MANAGEMENT CONTROL SYSTEM

An Integrated Framework to drive an organization on a Growth track.

Recommended Text Book : Management Control Systems Robert Anthony & Vijay Govindrajan (11th /12th Edition.)
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strategy formation process in a firm

Internal Analysis Technology/Marketing/ Manuf./Supply Chain

Environmental Analysis Competitor/Customer/ Supplier/Laws/Political

S.W O.T. K.S.F.

Strategy
Strategy implementation process
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Why Management control in an organization

Ambitious Growth plan

Well planned & controlled strategy execution

Achieve sustainability & inorganic growth in a competitive market place.

Management control is a process of evaluating, monitoring and controlling of the financial resources committed for execution of growth strategy by management to ensure that management achieves the desired out put.

Management Control Focuses primarily on Strategy Implementation.

Strategy Formulation Management Control Task Control

Goals, Strategies, Policies

Implementation of Strategies

Performance of specific Tasks

Management control does not necessarily require that all actions are as per the previously determined Plan; It, however, requires inducing people to act in pursuit of own goals in ways that organizations goal are also met: Goal Congruence.

Cybernetic framework for management control.

External & Internal Decision Maker environment To which organization has to respond Sensors

Goal ( Desired
Result)

Perception
(Actual result )

Comparator

Effectors

Behavior Choice
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Conceptual model of Management Control Systems.

Control Device
Detector: Assessor:

Effector: Behaviour Alteration, if needed.

Controlled Entity

Desired performance by the management

Building blocks for

Management Control System
(Financial ) Controls Organization Structure Culture H. R. Practices

Performance

Org. Structure specifies creating roles, reporting relationships, responsibilities that shape decision making; Culture refers to the set of common beliefs, attitudes that guide management actions; HR Management drives performance related career progression , compensation which enable people to execute strategy more efficiently.
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Strategy

Management control Objective : 1.Build a culture of shared vision. ( Goal congruence ) 2.Build control measures on critical resources( Financial control) for sustained growth 3.Measure organizational performance using financial & non financial parameters. ( Balance Score Card .)
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McKinsey 7-S Framework to support control system Of an organization.

STRUCTURE STRATEGY SHARED VALUES SKILLS STYLE SYSTEMS

STAFF
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Internal Control process

A process effected by an entitys board of
directors, management and other personnel, designed to provide reasonable assurance regarding the achievements of objectives in the following categories: Effectiveness & efficiency of operations. Reliability of financial reporting. Compliance with applicable laws and regulations.
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Objective of Internal Control :

It can help achieve performance &

profitability targets.( Financial Guideline ) It can help prevent loss of resources. It can help ensure reliable financial reporting.
It can help ensure compliance with laws.

It can help an entity get to where it wants to go, ( Goal ) and avoid pitfalls and surprises along the way.
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 Internal control is a process. It is a means

to an end, not an end in itself. Internal control is effected by people. Its not merely policy manuals and forms, but people at every level of an organization. Internal control can be expected to provide only reasonable assurance, not absolute assurance, to an entitys management and board. Internal control is geared to the achievement of objectives in one or more separate but overlapping categories.

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Steps for Internal Control

Create Control Environment.

Define Risk Assessment process .

Create Control Activities.

( Who , when , how )

Monitoring. ( Control deviation at cost ,

expense , profit , investment , process defects , productivity )

Management Information system should form the back bone of internal control process to build decision support at management decision stage.
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Control Environment
Sets the tone of the organization.

The foundation for all other components.

It includes the integrity,ethical values and

competence of the people. Reflects managements philosophy & operating style,the way management assigns authority and responsibility and organizes and develops its people, and the attention and direction provided by the board of directors.

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Risk Assessment
Every entity faces internal &external risks.

Every entity sets objectives.

Risk assessment is the identification and

analysis of relevant risks to achievements of the objectives.

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Control Activities
The policies and procedures that help

ensure management directives are carried out. They help ensure that necessary actions are taken to address risks. Control activities occur throughout the entity at all levels and in all functions. They include activities such as approvals , authorization,reconciliations and segregation of duties.

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Information & Communication

Relevant information must be identified ,

captured and communicated in a form & timeframe that enables people to carry out their responsibilities. Information systems produce reports containing operational,financial and compliance related information that make it possible to run and control the business. Effective communication must occur in a broader sense,flowing down,across and up the organization.
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Monitoring
Internal control systems need to be monitored.

Types of monitoring:

- ongoing during the course of operations. - evaluation for which the scope and frequency will depend primarily on an assessment of risks and the effectiveness of ongoing monitoring procedures.

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Internal controls ,no matter how well designed and operated,can provide only reasonable assurance to management regarding achievements of an entitys objectives.

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Management of an organization is responsible for creating wealth for its shareholders. All management action & strategies are guided by SVC . shareholder's value . Shareholder Value Creation can be explained as excess of market value over book value. When MV is in excess of invested capital , MVA is said to be positive . Hence firm is said to have created value for its shareholder.

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Market value per share = Market value of equity Number of shares outstanding Book value per share = Invested equity capital Number of shares outstanding

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Formal Management Process. An idea or strategy is more glamorous and sexy compared to actual execution. When not executed well it just remain as a great idea.

Goals & Strategies

Other Info.

Rules
Task Control Safeguards

Periodic Review

Management decision
Reward

Y
Strategic Planning Budgeting
Resp Center Performance

Reports: A vs P

Analysis/ Actions

OK?

Revision

Measurement

N
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Budgeting & Budgetary Control.

Budgets are integral part of management control system . When administered systematically , budgets Promote Coordination & communication among sub units with the company.

Budget estimates the profit potential of a BU .

Provides framework for judging the performance

Creates motivation & involvement within managers .

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It provides monetary & non monetary indicators to the managers for effective decision making in line with the goal of the BU. It is reviewed periodically by the concern managers for necessary action & strategy. It forms the basis for Financial budgets like :

Capital expenditure budget Budgeted balance sheet Cash Budget & Budgeted cash flow statement .
Revenue budget
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An operating budgets is prepared for a fiscal year . It is split in to half yearly, quarterly, or monthly for easy administration & control. If the business is highly driven by seasonality , it is desired that the budgets are made for peak & lean season. Once approved , it is only changed under specific conditions. Budgets are compared with the actual financial performance achieved during the period for taking necessary financial control.

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Revenue Budget
Inventory Budget Production Budget

Direct Manufacturing labor, Material cost , Manufacturing overhead COG Sold Budget

R&D , Marketing , Distribution , Customer Service Administrative cost

Budgeted Income Statement Financial Capital Budget Cash Budget Budgeted cash flow
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Preparation of master budgets : operation Budget, created after taking & having debated sufficiently with the line managers & functional managers are used for preparing master budget . Outcome of operation budgets is budgeted income statement for the fiscal year. Cash budget is prepared from this statement , which is used for planning capital expenditure budget , Cash flow statement & budgeted balance sheet . The decision of the organization as how much to source fund ( Source of fund : External equity , Debt, Reserve fund ) for capital expenditure can only be known form budgeted income statement .
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Operational budgets include : I. Revenue budgets : Projected Sales Projected volume ( Non Financial )
FY08-09 Product 1 Product 2 Vol Av selling price Revenue X Y XxY A B AxB ___________________________

