivate managers to minimize tax liability. Capital employed for the company as a whole can be arrived at as follows: Share capital of the company xxx Reserves and surplus xxx Loans (secured/unsecured) xxx Less: a. Productivity is generally defined as some measure of output per input. but see the alternatives below.e. Note that the source of the investment (i. The following techniques are useful in evaluating the performance of an investment centre: 1. loans etc. The profit figure used is in calculating ROI is usually taken from the profit and loss account. Return on investment (ROI): The rate of return on investment is determined by dividing net profit or income by the capital employed or investment made to achieve that profit. output is defined in terms of sales dollars and inputs are typically represented by total assets.

interest on the capital invested in the company is treated as a cost and any surplus is the residual income.. such as per headcount. Decrease cost with no unfavorable effects on quality or increase in assets employed. It has been argued that a more suitable measure of performance 9 . A. Increasing Capital Turnover Increase sales with the same investment base.e. or minimum desired rate of return. Using ROI as a performance measurement may cause many managers to reject profitable projects if the projects would tend to lower the ROI. In other words. Residual income: Residual income can be defined as the operating profit (or income) of the company less the imputed interest on the assets used by the company.1(100) = 3.5%. As a result. of 10 percent. i. Efficiency and cost control are reflected in this measure as well as other factors such as productivity and the sales level.135 or 13. 12 or 13 percent? Probably not. 2. Some possibilities include the following.5 million Would a manager evaluated on the basis of the ROI accept a new project with an expected return of 11.5 . income of 13.The Profit Margin is the rate of return on sales (ROS) and measures management's ability to control the spread between prices and costs. goal congruence is not obtained. Not all projects start off with positive or sufficiently large positive profits in the early years of a project to produce a positive increment to residual income. This is probably the main reason why the management continues to make use of ROI which is relative measure.. Increasing Profit Margin: Increase prices with no unfavorable effects on sales. ROI may be increased in various ways. Increase sales with no changes in prices or costs. B. Residual income is profit minus notional interest charge on capital employed. Productivity in this measurement refers to the quantity of products or services produced per input. Assume that a division has a cost of capital.5/100 = .5% RI or EVA = 13.5 million and 100 million in capital. ROI = 13. Decrease the investment base with the same sales level. a conflict arises between the goals of the manager and the goal of the organization. since it would reduce the division's overall ROI below the current 13. Residual income is affected by the size of the organization and therefore will not provide a basis for evaluation of organizational performance.

for investment centre. The significant difference between the various types of organization is observed when we analyze the manufacturing or service environment in which they operate. which could encourage managers to be more willing to undertake marginally profitable projects. this sector includes hospitality. These industries are further classified into two as Process Industries (Flow production or continuous process production industries) and Discrete Manufacturing Industries. 10 . can automate production. Elements of the manufacturing environment include external environmental forces. product/process design. Service organization include those industries that do not produce goods. production on demand or for inventory. business unit strategy. unlike service firms. advertising. Manufacturers. customer-specific production. insurance. finance. etc. Typically. is residual income. product selection. There are five main differences between service and manufacturing organizations: the tangibility of their output. and market intangible services The peculiarity of these industries is that often the consumption of the service takes place while it is in the generation. product/process technology and management of competencies. Many manufacturers offer their own service operations and both require skilled people to create a profitable business. logistics. So the better method of judging the performance of both the center is ROI ± Return on investment Q2. How does a service organization differ from a manufacturing organization? How is a professional service organization differ from a normal service organization? How is the pricing and marketing done by professional service organizations? Manufacturing organization engaged in the production of goods (finished products) and market tangible goods that have value in the marketplace. labor-intensive or automated operations. banking. engineering. consultancy. and the need for a physical production location. service and manufacturing organizations share many characteristics.). However. etc. other functional strategies (marketing. corporate strategy. in practice.

global firms such as consultants Deloitte use communication networks to access the most appropriate service skills and knowledge from offices around the world. However. although some manufacturing organizations are labor intensive. relying on the accuracy of demand forecasts and their production capacity to meet demand on a just-intime basis. unlike manufacturers. 5. do not hold inventory. although knowledge management systems enable a degree of knowledge capture and sharing. particularly in countries where labor costs are low. such as consultancy. The people creating and delivering the service can be located anywhere. Manufacturers can produce goods without a customer order or forecast of customer demand. plus 14 hours of design and 10 hours of installation. Service delivery is labor intensive and cannot be easily automated. For example. Customers: Service firms do not produce a service unless a customer requires it. Manufacturers can automate many of their production processes to reduce their labor requirements. Goods: The key difference between service firms and manufacturers is the tangibility of their output. for example. Some manufacturers maintain minimum stock levels. 3. Labor: A service firm recruits people with specific knowledge and skills in the service disciplines that it offers. Service firms generally produce a service tailored to customers' needs. Manufacturers must have a physical location for their 11 . 4. producing goods that do not meet market needs is a poor strategy. although they design and develop the scope and content of services in advance of any orders. Location: Service firms do not require a physical production site. The output of a service firm. with inventory levels aligned to forecasts of market demand. Manufacturers produce physical goods that customers can see and touch.1. Inventory also represents a cost for a manufacturing organization. training or maintenance. they create a service when a client requires it. 2. such as 12 hours of consultancy. is intangible. Inventory: Service firms. Manufacturers produce goods for stock.

