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 organizations 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 A!A"E E!# $%!#&%L S'S#E are as follo(s)

1 #otal System) MANA !M!N" #$N"%$& '('"!M is an overall process of the enterprise )hich aims to fit
together the separate plans for various segments as to assure that each harmonizes )ith the others and that the aggregate effect of all of them on the )hole enterprise is satisfactory.

onetary Stan*ar*) MANA !M!N" #$N"%$& '('"!M is built around a financial structure and all the resources and outputs are e+pressed in terms of money. "he results of each responsibility centre in respect to production and resources are e+pressed in terms of a common denominator of money.

, Definite pattern) It follo)s a definite pattern and time table. "he )hole operational activity is regular and
rhythmic. It is a continuous process even if the plans are changed in the light of e+perience or technology.

- $oor*inate* System) It is a fully coordinated and integrated system. . Emphasis) Management control re/uires emphasis both on the search for planning as )ell as control. 0oth
should go hand in hand to achieve the best results.

1 +unction of e,ery manager) Manager at every level as to focus to)ards future operational and accounting data2
ta3ing into consideration past performance2 present trends and anticipated economic and technological changes. "he nature2 scope and level of control )ill be governed by the level of manager e+ercising it.

4 Existence of goals an* plans) MANA !M!N" #$N"%$& '('"!M is not possible )ithout predetermined
goals and plans. "hese t)o provide a lin3 bet)een such future anticipations and actual performance.

5 +or(ar* loo-ing) MANA !M!N" #$N"%$& '('"!M is on the basis of evaluation of past performance that
the future plans or guidelines can be laid do)n. Management #ontrol involves managing the overall activity of the enterprise for the future. It prevents deviations in operational goals.

6 $ontinuous process) It is a continuous process over the human and material resources. It demands vigilance at
every step. 7eciding2 planning and regulating the activities of people associated in the common tas3 of attaining the objectives of the organization is a the primary aim of MANA !M!N" #$N"%$& '('"!M.

18

.eople oriente*) It is the managers2 engineers and operators )hich implement the ideas and objectives of the management. "he coordination of the main division of an organization helps in smoother operations and less friction )hich results in the achievement of the predetermined objectives.

Scope of control

Scope of control

9ay dividends to shareholders. ,. %epurchase stoc3 from shareholders. -. 0uy mar3etable securities or other non operating assets. In practice2 most companies combine these five uses in such a )ay that the net total is e/ual to :#:. :or e+ample2 a company might pay interest and dividends2 issue ne) debts2 also sell some of its mar3etable securities. 'ome of these activities are cash outflo)s ;paying interest and dividends< and some are cash inflo)s ;issuing debt and selling mar3etable securities<2 but the net cash flo) from these five activities is e/ual to free cash flo)s. $omputation of free cash flo(s) Eg) 'uppose the company had a *881 N$9A" of =148.,million and depreciation is only the non cash charge )hich is =188million then its operating cash flo) in *881 )ould be N$9A" plus any non cash adjustment on the statement of cash flo)s. $perating cash flo) >N$9A" ?depreciation ;non cash adjustment< 1> =14.8, ? =188 *> =*48., #ompany has =12-..million operating assets2 at the end of *8882 but =12588 at the end of *881.it made a net investment in operating assets of Net investment in operating assets > =152 88 @ =12-.. > =,-.million If net fi+ed assets rose from =548million to =1888million ho)ever company reported =188million of depreciation. 'o its gross investment in fi+ed assets )ould be
ross investment > net investment ? depreciation > =1,8 ? =188 > =*,8million

#ompany free cash flo)s in *881 )as :#: > operating cash flo) A gross investment in operating assets 1> =*48., @ =--. *> @ =14-.4million An algebraically e/uivalent e/uation is :#: > N$9A" @ Net investment in operating assets 1> =148.,@ =,-. *> @ =14-.4million !ven though company had a positive N$9A"2 its very high investment in operating assets resulted in a negative free cash flo). 0ecause free cash flo) is )hat is available for distribution to investor2 not only )as there nothing for investors2 but investor actually had to provide additional money to 3eep the business ongoing. A negative current :#: not necessarily bad provided it is due to the high gro)th or to support the gro)th. "here is nothing )rong )ith profitable gro)thB even it causes negative free cash flo) in the short term Q./) 0hat is 1alance Scorecar*? 0hat is the process of implementation an* *ifficulties in implementation? "he 1alance* Scorecar* ;0'#< is a performance management tool )hich began as a concept for measuring )hether the smaller@scale operational activities of a company are aligned )ith its larger@scale objectives in terms of vision and strategy. 0y focusing not only on financial outcomes but also on the operational2 mar3eting and developmental inputs to these2 the 0alanced 'corecard helps provide a more comprehensive vie) of a business2 )hich in turn helps organizations act in their best long@term interests.

