Q.1) Explain briefly features of an IDEAL management control system?
Management control is a process of assuming that resources are obtained and used effectively and efficiently in the accomplishment of the organization’s objectives. It is a fundamental necessity for the success of a business and hence from time to time the current performance of the various operations is compared to a predetermined standard or ideal performance and in case of variance remedial measures are adopted to confirm operations to set plan or policy.
Some of the features of MANAGEMENT CONTROL SYSTEM are as follows:
Total System: MANAGEMENT CONTROL SYSTEM is an overall process of
the enterprise which aims to fit together the separate plans for various segments as to assure that each harmonizes with the others and that the aggregate effect of all of them on the whole enterprise is satisfactory.
Monetary Standard: MANAGEMENT CONTROL SYSTEM is built around a
financial structure and all the resources and outputs are expressed in terms of money. The results of each responsibility centre in respect to production and resources are expressed in terms of a common denominator of money.
Definite pattern: It follows a definite pattern and time table. The whole
operational activity is regular and rhythmic. It is a continuous process even if the plans are changed in the light of experience or technology.
Coordinated System: It is a fully coordinated and integrated system.
Emphasis: Management control requires emphasis both on the search for
planning as well as control. Both should go hand in hand to achieve the best results.
Function of every manager: Manager at every level as to focus towards future
operational and accounting data, taking into consideration past performance, present trends and anticipated economic and technological changes. The nature, scope and level of control will be governed by the level of manager exercising it.
Existence of goals and plans: MANAGEMENT CONTROL SYSTEM is not
possible without predetermined goals and plans. These two provide a link between such future anticipations and actual performance.
Forward looking: MANAGEMENT CONTROL SYSTEM is on the basis of
evaluation of past performance that the future plans or guidelines can be laid down. Management Control involves managing the overall activity of the enterprise for the future. It prevents deviations in operational goals.
Continuous process: It is a continuous process over the human and material
resources. It demands vigilance at every step. Deciding, planning and regulating the activities of people associated in the common task of attaining the objectives of the organization is a the primary aim of MANAGEMENT CONTROL SYSTEM.
People oriented: It is the managers, engineers and operators which implement
the ideas and objectives of the management. The coordination of the main division of an organization helps in smoother operations and less friction which results in the achievement of the predetermined objectives.
Scope of control
MANAGEMENT CONTROL SYSTEM is an important process in which accounting information is used to accomplish the organizations objectives. Therefore the scope of control is very wide which covers a very wide range of management activities.
Policies control: Success if a business depends on formulation of sound policies
and their proper implementation.
Control over organization: It involves designing and organizing the various
departments for the smooth running of the business. It attempts to remove the causes of such friction and rationalizes the organizational structure as and when the need arises.
Control over personnel: Anything that the business accomplishes is the result
of the action of those people who work in the organization. It is the people, and not the figures, that get things done.
Control over costs: The cost accountant is responsible to control cost sets, cost
standards, labour material and over heads. He makes comparisons of actual cost data with standard cost. Cost control is a delicate task and is supplemented by budgetary control systems.
Control over techniques: It involves the use of best methods and techniques so
as to eliminate all wastages in time, energy and material. The task is accomplished by periodic analysis and checking of activities of each department with a view to avoid an eliminate all non-essential motions, functions and methods.
Control over capital Expenditure: Capital budget is prepared for the whole
concern. Every project is evaluated in terms if the advantage it accrues to the firm. For this purpose capital budgeting, project analysis, study of cost of capital etc are carried out.
Overall control: A master plan is prepared for overall control and all the
Q.2 What is the concept of free cash flow as applied to organization. Explain process of computation?
We define net cash flow as net income plus non cash adjustment which typically means net income plus depreciation though that cash flows cannot be maintained over time unless depreciated fixed assets are replaced. So management is not completely free to use its cash flows however it chooses. Therefore we define the term free cash flows.
Free cash flow is the cash flow actually available for distribution to investor after the company has made all the investment in fixed assets and working capital necessary to sustain ongoing operation. When we studied income statement in accounting the emphasis was probably on the firm’s net income, which is accounting profit. However the value of company’s operation is determined by the stream of cash flows that the operations will generate now and in the future. To be more specific, the value of operation depends on all the future expected free cash flows, defined as after- tax operating profit minus the amount of new investment in working capital and fixed assets necessary to sustain the business. Therefore the way for managers to make their companies more valuable is to increase their free cash flow.
Uses of FCF:
1. Pay interest to debt holders, keeping in mind that the net cost to the company is the after tax interest expense.
2. Repay debt holders, that is, pay off some of debt. 3. Pay dividends to shareholders.
4. Repurchase stock from shareholders.
5. Buy marketable securities or other non operating assets.
In practice, most companies combine these five uses in such a way that the net total is equal to FCF. For example, a company might pay interest and dividends, issue new debts, also sell some of its marketable securities. Some of these activities are cash outflows (paying interest and dividends) and some are cash inflows (issuing debt and selling marketable securities), but the net cash flow from these five activities is equal to free cash flows.
Computation of free cash flows: Eg:
Suppose the company had a 2001 NOPAT of $170.3million and depreciation is only the non cash charge which is $100million then its operating cash flow in 2001 would be NOPAT plus any non cash adjustment on the statement of cash flows. Operating cash flow =NOPAT +depreciation (non cash adjustment) = $17.03 + $100
= $270.3
Company has $1,455million operating assets, at the end of 2000, but $1,800 at the end of 2001.it made a net investment in operating assets of
Net investment in operating assets = $18, 00 - $1,455 = $345million
If net fixed assets rose from $870million to $1000million however company reported $100million of depreciation. So its gross investment in fixed assets would be
Gross investment = net investment + depreciation = $130 + $100 = $230million Company free cash flows in 2001 was
FCF = operating cash flow – gross investment in operating assets = $270.3 - $445
= - $174.7million An algebraically equivalent equation is
FCF = NOPAT - Net investment in operating assets = $170.3- $345
= - $174.7million
Even though company had a positive NOPAT, its very high investment in operating assets resulted in a negative free cash flow. Because free cash flow is what is available for distribution to investor, not only was there nothing for investors, but investor actually had to provide additional money to keep the business ongoing. A negative current FCF not necessarily bad provided it is due to the high growth or to support the growth. There is nothing wrong with profitable growth; even it causes negative free cash flow in the short term
Q.3) What is Balance Scorecard? What is the process of implementation and explain the difficulties in implementation?