Many professionals prefer to work independently. In many organizations. technical. funeral directors. A professional organization has relatively few tangible assets. A professional service is an industry of infrequent. Professionals who are also managers tend to work only part time on management activities. a related goal is to increase their size. While not limited to licentiates (individuals holding professional licenses). In part. specifically a satisfactory return on assets employed. translators. its principal asset is the skill of its professional staff.production and stock holding operations. the services are consider professional" and the contract may run to partnerships. engineers. is essentially meaningless in such organizations. therefore. researchers. Production does not necessarily take place on the manufacturer's own site. or unique functions performed by independent contractors or by consultants whose occupation is the rendering of such services. and the labor is of a special type. which doesn't appear on its balance sheet. copywriters. this reflects the natural tendency to associate success with large size. brokers. rather than as part of a team. law firms. 2.senior partners in law firms have 12 . architects. Return on assets 1. Their financial goal is to provide adequate compensation to the professionals. it can take place at any point in the supply chain Professional Service organization differ from normal service organization The term "professional services" is also used frequently by corporations such as banks and retailers that offer infrequent or ongoing services for their customers. actuaries. senior partners in an accounting firm participate actively in audit engagements . it reflects economies of scale in using the efforts of a central personnel staff and units responsible for keeping the organization up to. or corporations as well as to individuals The special characteristics of professional organization which would have a bearing on their control system. real estate. firms. Professionals: Professional organizations are labor intensive. Large public accounting firms need to have enough local offices to enable them to audit clients who have facilities located throughout the world. business development managers and business consultants. recruiters. Eg: accountants. attorneys. appraisers. public relations professionals. In part. Goals: A dominant goal of a manufacturing company is to earn a satisfactory profit.

Some tasks are essentially repetitive: the drafting of simple wills. which is of some use in identifying slackers and hard workers. professionals tend to look down on managers. 4. what is measured is the physician's efficiency in treating patients. sales contracts. and even classify these visits by type of complaint. Small Size: With a few exceptions. Senior management in such organizations can personally observe what is going on and personally motivate employees. not output. professional organizations are relatively small and operate at a single location. and to judge how satisfactory the performance was. for this and other reasons. rather than management. No two consulting jobs or research and development projects are quite the same. Furthermore. at most. not to their quality (although poor quality is reflected in reduced revenues in the long run). unusual circumstances that affect a specific job must be taken into account. such as units. but quite naturally stresses the skills of the profession. the work done by many professionals is non repetitive. even a small organization needs a budget. such as some law firms and accounting firms. We can measure the number of patients a physician treats in a day. although in using these standards. Professionals tend to give inadequate weight to the financial implications of their decisions. Education for most professions does not include education in management. This makes it difficult to plan the time required for a task. The development of standards for such tasks may be worthwhile. deeds. a 13 . to set reasonable standards for task performance.I regardless of its cost. 3. but this is by no means equivalent to measuring the amount or quality of service the physician has provided. but these monetary amounts. with profit centers and formal performance reports. they want to do the best job they can. At most. We can measure the number of hours a lawyer spends on a case. Output is the effectiveness of the lawyer's work. and this is not measured by the number of pages in a brief or the number of hours in the courtroom.clients. it leads to inadequate cost control. there is less need for a sophisticated management control system. and similar documents. re. or gallons. This attitude affects the attitude of support staffs and nonprofessionals in the organization. Thus. Output and Input Measurement: The output of a professional organization cannot be measured in physical terms. relate to the quantity of services rendered. and certain medical and surgical procedures. tons. but this is a measure of input. the taking of a physical inventory by an auditor. Nevertheless. Revenues earned is one measure of output in some professional organizations.