Total Since input for revenue budgets is drawn form sales forecast, an in accurate sales forecast leads to upset the budget plan of the BU.
Control : Measured periodically by revenue center head ( Sales & Marketing Head ) . BU finance head reports the variation in plan Versus actual to the profit center head for necessary action. Action : Revise overhead budgets , non financial budgets etc.
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Days Sales Outstanding (DSO) is the number of days it takes to collect your receivables in a given amount of time. It is an important financial

indicator as it shows both the age of a companys accounts receivable and the average time it takes to turn those receivables into cash. DSO reveals how many days worth of
sales are outstanding and unpaid within a specific period.( credit term) Having a high DSO is harmful for the business . As a Rule of Thumb, DSO delinquent balances should not exceed 33% of the selling terms. If terms are 30 days, then an acceptable DSO or the Safe Collection Period is 40 days. Less the money that is being tied up in accounts receivable, the more money that can be used for company investment or dividends. It provides a good understanding of the effectiveness of the account receivable collection policies and staff in charge of executing on those policies.
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The most common method is to take the Total Receivables divided by the Total Credit Sales multiplied by Days in Sales. Example: Total Receivables = 50,00,000 Total Credit Sales = 90,00,000 Days In Sales = 90 for a quarter for the quarter

DSO= (50,00,000/90,00,000) x 90 = 50 Total Credit Sales- The number should only include only credit sales. Total Receivables- The total receivables in the Days Days in Sales- Is a period in time as defined by the following: Quarterly (3 months)- 90 days Bi-Annually (6 months)- 180 days Annually (1 year)- 365 days
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The Days Payable Outstanding (DPO) calculates the total time it takes a business to pay back its creditors. The days payable outstanding formula is a

financial ratio and is calculated by taking the accounts payable divided by the cost of sales and then multiply that number by the total number of days.

DPO is calculated on a quarterly and yearly basis.

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Why was Dell Computers so cash rich?

In 2007 Dell's accounts payable was 10,430 (number in millions) and the cost of sales was 47,433. ( calculated annually ) Calculate the days payables outstanding (DPO) for Dell ? (10,430/47,433) * 365 = 80.25. This means that it takes Dell roughly 80 days to pay back its creditors.

Dell leveraged on internet to transform its business online . As a result 100% of it B2C transactions were through online payment . In B2B business, it operated on 15 days credit sales. Average DSO ( annualized ) for Dell in 2007 was 10 days .
Dells supply chain practice ensured 90 days credit from all vendors as a corporate policy.

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Days Sales Of Inventory - DSI A financial measure of a company's performance that gives an idea of how long it takes a company to turn its inventory (including goods that are work in progress, if applicable) into sales. Generally, the lower the DSI the better. The average DSI varies from one industry to another. How is DSI calculated: DSI = Inventory Cost of Sales X 365

The days sales in inventory tells you the average number of days that it took to sell the average inventory held during the specified one-year period. It can also be interpreted as the number of days of sales that was held in inventory during the specified year. The calculation of the days sales in inventory is: the number of days in a year (365 or 360 days) divided by the inventory turnover ratio.
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Ratios are most powerful tool financial analysis & control. It helps to know the divisions ability to meet current obligation. Firms ability to use long term solvency borrowing funds. Efficiency with which the firm is utilizing its asset in generating sales revenue Overall operating efficiency & performance of the firm. Control role of ratios: Ratio analysis raise pertinent questions on a number of managerial issues. It provides basis to investigate such issues in micro detail. To prevent from being misled by ratio , managers must do trend analysis & competitive analysis before arriving at any conclusion.
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What mangers should focus while using Ratios : Profitability analysis : Is return on equity due to ROI , Financing mix or capitalization for reserves. What is the trend of profitability & compare it with like market factors . Is it improving because of better utilization of resources or curtailment of expenses. Asset utilization : How effectively the company utilize the assets in generating sales. Are the levels of debtors & inventories relative to sales acceptable ,given the competitive environment & operating efficiency.

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Liquidity analysis : What is the level of CA relative to CL . Is it acceptable , given the nature of the business. How fast it converts it current asset in to cash. What is the desired mix of debt & equity . Accordingly , the managers may use : Liquidity ratio Leverage ratio Activity Ratio Profitability ratio

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Flexible budgets must help the mangers to evaluate & control variances in price & efficiency with respect to cost measures. Management by Exception is the practice of concentrating on areas not operating as expected. Information gained out of variances are used for reallocating resources & seek manager explanation for early correction. Budgeted revenue & budgeted costs are compared against the actual in the same budget period. On the basis of this, a deviation statement ( flexible budget statement ) is prepared & reported to the concern managers. This also forms a basis for variable compensation component of the managers & his team popular in industry as MPLC.
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If budgeted selling price is Rs 1200 /unit & budgeted variable costs are Rs 880 & budgeted Fixed costs are 2,60,000. for planned volume of 12,000 units. At the end of the month sale is 10000, the variance analysis can be as follows:

Direct Material cost = Rs 600/unit Direct labour = Rs 160/ unit Overhead = Rs 120 /unit

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Sales- Volume Variance analysis report for Q1 April 2008 .

flexible Sales Vol Static budget Variance budget ___________________________________________________________ 10000 0 10000 2000U 12000 Actual Variance 5,00,000F 2,16,000U 3,80,000U 1,05,000 U 7,01,000U 2,01,000 U 90,000U 2,91,000U 1,20,00,000 24,00,000U 1.44 Cr 60,00,000 12,00,000F 72 L 16,00,000 3,20,000F 19.2 L 12,00,000 2,40,000 F 14.4 L 88,00,000 17,60,000F 1,05,60,000 32,00,000 6,40,000U 38.4 L 27,60,000 4,40,000 0 6,40,000U 27.6 L 10.8L
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Units sold Revenue 1,25,00,000 Dir Mat 62,16,000 D-M-L 19,80,000 Mfg O/H 13,05,000 Total 95,01,000 Cont 29,99,000 Margin Fixed cost 28,50,000 operating 1,49,000 income

The total sales of cement division of India Cement is Rs 6,40,000 & its gross profit margin is 15% . The division is operating at sustained current ratio of 2.5 . Its Current liabilities: Rs 96000 Current asset 1 Inventories Rs 48000 II Cash Rs 16000 Average inventory carried by the division : Rs 1,20,000 Inventory turnover : 5 Opening balance of debtors is 80,000 & competitive analysis by ETIG shows that average collection period for cement business is 60 days . BUH has a guideline for maximizing he profit . While there is much scope to increase the price , he feels division should operate more efficiently & eliminate operating inefficiency. You have been asked to analyze & prepare a financial report .
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Inventory turn over = Average collection Period =

COG Sold / Av Inventory (Av Debtors / Credit sales )x 365

Av debtors = (OP Debtor + Cl Debtors) / 2 For closing balance of debtor , find Current asset . Less Inventory & Cash

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 Management control is the process by which managers at all levels ensure their team align themselves to the goal of the BU, division or organization referred as Goal congruence or Goal alignment Challenges of building good control system are: Unlike the simpler systems, the standard is not pre-set , keep changing in dynamic market Control requires coordination amongst individuals. The link between need for action and determining the action is not always clear; Much of control is self control.
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 Management planning & Control requires

to be done in 3 areas. The Environment focusing on the characteristics of organizations and individual behaviour; organizing for control and generic responsibility and control devices in the behavioural context;
The Process how control is effected within organizations; interactions, formal and informal, to effect control and systems:
Strategic planning for goal setting; Budget preparation; Execution & budgetary control; Evaluation and start of next cycle of control;

The Developments variations to the theme of Control.