The Balanced Scorecard (BSC) is a performance management tool which began as a concept for measuring whether the smaller-scale operational activities of a company are aligned with its larger-scale objectives in terms of vision and strategy. By focusing not only on financial outcomes but also on the operational, marketing and developmental inputs to these, the Balanced Scorecard helps provide a more comprehensive view of a business, which in turn helps organizations act in their best long-term interests.
Organizations were encouraged to measure—in addition to financial outputs—what influenced such financial outputs. For example, process performance, market share / penetration, long term learning and skills development, and so on.
The underlying rationale is that organizations cannot directly influence financial outcomes, as these are "lag" measures, and that the use of financial measures alone to inform the strategic control of the firm is unwise. Organizations should instead also measure those areas where direct management intervention is possible. In so doing, the early versions of the Balanced Scorecard helped organizations achieve a degree of "balance" in selection of performance measures. In practice, early Scorecards achieved this balance by encouraging managers to select measures from three additional categories or perspectives: "Customer," "Internal Business
The balance scorecard suggests that we view the organization from four perspectives, and to develop metrics, collect data and analyze it relative to each of these perspectives:
• The learning and growth perspective : “To achieve our vision, how will we sustain our ability to change and improve?”
• The business process perspective : “To satisfy our shareholders and customers what business processes must we excel at?”
• The customer perspective : “To achieve our vision, how should we appear to our customer?”
• The financial perspective : “To succeed financially, how should we appear to our shareholders?”
Implementing a Balanced Scorecard
We can summarize the implementation of a balanced scorecard in four general steps;
1. Define strategy.
2. Define measure of strategy.
3. Integrate measures into the management system. 4. Review measures and result frequently.
Each of these steps is iterative, requiring the participation of senior executive and employees throughout the organization
Define Strategy
The balance scorecard builds a link between strategy and operational action. As a result it is necessary to begin the process of defining a balanced scorecard by defining the organization goals are explicit and what that targets have been developed.
Define Measures of Strategy
The next step is to develop measures in support of the articulate strategy. It is imperative that the organization focuses on a few critical measures at this point; otherwise management will be overloaded with measures. Also, it is important that the individual measures be linked with each other in a cause effect manner
The balanced scorecard must be integrated with the organization formal and informal structure, its culture, and its human resources practice. While the balanced Scorecard gives some means for balancing measures, the measures can still become unbalanced by others system in the organization such as compensation policies that compensate the manager strictly based on financial performance.
Review Measures and result Frequently
Once the balance scorecard is up and running it must be consistently reviewed by senior management. The organization should be looking for the following
How do the outcome measures say the organization is doing? How do the driver measures say the organization is doing?
How has the organization’s strategy changed since the last review? How has the scorecard measures changed?
The most important aspects of these reviews are as follows;
They tell management whether the strategy is being implemented
correctly and how successfully the strategy is working.
They show that management is serious about the importance of these measures.
They maintain alignment of measure to ever changing strategies.
Difficulties in implementing Balanced Scorecard
The following problems unless suitably dealt with, could limit the usefulness of the balanced scorecard approach:
• Poor correlation between nonfinancial measures and result. • Fixation on financial result. No mechanism for improvement. • No mechanism for improvement.
• Measures overload.
Poor Correlation between Nonfinancial measures and result
Simply put there is no guarantee that future profitably will allow targets achievement in any nonfinancial area. This is probably the biggest problem with the balanced scorecard because there is an inherent assumption that future profitability does follow from achieving the scorecard measures, identifying the cause effect relationships among the different measures is easier said than done.
This will be a problem with any system that is trying to develop proxy measures for future performance. While this does not mean that the balanced Scorecard should be abandoned it is imp that comp adopting such a system understand that the links between nonfinancial measures and financial performance are still poorly understood.
Fixation on Financial Results
As previously discussed not only are most senior managers well trained and very adept with financial measures but they also most keenly feel pressure regarding the financial performance of their comp. Shareholder are vocal and the board of directors often applies pressure on the stakeholders behalf .this pressure often overwhelms the long term uncertain payback of the nonfinancial measures.
Non mechanism for Improvement
One of the most overlooked pitfalls of the balanced scorecard is that a company cannot achieve Stretch goals if the Company has no mechanism for improvement .Unfortunately achieving many of these goals require complete shifts in the way that business is done yet the company often does not have mechanism to make those shifts . The mechanism available takes additional resource and requires a change in the company culture. These changes do not happen overnight nor do they respond automatically to a new stretch targets. Inertia often works against the company employees are accustomed to a self limited cycle of setting targets, missing those targets and readjusting the targets to reflect what was actually achieved. Without a method for making improvement, improvements are unlikely to consistently happen no matter how good the stretch goal sounds.
Measurement overload
How many critical measures can one manager track at one time without losing? Unfortunately there is no right answer to this question except it is more than 1 and less than 50. It too few then the manager is ignoring measures that are critical to creating success. If it too many then the manager may risk losing focus and trying to do too many things at once.
Q.5ABC ltd. (MCS-2008) Numerical
Particulars Division X (Rs.) Division Y (Rs.)