5. it is difficult to assign appropriate credit to the person responsible for "selling" a new customer. they were taken into account in promotion and compensation decisions. Until fairly recently. In this situation. Typically.that is. and a way of relating compensation to performance. working for clients. perhaps as a percentage of the project's revenue. which is a buffer that dampens the impact on production activity of fluctuations in sales volume. physicians. Such a clean separation does not exist in most professional organizations. Thus. The airplane seat. In some. Marketing is an essential activity in almost all organizations. it takes the form of personal contacts. such as law. In a consulting firm. Absence of Inventory Buffer: Goods can be held as inventory. or from the reputation of one of the firm's professionals as an outgrowth of speeches or articles. conversations on the golf course. and other professionals that are not used today are gone forever. These marketing activities are conducted by professionals. The characteristics of normal service organization are as follows: 1. this sector includes hospitality. the profession's ethical code limits the amount and character of overt marketing efforts by professionals (although these restrictions have been relaxed in recent years). Marketing: In a manufacturing company there is a clear dividing line between marketing activities and production activities. Service organization include those industries that do not produce goods. hospital operating room. for example. although a manufacturing 14 . hotel room. only senior management is concerned with both.regular comparison of performance against budget. speeches. medicine. the professional who is responsible for obtaining the engagement may not be personally involved in carrying it out. Services cannot be stored. and market intangible services The peculiarity of these industries is that often the consumption of the service takes place while it is in the generation. if the person who "sold" the project can be identified. usually by professionals who spend much of their time in production work-that is. and so on. articles. however. Barber service etc. or the hours of lawyers. these marketing contributions were rewarded subjectively. and accounting. Some organizations now give explicit credit. scientists. If it can't be conducted openly. Moreover. a new engagement may result from a conversation between a member of the firm and an acquaintance in a company.

thereby replacing labor and reducing costs. and in other ways. Difficulty in Controlling Quality: A manufacturing company can inspect its products before they are shipped to the consumer. and other professional organizations are reluctant to layoff professional personnel in times of low sales volume because of the effect on morale and the costs of rehiring and training. but mostly to provide better treatment. law firms. In the short run. gasoline service stations. The similarity of the separate units provides a common basis for analyzing budgets and evaluating performance not available to the manufacturing company. weight. 2. a service company cannot do so. care must be taken in making such comparisons 15 . and their quality can be measured visually or with instruments (tolerances. Multi-Unit Organizations: Some service organizations operate many units in various locations. The quality of education is so difficult to measure that few educational organizations have a formal quality control system. Most service companies are labor intensive and cannot do this. Moreover. purity. Restaurant management can examine the food in the kitchen. and high performers and low performers can be identified. the costs of many service organizations are essentially fixed in the short run. Labor Intensive: Manufacturing companies add equipment and automate production lines. each unit relatively small. auto rental companies. A service company cannot judge product quality until the moment the service is rendered. others operate under a franchise. 3. and this increases can earn revenue in the future from products that are on hand today. color. 4. These organizations are fast-food restaurant chains. The information for each unit can be compared with system wide or regional averages. but customer satisfaction depends to a considerable extent on the way it is served. and then the judgments are often subjective. in the resources that they use. Some of the units are owned. a hotel cannot reduce its costs substantially by closing off some of its rooms. and many others. It must try to minimize its unused capacity. and so on). A law firm expands by adding partners and new support personnel. Hospitals do add expensive equipment. However because units differ in the mix of services they provide. Accounting firms.

and creativity. Some professional-service providers are able to give fixed rates for projects. independent contractors for professional services were located and hired by various means. knowledge. yellow pages). while others define the price only after assessing the work involved. it is common to hire professionals on the basis of an hourly fee and of an estimated length of project In the past. they are relatively low for research scientists and relatively high for accountants and physicians. This is what a narrow definition and limit the term transfer price to the value placed on a transfer of goods or services in transaction in which at least one of the two parties involved in the profit center. The popularity of the Internet has led to a new crop of professional-services sites that allow independent contractors to offer their services to a larger audience. the fee typically is based on the monetary size of the security issue. reputation. As noted the principal asset of a professional organization is the skill of its professional which is nit measurable. Such a price typically includes a profit element because an independent company normally would not transfer goods or services to 16 . In still others. Prices for services. ethics. fees generally are related to professional time spent on the engagement. Q3. In other professions. If the profession is one in which members are accustomed to keeping track of their time. Marketing The selection of an independent contractor or consultant providing professional services usually depends on skill. such as investment banking. Actually the total value of the whole organization is greater than the sum of what the value of the individuals would be if they worked separately. Prices vary widely among professional. Transfer pricing is not an accounting tool? Comment with illustration? Transfer pricing refer to the amount used in accounting for any transfer of goods and services between responsibility centers. For this reason. there is a fixed price for the project. while allowing individuals or companies to find professionals quickly and easily.The pricing and marketing done in professional service organization are as follows Pricing The selling price of work is set in a traditional way in many professional firms. The hourly billing rate typically is based on the compensation of the grade of the professional plus a loading for overhead costs and profit. vary greatly. even within the same field.g. including recommendation and directories (e.

