MANAGEMENT PLANNING & CONTROL SYSTEMS

TRIMESTER - V

PADAMSINGH ENTERPRISES LTD (A)

After attending a top level seminar on Management Controls, Padamsingh Kalantri, the Managing Director of Padamsingh Enterprises Ltd., was concerned about the way the performance in his company was traditionally evaluated in terms of Return on Sales and called in his Chief Accountant, Mr. Potey to try and report the results of the application of the new concept of Return on Investment to each of the companys plants. Padamsingh Enterprises has three plants manufacturing and selling the following lines : Plant I Plant II Plant III : : : A line of mechanical toys Stainless steel novelties A range of electrical appliances for homes and offices

All the three plants and the general administrative building are located on the same premises near Pune. Although each plant manager is responsible for the sales of his products, the company maintains a team of senior sales force to promote the products of all the three plants. Addressing himself to the task, Mr. Potey developed the performance report of the three plants as given in Exhibit I. While preparing this report, Mr. Potey assured himself (1) that he followed what he considered the fundamental accounting principles, and (2) that he clarified every point so that his report could be easily understood and appreciated. On receiving Mr. Poteys report, Mr. Kalantri convened a meeting attended by the following : Mr. Padamsingh Kalantri : Mr. Potey : Mr. Kantilal : Mr. Kini : Mr. Godse : In the Chair Chief Accountant Manager Plant I Toys Manager Plant II Steel novelties Manager Plant III Appliances

Mr. Padamsingh

Gentlemen, we want to try out a new concept of performance evaluation. I believe it will be in the larger interests of our company and what is good for the company should also be good for each of the plants. As we discuss the concept, I expect constructive criticism and active participation by you all. Before we begin, Mr. Potey will briefly present the findings of his analysis under the new concept.

Mr. Potey

When we are in business, we invest funds, we effect sales and we earn profits. In fact the three elements investment, sales and profits are integral aspects of the business and are equally important. If we relate profit to investment (ROI) we get another picture. This is precisely what has happened in the Appliances and Novelties Plants. Because the investment base is greater in the Appliances Plant, its ROI becomes less although its Return on Sales is higher. Further, although the Return on Sales of Novelties is the lowest, its ROI is about equal to that of the company because the investment is low in that Plant. So, you say my Plants performance is the lowest. I do not agree with you. No doubt, the direct investment in my plant is the highest of all; it does not mean that my plant should be allocated a higher proportion of the companys investments in marketable securities and in the shares of associate companies. This jugglery of figures may be all right for Accountants, but is certainly unfair to us in Plant III. This not any jugglery. I have tried to use the most logical basis of allocation. Talking about logical allocations, I am confused. What is the logic in allocating the investment in warehouses, delivery equipment, and administration building on the basis of sales? I have a question on these allocations. The liabilities should have been deducted not on the basis of total investment but on the basis of operating costs because .. Wait a minute, the allocation of combined selling expenses on the basis of sales of our plant is clearly unfair because as you know, our novelties sell like hot cakes and company sales force do not spend any of their time on our products. Further, we require practically no technical assistance from the companys executive staff. Well then, why not I also question the allocation of selling expenses. Our average order is much larger than those of the other divisions, resulting in lower accounting and clerical costs per rupee of sales. Therefore, rupee sales volume should not be the basis of allocation. I just discovered that you have included assets under construction in my investment base before I earn any income on them, and you compare the ROI of my plant with that of other plants. Is not such a comparison distorted?

Mr. Godse

Mr. Potey

Mr. Padamsingh

Mr. Kantilal

Mr. Kini

Mr. Godse

Mr. Kini

Mr. Godse

That reminds me of the investment in my plant which is the newest in the company and is therefore, relatively higher than the other divisions. How can you meaningfully compare the return on new investments with the return on old investments without removing the distortions? Talking about distortions in performance, I am not yet clear in my mind as to how we use this ROI in evaluation. To be able to evaluate we need a standard to compare with. Do you propose to compare the ROI of one plant with that of another? If that is going to happen, I can only say you are going to equate Toys with Appliances.

Mr. Kini

Mr. Kantilal

You have used ROI as a measure of current yearly performance or profitability. But I am afraid such a measure does not fully reflect the long run performance. For example, in our plant we spend considerable amounts each year on sales and promotion of Toys, but the effect of all that is not immediately reflected in that years sales. We slowly build up our brand name, goodwill, dealer support, quality reputation and things of that type which are bound to pay off in the years to come. Likewise we spend on developing new Toys call it R&D and on building a strong sales organization which is vital for this line of products. There are two aspects of this development expenditure : (1) It pulls the ROI down in the year in which it is incurred, and (2) it has the potential of increasing the ROI of the plant in future years. How does your ROI concept take this into consideration? My goodness! I thought the ROI concept would be simpler than Return on Sales. What do you think about all this Potey? I am thinking about all this and I want to think some more before we meet again. Before we adjourn, what about the parts we supply at cost to the Toy Plant? -----------

Mr. Padamsingh

Mr. Potey

Mr. Godse

PADAMSHRI ENTERPRISES LTD (A) Divisional Return on Sales and on Capital Employed Rs. in crores DIVISIONS Stainless Steel Appliances Total Novelties 130.0 88.0 42.0 190.0 128.0 64.0 520.0 342.0 178.0