ROI 28% 26%
Sales 100 Lacs 500 lacs
Investment 25 lacs 100 Lacs
Analyze and comment upon performances of both the divisions Solution:
Division X
ROI = (Profit / investment)* 100
Profit = (28/100)*25lacs
= 7lacs
Profit margin = (Profit/sales)*100 = (7/100)*100
= 7lacs
Turnover of investments = (Sales/investment)*100 = (100/25)*100
= 4 times Division Y
ROI = (Profit / investment)* 100
Profit = (26/100)*100lacs
= 26lacs
Profit margin = (Profit/sales)*100 = (26/500)*100
= 5.2lacs
Turnover of investments = (Sales/investment)*100 = (500/100)*100
= 5 times
Profit margin of X is better than profit margin of division Y. Turnover of investment of division Y is better than Division X.
Hence cost management of Division X is better than Division Y.
SET. 2
Q1. MCS designers apparently disagree whether single measure to evaluate the profit performance and capital investment performance is preferable or SEPARATE measures for each are preferable – COMMENT ?
ANS. There should be different measures used for evaluating profit performance and capital investment performance as needed.
The goal of performance measurement systems is to implement strategy. In setting up such systems, senior management selects measures that best represent the company's strategy. These measures can be seen as current and future critical success factors; if they are improved, the company has implemented its strategy. The strategy's success depends on its soundness. A performance measurement system is simply a mechanism that improves the likelihood the organisation will implement its strategy successfully.
Measuring Profitability
There are two types of profitability measurements used in evaluating a profit center, just as there are in evaluating an organization as a whole. First, there is a measure of management performance, which focuses on how well the manager is doing. This measure is used for planning, coordinating, and controlling the profit center's day-to-day activities and as a device for providing the proper motivation for its manager. Second, there is the measure of economic performance, which focuses on how well the profit center is doing as an economic entity. The messages conveyed by these two measures may be quite different from each other. For example, the management performance report for a branch store may show that the store's manager is doing an excellent job under the circumstances, while the economic performance report may indicate that because of economic and competitive conditions in its area the store is a losing proposition and should be closed.
The necessary information for both purposes usually cannot be obtained from a single set of data. Because the management report is used frequently, while the economic report is prepared only on those occasions when economic decisions must be made, considerations relating to management performance measurement have first priority in systems design-that is, the system should be designed to measure
management performance routinely, with economic information being derived from these performance reports as well as from other sources.
Capital Investment Measurement
Most proposals require significant new capital. Techniques for analyzing capital investment proposals attempt to find either (a) The net present value of the project, that is, the excess of the present value of the estimated cash inflows over the amount of investment required, or
(b) The internal rate of return implicit in the relationship between inflows and outflows. An important point is that these techniques are used in only about half the situations in which, conceptually, they are applicable.
There are at least four reasons for not using present value techniques in analyzing all proposals.
1) The proposal may be so obviously attractive that a calculation of its net present value is unnecessary. A newly developed machine that reduces costs so substantially that it will pay for itself in a year is an example.
2) The estimates involved in the proposal are so uncertain that making present value calculations is believed to be not worth the effort-one can't draw a reliable conclusion from unreliable data. This situation is common when the results are heavily dependent on estimates of sales volume of new products for which no good market data exist. In these situations, the "payback period" criterion is used frequently.
3) The rationale for the proposal is something other than increased profitability. The present value approach assumes that the "objective function" is to increase profits, but many proposed investments win approval on the grounds that they improve employee morale, the company's image, or safety.
4) There is no feasible alternative to adoption. Environmental laws may require
should provide an orderly way of deciding on proposals that cannot be analyzed by quantitative techniques. Systems that attempt to rank non-quantifiable projects in order of profitability won't work. Many projects do not fit into a mechanical ranking scheme.
Q.No. 2. What are the different methods to measure profits of a profit center in organizations? Which different messages each type of measure is likely to convey to managers?
Ans: When financial performance in a responsibility center is measured in terms of profit, which is the difference between the revenues and expenses, the responsibility center is called a profit center. Profit as a measure of performance is especially useful since it enables senior management to use one comprehensive measure instead of several measures that often point to different directions.
There are two types of profitability measurements in a profit center, just as there are for the organization as a whole. There is, first, a measure of management performance, in which the focus is on how well the manager is doing. This measure is used for planning, coordinating and controlling the day-to-day activities of the profit center. Second, there is a measure of economic performance, in which the focus is on how well the profit center is doing as an economic entity. The message given by these two measures may be quite different.
Types of Profitability measures:
In order to evaluate the economic performance of a profit center, one must use net income after allocating all costs. However, in evaluating the performance of manager, any of five different measures of profitability can be used.
1) Contribution Margin: The logic behind using contribution margin as a
expenses. But the problem with this is that some fixed costs are controllable and all fixed costs are partially controllable. A focus on the contribution margin tends to direct attention away from this responsibility.
2) Direct Profit: This measure shows the amount that the profit center
contributes to the general overhead and profit of the corporation. It incorporates all expenses incurred in or directly traced to the profit center, regardless of whether these items are entirely controllable by the profit center manager. A weakness of this measure is that it does not recognize the motivational benefit of charging headquarters costs.
3) Controllable Profit: Headquarters expenses are divided into two categories:
controllable and non-controllable. The controllable expenses are controlled by business unit manager. Consequently, if these costs are included in the management system, the profit will be after the deduction of all expenses that are influenced by profit center manager.
4) Income before Taxes: In this measure, all corporate overhead is allocated to
profit centers. The basis of allocation reflects the relative amount of expense that is incurred for each profit center. If corporate overheads are allocated to profit centers, budgeted costs, not actual costs, should be allocated. Then the performance report will show an identical amount in the “budget” and “actual” columns for such overheads.
5) Net Income: Here, companies measure performance of domestic profit
centers at the bottom line, the amount of net income after income tax. There are two arguments 1) Income after tax is constant percentage of the pretax income, so there is no advantage in incorporating income taxes 2) many decisions that have impact on income taxes are made at headquarters, and it is believed that profit center manager should not be judged by the consequences of these decisions.
Q3: Explain special characteristics of professional organizations which impact Management Control. What are interactive controls?