For this the group should fix a very high transfer price if the Division in Country A provides goods to the Division in Country B. In the larger interest of the group. since the same drugs were available from an Italian firm for 9 pounds and 28 pounds per kilo. Therefore. While the tax authorities in UK accepted the price. The company had incurred an R&D cost that was included in the price. the tax authorities monitor transfer prices closely in an attempt to collect the full amount of tax due. manipulating the transfer prices between the subsidiaries can scale down the overall tax bill of the group. There is also a temptation to set up marketing subsidiaries in countries with low tax rates and transfer products to them at a relatively low transfer price. Transfer price is viewed as a major international tax issue. the group can adjust the transfer price in such a way that the profits in Country A increase and that in Country B get reduced. 17 . the mechanism for allocating cost in an accounting system. then the company is forced to pay tax in both countries leading to double taxation. For this. such cost do not include a profit element. The reverse will be true if the Division in Country A acquires goods from the Division in Country B. There have been instances where companies have fixed unrealistic transfer prices. 1. The price was not set on cost but on what the market would bear and 2. For example the tax rate in Country A is 20% and is 50% in Country B. If a group has subsidiaries that operate in different countries with different tax rates. it would be advisable to show lower profits in Country B and higher profits in Country A. The first case relates to Hoffman La Roche that imported two drugs Librium and Valium into UK at prices of 437 pounds and 979 pounds per kilo respectively.another independent company at cost or less. While companies indulge in all types of activities to lower their tax liability. The company's lawyers argued the case before the Commission on two grounds viz. The term price as used here has the same meaning as it has when used in connection transaction between independent companies. This will maximize the profits in Country A and minimize the profits in Country B. the Monopolies Commission did not accept the company's argument. But if companies set unrealistic transfer price to minimize their tax liabilities and the same is spotted by the tax authority. For this they enter into agreements whereby tax is paid on specific transactions in one country only.

If the tax payer fails to do this he is required to pay heavy penalty. in USA. The company had falsely inflated freight charges by 40-60% to reduce the profits. professionally 18 . For example. Q4. as transfer prices on import of cars and trucks were too high. it has to be admitted that setting a fair transfer price is not easy. Cost Audit Cost audit is an examination of cost accounting records and verification of the facts to ascertain that the cost of the product under reference has been arrived at in accordance with principles of Cost Accounting and evaluation of adequacy of proper Cost Accounting Records and their maintenance. Write Short notes on the following 1. The price is determined through: y Comparable Price Method where the price is fixed on the basis of prices of similar products or an approximation to one. The principle states that the transfer price would be arrived at on the basis as if the two Companies are independent and unrelated. failure to provide documentary evidence results in a 40% penalty on the arm's length price. y Gross Margin Method where a gross margin is established and applied to the seller's manufacturing cost. So the onus of proving the price has been put on the taxpayer who is required to produce supporting documents. They evolved what came to be known as the arm's length price. These guidelines aim at encouraging world trade. In spite of all these efforts. The second case is of Nissan. Interestingly the Japanese tax authorities took a different view and returned the double tax.85 million pounds for the manipulative practices adopted while fixing the transfer price. With a view to avoid such cases from recurring. Organization for Economic Cooperation and Development Issued some guidelines in 1995.These arguments did not go well with the Commission and the company was fined 1. The manipulation helped the company to hide tax to the tune of 237 million dollars. The cost audit is performed by an independent. The next year Nissan was made to pay 106 million dollars in unpaid tax in the USA because the authorities felt that part of their US marketing profits were being transferred to Japan. Other countries are also in the process of evolving tight norms for the same. In UK the penalty is to the tune of 100% of any tax adjustment. Countries across the globe also allow the taxpayer to enter into an Advance Pricing Agreement whereby dispute Can be avoided and so also the costly penalty of double taxation and penalty.

manufacturing or mining activities.1961 (X of 1961). Where any company or class of companies is required under clause (e) of subsection (1) of Section 230 to include in its books of accounts the particulars referred to therein. 19 .qualified Cost and Management Accountant or Chartered Accountant. makes an additional provision in sub-section (1) (e) of that Section which reads: in the case of company engaged in production. if such class of companies is required by the Authority by a general or special order to include such particulars in the books of accounts The Companies Ordinance 1984 provides for Audit of Cost Accounts vide Section 258 which reads:-258. unprejudiced opinion on the cost performance of the entity. such particulars relating to utilization of material or labor or to other inputs or items of cost as may be prescribed. independent. Cost audit is carried out to evaluate cost performance of the entity for which Cost Accounting Records have been prescribed by the Securities and Exchange Commission of Pakistan (SECP). Cost audit refers to the detailed checking of the costing system. The Cost Auditor. or a cost and management accountant within the meaning of the Cost and Management Accountants Act. Legal Provisions: The Companies Ordinance 1984 while providing for the books of accounts to be kept by a company under Section 230. 1966 (XIV of 1966). Audit of Cost Accounts. and a check on adherence to prescribed cost accounting procedures and their continuing relevance. The verification of cost records and accounts. carries out such tests and makes such inquiries which enable him to give a professional. and such auditor shall have the same powers. the Federal Government may direct that an audit of cost accounts of the company shall be conducted in such manner and with such stipulations as may be specified in the order by an auditor who is a chartered accountant within the meaning of the Chartered Accountants Ordinance. Special attention is given to verification of cost records and adherence to acceptable cost accounting procedures. as reflected in the cost information provided in the schedules which are prepared by the entity in accordance with the cost accounting records maintained. It also ensures that the company is adhering to the objective of cost accountancy. duties and liabilities as an auditor of a company and such other powers. therefore. processing. duties and liabilities as may be prescribed. the techniques used and the accounts to verify their accuracy.

