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.)

1
 strategy formation process in a firm

Internal Analysis Environmental Analysis

Technology/Marketing/ Competitor/Customer/
Manuf./Supply Chain Supplier/Laws/Political

S.W O.T.

K.S.F.

“Strategy”

Strategy implementation process

2
 Why Management control in an
organization
Ambitious
Growth plan

Well planned & controlled strategy

execution
Achieve sustainability & inorganic
growth in a competitive market place.

3
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.

4
 Management Control Focuses
primarily on Strategy Implementation.

Strategy Goals, Strategies, Policies

Formulation

Management
Implementation of Strategies
Control

Task
Control 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 organization’s goal are also
met: Goal Congruence.
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Cybernetic framework for management
control.
External &
Internal Decision Maker Goal ( Desired
environment Result)
To which
organization
has to respond

Sensors Perception Comparator

(Actual
result )

Behavior
Effectors
Choice
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 Conceptual model of Management
Control Systems.

Assessor:
Control Device

Detector: Effector: Behaviour

Alteration, if needed.

Controlled Entity Desired performance

by the management

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 Building blocks for
Management Control System

(Financial )

Performance
Controls
Strategy

Organization H. R.
Structure Practices

Culture

• 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
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 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 SYSTEMS

SHARED
VALUES

SKILLS STYLE

STAFF

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 Internal Control process
“A process effected by an entity’s 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. It’s 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 entity’s 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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15
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 management’s 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 entity’s
objectives.

21
Management of an organization is responsible for
creating wealth for it’s 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.

22
Market value per share = Market value of equity
Number of shares
outstanding

Book value per share = Invested equity capital

Number of shares outstanding

23
 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.

Management
“Rules” Periodic decision
Goals & Other
Strategies Info.
•Task Control Review
•Safeguards “Reward”
Y
Strategic Resp Center Reports: Analysis/
Budgeting Performance
OK?
Planning “A vs P” Actions

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 Production
Budget Budget

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

R&D , Marketing , Distribution , Customer Service Administrative

cost
Budgeted Income Statement
Financial Capital Cash Budget Budgeted cash flow
Budget 28
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
Vol Av selling price Revenue
Product 1 X Y XxY
Product 2 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 company’s
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 for a quarter
Total Credit Sales = 90,00,000 for the quarter
Days In Sales = 90

 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 .

Dell’s 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 division’s ability to meet current

obligation.
•Firms ability to use long term solvency borrowing funds.
•Efficiency with which the firm is utilizing it’s 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 re-
allocating 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 .
Actual Variance flexible Sales –Vol Static
budget Variance budget
___________________________________________________________
Units 10000 0 10000 2000U 12000
sold
Revenue 1,25,00,000 5,00,000F 1,20,00,000 24,00,000U 1.44 Cr

Dir Mat 62,16,000 2,16,000U 60,00,000 12,00,000F 72 L

D-M-L 19,80,000 3,80,000U 16,00,000 3,20,000F 19.2 L

Mfg O/H 13,05,000 1,05,000 U 12,00,000 2,40,000 F 14.4 L

Total 95,01,000 7,01,000U 88,00,000 17,60,000F
1,05,60,000
Cont 29,99,000 2,01,000 U 32,00,000 6,40,000U 38.4 L
Margin
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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 .
It’s 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 .
42
Inventory turn over = COG Sold / Av Inventory

Average collection (Av Debtors / Credit sales )x 365

Period =

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.
44
 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.

45
Responsibility centres for
Management Control

46
 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.

47
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 centre’s output and
attainment of its objectives; i.e. how well is the
centre achieving its objectives.

48
 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.

49
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.

50
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.

51
 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.

52
Revenue Centre ( Sales Department ) Traditional view
Inputs not related to
Outputs

Revenue
Centre
Input (money Output (money
only for direct revenue)
Costs incurred)

Contemporary view : Profit center : Since it’s 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
53
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. 54
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 .

55
 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;.

56
 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 manager’s performance are measured
on the profit objective they achieve. ( Profit target )
In an organization all products / category are treated
as independent profit centre.

57
Profit & Investment Centre ( Independent BU)
Inputs are related to
Outputs

Profit
Centre
Input (money Output (money
as costs) in profits)

Inputs are related to

Capital Employed

Investment
Centre
Input (money Output (money
as costs) in profits)
58
 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.

59
• 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
BU’s 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

61
 Measurement of Profitability of profit center

Income statement: Control-level Possibilities

Revenue 1000 Most elementary form of “Profit”
less Cost of Sales 780 – with no control responsibility
for “Fixed Costs”.
( Variable Cost)
Contribution Margin 220
less Fixed Exp. 90
“Direct” Profit 130 Discretionary cost for shared
less “Controllable” Corp Charge 10 services.
“Controllable” Profit 120
less Corp. allocation 20 Real “Profit” of profit center for
shaping Corporate structure
Profit before Taxes 100
less Taxes 35
Integrated form of “Profit” –
Profit After Taxes 65 highest level of responsibility. 62
 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.