Special Characteristic of a Professional Organization: 1. Goals
A goal of a manufacturing company is to earn a satisfactory profit specially a satisfaction profit, specially a satisfactory return on assets its principle assets is the skill of its professional staff which doesn’t appear on its balance sheet .return on assets employed therefore is essential meaningless in such organization .their financial goal is to provide adequate compensation to the professional.
2. Professionals
Professional organization is labour intensive and the labour is of a special type. Research and development organization use in setting selling price and for other management purposes .standard cost system ,separation of fixed and variable cost and analyses of variance were built on the foundation are example of organization whose product are professional service. Professional tends to give in adequate weight to the financial implication of their decision they want to do the best job they can regardless of its cost.
Because profession are the organization most important resource some authors have advocated that the value of these profession should be counted as assets the system that does this is called human resource accounting .in the 1970’s many books and articles were written on this subject but few comp actually such a system and we do not know of any that one current .the problem of measuring the value of human assets is intractable.
3. Output and input measurement
The output of a profession organisation cannot be measured in physical terms, use in setting selling price and for other management purposes .standard cost system,
seperstion of fixed and variable cost and analyses of variance were built on the foundation. We can measures the number of patient a physician treats n a day and even classify these visit by type of complaint but this is by no means equivalent to measuring the amt or quality earned is one measures of output in some professional organization but these monetary amts at most relate to the quantity of service rendered not to their quality.
Some profession notably scientist engineer, and professional are reluctant to keep track of how they spend their time and this complicate the track of measuring performance .this reluctant seems to have its root in tradition usually it can be overcome if senior management is willing to put appropriate emphasis on the necessity for accurate time reporting .nevertheless difficult problem arise in deciding how time should be charged to clients .if the normal work week is 40 hrs should a job be charged for 1/40th of a week compensation for each other spent on it? If so
how should work done on evening and weekend be counted how to account for time spent reading literature ,going to meeting ,and otherwise keeping up to date?
4. Small Size
With a few exception such as some law firm and accounting firms ,professional organisations are relatively small and operate at a single location .senior management in such organisations can personally observe what is going on and personally motivate employee .thus there is less need for a sophisticated management control system ,with profit centres and formal performance reports nevertheless even a small organisations need a budget a regular comparison of performance against budget ,and a way relating compensation to performance.
5. Marketing
In a manufacturing company there is a dividing line between marketing activities and production activities only senior management is concerned with both .such a clean separation does not exist in most Professional organisation, however their time and this complicate the track of measuring performance .this reluctant seems to have its
appropriate emphasis on the necessity for accurate time reporting. Nevertheless difficult problem arise in deciding how time should be charged to clients .if the normal work. These marketing activities are conducted by professional usually by professional, usually by professional who spend much of their time in production work that is working for clients.
In such situation it is difficult to assign appropriate credit to the person responsible for selling a new customer; in a consulting firm for example a new engagement may result from a conversation between a member of the firm or from the reputation of one of the firm professional as an outgrowth of speeches or articles. Moreover the profession al who is responsible for obtaining the engagement may not personally involved in carrying it out .until fairly recently these marketing contribution were rewarded subjectively –that is they were taken into account in promotion and compensation decisions .some organisation now give explicit credit, perhaps as a percentage of the project revenue, if the person revenue, if the person who hold sold the project can be identified.
What is Interactive Control?
Interactive control alerts management of strategic uncertainties either trouble or opportunities that become the basis for manager to adapt to a rapidly changing environments by thinking about new strategies.
1. A subset of the management control information that has a bearing on the strategic uncertainties facing the buss becomes the focal point.
2. Senior executive take such information seriously.
3. Managers at all levels of the org focus attention on the information produced by the system.
Shandilya Ltd. has adopted Economic Value Added (EVA) technique for the appraisal of performance of its three divisions A,B and C. Company charges 6% for current assets and 8 % for Fixed Assets, while computing EVA relevant data are given below
:-Particulars Div A Div B Div C Total
Budgeted Actual Budgeted Actual Budgeted Actual Budgeted Actual
Profit 360 320 220 240 200 200 780 760 Current Assets 400 360 800 760 1200 1400 2400 2520 Fixed Assets 1600 1600 1600 1800 2000 2200 5200 5600 Solution:
Particulars Div A Div B Div C Total
Budgeted Actual Budgeted Actual Budgeted Actual Budgeted Actual
ROA 18% 16% 9% 9% 6% 6% 10% 9%
EVA 208 170.4 44 50.4 -32 -60 220 160.8
b) Comment upon both methods, based on results.
There are three apparent benefits of an ROA measure. First, it is a comprehensive measure in that anything that effects the financial statements is reflected in this ratio. Secondly, ROA is easy to calculate, easy to understand, and meaningful in absolute sense. Finally, it is a common denominator that may be applied to any organizational units responsible for profitability, no matter what its size or what business it practices. The performance of different units may be compared directly to each other. Also, ROI data is available for competitors that can be used as a basis for comparison. Nevertheless, the EVA approach has some inherent advantages over ROA.
There are three compelling reasons to use EVA over ROI. First, with EVA all business units have the same profit objective for comparable investments. The ROI approach, on the other hand, provides different incentives for investment across business units. For example, a business unit that is currently achieving 30% ROA would be most reluctant to expand unless it is able to earn a ROI of 30% or more on additional assets. Second, decision that increase a centre’s ROI may decrease its overall profits. Third advantage of EVA is that different interest rates may be used for different types of assets. For example, a relatively low rate May be used for inventories while a higher rate may be used for different types of fixed assets.
SET .3
MANAGEMENT CONTROL SYSTEM
Q.1) Describe differences in budgeting perspective of engineered and
discretionary expense centre
1.Expense centers:
Expenses center are responsibility centers for which input or expenses are measured in monetary terms, but for which outputs are not measured in monetary terms. There are two general types: engineered expense center and discretionary expense center. They correspond to two types of costs.. Engineered costs are elements of cost for which the right or proper amount of costs that should be incurred can be estimated with a reasonable degree of reliability. Costs incurred in factory for direct labour direct material component supplies and utilities are examples.