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Responsibility centres for Management Control

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Responsibility centres
Decentralization, in contemporary Management Systems which leads to Responsibility Centres. A Responsibility Centre is a business unit that is headed by a business head responsible for planning & controlling of its assets to meet organizational goal in terms of revenue & profit maximization , cost effectiveness , process efficiency & people effectiveness.

Responsibility canter enjoys high degree of autonomy in decision making process.

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Objective of responsibility center incude planning & control of : Cost /Profit /Revenue : Monetary measure of the amount of resources used by a responsibility centre.

Efficiency: which is the ratio of outputs to inputs, or the amount of output per unit of input; i.e. least sacrifice of resources for obtaining the required output.
Effectiveness: is determined by the relationship between the responsibility centres output and attainment of its objectives; i.e. how well is the centre achieving its objectives.

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Responsibility accounting system to establish an incentive mechanism

To establish a scientific and rational enterprise level performance evaluation system, management responsibility is inseparable.
To ensure the attainment of enterprise goals, enterprise operation and management is divided according to the needs of the various responsibility (ie, the responsibility of units) called responsibility centers. Various responsibility centers have clear objectives and tasks to form supported by 'responsible budget' . The responsible budget is assessed through the 'responsibility accounting around each responsibility center. Responsibility accounting measure the results on the basis of predefined accounting norms & accountability of the management to ensure tight internal control system.
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Area of evaluation of Responsibility center is divided into Revenue center Expense centers, profit centers and investment centers. Assessment of revenue center would be on pre budgeted revenue plan for the business unit in line with the enterprise objective. Assessment of the the expense centers would be on pre budgeted cost (standard cost ) compared to actual expense thus to evaluate the performance of its cost control. The so-called liability cost, is to the responsibility of the Center for the object, with its scope of responsibility for the imputation of the cost, that is the center of all controllable costs. The performance evaluation of cost centers, not only related to the budget, but also quality of their work and service. The quality of work and service levels are difficult to quantify, but closely related expenses again. A cost center's controllable cost does not exceed cost estimates, only show that cost control performance, it is likely that the Center's work below the level of quality and service business program requirements.
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Investment Center have autonomy in the formulation of not only the price, but also short-term operational decision-making and certain investment decision-making power.

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Types Responsibility Centres:

1. Revenue Center: Outputs in monetary terms, inputs non-monetary ( MANAGER ACCOUTABLE FOR REVENUE OBJECTIVE )
2. Expense Center : Outputs non-monetary, inputs monetary (as costs) 3. Profit Center: Inputs & Outputs monetary (as expenses & revenues)

4. Investment Center: Profit centres + Investment made in them.

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Revenue Centre ( Sales Department ) Traditional view

Inputs not related to Outputs

Input (money only for direct Costs incurred)

Revenue Centre

Output (money revenue)

Contemporary view : Profit center : Since its performance is measured on revenue generated, profit earned , cost control. Management control on : Cost of sale :- sales return , in effective recovery management Low customer retention
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Expense Centres ( Manufacturing function)

Optimal Relationship can be established
Engineered Expense Centre

Input (money)

Output (physical)

Planned expense on RM Inventory: Capital expenditure planned on long term assets. Management control through : Monitoring planned production targets Rejection cost Down time cost Low productivity ( Benchmark standard versus actual ) High production cost : Excess overtime.

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Expense Centres
e.g. R & D Function & other service function Optimal Relationship cannot be established
Discretionary Expense Centre

Input (money)

Output (physical)

Monitoring & Evaluation of asset is relatively difficult : Long gestation period . No direct correlation Cost allocation under common overhead .

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Expense Centres: Control Characteristics

Budget Preparation:
For Engineered expense Centre, a proposed

operating budget focuses on efficiently performing

the task; For discretionary expense Centre, budget itself is

the start of the financial control process. There are

two approaches: o Incremental Budgeting & o Zero-based Reviews. Input Costs tend to be structural (semi-variable)

in nature, so short-term control is difficult;.

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Profit Centre
A department /division in an organization responsible for generating specified quantum of profit form the activities it performs. The performance of the department is judged in terms of the profit it booked and cost it incurred. The divisional managers performance are measured on the profit objective they achieve. ( Profit target ) In an organization all products / category are treated as independent profit centre.

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Profit & Investment Centre ( Independent BU)

Inputs are related to Outputs
Profit Centre

Input (money as costs)

Inputs are related to Capital Employed
Investment Centre

Output (money in profits)

Input (money as costs)

Output (money in profits)

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Profit Centres: General Considerations

At operating levels, all organizations are functionally
structured. Divisional managers are delegated the responsibilities of cost benefit decisions . Delegating responsibility to profit centre requires trade-offs between expenses & revenues, therefore pre-requisites are: relevant information for effecting the trade-offs

a device for measurement of effectiveness of

decisions.
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 Benefits of a Profit centre are:

Increased speed & quality of decision making

Greater delegation, better focus all around increased profit orientation: consciousness & measurement; Focused HR practices & resource: specializations and training specific information on performance of diverse resources better service to target Customers & markets.
>70% of multi-product Companies have adopted the Profit Centre format within the BU structure, with a focus on financial control as the primary method for strategy implementation;
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Drawbacks of Profit Center

Less top management control at operational end loss of cohesion within Organization: Sibling Rivalry increased short-term profit focus unbalanced, tactical poor and uncertain linkages between sub & overall optimization . additional costs due to redundancies.
Synergy & control trade-off imposes limitation on BUs autonomy

Product/Market independence/interdependence Financing/company-structure issues Share-holding, legal entity, global fit etc. PR, Brand-building, restructuring etc. Constraints on long-term issues: R&D, Investments, Systems

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Measurement of Profitability of profit center Income statement: Revenue 1000

less Cost of Sales ( Variable Cost) 780
Control-level Possibilities Most elementary form of Profit with no control responsibility for Fixed Costs.

Contribution Margin
less Fixed Exp.

220
90
Discretionary cost for shared services. Real Profit of profit center for shaping Corporate structure

Direct Profit 130 less Controllable Corp Charge 10

Controllable Profit
less Corp. allocation

120
20

Profit before Taxes

less Taxes

100
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Profit After Taxes

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Integrated form of Profit highest level of responsibility.

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Profit Centres:

Project Manufacturing Function:

Usually, an expense centre: but for a more balanced approach (Quality, on-time delivery etc.) and for aggressive standard setting, converted to Profit Centre by affixing a price to transfer (internal sale) goods; Though imperfect, the transfer price mechanism is pragmatic tool; Convenient when it has more than one customer;

Service & Support units:

service providing departments as profit centers to support make/buy decisions; Allows for competitive functional excellence build-up through aggressive standard setting; Allows for revenues (Outside Customers) if world-class levels of performance achieved.
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Human Behaviour & Management Control

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Organizational Behaviour & Management Control

Human Behavior must create a favorable organizational climate for Management control to influence employees towards achieving a firms Strategic Objective.

Formal & informal organizational System:

Strategy which radically influences Organization Structure and in turn, significantly affects design for Control System and its implementation is known as formal system .

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Formal organizational system for management Control.

Goal Congruence: Employees are led to take in their perceived self-interest in the interest of the firm: Actions in the best interest of the Organization

Organizations Objective Measure through Well defined KPI Define KRA For Employee

Define KRA For SBU

SBUs financial & Non financial Performance Individual employee Performance through P.A system

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Work Ethic: Norms of desirable behavior that exist in the society of which the Organization is a part of. Informal processes need to be recognized since they are loosely defined and are both intrinsic and extrinsic to an Organization.