Companies (Audit of Cost Accounts) Rules 1998 have been published as Appendix I. and the Companies (Audit of Cost Accounts) Rules 20 .Companies (Audit of Cost Accounts) Rules. the cost auditor has to safeguard his independence and professional status in planning and performing the cost audit. Cost Accounting Records Orders: Under Sub-section (I)(e) of Section 230 of the Companies Ordinance 1984. 2001 were framed by SECP which came into force from 1stJuly 1994 and 13th February 2001 (Appendix III. units of Cement Industry and Sugar Industry are required to maintain cost accounting records to provide cost accounting information in a verifiable form.Cost Audit has to be carried out every year from 1997-98 in all industries to which Cost Account Records Orders issued by SECP apply. Vegetable Ghee and Cooking Oil Companies. On the one hand. Subsequently the Cement Industry (Cost Accounting Records) Order 1994 and Sugar Industry (Cost Accounting Records) Order. Under these three Orders. IV and V). the ICMAP. the SECP (former Corporate Law Authority) framed the Vegetable Ghee and Cooking Oil Companies (Cost Accounting Records) Order. There are also principles that the cost auditor has to see are being observed by the company he is auditing. the cost accounting system is also studied. which should be proper and adequate for ascertaining cost of the product under reference and for providing all information required to complete the prescribed schedules and annexure given n the relevant cost accounting record orders/rules. During cost audit. required to fill in the schedules and annexures prescribed in these orders. 1998. Other industries may be brought within the ambit of Cost Audit as and when relevant Cost Accounting Records Orders are issued. Principles of Cost Audit 1. 1998: The basic structure of the Cost Audit has been laid down in the Companies (Audit of Cost Accounts) Rules. as well as by the Companies Ordinance 1984. Cost audit ascertains compliance with Cost Accounting Record Orders. ensuring quality and standard of cost audit. Planning and Performing Cost Audit: There are certain principles that the cost auditor has to observe in planning and performing the cost audit. 1990 which came into force from 1st January 1991. as required by his professional body.

integrity. Financial involvement with the client effects independence and may lead a reasonable observer to conclude that it has been impaired. including relevant national and international 21 . Cost audit is to meet the management and the Government need for credibility in cost information and cost accounting systems. maintaining cost accounting records. 4. with which all ICMAP members are equipped. Professional competence requires to be maintained by a continuing awareness of developments in the accountancy profession. He should be fair and should not allow any prejudice or bias. professional competence and due care. he has also to see that the client unit operates within the legal framework provided for the industry. training and examination in professionally relevant subjects and a period of work experience. 3. which go to mar his independence.1998. Code of Ethics: Cost Auditor should comply with the code of ethics for professional accountants. The principle of objectivity imposes the obligation on all professional accountants to be fair. cannot be appointed as a cost auditor. confidentiality. He has neither any ulterior motives nor any personal ends to serve. 5. 2. professional behavior. Professional Competence and Due Care: A professional accountant should not project himself as having expertise or experience which he does not possess. objectivity. and other rules regulating his audit engagement and reporting.under which a person who has or had specified relationships. and technical standards. Independence of Cost Auditor: The independence of the cost auditor is largely covered by the Companies (Audit of Cost Accounts) Rules 1998. Attainment of professional competence requires a high standard of general education followed by specific education. The fundamental principles governing the professional responsibility of the Cost Auditors are enumerated as follows: independence. Integrity and Objectivity: Integrity implies not only honesty but fair dealings and truthfulness. conflict of interest or any other influence to override objectivity. On the other hand. A professional cost and management accountant should be straightforward and honest in rendering professional services as a cost auditor. intellectually honest and free of conflict of interest. in accordance with the cost accounting records order rules applicable to the industry.

in accordance with the instructions of the clients or employers. Confidentiality: A cost and management accountant should respect the confidentiality of information acquired during the course of performing professional services and should not use or disclose any such information without proper and specific authority or unless there is a legal or professional right or duty to disclose. being a member of the Institute of Cost and Management Accountants of Pakistan. 8. independence. Moreover. A Cost and Management Accountant has a duty to render professional services with care and skill. IFAC. The duty of confidentiality continues seven after the end of the relationship between the cost auditor and the client or the cost and management accountant and the employer. based on up-to-date developments in practice. 6. objectivity. legislation and techniques. and in the case of Cost and Management Accountants in public practice. He has to ensure professional behavior while meeting his responsibilities to clients. Professional Behaviors: A professional Cost and Management Accountant. insofar as they are compatible with the requirements of integrity. Technical Standards: A professional Cost and Management Accountant should carry out professional services in accordance with the relevant technical and professional standards. IASC and the relevant laws. 7. 9. employers and the general public.pronouncements on accounting. should act in a manner consistent with the good reputation of the profession. staff. auditing and other relevant regulations and statutory requirements. The cost and management accountant has to maintain professional knowledge and skill at a level required to ensure that a client or employer receives the advantage of competent professional service.rules and regulations. Professional Code of Ethics: 22 . He should meticulously avoid any such conduct or behavior as may cast an unfavorable aspersion on the profession. they have to conform to the technical and professional standards laid down by the Institute of Cost and Management Accountants of Pakistan. other members of the cost and management accounting profession. third parties. orders .