2.Engineered expense centers:
Engineered expense center have the following characteristics: 1. Their inputs can be measured in monetary terms.
2. Their output can be measured in physical terms.
3. The optimal dollar amount of input required to produce one unit of output can be established
Engineered expense center usually are found in manufacturing operations. Warehousing, distribution, trucking and similar units in the marketing organization also may be engineered expense center and so many certain responsibility center within administrative and support department. Examples are accounts receivable account payable and payroll section in the controller department personnel record and cafeteria in the human resource department shareholder record in the corporate secretary department and the company motor pool. Such units perform repetitive task for which standard cost can be developed
In an engineered expense center the output multiplied by the standard cost or each unit produced represents what the finished product should have cost. When this cost is compared to actual costs, the difference between the two represents the efficiency of the organization unit being measured.
We emphasize that engineered expense centers have other important tasks not measured by cast alone. The effectiveness of these aspects of performance should be controlled. For example expenses center supervisor are responsible for the quality of good and for the volume of production in addition to their responsibility for cost efficiency. Therefore the type and amount of production is prescribed and specific quality standards are set so that manufacturing costs are not minimized at the expense of quality. Moreover manager of engineered expense center may be responsible for activities such a training that are not related to current production judgment about their performance should include an appraisal of how well they carry out these responsibilities.
There are few if any responsibility center in which all cost items are engineered. Even in highly automated production department the amount of indirect labour and of various services used can vary with management discretion.
Thus, the term engineered costs center refers to responsibility center in which engineered cost predominate but it does not imply that valid engineering estimates can be made for each and every cost item.
The output of discretionary expenses center cannot be measured in monetary terms. They include administration and support units research and development organization and most marketing activities.
The term discretionary does not mean that management judgments are capricious or haphazard. Management has decided on certain policies that should govern the operation of the company. One company may have a small headquarter staff another company of similar size and in the same industry may have a staff that is 10 time as large the management of both companies may be concerned that they made the correct decision on staff size but there is no objective way judging which decision was actually better manager are hired and paid to make such decision after such a drastic change the level of discretionary expenses generally has a similar pattern from one year to the next.
The difference between budgeted and actual expense is not a measure of efficiency in a discretionary expense centre it is simply the difference between the budgeted input and the actual input. It in no way measures the value of the output, if actual expense do not exceed the budget amount, the manager has ‘lived within the budget ‘ however ,because by definition the budget does not purport to measure the optimum amount of spending we cannot say that living within the budget is efficient performance .
4. Differences in budgeting perspective of engineered and discretionary expense centre
Budget preparation
The decision that management make about a discretionary expense budget are different from the decisions that it makes about the budget for an engineered expense center. For the latter, management decides whether the proposed operating budget represent the cost of performing task efficiently for the coming period. Management is not so much concerned with the magnitude of the task because this is largely determined by the actions of other responsibility centers, such as the marketing departments’ ability to generate sales. In formulating the budget for a discretionary expense center, however management principal task is to decide on the magnitude of the job that should be done.
Incremental budgeting:
Here the current level expenses in a discretionary expense center is taken as a starting points this amount is adjusted for inflation for anticipated changes in the workload of continuing tasks for special tasks and if the data are readily available for the cost of comparable work in similar units.
There are two drawbacks to incremental budgeting. First because managers of these centers typically want to provide more service they tend to request additional resources in the budgeting process and if they make a sufficiently strong case these request will be granted. This tendency is expressed in Parkinson’s second law: overhead costs tend to increase period. There is ample evidence that not all this upward creep in cost is necessary.
This problem is especially compounded by the fact that the current level of expenditure in the discretionary expenses center is taken for granted and is not re-examined during the budget preparation process. Second when a company faces a crises or when a new management takes over overhead costs are sometimes drastically reduced without any adverse consequences.
Despite this limitation most budgeting in discretionary expense centers is incremental. Time does not permit the more thorough analysis described in the next section.
Zero based review:
An alternative approach is to make a thorough analysis of each discretionary expense center on a schedule that will cover all of them over a period of five year or so. That analysis provides a new base. There is a likelihood that expenses will creep up gradually over the next five years and this is tolerated at the end of five years, another new base is established. Such an analysis is often called a zero base review.
In contrast with incremental budgeting which takes the current level of spending as the starting point this more intensive review attempts to build up de now the resources that actually are needed by the activity. Basic question are raised;(1) should use customer?(2) what should the quality level be ?are we doing too much(3)should the function be performed in this way (4) how much should it cost?
Cost variability:
In discretionary expense center costs tend to vary with volume from one year to the next but they tend not to vary with short run fluctuation in volume within a given year. By contrast costs in engineering expense center are expected to vary with short run changes in volume. In part this reflect the fact that volume changes do have an impact throughout the company even though their actual impact cannot be measures the ; in part this reflect the fact that volume changes do have an impact throughout the company even though their actual impact cannot be measured in part this result from a management personnel and personnel related costs are by far the largest expense item in most discretionary expense center the annual budget for these center tend to be a constant percentage of budgeted sales volume.
Q.2) Explain some factors which may influence top management style
and the implication of the top management style on management control.
The management control function in an organization is influenced by the style of senior management. The style of the chief executive officer affects the management control process in the entire organization. Similarly, the style of the business unit manager affects the unit's management control process, and
the style of functional department managers affects the management control process in their functional areas.
Differences in Management Styles
Managers manage differently. Some rely heavily on reports and certain formal documents; others prefer conversations and informal contacts. Some are analytical; others use trial and error. Some are risk takers; others are risk averse. Some are process oriented; others are results oriented. Some are long-term oriented; others are short-long-term oriented. Some emphasize monetary rewards; others emphasize a broader set of rewards.
Management style is influenced by the manager's background and personality. Background includes things like age, formal education, and experience in a given function, such as manufacturing, technology, marketing, or finance. Personality characteristics include such variables as the manager's willingness to take risks and his or her tolerance for ambiguity.