63
 Human Behaviour
&
Management Control

64
 Organizational Behaviour & Management
Control
Human Behavior must create a favorable
organizational climate for Management control to
influence employees towards achieving a firm’s
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 .

65
 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

Organization’s
Objective SBU’s financial &
Define KRA Non financial
For SBU Performance
Measure through
Well defined KPI Individual employee
Define KRA Performance through
For Employee P.A system 66
“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.

67
 Intrinsic:
– Organizational Culture: the set of common
beliefs& values explicitly accepted.

– (Management) Style

– Power distance & centers

– Communication & Perceptions

– Cooperation & Conflict:

68
 Concept of Transfer pricing
for management control system.

69
 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

70
 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.
71
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. ( Arm’s 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 subunit’s 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.
73
 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.
74
 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 arm’s length pricing policy.

Any exception to this should be a subject matter of close

scrutiny, proper disclosure and effective accountability.
 
75
 Transfer price manipulation (TPM) is fixing
transfer price on non-market basis which generally
results in saving the total quantum of organization’s
tax by shifting accounting profits from high tax to
low tax jurisdictions. The implication is moving of
one nation’s 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.

76
 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)
77
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 .

78
Types of transactions between MNE’s 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.

79
 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.
80
 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.

81
 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).

82
    4.The aforesaid disclosure are to be given in the
Director’s 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.Director’s certificate of compliance on Transfer

Pricing

83
·       Under an agreement of Organization for
Economic Co- operation & Development (OECD)
world’s leading industrialized countries, have stated
their acceptance of the arm’s-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.
84
85
Birch paper company Case 6.2

Divisions :Thomson Northern Southern Timber

Div Div Div Div

Custom made RM
boxes & label.

Liner board
& corrugated box

86
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 B’s
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 B’s 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 ?
87
 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 5,00,000
VC = 1 50 000
Sales O/H = 1,00,000
Total Cost = 6,50,000
unit cost = 65 ( if sells internally )
Market
Price = 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 A’s 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 Petroleum’s ( 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 unit’s 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 @ full cost @ Negotiated

with 10% margin Price
Transport unit
17,600 19200
Revenue 210X100=21000 (120+10+30)x1.1
12000 12000
Purchase cost 120x100= 12000
1000
VC ( 10X100) 1,000 1000
3000 3000 3000
F.C 30 x100
Unit operating 5000 1,600 3,200
income
Refining Unit 29000
29000 29000
Revenue(580 x 50) 21000 17600 19200
Transferred in cost 4000 4000 4000
VC 3000
3000 3000
FC
Operating Income 1000 4400 2800 92
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 @ full cost @ Negotiated

with 10% margin Price
Transport unit
17,600 19200
Revenue 210X100=21000 (120+10+30)x1.1
12000 12000
Purchase cost 120x100= 12000
1000
VC ( 10X100) 1,000 1000
3000 3000 3000
F.C 30 x100
Unit operating 5000 1,600 3,200
income
Refining Unit 29000
29000 29000
Revenue(580 x 50) 21000 17600 19200
Transferred in cost 4000 4000 4000
VC 3000
3000 3000
FC
Operating Income 1000 4400 2800 94
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 arm’s 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 arm’s 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 arm’s 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 arm’s 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 $430/Th $432/Th
Thomson West paper Eire paper

Cost material 280 90

cost ( 70%)
Label 25 30
Other cost 95 164.5 ( 254.4 - 90
(comparable internal cost )
Total cost $ 400 284.5

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 costs—they 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
make them! 109
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 manufacturer’s 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
growth—can 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
Cost ( Rs)
Products
Category Selling sales Reverse packaging Total
overhead promotion logistics
Lifebuy 110 0 40 120 270

Liril 200 80 140 120 540

Lux 150 40 80 145 415

Dove 140 40 60 165 405

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. Liril’s cost getting heavily subsidized by
lifebouy. 112
 Profit center cost Management

Peanut butter costing to Activity based costing

Revenue of a Bill of Cost activities Profit /Loss

Profit center - of profit center = 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 Bill of Cost activities Profit /Loss
Profit center - of profit center = incurred at
( Price X Volume ) profit center

114
 Total
Direct Costs Direct Costs
+
In Direct Cost Pool Cost Allocation Bases Bill of activities
cost
Total Hrs X Hrly
production Rate
no. of trips X Cold chain
transport Cost
Specialized material
handling equipments hired