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Intrinsic:
Organizational Culture: the set of common beliefs& values explicitly accepted. (Management) Style

Power distance & centers

Communication & Perceptions Cooperation & Conflict:
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Concept of Transfer pricing for management control system.

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Transfer Pricing A business practice followed for satisfactorily

profit accounting of the transfer of goods & services between profit centers in a Company.
. Objective of TP practice are :
relevant trade-off between in-company costs and revenues for economic performance of individual profit centers. towards better goal congruence i.e. designed system must support better SBU profit & accountability

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Benefit of T.P to the organization:

Identify the unit contribution to the total profit. Encourage profit consciousness among managers Measure management performance. Maximize operating unit profitability Identify the areas of inefficiency Build value addition Facilitate & maximize de centralized decision making process Exercise effective management control.
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Transfer price can be either Market-based, i.e. equivalent to what is being charged in the outside market for similar goods, or it can be non-market based. More often transfer pricing is non-market based. Prominent issues of T.P are
Divisional mangers tend to become more divisional profit centric than corporate profit centric. Lengthy disagreements on the T.P policy . Whenever the market prices are not available to bench mark , the decision process of convincing the T.P is difficult . De motivation arises when personal performance of a division gets affected due to improper T.P 72

There are three methods for determining T.P Market based TP. Top management of the company choose to follow the price for the product or service in accordance with the comparable market price information. ( Arms length pricing policy ) Cost based TP. It is determined on the basis of the cost of producing the product or service. Full cost of the product is assessed upon calculating all variable & fixed cost . It may use actual cost or budgeted cost & include markup ( margin ) as return on subunits investment. ( when comparable price is not available ) Negotiated T.P : Subunits are given the freedom & autonomy to negotiate the price in line with the ability to earn profit. In a highly volatile market , such practice is common in large enterprises.
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Transfer price and international business .

Transfer pricing is inherent in the way the global economy is structured with sourcing and consuming destinations being different, with numerous organizations operating in multiple countries and most importantly due to varying tax and other laws in different nations. Nations have to achieve a fine balance between loss of revenues in the form of outflow of tax and making their country an attractive investment destination by giving flexibility in Transfer Pricing. As every country want to increase in total inflow through tax or FDI, countries will need to enact legislations on their own. Thus, achieving an understanding , suiting their conditions and pattern of international transactions, according to the stage of economic development they are in, are some of the challenges companies are facing as they become a global economic community.
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Issues related to transfer of economic resources in international business.

Transfer pricing practices adopted in international business transaction by the companies could be a possible tool for evasion/avoidance of tax . A transfer pricing cases, causing transfer of economic resources to the related party at less than the comparable price raises issues such as : evasion/avoidance of tax liability . Transfer of resources to and from the related party should comply to arms length pricing policy. Any exception to this should be a subject matter of close scrutiny, proper disclosure and effective accountability.
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Transfer price manipulation (TPM) is fixing transfer price on non-market basis which generally results in saving the total quantum of organizations tax by shifting accounting profits from high tax to low tax jurisdictions. The implication is moving of one nations tax revenue to another. A similar phenomenon exists in domestic markets where different states attract investment by under cutting Sales tax rates, leading to outflow from one state to another.
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MOTIVATIONS FOR TPM It is not just the Corporate Tax differential that induces organizations to manipulations in Transfer Pricing.

Some of the other reasons are:

High Customs Duty leading to under-invoicing of goods. Restriction on Profit Repatriation leading to over-invoicing of raw materials, etc transferred from parent country, hence compensating for locked forex. Ownership Restrictions ( E.g. Insurance Sector 26%) since this leads to less than justified returns on the technology or knowledge invested in the JV, MNEs circumvent it through over charging on royalties for technology, etc. There can be various other similar motivations for TPM. The transactions most likely disputed by Governments are Administration & Management Fees, Royalties for intangibles and transfer of finished goods for resale. (Source: E & Y Survey)
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From a business perspective, following dimensions influence the decision to TPM , while doing transaction between two countries.
1. Payment of Compensation for services delivered in other country . 2. 2.Low cost of operation raw material in manufacturing country . 3. High Tax slab in operating country .

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Types of transactions between MNEs that come under the scope of TPM are :
1 Charges for administrative or management services . 2 Royalties and other charges for intangibles. 3 Transfer pricing for goods for resale. 4 Financing transactions. 5 Charges for technical services.
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EFFCECTS OF TPM ON NATIONS

1.Loss of Government Tax and Custom Duty revenues. Loss of tax revenues in this form leads to a burden on the rest of the population through over taxation and/or borrowings by the Government, which becomes essential to meet expenditure requirements.

2. TPM also leads to distortions in Balance of Payments between the host and home country.
3. Another implication is on the location of international production and employment. Given the objective of maximization of global profits, MNEs will open subsidiaries where production is most profitable, where tax burden is less.
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CHECKING TRANSFER PRICING MANIPULATION

Transfer price accounting transaction is an integral part of Accounting Standards, (AS) 18. AS-18 came in the effect for the accounting periods commencing on or after 1st April, 2001. The Standard provides for disclosure of related party relationships, and certain particulars of transactions with the related parties, in case of listed companies.

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Under this rules, cost statement of each service (segment-wise and elements of cost) is Required to be given. The cost statement is also required to be submitted to the Audit Committee under Section 292A of the Companies Act, 1956.

Separate audit of record of transactions (related party) and expression of opinion thereon. The record of transactions in the prescribed format to form part of the audit report. 1. Verification of the report on implementation on transfer pricing, by the separate auditor. 2. Disclosure in Directors Report/Annual Report: 3 .Transfer Policy Statement (a comprehensive and detailed one).

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4.The aforesaid disclosure are to be given in the Directors Report along with those required under Accounting Standard 18 (disclosures as per AS 18 form part of accounts and, therefore, would require to be re-disclosed in the Directors Report.) 5.Directors certificate of compliance on Transfer Pricing

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Under an agreement of Organization for Economic Co- operation & Development (OECD) worlds leading industrialized countries, have stated their acceptance of the arms-length standard for setting inter-company transfer prices and have set out guidelines for methods that should be used in adhering to the standard.

The Policy States that a specific transfer pricing methods to be used for different classes of transactions with different parties with special emphasis on those transactions where a Comparable Uncontrolled Price/Transaction (CUP/CUT) method could not be adopted.
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Birch paper company Case 6.2

Divisions :Thomson Div Northern Div Southern Timber Div Div RM

Custom made boxes & label.