objectivity or independence or the good reputation of the profession. Improving Audit Efficiency-³Efficiency´ is the ratio of inputs per output: Hours spent per audit report. Engagement on other occupation: A professional accountant in public practice should not concurrently be engaged in any business occupation and activity which might impair his integrity. Years spent per audit report. Government. auditor investigates the reasons of variances in actual performance and planned performance. This reliance imposes a public interest responsibility on the professional cost and management accountant. Efficiency Audit Efficiency audit is conducted to ensure that money is so utilized as to generate handsome returns. or externally by regulatory bodies. A process of checking whether an organization is working as efficiently as possible. Core idea: Make each time investment count in your audit office The objectives of efficiency audit are: y y To invest the capital in areas that generates optimum returns. highly efficient auditors and offices have ³traction´ to create audit yield with each hour of audit time invested.A distinguishing mark of a profession is its acceptance of responsibilities to the society. employees. who all rely on the objectivity and integrity of the Cost and Management Accountant. 2. from planning and scoping through reporting. Efficiency happens in all stages of the audit. 3. In this. as management tries to improve profitability. To plan and invest judiciously in various functions. Efficiency audit is related to that whether corporate plans are effectively executed. the financial community and the consumers at large. This may be done internally. employers. The Cost Auditor independence is to be judged by his clients. 10. Management Audit 23 . The code of professional ethics of the Institute of Cost and Management Accountants of Pakistan must be carefully observed. investors in the business. It also investigates that capital resources of company are properly utilized or not.

resource procurement. the structure of a company. such as division or department and its plans. It requires inter/multi-disciplinary approach as it involves examination. leadership etc are examined in the management audit. It undertakes comprehensive and critical review of all organizational activities with wider perspective. These audits may be less formal if conducted by internal managers or employees rather than a public accounting firm or third-party management consultant. review and appraisal of various policies and actions of management on the basis of certain norms/standards. 24 . It is highly result oriented. For e. Its aim is to identify existing and potential management weaknesses within an organization and to recommend ways to rectify these weaknesses. thus facilitating the most effective relationship with the outside world and the most efficient and smooth running internally. It is a complex task closely related with the process of management. aimed both at individual managers and toward the management team as an interlocking system of decision makers. institution or branch of government or of any components thereof. Audits test a variety of business functions. including production operations. reporting and follow up Procedures. Leslie Howard It is an audit performed with the object of examining the efficacy of the institution/control systems. direction given by the management to the company. It goes beyond conventional audit and audits the efficacy of the management itself.A management audit is a periodic assessment conducted by company managers to determine the effectiveness or efficiency of business operations. employee hiring practices and financial reporting. It's a comprehensive and constructive examination of an organization. its means of operations and its use of human and physical facilities. William P. Management audit concerned with the ways and means to perform specific task. Churchill & Cyert It is an objective and independent appraisal of the effectiveness of managers and the effectiveness of the corporate structure in the achievement of company objectives and policies. Leonard It's an investigation of a business from the higher level downwards in order to ascertain whether sound management prevails throughout. management procedures towards the achievement of enterprise goals. A management audit may be described as a systematic and objective appraisal of the quality of management. objectives.g. it involves the decision taken by the management.

To evaluate the methods and processes used by the management to accomplish its organizational objectives. It helps to ascertain the appropriateness of the management¶s decisions for achieving the organization objectiveness. Ascertain objectives of the organization are properly communicated and understood at all levels. To assist the management to achieve the most efficient administration of its operations. To assist the management to achieve the most efficient administration of its operations. The authority and responsibility given at the different levels of the management. The audit starts right at the top level of the management. Critically analyze and evaluate management performance. To reveal defects or irregularities in any of the elements examined and to indicate what improvements are possible to obtain the best results of the operations of the company. its management team and its corporate culture. One of the most 25 . It aims to achieve the efficiency of management and assess the strength and weaknesses of the organization structure. its management team and its corporate culture To reveal defects or irregularities in any of the elements examined and to indicate what improvements are possible to obtain the best results of the operations of the company. To suggests to the management the ways and means to achieve the objectives if the management of the organization itself lacks the knowledge of efficient management. To help the management at all levels in the effective and efficient discharge of their duties and responsibilities.Objectives To ascertain the provision of proper control at different levels and their effectiveness in accomplishing management goals. The audit has to study the decision-making system of the organization and also the level of autonomy granted to the managers at different levels of the organization. To detect and overcome existing management deficiencies and resulting operational problems. It helps to determine the effectiveness of the management in PODC the organization activities. The auditor must apprise managerial performance at all levels of the organization. It aims to achieve the efficiency of management and assess the strength and weaknesses of the organization structure. To suggest to the management the ways and means to achieve the objectives if the management of the organization itself lacks the knowledge of efficient management. It studies the managerial performance at all the levels of management.