Implications for Management Control
The various dimensions of management style significantly influence the operation of the control systems. Even if the same reports with the same set of data go with the same frequency to the CEO, two CEOs with different styles would use these reports very differently to manage the business units.
Style affects the management control process – how the CEO prefers to use the information, conducts performance review meetings, and so on – which in turn affects how the control system actually operates, even if the formal structure does not change under a new CEO. In fact, when CEOs change, subordinates typically infer what the new CEO really wants based on how he or she interacts during the management control process.
Personal versus Impersonal Controls
Presence of personal versus impersonal controls in organizations is an aspect of managerial style. Managers differ on how much importance they attach to formal budgets and reports as well as informal conversations and other personal contacts. Some managers are "numbers oriented"; they want a large flow of quantitative information, and they spend much time analyzing this information and deriving tentative conclusions from it. Other managers are "people oriented"; they look at a few numbers, but they usually arrive at their conclusions by talking with people, judging the relevance and importance of what they learn partly on their appraisal of the other person. They visit various locations and spend time talking with both supervisors and staff to get a sense of how well things are going.
Managers' attitudes toward formal reports affect the amount of detail they want, the frequency of these reports, and even their preference for graphs rather than tables of numbers, and whether they want numerical reports supplemented with written comments. Designers of management control systems need to identify these preferences and accommodate them.
Tight versus Loose Controls
A manager's style affects the degree of tight versus loose control in any situation. The manager of a routine production responsibility center can be controlled relatively tightly or loosely, and the actual control reflects the style of the manager's superior. Thus, the degree of tightness or looseness often is not revealed by the content of the forms or aspects of the formal control documents, rules, or procedures. It is a factor of how these formal devices are used. The degree of looseness tends to increase at successively higher levels in the organization hierarchy: higher-level managers typically tend to pay less attention to details and more to overall results.
The style of the CEO has a profound impact on management control. If a new senior manager with a different style takes over, the system tends to change correspondingly. It might happen that the manager's style is not a good fit with the organization's management control requirements. If the manager recognizes this incongruity and adapts his or her style accordingly, the problem disappears. If, however, the manager is unwilling or unable to
change, the organization will experience performance problems. The solution in this case might be to change the manager.
Q.3) Explain advantages and disadvantages of two step transfer pricing and profit sharing methods
Transfer pricing: If two or more profit center is jointly
responsible for product development manufacturing and marketing each should share in the revenue that is generated when the product is finally sold. The transfer price is not primarily an accounting tool; rather, it is a behavioral tool that motivates manager to make the right decisions. In particular the transfer price should be designed so that it accomplishes the following objective: It should provide each segment with the relevant information required to determine the optimum tradeoff between company cost and revenues It should induce goal congruent decisions that is the system should be so designed that decision improve business unit to earn more profit It should help measure the economic performance of the individual profit center
Two step pricing: First, a charge is made for
each unit sold that is equal to the standard variable cost of production. Second a periodic charge is made for the buying unit. One or both of these components should include a profit margin. The two step pricing method correct this problem by transferring variable cost on a per unit basis, and transferring fixed cost and profit on a lump sum basis under this method the transfer price for product A would be 5$ for each unit that unit Y purchases plus $20000 per month for fixed cost. Plus $10000 per month for profit: if transfer of product A in a certain month are at the expected amount 5000 units then under the two step method unit y will pay the variable cost of $25000 plus $30000 for the fixed cost and profit a total of $55000 .this is the same amount as the amount it would pay unit x if the transfer price is less than 5000 units say 4000unoits.unit y would pay $50000 under the two step methods
compared with the $44000 it would pay if the transfer price were $11 per unit. The difference is their transfer prices were for not using a portion of unit X capacity that it has reserved. Note that under two step method the company variable cost for product A is identifiable to unit Y variable cost for the product, and unit Y will make the correct short term marketing decisions. Unit Y also has information on upstream fixed costs and profit related to product A and it can use these data for long term decision. The fixed cost calculation in the two step pricing method is based on the capacity that is reserved for the production of product A that is sold to unit Y the investment represented by this capacity is allocated to product A. The return on investment that unit X earns on competitive product is calculated and multiplied by the investment assigned to the product. In the example we calculated the profit allowance as a fixed monthly amount. It would be appropriate under some circumstance to divide the investment into variable and fixed component. Then, a profit allowance based on a return on investment on variable assets would be added to the standard variable cost for each unit sold.
Profit sharing: If the two step pricing system just described is not
feasible, a profit sharing system might be used to ensure congruence of business unit interest with company interest. This system operates somewhat as follows.
1. The product is transferred to the marketing unit at standard variable cost. 2. After the product is sold, the business units share the contribution earned which is selling price minus the variable manufacturing and marketing costs.
This method of pricing may be appropriate if the demand for the manufactured product is not steady enough to warrant the permanent assignment of facilities as in the two step method. In general, this method accomplished the purpose of making the marketing unit’s interest congruent with the companies. There are several practical problems in implementing such profit sharing system. First, there can be arguments over the way contribution is divided between the two profit centers. Which is costly, time consuming and work against basic reason for decentralization namely autonomy of the business units mangers. Second, arbitrarily divided up the profit between units does not give valid information on the profitability of each segment of the organization.
Third since the contribution is not allocated until after the sale has been made the manufacturing units contribution depends upon the marketing unit’s ability to sell and on the actual selling price. Manufacturing units may perceive this situation to be unfair
Two set of price: in this method, the manufacturing unit’s revenue is
credited at the outside sales price, and the buying unit is charged the total standard costs. The difference is changed to a headquarter account and eliminated when the business unit statement are consolidated, this transfer pricing method is sometimes used when there are frequent conflict between the buying and selling units that cannot be resolved by one of the other method both the buying and selling
There are several disadvantages to the system of having two set of
greater than overall company profits, senior management must be aware of this situation in approved budget for the business units and in subsequent evaluation of performance against these budget. Also, this system create an illusion feeling that business units are making money while in fact the overall company might be losing after taking account of the debits to headquarter. Further this system might motivate business unit to concentrate more on internal transfers at the expense of outside sales
The fact that the conflict between the business units would be
lessened under this system could be viewed as a weakness. Sometime, it is better for the headquarter to be aware of the conflict arising out of transfer prices because such conflict may signal problem in either the organizational structure or In other management systems. Under the two sets of prices method these conflicts are smoothed over thereby not alerting senior management to these problems.