$rganizations )ere encouraged to measureCin addition to financial outputsC)hat influenced such financial outputs. :or e+ample2 process performance2 mar3et share D penetration2 long term learning and s3ills development2 and so on. "he underlying rationale is that organizations cannot directly influence financial outcomes2 as these are ElagE measures2 and that the use of financial measures alone to inform the strategic control of the firm is un)ise. $rganizations should instead also measure those areas )here direct management intervention is possible. In so doing2 the early versions of the 0alanced 'corecard helped organizations achieve a degree of EbalanceE in selection of performance measures. In practice2 early 'corecards achieved this balance by encouraging managers to select measures from three additional categories or perspectivesF E#ustomer2E EInternal 0usiness 9rocessesE and E&earning and ro)th.E

"he balance scorecard suggests that )e vie) the organization from four perspectives2 and to develop metrics2 collect data and analyze it relative to each of these perspectivesF

1G #he learning an* gro(th perspecti,e ) H"o achieve

our vision2 ho) )ill )e sustain our ability to change and improveIJ

*G #he business process perspecti,e ) H"o satisfy our

shareholders and customers )hat business processes must )e e+cel atIJ

,G #he customer perspecti,e ) H"o achieve our vision2 ho) should )e appear to our customerIJ -G #he financial perspecti,e ) H"o succeed financially2 ho) should )e appear to our shareholdersIJ
Implementing a 1alance* Scorecar* Ke can summarize the implantation of a balanced scorecard in four general stepsB 1. 7efine strategy. *. 7efine measure of strategy. ,. Integrate measures into the management system. -. %evie) measures and result fre/uently. !ach of these steps is iterative2 re/uiring the participation of senior e+ecutive and employees throughout the organization

1 Define Strategy
"he balance scorecard builds a lin3 bet)een 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 e+plicit and )hat that targets have been developed.

1 Define easures of Strategy

"he ne+t step is to develop measures in support of the articulate strategy. It is imperative that the organization focuses on a fe) critical measures at this pointB other)ise management )ill be overloaded )ith measures. Also2 it is important that the individual measures be lin3ed )ith each other in a cause effect manner

1 Integrate*

easures into the management system "he balanced scorecard must be integrated )ith the organization formal and informal structure2 its culture2 and its human resources practice. Khile the balanced 'corecard gives some means for balancing measures2 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.

1 &e,ie(

easures an* result +re2uently $nce the balance scorecard is up and running it must be consistently revie)ed by senior management. "he organization should be loo3ing for the follo)ing

1 Lo) do the outcome measures say the organization is doingI * Lo) do the driver measures say the organization is doingI , Lo) has the organizations strategy changed since the last revie)I - Lo) has the scorecard measures changedI
"he most important aspects of these revie)s are as follo)sB

1 "hey tell management )hether the strategy is being implemented correctly and ho) successfully the strategy
is )or3ing. * "hey sho) that management is serious about the importance of these measures. , "hey maintain alignment of measure to ever changing strategies.

* Difficulties in implementing 1alance* Scorecar*

"he follo)ing problems unless suitably dealt )ith2 could limit the usefulness of the balanced scorecard approachF 1G 9oor correlation bet)een nonfinancial measures and result. *G :i+ation on financial result. No mechanism for improvement. ,G No mechanism for improvement. -G Measures overload.

* .oor $orrelation bet(een !onfinancial measures an* result

'imply put there is no guarantee that future profitably )ill allo) targets achievement in any nonfinancial area. "his is probably the biggest problem )ith the balanced scorecard because there is an inherent assumption that future profitability does follo) from achieving the scorecard measures2 identifying the cause effect relationships among the different measures is easier said than done. "his )ill be a problem )ith any system that is trying to develop pro+y measures for future performance. Khile this does not mean that the balanced 'corecard should be abandoned it is imp that comp adopting such a system understand that the lin3s bet)een nonfinancial measures and financial performance are still poorly understood.

1 +ixation on +inancial &esults

As previously discussed not only are most senior managers )ell trained and very adept )ith financial measures but they also most 3eenly feel pressure regarding the financial performance of their comp. 'hareholder are vocal and the board of directors often applies pressure on the sta3eholders behalf .this pressure often over)helms the long term uncertain paybac3 of the nonfinancial measures.

1 !on mechanism for Impro,ement

$ne of the most overloo3ed pitfalls of the balanced scorecard is that a company cannot achieve 'tretch goals if the #ompany has no mechanism for improvement .Mnfortunately achieving many of these goals re/uire complete shifts in the )ay that business is done yet the company often does not have mechanism to ma3e those shifts . "he mechanism available ta3es additional resource and re/uires a changed in the company culture. "hese changes do not happen overnight nor do they respond automatically to a ne) stretch targets. Inertia often )or3s against the company employees are accustomed to a self limited cycle of setting targets2 missing those targets and readjusting the targets to reflect )hat )as actually achieved. Kithout a method for ma3ing improvement2 improvements are unli3ely to consistently happen no matter ho) good the stretch goal sound.