which one individual may not possess. The management auditor reports on performance of the management during a particular period and suggests ways to remedy the deficiencies. The auditor reports to the management Types of management audit: 26 . The team may consist of management experts. It indicates the financial position and over~ performance of the business. policies etc. Conducting Management Audit Management audit requires an interdisciplinary approach since it involves a review of all aspects of management functions. Financial audit is applicable to all classes of companies and industries irrespective of size and Dan of operations. It has to be conducted by a team of experts because this requires 3 varieties of skills. Financial audit is organization . Under financial audit. They need to have through knowledge of the management science and they should be acquainted with the salient features of various functional areas. regardless of its performance in various segments. the entire emphasis is on macro-aspect. accountants. It is conducted under Sections 224 232 of the Companies Act 1956. Instead of serving the interest of the management and the Government. Financial audit is not concerned with ~ avoidance of profiteering motive.oriented. of Profit and Loss Account and Balance Sheet. policies and procedures of the enterprise. No limit as to the period to be covered. and scrutinizes individual transactions for the purpose of verification. the individual transactions being. There is legal compulsion as regards management audit. It is concerned with examination of transactions recorded in the books of account.scrutinized for check of the aggregates. The auditors must have analytical mind and ability to look at a management function form the point of view of the organization as a whole. and the operation research specialists. They therefore have to be properly trained in this aspect.important things that the audit must study is that the mangers at various levels use the authority. It is concerned with the review of the past Performance to ascertain whether it is in tune with the objectives. including modification of objectives. It reviews the procedure and internal checks. it serves interest of shareholders. the industry experts and even social scientists.

research and development units. One has to mold and remold the management control system to suit the given organization structure. Functional management audit. For e. Compliance management audit. Time and other aspects. account supervisors are shifted from one account to another on periodic basis. and functional units provide resources to the projects. this practice 27 . setting a system.g:. A citation by Anthony is worth noting in this regard. Usually in an advertisement agency. manufactures of complicated plant and machinery are examples of matrix structure. 4. etc. Organizing the management audit Devising the statement of policy. operations. new machine. Program management audit. it poses problems of casting the individual responsibility. MCS in Matrix Organization In a Matrix organization.objective.Complete management audit. Evaluation of performance of such organizational entities is very difficult. Allocation of personnel. persons service from various functional units in accomplishing the objectives and when the objective is achieved the project is terminated. engineering. Project managers are responsible for dealing with the customers. from the point of view of management control system. Responsibility centers. organizing an advertising campaign etc. Staff training program. Efficiency management audit. Each project is set up for a specific purpose. Matrix organizational structure assigns multiple responsibilities to the functional heads. construction companies. It is virtually a marriage between two types of organization structures one arranged by functions and the other arranged by projects. At the end we must not forget that the management control system is for the organization and not the organization exists for management control system. This form of organization is very complex. Organizations like consultancy firms. A project is ant task or group of tasks involved in reaching a specified end.installation of a plant. Propriety audit. The project managers use material. Though they offer economies of using scares functional staff. on the other hand are arranged by functions such as purchase and procurement. Frequency.

Matrix of organization structure Management control in a matrix organization is obviously more difficult than the other two types because: Profitability is the joint responsibility of several managers.Matrix of organization structure The number of products grows to be relatively large. So the capital investment proposal described in Exhibit 3 is an attractive on for QMSC. This does not mean a control system designer should insist on abandoning the rotation system of the executives.182 28 . the purpose of a company is to maximum the profit. and as Elizabeth Barret suggested. Investment in machine $540. Planning must harmonize the requirement of the projects with the resources that are available at the functional units and perfect co-ordination is required in scheduling the activities. so that the projects are completed in time. products require close coordination among many specialized discipline and the market are too small to justify separate divisions for each product.allows the agency to look at the account from the perspectives of different executives. However taking in to consideration the time lag of result realization in such services is quite large. but personnel are not idle at any time. CASE STUDY SOLUTION QUALITY METAL SERVCE CENTER Q1. And this may pose problem of performance assessment of a particular executive. Disadvantages. Matrix structure offers advantages such as faster decision making process.000 10 years cash inflow $286. it can help company to make more profit. efficiency and effectiveness but simultaneously it may pose problems such as added complexity in control function. Is the capital investment proposal described in Exhibit 3 an attractive one for Quality Metal Service Center? Yes. Advantages.000 PV of cash inflow $39. assignment of responsibility and authority etc.