Liner board & corrugated box

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Division A manufactures certain item and transfers it to div B which in turn add value and sell it in open market at Rs 200 per unit. The variable cost incurred by division B is Rs 30 per unit. B buys goods from A at Rs 120 per unit. As Bs competition dropped the price to Rs 180 , Division B wants division A to reduce the price to Rs 100 per unit. The competition of B meanwhile approached division A and were ready to pay Rs 115 for per unit. The cost details of Div A is as follows : Fixed cost : Rs 5 lac VC per unit Rs 15 Production capacity : 10000 units If div A decides to sell to Bs competition , sales and distribution overhead estimated is Rs 10 per unit . Competition has assured to take 90% output of division A. As a profit center head of Division A what decision would you take . At what TP will you sell items to division B ?
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What action will you initiate from the point of view of SBU head to ensure the corporate objective is being met ? What TP methodology will you recommend. ? Div A Fixed Cost = Rs VC = Sales O/H = Total Cost = unit cost = Market Price =

5,00,000 1 50 000 1,00,000 6,50,000 65 ( if sells internally ) 115

Case 1 : If 90% output is sold to open market & 10 % internally (115 75 =45) Case 2 : If 100 % sold to division B at Rs 100, ( 100- 65 = 35 )
88

Case 3 : Div As ability to earn profit = Rs 115 65 =50x 10000 = Rs 5,00,000 Profit difference /unit on the basis of market price : 5,00,000-4,40,000 =60,000/10000 =6 Loss difference 115 6 = Rs 109/unit 109 x 10000 = 10,90,000 Less 65 x 10000 = 6,50,000 Profit = 4,40,000

89

Illustration: Hindustan Petroleums ( H.P) refinery & transportation unit operates as independent profit center. Transport unit supplies crude oil to refinery unit, which is processed & transformed in to gasoline by refinery unit. It takes two barrels of crude to convert one barrel of gasoline. Variable cost is computed for each division & fixed costs are based on budgeted annual output of each division. Transportation Unit : Purchase cost of crude oil from oil field: Rs 120/barrel VC /barrel Rs 10.00 FC/barrel Rs 30.00 Pipeline capacity to transport crude oil/day is 40,000 barrels .

90

Refinery Unit : Refinery units selling price is Rs 580/barrel. VC /barrel Rs 80.00 FC/barrel Rs 60.00 Operating capacity /day = 30000 barrels ( Consumes an average of 10000barrels /day supplied by transport division & 20000 barrels /day bought from outside @ R210/barrel locally. Using all three methods calculate TP, & compare the operating income of H.P Suggest what should be an appropriate managerial decision .

91

Operating Income of HP with 100 barrels under alternative T.P Methods. @ Market Price Transport unit Revenue Purchase cost
VC ( 10X100) F.C 30 x100 210X100=21000 120x100= 12000 1,000 3000 5000

@ full cost with 10% margin

17,600 12000 1000 3000 1,600

@ Negotiated Price
19200
12000 1000 3000 3,200

(120+10+30)x1.1

Unit operating income Refining Unit Revenue(580 x 50) Transferred in cost

VC

FC Operating Income

29000 21000 4000 3000

29000 17600 4000 3000 4400

29000 19200 4000 3000 2800

92

1000

When market price of crude oil fluctuates( upward or downward) , it will have an impact on the operating income of transportation unit. In such a given market situation, both division would like to negotiate an acceptable & stable long term TP. price . The price per barrel of crude oil drops to Rs 160.

93

Operating Income of HP with 100 barrels under alternative T.P Methods. @ Market Price Transport unit Revenue Purchase cost
VC ( 10X100) F.C 30 x100 210X100=21000 120x100= 12000 1,000 3000 5000

@ full cost with 10% margin

17,600 12000 1000 3000 1,600

@ Negotiated Price
19200
12000 1000 3000 3,200

(120+10+30)x1.1

Unit operating income Refining Unit Revenue(580 x 50) Transferred in cost

VC

FC Operating Income

29000 21000 4000 3000

29000 17600 4000 3000 4400

29000 19200 4000 3000 2800

94

1000

Methods Of Computation T.P shall be determined by any of the following methods, being the most appropriate method, having regard to the nature of transaction or class of transaction, namely :(1) Comparable Uncontrolled Price Method (2) Resale Price Method (3) Cost Plus Method (4) Profit Split Method (5) Transactional Net Margin Method (6) Any other basis approved by the Central Government, which has the effect of valuing such transaction at arms length price.
95

Comparable Uncontrolled Price (CUP) Method : ( Negotiated Transfer price.) The price charged or paid in a comparable uncontrolled transaction or a number of such transactions shall be identified , between the related party transaction and the comparable uncontrolled transactions or between the enterprises entering into such transactions, which could materially affect the price in the open market. The adjusted price shall be taken as arms length price.

96

The resale price method would normally be adopted where the seller adds relatively little or no value to the product or where there is little or no value addition by the reseller prior to the resale of the finished products or other goods acquired from related parties. This method is often used when goods are transferred between related parties before sale to an independent party.

97

Cost based Method : The total cost of production incurred by the enterprise in respect of goods transferred or services provided to a related party shall be determined. The amount of a normal gross profit mark-up to such costs arising from the transfer of same or similar goods or services by the enterprise or by an unrelated enterprise in a comparable uncontrolled transaction or a number of such transactions, shall be determined. The total cost of production referred to above increased by the adjusted profit mark-up shall be taken as arms length price.
98

The cost plus method would normally be adopted if CUP method or resale price method cannot be applied to a specific transaction or where goods are sold between associates at such stage where uncontrolled price is not available or where there are long term buy and supply arrangements or in the case of provision of services or contract manufacturing.

99

Profit Split Method : The combined net profit of the related parties arising from a transaction in which they are engaged shall be determined. This combined net profit shall be partially allocated to each enterprise so as to provide it with a basic return appropriate for the type of transaction in which it is engaged with reference to market returns achieved for similar types transactions by independent enterprises. The residual net profit, thereafter, shall be split amongst the related parties in proportion to their relative contribution to the combined net profit.
100

This relative contribution of the related parties shall be evaluated on the basis of the function performed, assets employed or to be employed and risks assumed by each enterprise and on the basis of reliable market data which indicates how such contribution would be evaluated by unrelated enterprises performing comparable functions in similar circumstances. . The profit so apportioned shall be taken into account to
arrive at an arms length price . This method would normally be adopted in those transactions where integrated services are provided by more than one enterprise or in the case multiple inter-related transactions which cannot be separately evaluated.
101

Transactional Net Margin Method : The net profit margin realised by the enterprise from a related party transaction shall be computed in relation to costs incurred or sales effected or assets employed or to be employed by the enterprise or having regard to any other relevant base. The net profit margin realised by the enterprise or by an unrelated enterprise from a comparable uncontrolled transaction or a number of such transactions, shall be computed having
102

regard to the same base. This net profit margin shall be adjusted to take into account the differences, if any, between the related party transaction and the comparable uncontrolled transactions or between the enterprises entering into such transactions, which could materially affect such net profit margin in the open market .
This method would normally be adopted in the case of transfer of semi finished goods.; distribution of finished products where resale price method cannot be adequately applied; and transaction involving provision of services.

103

Northern Division
Price : $480/ Th Thomson $430/Th West paper $432/Th Eire paper

Cost material 280 cost ( 70%) Label 25 Other cost 95

Total cost $ 400

90
30 164.5 ( 254.4 - 90 (comparable internal cost ) 284.5

Loading 20% margin on cost , Thomson division can be much more competitive than the prevailing market price , if it is able shed the excess unproductive cost. Using market price as a bench mark , 430- 284.5 = 145.5 is the potential market opportunity for Thomson division.

104

ACTIVITY BASED COSTING/ MANAGEMENT

105

Traditional financial reporting does not reveal a separate profits and losses of products or customers for three reasons: (1) It examines and reports department-level expenses but not the work-efforts within a department that matter .
(2) The in-direct product and non-base-service costs are usually allocated using broad averaging approach ( Peanut Butter costing ) but not traced to respective products or base services . (3) Customer-related activity costs are rarely isolated and directly charged to the specific customer segments causing these costs. As business units have been restructured in profit center & product , service & customer diversity increased, above approach proved to be inaccurate method of assigning .
106

Today, selling, merchandising, and distribution costs are no longer trivial coststhey are sizable. For example, it now costs General Motors more to sell its trucks and cars than to make them! A high-tech semiconductor manufacturer discovered that it was making roughly 90 percent of its profits from 10 percent of its customers. That alone is not unusual, but it was losing money on half of its customers. Upon discovering this, this manufacturer could alter their own approach to lessen the loss so that a fair profit could be attained.