Q.4) Discuss special challenges faced in controlling R & D activities and possible management initiatives
Type of financial control: The financial control exercised in a
discretionary expense center is quite different from that in engineered center the latter attempts to minimize operating cost by setting a standard and reporting actual costs against this standards. The main purpose of a discretionary expense budget on the other hand is to allow the manager to control Cost for particular in the planning. Costs are controlled primarily by deciding what task should be undertaken and what level of effort is appropriate for each. Thus in a discretionary expense center financial control is primary exercised at the planning stage before the amount are incurred.
Measurement of performance: The primary job of the manager of a
discretionary expense center is to accomplish the desired output spending an amount that is on budget is satisfactory. This is in contrast with the report in an engineered expense center which helps higher management to evaluate the manger efficiency. If these two types of
responsibility center are carefully distinguished management may treat the performance report for the discretionary expense center as if it were an indication of efficiency Control over spending can be exercised by requiring that the manger approval be obtain before the budget is over sometimes a certain percentage of overrun is permitted without additional approval if the budget really set forth the best estimate of actual cost there is 50 percent probability that it will overrun and this is the reason that some latitude is often permitted.
Control problems: The control of R & D centers, which are also
discretionary expense center is difficult for the following at least a semi tangible output reasons.
1. Results are difficult to measure quantitatively. As contrasted with administrative activities, R&D usually has at least a semi tangible output in patent, new products, or new processes. Nevertheless, the relationship of these outputs to inputs is difficult to measure and appraise. A complete product of an R&D group may require several year of effort; consequently input as stated in an annual budget may be unrelated to outputs. Even if an output can be identified a reliable estimate of its value often cannot be made. Even if the value of the output can be calculated, it is usually not possible for management to evaluate the efficiency of the R&D effort because of its technical nature. A brilliant effort may come up against an insuperable obstacle, whereas a mediocre effort may, by luck result in a bonanza.
2. The goal congruence problem in R&D center is similar to that in administrative centers. The research managers typically want to build the best research organization that money can buy, even though this is more expensive than the company can afford. A further problem is that research people often may not have sufficient knowledge of the business to determine the optimum direction of the research efforts.
3. Research and development can seldom be controlled effectively on an annual basis. A research project may take year s to reach fruition, and the organization must be built up slowly over a long time period. The principal cost is for the work force obtaining highly skilled scientific talented is often difficult, and short term fluctuation in the work force are in efficient. It is not reasonable, therefore to reduce R&D costs in years when profits are low and increase them in year when profits are high. R&D should be looked at as a long term investment not as an activity that varies with short run corporate profitability.
The R&D continuum: Activities conducted by R&D organization lie
along a continuum. At one extreme is basic research; the other extreme is product testing. Basic research has two characteristics: first, it is unplanned management at most can specify the general area that is to be explored second there is often a very long time lag before basic research result in successful new product introductions. Financial control system has little value in managing basic research activities. In some companies, basic research in included as a lump sum in the research program and budget. In others, no specific allowance is made for basic research as such; there is an understanding that scientists and engineers can devote part of their time to explorations in whatever direction they find most interesting, subject only to informal agreement with their supervisor. For product testing projects, on the other hand, the time and financial requirement can be estimated, not as accurately as production activities.
Q.5) Explain problems faced in pricing corporate services provided to business units organized as Profit Centers
Services are intangible in nature. This characteristic of services makes it difficult for pricing. Charging business units for services furnished by corporate staff units becomes challenging work due to intangibility of services. While pricing corporate services, we exclude the cost of central service staff units over which business units have no control (e.g., central accounting, public relations, and administration). If these costs are charged at all, they are allocated, and the allocations do not include a profit component. The allocations are not transfer prices.
We need to consider two types of transfers:
O For central services that the receiving unit must accept but can at
least partially control the amount used.
O For central services that the business unit can decide whether or not to use.
Business units may be required to use company staffs for services such as information technology and research and development. In these situations, the business unit manager cannot control the efficiency with which these activities are performed but can control the amount of the service received. There are three schools of thought about such services.
One school holds that a business unit should pay the standard variable cost of the discretionary services. If it pays less than this, it will be motivated to use more of the service than is economically justified. On the other hand, if business unit managers are required to pay more than the variable cost, they might not elect to use certain services that senior management believes worthwhile from the company's viewpoint. This possibility is most likely when senior management introduces a new service, such as a new project analysis program. The low price is analogous to the introductory price that companies sometimes use for new products.
A second school of thought advocates a price equal to the standard variable cost plus a fair share of the standard fixed costs-that is, the full cost. Proponents argue that if the business units do not believe the services are worth at least this amount, something is wrong with either the quality or the efficiency of the service unit. Full cost represents the company's long run costs, and this is the amount that should be paid.
A third school advocates a price that is equivalent to the market price, or to standard full cost plus a profit margin. The market price would be used if available (e.g., costs charged by a computer service bureau); if not, the price would be full cost plus a return on investment. The rationale for this position is that the capital employed by service units should earn a return just as the capital employed by manufacturing units does. Also, the business units would incur the investment if they provided their own service.
Optional Use of Services
In some cases, management may decide that business units can choose whether to use central service units. Business units may procure the service from outside, develop their own capability, or choose not to use the service at all. This type of arrangement is most often found for such activities as information technology, internal consulting groups, and maintenance work. These service centers are independent; they must stand on their own feet. If the internal services are not competitive with outside providers, the scope of their activity will be contracted or their services may be outsourced completely.