evaluate the way Quality computes the ³investment base´ for its districts. And another reason is. the general question is: What practices will motivate the district mangers to use their assets most efficiently and to acquire the proper amount and kind of new ssets? Presumably. Given this general line of reasoning. For each asset category.Payback period = 4.000 and all capital leasing decisions require corporate approval. when his redesire that the actions he takes toward this end be actions that are in the best interest of the whole corporation. Should Ken Richards send that proposal to home office for approval? Ken need send this proposal to home office for approval. Q4. ROA can be computed as Net Income/ Total Assets.8% Reasons for selection:    Positive cash flow IRR> COC Payback period is less than the standard Q2. or strategy paining. because this proposal is good for the company and can make a lot of profit for the company. management service histories. An indicator of how profitable a company is relative to its total assets. capital expenditures in excess of $10. What are the likely motivational problems that could arise in such a system? What can you recommend to overcome such dysfunctional effects? 29 . Comment on the general usefulness of ROA as the basis of evaluating district managers¶ performance. To make it more effective QMSC can use: Multiple performance measure. discuss whether the basis of measurement used by the company is the best for the purpose of measuring district¶s return on assets. Could this performance measure be made more effective? The Return on Assets (ROA) percentage shows how profitable a company's assets are in generating revenue. Q3. ROA gives an idea as to how efficient management is at using its assets to generate earnings.5 years NPV= 286000 IRR= 2.In deciding the investment base for evaluating managers of investment centers.

Thus. The managers are responsibility for the segment¶s. QMSC should use EVA instead of ROA as the measure of district and manager performance. return on investment. investment and asset base as well as the profits.Yes. improving EVA will also improve the company¶s overall performance. Leased buildings and equipment are also part of the asset base. evaluation might include a variety of measures such as profit. warehouse buildings. This is a good practice because these are representative of the assets used during the period and thus. Usually. This motivates managers to lease rather own assets whenever the interest charge that is built into the rental cost is less than the capital charge that is applied to the investment base. QMSC also includes inventory and accounts receivables. QMSC includes land. Barret¶s proposal. The purchase of the new processing equipment is also in line with the company¶s objective to develop techniques and marketing program that would increase market share in identified industries and geographic markets of specialty metal users. addressing the concern of potential customers. in the investment center. profits increased. And also. and equipment at gross book value in its investment base. residual income. evaluate based on the return on assets employed. Richards to employ additional assets which will promote the growth of both the Columbus district and QMSC. the head office must think carefully before approving the leases of the districts as the managers might just be using it to window dress their performance. economical valued added and a range of non-financial measures. Having the equipment will allow QMSC to provide the demand for processed metals in the Columbus District with a short lead time. such as the one in Ms. using average values for the period. This results to an EVA that signals a decrease in profitability during the early years of the assets when in fact. 30 . It will be better for the company to use annuity depreciation so that the profitability calculations will show the correct EVA. Hence the manager in the districts should consider about the acquisition of new equipment which is an investment for the segment. without subtracting standard accounts payable. conceptually a satisfactory measure of the amount that should be related to profits. This will induce Mr. Another aspect of the issue that needs to be looked into is the decision on what assets should be included in the investment base and what expenses should be charged from profits. Since EVA is the best proxy for shareholder value at the business unit level. May be it can also be the profit center because the managers usually evaluated in terms of effectiveness in raising segment profit level and controlling costs. based on the return on assets employed. they evaluated equipments and accounts receivable etc. The managers¶ district objectives will then be congruent with the company¶s overall objectives.

Expenses were separated into controllable and non controllable categories. Elizabeth Barret. 31 . The motivational impact on the district mangers that thing before taking corporate overheads. However. Acquiring the new processing equipment reduces the incentive bonus of the Columbus District Manager. No corporate overhead expenses were allocated to the districts.1% to 4. Ken Richards. Mr. Q6. While computing district profits for performance evaluation purposes. the company had considered a proposal to allocate corporate overheads to the districts. the proposal had been rejected on the grounds that the allocation bases were arbitrary and that such expenses could not be controlled at the district level.Q5.28% of his base salary. make specific recommendations to improve the system? The key issue in the case is that the incentive compensation system does not motivate district managers to make decisions which are consistent with the strategy of Quality Metal Service Center (QMSC) because it is tied to the district¶s target ROA. for each district was calculated based on current inventory replacement values. This may motivate him to not proceed with the purchase even if the proposal of the Sales Manager. shows that the acquisition results to a positive NPV and thus. A few years earlier. Ms. Evaluate Quality¶s incentive compensation system. should there be a charge for income taxes? Should corporate overheads be allocated to districts? Should profits be computed on the basis of historical costs or on the basis of replacement costs? Evaluate these issues from the standpoint of their motivational impact on the district managers? No. should be sent to the home office for approval. Does the present system motivate district managers to make decisions which are consistent with the strategy of the firm? If not. This happens because the asset base increases with the new equipment and will exceed the target for 1992. from 11. while computing district profits for performance evaluation purpose did not charge for income taxes. So profit should be computed on the basis of historical costs and performance.

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