107

Traditional financial reporting does not reveal the separate profits and losses of products or customers for three reasons: 1) It examines and reports department-level expenses but not the work-efforts within a department that matter.

2) The in-direct product and non-base-service costs are usually allocated but not traced to products or base services.
3) Customer-related activity costs are rarely isolated and directly charged to the specific customer segments causing these costs.
108

Therefore , in financial accounting terms, the costs for selling, advertising, marketing, logistics, warehousing, and distribution are immediately charged to the time period in which they occur. Consequently, the accountants are not tasked to trace them to channels or customer segments.

As selling, merchandising, and distribution costs are sizable, a firm must allocate the expenses to the respective head to analyze the true profit generated by the product line. As an example, For General Motors it costs more to sell its trucks and cars than to 109 make them!

As an example, a high-tech semiconductor manufacturer performed ABC/M and discovered it was making roughly 90 percent of its profits from 10 percent of its customers. That alone is not unusual, but it was losing money on half of its customers. Upon discovering this, this manufacturer explained to some of its unprofitable customers how those specific customers could alter their own behavior to lessen the workload on the manufacturer so that a fair profit could be attained. The remaining unprofitable customers were fired, asked to take their business elsewhere because it was evident their was little hope their sales would cover their costs. Thus manufacturers sales levels dipped, but profits tripled.
110

The lesson from this example is that there is a quality of profit associated with sales volume and product mix. There should be a focus on the customer contribution margin devoid of simplistic cost allocations.
There is a red-flag warning from this: Two traditionally popular measures market share and growthcan potentially be dangerous in the new order of competition. This is because organizations now realize that there can be a sizable unprofitable segment of products, service lines, and customers in the mix.

111

Over costing Under costing Products Category Cost ( Rs) Selling sales Reverse packaging Total overhead promotion logistics 270 110 0 40 120 200 150 140 80 40 40 140 80 60 120 145 165 540 415 405

Lifebuy
Liril

Lux
Dove

Total 600 160 320 550 1630 Average 150 + 40 + 80 + 137.5 = 407.5 Cost allocation Cost analysis revels that average apportion of cost leads to cross subsidization. Lirils cost getting heavily subsidized by lifebouy. 112

Profit center cost Management

Peanut butter costing to Activity based costing Profit /Loss incurred in profit center 1. Identify the direct & indirect cost associated to product , service , staff & cost involved in serving specific customer of the division. ( Cost Pool) 2. Identify cost allocation bases for allocating indirect cost to cost base. 3. Identify total indirect costs associated to each base. 4. Compute cost per unit of product or service.
113

Revenue of a Profit center -

Bill of Cost activities of profit center =

Revenue of a Bill of Cost activities Profit center - of profit center ( Price X Volume )

Profit /Loss = incurred at profit center

114

Direct Costs

Total Direct Costs + Cost Allocation Bases Total Hrs X Hrly production Rate no. of trips X Cold chain transport Cost Specialized material handling equipments hired
115

In Direct Cost Pool

Bill of activities cost

See Vision has been a pioneer in cosmetic contact lenses. The produce simple lens called S3 & cosmetic contact lens called CCL 5. Company has historically simple costing system . Annual production of lenses are as follows : 60000 S3 & 15000 CCL5 . As a practice , total material & manufacturing costs are divided by total budgeted production volume. Cost elements for : S3 ( Rs) Cost elements for CCL5 ( Rs) Material : 1,12,50,000 67,50,000 Manufacturing 60,00,000 19,50,000 Labour To allocate the following costs to S3 & CCL5 , company uses manufacturing labour- hour as an allocation base. Estimated manufacturing labour hour is 39750 Hrs. ( 30000 M-L Hr for S3 & 9750 M-L-Hr for CCL5 )
116

Total budgeted cost for salary , Administration, Sales , distribution Customer service , promotion, adds to Rs 2,38,50,000. SeeVisions selling price for S3 is far more than that offered by its immediate rivals price of Rs 530. Management countered it by saying that the technology & process are inefficient in manufacturing & distribution. However management is not convinced as they have years of experience in S3 . They often make process improvement . Kaizan initiative is used to drive manufacturing process. However management has less experience in CCL5 as it started it recently . Management is surprised to know that the market finds its CCL5 prices fairly competitive. At its price point , organization earns large profit margin on CCL5. Ever since See Vision restructured its business as profit center units, business managers of S3 are de motivated & has low morale. 117

Revenue breakup from S3 & CCLS5 is s follows : S3 Rs 3,78,00,000 & CCL5 Rs 2,05,50,000 Business unit head is less certain about the accuracy of the costing system & measuring the overhead resources used by each type of lens. The finance manager of the division has been empowered with any system of cost control to improve the profitability of the division. 1. As a finance manger of the division , how would you approach the issue. 2. What additional inputs are required by you to convince CFO & Business unit head. 3. At what operating margin is S3 currently doing their business.
118

S3 Lens Volume : 60000 Units

Per unit Material 1,12,50,000 187.5 Manufacturing 60,00,000 100 labour Total 287.5 Indirect cost 1,80,00,000 300. Total cost 3,52,50,000 587.5

CCL5 Lens 15000 Units

67,50,000 19,50,000 Per unit 450 130 580 390 970

58,50,000 1,45,50,000

Indirect cost rate = 2,38,50,000/ 39750= Rs 600 For S3 : 600 X 30000= 1,80,00,000/60000=300 For CCL5 :600 X 9750 = 58,50,000/15000=390

119

S3 Lens

( 6000units)

Revenue: Cost Operating Income Profit margin%

CCL5 Lens ( 15000 units) per unit per unit 3,78,00,000 630 2,05,50,000 1370 3,52,50,000 587.5 1,45,50,000 970 25,50,000 42.5 60,00,000 400
6.74 29.19

120

Activity based costing approach for See Vision. Manufacturing labour hour has little effect on overhead resources . Identifying indirect cost pool : Set up activity at production for manufacturing each type of lens . Resources required for CCL5, like molding machines , cleaning time , small batch production adds to more resources per setup. Set up data for : S3 CCL5 Volume 60000 15000 Output/batch 240 50 No of batch 250 300 Setup time 2 hr 5hr Per batch Total Hr 500 1500
121

Set up data for : S3 Volume 60000 Output/batch 240 No of batch 250 Setup time 2 hr Per batch Total Hr 500

CCL5 15000 50 300 5hr 1500

Total cost of set up comprises of cost of process engineers , quality engineers , supervisors , & equipment used adds to Rs30,00,000 . (30,00000/2000) x 500= 750,000 (30,00,000/2000) x 1500= 22,50,000
Other cost drivers identified having impact are packing & shipment cost , distribution cost , administration cost .
122

S3 Lens Volume : 60000 Units Per unit Material 1,12,50,000 187.5 Manufacturing 60,00,000 100 labour Mold cleaning 12,00,000 20.00 & Maint Total dir cost 1,84,50,000 307.5 Indirect cost Design 13,50,000 22.5 Setup 7,50,000 12.5 Mold 45,00,000 75 Operation Shipping 4,05,000 6.7 Distribution 26,10,000 43.5 Admin 19,24,530 32.1 Total cost 2,99,89,530 499.8