115
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.
SeeVision’s selling price for S3 is far more than that
offered by its immediate rival’s 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 it’s
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 CCL5 Lens
Volume : 60000 Units 15000 Units
Per unit Per unit
Material 1,12,50,000 187.5 67,50,000 450
Manufacturing 60,00,000 100 19,50,000 130
labour
Total 287.5 580
Indirect cost 1,80,00,000 300. 58,50,000 390
Total cost 3,52,50,000 587.5 1,45,50,000 970

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) CCL5 Lens ( 15000 units)
per unit per unit
Revenue: 3,78,00,000 630 2,05,50,000 1370
Cost 3,52,50,000 587.5 1,45,50,000 970
Operating 25,50,000 42.5 60,00,000 400
Income
Profit margin% 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 CCL5
Volume 60000 15000
Output/batch 240 50
No of batch 250 300
Setup time 2 hr 5hr
Per batch
Total Hr 500 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 CCL5 Lens
Volume : 60000 Units 15000 Units
Per unit Per unit
Material 1,12,50,000 187.5 67,50,000 450
Manufacturing 60,00,000 100 19,50,000 130
labour
Mold cleaning 12,00,000 20.00 15,00,000 100
& Maint
Total dir cost 1,84,50,000 307.5 1,02,00,000 680
Indirect cost
Design 13,50,000 22.5 31,50,000 390
Setup 7,50,000 12.5 22,50,000 150
Mold 45,00,000 75 18,75,000 125
Operation
Shipping 4,05,000 6.7 4,05,000 27
Distribution 26,10,000 43.5 13,05,000 87
Admin 19,24,530 32.1 6,25,470 41.7
Total cost 2,99,89,530 499.8 198,10,470 1320.7
123
Investment center Decisions

124
ROI Problems
 Feed the Dogs ( Over Investment )
 Starve the Stars ( Under Investment )

High

STAR PROBLEM
CHILD
Relative
Market
Growth CASH COW DOG
Low
High Market Share Low
125
 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 forward-
looking 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 EVA’s popularity parallels the 1980s
“total quality management” trend. Like quality, value is
every employee’s 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 Company’s
Economic Value Added (EVA)?
Only following the information is needed for a
calculation of a company’s EVA:

•Company’s Income Statement

•Company’s 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 550.00

Interest : 200.00
Income Before Tax 350.00
Income Tax (40%) 140.00

Net Profit After Taxes 210.00

Add Interest 200.00
NOPAT 410.00
134
Illustration: Balance Sheet

Current Assets Current Liabilities

Cash 50.00 Accounts Payable 100.00
Non
Receivable 370.00 Accrued Expenses 250.00 Interest
Inventory 235.00 Short-Term Debt 300.00 Bearing
Liabilities
Other Current
Assets 145.00
Total current Assets 800.00 Total Current Liabilities 650.00
Fixed Assets Long-Term Liabilities
Long-Term Debt 760.00
Land 650.00 Total Long-Term Liabilities 760.00
Equipment 410.00 Capital (Common Equity)
Other Long
Term Assets 490.00 Capital Stock 300.00
Total Fixed Assets 1,550.00 Retained Earnings 430.00
YTD Profit/Loss 210.00
Total Equity Capital 940.00
TOTAL ASSETS 2,350.00 TOTAL LIABILITIES 2,350.00
135
CCRDebt = [Debt/(Debt+Equity)](1-t) Where t represents the
company’s 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 Company’s Capital (C)
Company’s Capital (C) are

Total Liabilities less Non-Interest Bearing Liabilities:

Total Liabilities 2,350.00

less
Accounts Payable 100.00 [ No interest cost incurred on these
Accrued Expenses 250.00 Liabilities. ]
----------------------------------
Capital : 2,000.00

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 it’s 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 yield-
to-maturity rate for government bonds. In contrast, RP
reflects the risk resulting from investing in a company’s
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.

12 % - 18 % Moderate risk, established profitable

company with moderate fluctuation in
cash flow 18 % and more High business
risk

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 Product’s case that all financing will
be made using owner’s 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 Product’s income statement does
not show categories, such as Research & Development, market-
building 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 company’s 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 company’s progress in
achieving its strategic goals and in measuring
divisional performance. Other more forward-
looking 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

Control &
Compliance
Integrate Track , Measure &
Long term audit Financial and
Financial Initiate operational
goal necessary Performance
With key changes at
process business
Initiative operation
process Drive internal
& people Process using IT
level.

Clearly define
expectation

Set role models ,

examples
Within the
business 149
1. Creates a bridge between Strategy, KPI’s, 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 Company’s independent auditor, the
performance of the Company’s 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 Company’s 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

Company’s disclosures under “Management’s Discussion
and Analysis and Analysis of Financial Condition and
Results of Operations”, prior to the filing of the Company’s
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 Company’s 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
subsidiary’s financial statements particularly investment plans.

The minutes of the subsidiary’s 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 company’s 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 company’s 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
164