Description

Basis of Allocation

Mechanical Toys

Sales Cost of Production Gross Profit Less Selling & Admin Exp Direct Division Management Division Accounting Selling Advertising & Promotion Delivery Sub total Allocated Combined Selling & Promotion General Advertising Company Management Company Administration General Sub - total Total Selling & Expenses Net Profit before Tax Return on Sales

200.0 128.0 72.0

1.6 1.0 19.2 2.8 4.0 28.6

1.4 0.6 11.6 2.0 2.8 18.4

1.4 1.2 16.0 3.0 5.0 26.6

4.4 2.8 46.8 7.8 11.8 73.6

Sales Sales Sales Sales Sales

18.2 1.2 1.5 1.3 1.2 23.4 52.0 20.0 10.00%

11.8 0.6 1.0 0.8 0.6 14.8 33.2 8.8 6.77%

18.0 1.2 1.5 1.3 1.2 23.2 49.8 14.2 7.47%

48.0 3.0 4.0 3.4 3.0 61.4 135.0 43.0 8.27%

Admin

Capital Investment (average annual) Direct Cash Receivables Inventories Assets under Construction Machinery & Equipments Plant Sub-total Prodn.cost Dir. Invst. Allocated Dir. Invst Cash Sales Marketable Securities Sales

0.4 18.0 26.0 0.0 28.0 46.0 118.4

0.8 8.2 17.0 6.0 12.0 14.0 58.0

0.5 19.8 42.0 0.0 40.0 60.0 162.3

1.7 46.0 85.0 6.0 80.0 120.0 338.7

3.8 2.2 14.0 9.2 0.7

2.6 1.0 6.0 6.0 0.5

3.6 2.8 18.0 8.8 0.7

10.0 6.0 38.0 24.0 1.9

Investment in associate Sales companies Warehouses Delivery equipment Admin bldg Sub-total Total Capital employed Less : Liabilities Shareholders investment Return on investment Turnover of Investment

3.8 33.7 152.1 51.8 100.3 13.15% 1.31

2.5 18.6 76.6 24.2 52.4 11.49% 1.70

3.7 37.6 199.9 64.2 135.7

10.0 89.9 428.6 140.2 288.4

7.10% 10.03% 0.95 1.21

PADAMSHRI ENTERERISES LTD. (B)

Reflecting on the battery of views expressed in the last meeting. Mr. Potey was almost overpowered by the bombshell as he called it. However, he regained confidence in himself and decided to develop a different strategy in preparing the notes for the next meeting. He was able to thrash out many of the issues raised at the last meeting to his satisfaction but in regard to the question of valuation of goods and services supplied by one plant to another, he was not sure of the one generally accepted practice. He did considerable homework on the subject and finally came up with three approaches which he decided to leave open for discussion at the forthcoming meeting. For developing the three approaches Mr. Potnis carefully assembled the following data pertaining to the interplant transfer of goods and services. At present the Appliances Plant supplies parts of the value of Rs.32 crores at its cost to the Toy Plant. The break up of the cost is : Direct Materials : Labor & overheads : Rs.26 crores 6 ---------

The direct hourly rate works out to Rs.2.0 per hour and the overhead rate is 100% of direct labor cost. The Appliances Plant works at capacity. The total direct labor in the Appliances Plant is Rs.25 crores and overheads amount to Rs.25 crores. If any time they have spare capacity, they do undertake job work which is charged to outside parties at actual cost of labor and overhead plus 50% as profit margin. About Rs.8 crores of the inventory carried by the Appliances Plant represents the work undertaken for the Toys Plant. The parts received from the Appliances Plant were further processed in the Toys Plant spending an amount of Rs.8 crores per year before they are finally sold for Rs.62 crores at a gross profit margin of about 35%. These parts in the past were purchased from an outside

firm M/s. MKK Engineering at material cost plus Rs.12 per labor hour inclusive of their margin. In view of the high cost involved, the Toy Plant asked the Appliances Plant to expand its facilities so as to take care of all the internal requirements. On the basis of the above data, Mr. Potey developed three approaches as outlined in Exhibit 1 and presented them at the meeting inviting questions involving clarifications of the concepts described therein. He listed the following as the potential areas of trouble shooting and was fully prepared to face the situation. Areas of Trouble Shooting 1. Under Approach A, is it not fair to include an element of profit also to the capital interest charge? 2. As the capital interest gets added to the cost at each plant the total cost finally charged to the receiving plant gets inflated with the result it may be difficult to sell the final product if the market is competitive. Is it not true? 3. Under Approach B how do you determine the opportunity cost if the product were such that it could not be obtained from any other source?

4. Once a commitment is made to buy from one plant internally, really speaking the plant which buys in-effect loses the opportunity of exploring alternative sources on cost considerations because the physical facilities once set up in the supplying division cannot be dismantled in another year. 5. In Approach C, the margin is allocated to the divisions in the proportion of standard costs. It is not clear whether the margin is also standard margin or actual margin ? 6. Where you cannot identify the margin on the parts supplied by one division what should be done? For example, the parts used in the fabrication of the finished products form a small part of the total cost of finished products and the margin is obtained on the sale of the finished products. 1. Where the goods supplied by one division to another are never sold to outside parties i.e., when goods are consumed internally as capital expenditure, what should be done? 8. Under Approach B, where a division has the opportunity of buying from outside at a very low price and yet it continues to buy from one of the divisions of the company at the opportunity cost price, the supplying division whose costs are greater than the low market price is bound to lose. Will it be fair to the supplying division and to the company?

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