For example, Commodore Business Machines outsourced one of its central service activities-customer service-to Federal Express. James Reeder, Commodore's vice president of customer satisfaction, said, "At that time we didn't have the greatest reputation for customer service and satisfaction. But this was FedEx's specialty, handling more than 300,000 calls for service each day. Commodore arranged for FedEx to handle the entire telephone customer service operation from FedEx's hub in Memphis.
After losing $29 million online the previous year, Borders Group turned to rival Amazon.com to manage its online sales. Borders get to maintain an Internet sales channel and gains the operational effectiveness provided by Amazon.com while being able to focus on the growth of its bricks and mortar business.
In this situation, business unit managers control both the amount and the efficiency of the central services. Under these conditions, these central groups are profit centers. Their transfer prices should be based on the same considerations as those governing other transfer prices.
(Numerical) MCS – 2004
Division B of Shayana company contracted to buy from Div. A, 20,000 units of a component for the final product made by Div. B. The transfer price for this internal transaction was set at Rs. 120 per unit by mutual agreement. This comprises of (per unit) Direct and Variable labour cost of
Rs. 20; Material Cost of Rs.60; Fixed overheads of Rs.20 (lumpsum Rs.4 lacs) and Rs.20 lacs that Div. A would require for this additional activity. During the year, actual off take of Div. B was 19,600 units. Div. A was able to reduce material consumption by 5% but its budgeted investment overshot by 10%.
a) As Financial controller of Div. A, compare Actual Vs Budgeted Performance
b) Its implications for Management Control? Solution: a) Particulars Budgeted (Rs. Per Unit) Budgeted (Total in Rs.) Actual (Rs. Per Unit) Actual (Total in Rs.) Direct and Variable Labour Cost 20 4,00,000 20 3,92,000 Material Cost 60 12,00,000 57 11,17,200 Fixed Overheads 20 4,00,000 4,00,000 Total Cost 100 20,00,000 19,09,200 Transfer Price 120 24,00,000 119.86 23,49,200 Profit 20 4,00,000 4,40,000 Investment 20 20,00,000 22,00,000 ROI = Profit/Investment 20% 20%
Despite of increase in investment by 10%, there is negligible difference in transfer price. Also the sales have decreased by 400 units. Therefore we can say that additional investment has not achieved any positive results.
SET-4
Q.1) A)Explain the concept of ROI. What are its advantages?
Return on investment (ROI) is the ratio of profit before tax to the gross investment. ROI is calculated with the help of the following formula:
For 20,000 Units
For 19,600 Units
ROI = (Pre-Tax Profit/Sales) X (Sales/Net Assets) or (Pre-Tax Profits/Net Assets) The numerator is profit before tax as reported in the P&L account. The profit should include only the profits arising out of the normal activities of the division. Unusual items of receipts and expenses should be excluded from the profit figure. One should also ignore windfalls and income from investments not related to the
operations of the division. Tax is excluded from the numerator because the marginal of the SBU is not responsible for or in control of the tax paid.
Capital employed can be ascertained from the balance sheet by including fixed and current assets. Assets not currently put to divisional use should be excluded from the investment base. One also needs to exclude their relative earnings if any. The company should also exclude intangible assets like goodwill, deferred revenue expenses, preliminary expenses, etc.
ROI can be improved by:
o Increasing the profit margin on sales. o Increasing the capital turnover
o Increasing both profit margin and capital turnover.
o Reducing cost as that adds to the total earnings of the firm.
o Increasing the profits by expanding present operations or developing new product line, increasing market share, etc.
o Diversifying, introducing productivity improvement measures, expansion,
replacement of old equipments Advantages of ROI
o ROI relates return to the level of investment and not sales as the rate of return is more realistic.
o ROI can be decomposed into other variables as shown. These variables have tremendous analytical value.
o ROI is an effective tool for inter-firm comparison. Question 1 (b):
Many experts regard EVA as a concept superior to ROI and yet in certain cases, EVA does not do justice to the evaluation of investment center. Explain this phenomenon with as illustration.
EVA does not solve all the problems of measuring profitability in an investment center. In particular, it does not solve the problem of accounting for fixed assets discussed above unless annuity depreciation is also used, and this is rarely done in practice. If gross book value is used, a business unit can increase its EVA by taking actions contrary to the interests of the company, as shown in Exhibit 7-3. If net book value is used, EVA will increase simply due to the passage of time.
Furthermore, EVA will be temporarily depressed by new investments because of the high net book value in the early years. EVA does solve the problem created by differing profit potentials. All business units, regardless of profitability, will be motivated to increase investments if the rate of return from a potential investment exceeds the required rate prescribed by the measurement system.
Moreover, some assets may be undervalued when they are capitalized, and others when they are expensed. Although the purchase cost of fixed assets is ordinarily capitalized, a substantial amount of investment in start-up costs, new product
development, dealer organization, and so forth may be written off as expenses, and, therefore, not appear in the investment base. This situation applies especially in marketing units. In these units the investment amount may be limited to inventories, receivables, and office furniture and equipment. When a group of units with varying degrees of marketing responsibility are ranked, the unit with the relatively larger marketing operations will tend to have the highest EVA.
In view of all these problems, some companies have decided to exclude fixed assets from the investment base. These companies make an interest charge for controllable assets only, and they control fixed assets by separate devices. Controllable assets are, essentially, receivables and inventory. Business unit management can make day-to-day decisions that affect the level of these assets. If these decisions are wrong, serious consequences can occur-quickly. For example, if inventories are too high, unnecessary capital is tied up, and the risk of obsolescence is increased;
whereas, if inventories are too low, production interruptions or lost customer business can result from the stockouts. To focus attention on these important controllable items, some companies, such as Quaker Oats, 17 include a capital charge for the items as an element of cost in the business unit income statement. This acts both to motivate business unit management properly and also to measure the real cost of resources committed to these items.