CCL5 Lens 15000 Units 67,50,000 19,50,000 15,00,000 1,02,00,000 Per unit 450 130 100 680

31,50,000 390 22,50,000 150 18,75,000 125 4,05,000 13,05,000 6,25,470 198,10,470 27 87 41.7 1320.7
123

Investment center Decisions

124

ROI Problems
Feed the Dogs

( Over Investment ) Starve the Stars ( Under Investment )

High STAR PROBLEM CHILD DOG Low
125

Relative Market Growth Low

High

CASH COW

Market Share

EVA Basic Premise Managers are obliged to create value for their investors . Investors invest money in a company because they expect returns . There level of return expected by the investors is called capital charge . Capital charge is the average equity return on equity markets; investors can achieve this return easily with diversified, long-term equity market investment . Thus creating less return (in the long run) than the capital charge is economically not acceptable (especially from shareholders perspective) Investors can also take their money away from the firm since they have other investment alternatives
126

EVA is the gain or loss that remains after assessing a charge for the cost of all types of capital employed. What an accountant calls profits in an income statement includes a charge for the debt capital employed which is commonly referred to as interest expense. However, an income statement does not include a charge for the equity capital that was employed during the accounting period. Therefore, EVA goes beyond conventional accounting standards by including a provision for the cost of equity capital. The cost of equity needs to be factored into business investment decisions in order to enhance shareholder value.

127

Although EVA is couched in financial analysis, its primary purpose is to shape management behavior.
EVA can be used as a performance measure to evaluate an overall company, a division within a company, a location within a division, or an individual manager. By setting goals, EVA can become a motivational tool at various levels of management. EVA can also be used in downsizing decisions.

128

EVA and Corporate Culture Paying managers for performance is a backward-looking practice, but the capital markets assign value on a forwardlooking basis. Therefore, companies that pay for past performance may be unwittingly paying their managers to undermine value creation.

When EVA-related performance measurement process is implemented throughout your company, all affected employees need to understand the goal, as well as how their actions contribute to meeting it. In this respect, the EVAs popularity parallels the 1980s total quality management trend. Like quality, value is every employees responsibility. To this end, management and employee training programs are a crucial component of any EVA plan. 129

130

Economic Value Added represents value generating power of an organization. There are three factors to compute EVA. (i) Adjusted earning before interest after tax. (ii) Weighted average cost of capital and (iii) Capital Employed.
A change in any of the three factors will change EVA. The various factors affecting the EVA can be understood from the chart given . The chart helps the management in concentrating attention on different factors affecting value. It is clear from the above chart that top management can take appropriate decision to create value in the following way:

Deploy more and more funds to those activities where the amount of NOPAT generated by the activities is greater than the cost of capital.
131

Withdraw fund from those activities wherein the amount of NOPAT is less than the amount of cost of capital unless there is strategic decision to lose in one activity in order to gain in another. Improve the operating efficiency of the organization to retain the same amount of NOPAT by possible continuous reduction of existing capital or / and continuous increase of the existing NOPAT with existing amount of capital. Optimize the capital structure through optimum debt equity mix in order to have the lowest possible weighted average cost of capital (WACC).

132

What is Needed to Calculate Companys Economic Value Added (EVA)? Only following the information is needed for a calculation of a companys EVA: Companys Income Statement Companys Balance Sheet

133

Illustration: Income Statement Net Sales 2,600.00 Cost of Goods Sold 1,400.00 SG&A Expenses 400.00 Depreciation 150.00 Other Operating Expenses 100.00 Operating income Interest : Income Before Tax Income Tax (40%) 550.00 200.00 350.00 140.00

Net Profit After Taxes 210.00 Add Interest 200.00 NOPAT 410.00
134

Illustration: Balance Sheet

Current Assets Cash 50.00 Receivable 370.00 Inventory 235.00 Other Current Assets 145.00 Total current Assets 800.00 Fixed Assets Land 650.00 Equipment 410.00 Other Long Term Assets 490.00 Total Fixed Assets 1,550.00 Current Liabilities Accounts Payable Accrued Expenses Short-Term Debt

100.00 250.00 300.00

Non Interest Bearing Liabilities

Total Current Liabilities 650.00 Long-Term Liabilities Long-Term Debt 760.00 Total Long-Term Liabilities 760.00 Capital (Common Equity)

TOTAL ASSETS 2,350.00

Capital Stock 300.00 Retained Earnings 430.00 YTD Profit/Loss 210.00 Total Equity Capital 940.00 TOTAL LIABILITIES 2,350.00
135

CCRDebt = [Debt/(Debt+Equity)](1-t) Where t represents the

companys tax rate.

+
CCREquity = Equity/(Debt+Equity) Capital Cost Rate (CCR) will be : Assume owners expect 13 % return* for using their money because less are not attractive to them, therefore, company has 940/2350 =40% (or 0.4) of equity with a cost of 13%.
Company has also 60% debt and assume that it has to pay 8% interest for it. So the average capital costs would be: CCR ** = Average Equity proportion * Equity cost + Average Debt proportion * Debt cost = 40% * 13% + 60% * 8% = 0.4 * 13% + 0.6 * 8% = 10%
136

** Note: if tax savings from interests are included (as they should if), then CCR would be: CCR = 40% * 13% + 60% * 8% *(1- tax rate) = 0.4 * 13% + 0.6 * 8% * (1 - 0.4) = 8.08 % (Using 40 % tax rate)

Companies paying high taxes and having high debts may have to consider tax savings effects, by adding the tax savings component later in the capital cost rate (CCR)

137

Identify Companys Capital (C) Companys Capital (C) are Total Liabilities less Non-Interest Bearing Liabilities:

Total Liabilities 2,350.00 less Accounts Payable 100.00 Accrued Expenses 250.00 ---------------------------------Capital : 2,000.00

[ No interest cost incurred on these Liabilities. ]

138

EVA = NOPAT - C * CCR = 410.00 - 2,000.00 * 0.10 = 210.00 This company created an EVA of 210. Note: this is the EVA calculation for one year. If a company calculates & reports EVA in its quarterly report ,then its capital costs will be : Q1 Capital costs for 3 months: 3/12 * 10% * 2,000 = 50 Capital costs for 4 months: 4/12 * 10% * 2,000 = 67 Q2 Capital costs for 6 months: 6/12 * 10% * 2,000 = 100 Q3 Capital costs for 9 months: 9/12 * 10% * 2,000 = 150

139

To estimate the cost of capital for a small company, a method derived from the WACC estimation and the CAPM( capital Asset Pricing ) model is called cost of capital cost rate CCR . . The CCR for a small company can be estimated as follows: CCRDebt = Prime Rate + Bank Charges Where the average Bank Charges for small companies vary between one to two percent per year. CCREquity can be estimated as follows: CCREquity = RF + RP Where RF is the risk free investment rate and RP is the risk premium investment rate. RF can be estimated using a yieldto-maturity rate for government bonds. In contrast, RP reflects the risk resulting from investing in a companys equity. The riskier the investment, the higher the RP.
140

General Guide line for RP 6 % and less Extremely low risk, established profitable company with extremely stable cash flows. 6 % - 12 % Low risk, established profitable company with relative low fluctuation in cash flow. Moderate risk, established profitable company with moderate fluctuation in cash flow 18 % and more High business risk

12 % - 18 %

141

Income statement

Balance Sheet

142

Cost of Capital Rate (CCR) Assume that the current Prime Rate is eight percent and that Pitt Products is paying one percent by borrowing new money, independent if they ask for short-term or long term debt.

143

In this case, the pre-tax CCRDebt will be : CCRDebt = Prime Rate + Bank Charges = 8% + 1% = 9% Assume that the yield-to-maturity of 10-year government bonds is five percent. Pitt . Products management, believe that RP of seven percent is adequate because its business .

CCREquity = RF + RP = 5% + 7% = 12% CCR = 9 % (600/(600+600))(1- 0.4) + 12 % (600/(600+600)) = 2.7% + 6% = 8.7%

144

Assume that in Pitt Products case that all financing will be made using owners equity. Thus, no interest expenses will be incurred. However, with this financing approach, tax savings are lost. Therefore ,its profit will increase by the interest savings component, less the tax shield on interest expenses. Tax shield, or tax savings, on interest expenses can be estimated by multiplying the interest expenses by the tax rate. In addition, owner-managers stated that they regard approximately 50,000 of their salaries as a kind of compensation for their investment in the company. Because Pitt Products income statement does not show categories, such as Research & Development, marketbuilding outlays, employee training, unusual write-offs or gains, there were no further adjustments needed. Hence e NOPAT is NOPAT = (Net Profit after Tax + Total Adjustments) Tax Savings on Adjustments = 192 + (42 +50) (42 +50) x 0.4 = 248.4

145

Calculation of EVA is must for internal reporting for all investment centers.
Permanent EVA improvement has to be the main management objective EVA has to be calculated periodically (at least every three months) Changes in EVA have to be analyzed EVA development is the basis for a companys financial and business policy Try to improve returns with no or with only minimal capital investments .

Invest new capital only in projects, equipment, machines able to cover

capital cost while avoiding investments with low returns Identify where capital employment can be reduced Identify where the returns are below the capital cost; divest those investments when improvements in returns are not feasible .

146

Creating an EVA-based Compensation Plan The four primary factors in creating a compensation plan are: 1. Align management performance and shareholder value. 2. Create strong wealth leverage, so employees work hard and make difficult decisions. 3. Employee retention risk, particularly in bear markets or industrial slumps, when performance-based compensation may decrease through no fault of the employee. 4. Cost of the compensation plan to shareholders.

147

Like other financial performance measures, such as return on investment (ROI), EVA, on its own, is inadequate for assessing a companys progress in achieving its strategic goals and in measuring divisional performance. Other more forwardlooking measures, often non-financial in nature, should be included in regular performance reports to provide early warning signs of problem areas . Another problem of EVA is that it is distorted by inflation, with the result that it cannot be used during inflationary times to estimate actual profitability. A superior measure, the adjusted EVA, corrects for inflationary distortions .

148

INVESTMENT CENTER MANAGEMENT MILESTONES.

Enjoy leadership in business

Integrate Long term Financial goal With key process Initiative

Initiate necessary changes at business operation process & people level.

Control & Compliance Track , Measure & audit Financial and operational Performance

Drive internal Process using IT

Clearly define expectation Set role models , examples Within the business

149

1. Creates a bridge between Strategy, KPIs, operational

measures and outcome measures. 2. Includes non-project Investments. 3. Focuses on organizational affordability and aggregate risk. 4 . Brings together the process disciplines of integrating Finance, operational efficiency and outcome measures linked to business objectives and Change Management . 5. Assists Executives to make choice and trade-offs between competing and non competing options to align with business goals.

150

151

Monetary Value Added 1. Accounting Value 2. Economic Value Added 3. Market Value Added Non-Monetary Value Added 1. Human Resource Value Added 2. Intellectual Value Added Customer Satisfaction 1. Price 2. Satisfaction Index 3. Quality 4. Service Learning & Growth 1. Technology Leadership 2. Research and Development 3. Market Leadership 4. Cost Leadership

152

Concept of Balance Score Card.

153

Competence and Learning perspective.

154

Audit : Compliance & Control Why Audit ? For Compliance & Control . What is to be audited ? 1.Financial performance Audit 2. Process Audit 3 People Audit 4 Knowledge Audit

155

The Audit Committee is created by the Board of Directors of the Company to assist the Board in maintaining the integrity of the financial statements and internal controls of the Company, the qualifications, independence and performance of the Companys independent auditor, the performance of the Companys internal audit function, compliance by the Company with legal and regulatory requirements; prepare the audit committee report that Securities and Exchange Commission rules require to be included in the Companys annual statement.

156

Financial Statements; Disclosure and Other Risk Management and Compliance Matters 1. The Audit Committee shall review and discuss with management: (a) the annual audited financial statements, including the Companys disclosures under Managements Discussion and Analysis and Analysis of Financial Condition and Results of Operations, prior to the filing of the Companys quarterly financial statements. (b) any analyses or reports prepared by management, the internal auditors and/or the independent auditor setting forth significant accounting or financial reporting issues and judgments made in connection with the financial statements, including critical accounting estimates analyses of the effects of alternative GAAP methods on the financial statements
157

(c) the effect of regulatory and accounting initiatives or actions, off-balance sheet structures and related party transactions on the financial statements of the Company; and any major issues regarding accounting principles and financial statement presentations, including any significant changes in the Companys selection or application of accounting principles .

158

With regard to material non-listed subsidiary companies Clause 49 stipulates the at least one independent director of the holding company to serve on the board of the subsidiary. The audit committee of the holding company should review the subsidiarys financial statements particularly investment plans.
The minutes of the subsidiarys board meetings should be presented at the board meeting of the holding company and the board members of the latter should be made aware of all significant (likely to exceed in value 10% of total revenues/expenses/assets/liabilities of the subsidiary) transactions entered into by the subsidiary.

159

Internal Audits : Compliance with management controls System and process improvements Financial impropriety and fraud audits Due diligence for acquisitions and investments

160

The areas where Clause 49 stipulates specific corporate disclosures are: (i) related party transactions; (ii) accounting treatment; (iii) risk management procedures; (iv) proceeds from various kinds of share issues; (v) remuneration of directors; (vi) a Management Discussion and Analysis section in the Annual report discussing different heads of general business conditions and outlook; (vii) background and committee memberships of new directors as well as presentations to analysts. In addition a board committee with a non-executive chair should address shareholder/investor grievances. .
161

The CEO and CFO or their equivalents need to sign off on the companys financial statements and disclosures and accept responsibility for establishing and maintaining effective internal control systems. The company is required to provide a separate section of corporate governance in its annual report with a detailed compliance report on corporate governance. It should also submit a quarterly compliance report to the stock exchange where it is listed. Finally, it needs to get its compliance with the mandatory specifications of Clause 49 certified by either the auditors or practicing company secretaries.

162

The system of internal control An internal control system encompasses the policies, processes, tasks, behaviors and other aspects of a company that, taken together: facilitate its effective and efficient operation by enabling it to respond appropriately to significant business, operational, financial, compliance and other risks to achieving the companys objectives . This includes the safeguarding of assets from inappropriate use or from loss and fraud, and ensuring that liabilities are identified and managed; help ensure the quality of internal and external reporting. This requires the maintenance of proper records and processes that generate a flow of timely, relevant and reliable information from within and outside the organization; help ensure compliance with applicable laws and regulations, and also internal policies with respect to the conduct of business.
163

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