easurement o,erloa* Lo) many critical measures can one manager trac3 at one time )ithout losingI Mnfortunately there is no right ans)er to this /uestion e+cept it is more than 1 and less than .8. It too fe) then the manager is ignoring measures that are

critical to creating success. If it too many then the manager may ris3 losing focus and trying to do too many things at once. Q.3A1$ lt*. 4 $S56778) !umerical .articular s %$I 'ales Investment !0I" Di,ision 9 4&s.) *5N 188 &acs *. lacs 4 &acs Di,ision ' 4&s.) *1N .88 lacs 188 &acs *1 lacs

Analy:e an* comment upon performances of both the *i,isions 'olutionF Di,ision 9 %$I 9rofit 9rofit margin > > > > > > > > > > > > > ;9rofitDsales<O188 ;9rofit D investment<O 188 ;*5D188<O*.lacs 4lacs ;9rofitDsales<O188 ;4D188<O188 4lacs ;'alesDinvestment<O188 ;188D*.<O188 - times ;9rofit D investment<O 188 ;*1D188<O188lacs *1lacs

"urnover of investments

Di,ision ' %$I 9rofit

9rofit margin

1> *>
"urnover of investments >

;*1D.88<O188 ..*lacs

;'alesDinvestment<O188

1> *>

;.88D188<O188 . times

9rofit margin of P is better than profit margin of division (. "urnover of investment of division ( is better than 7ivision P. Lence cost management of 7ivision P is better than 7ivision (.

SET. 2
Q1. $S *esigners apparently *isagree (hether single measure to e,aluate the profit performance an* capital E!# I

in,estment performance is preferable or SE.A&A#E measures for each are preferable ; $%

AN'. "here should be different measures used for evaluating profit performance and capital investment performance as needed. "he goal of performance measurement systems is to implement strategy. In setting up such systems2 senior management selects measures that best represent the companyQs strategy. "hese measures can be seen as current and

future critical success factorsB if they are improved2 the company has implemented its strategy. "he strategyQs success depends on its soundness. A performance measurement system is simply a mechanism that improves the li3elihood the organisation )ill implement its strategy successfully.

easuring .rofitability

"here are t)o types of profitability measurements used in evaluating a profit center2 just as there are in evaluating an organization as a )hole. :irst2 there is a measure of management performance2 )hich focuses on ho) )ell the manager is doing. "his measure is used for planning2 coordinating2 and controlling the profit centerQs day@to@day activities and as a device for providing the proper motivation for its manager. 'econd2 there is the measure of economic performance2 )hich focuses on ho) )ell the profit center is doing as an economic entity. "he messages conveyed by these t)o measures may be /uite different from each other. :or e+ample2 the management performance report for a branch store may sho) that the storeQs manager is doing an e+cellent job under the circumstances2 )hile 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. "he necessary information for both purposes usually cannot be obtained from a single set of data. 0ecause the management report is used fre/uently2 )hile the economic report is prepared only on those occasions )hen economic decisions must be made2 considerations relating to management performance measurement have first priority in systems design@that is2 the system should be designed to measure management performance routinely2 )ith economic information being derived from these performance reports as )ell as from other sources.

$apital In,estment

easurement

Most proposals re/uire significant ne) capital. "echni/ues for analyzing capital investment proposals attempt to find either ;a< "he net present value of the project2 that is2 the e+cess of the present value of the estimated cash inflo)s over the amount of investment re/uired2 or ;b< "he internal rate of return implicit in the relationship bet)een inflo)s and outflo)s. An important point is that these techni/ues are used in only about half the situations in )hich2 conceptually2 they are applicable. #here are at least four reasons for not using present ,alue techni2ues in analy:ing all proposals.

1< "he proposal may be so obviously attractive that a calculation of its net present value is unnecessary. A
ne)ly developed machine that reduces costs so substantially that it )ill pay for itself in a year is an e+ample.

*< "he estimates involved in the proposal are so uncertain that ma3ing present value calculations is believed to
be not )orth the effort@one canQt dra) a reliable conclusion from unreliable data. "his situation is common )hen the results are heavily dependent on estimates of sales volume of ne) products for )hich no good mar3et data e+ist. In these situations2 the Epaybac3 periodE criterion is used fre/uently.

,< "he rationale for the proposal is something other than increased profitability. "he present value approach
assumes that the Eobjective functionE is to increase profits2 but many proposed investments )in approval on the grounds that they improve employee morale2 the companyQs image2 or safety.

"here is no feasible alternative to adoption. !nvironmental la)s may re/uire investment in a ne) program2as an e+ample. "he management control system should provide an orderly )ay of deciding on proposals that cannot be analyzed by /uantitative techni/ues. 'ystems that attempt to ran3 non@/uantifiable projects in order of profitability )onQt )or3. Many projects do not fit into a mechanical ran3ing scheme. Q.!o. 6. 0hat are the *ifferent metho*s to measure profits of a profit center in organi:ations? 0hich *ifferent messages each type of measure is li-ely to con,ey to managers? Ans) Khen financial performance in a responsibility center is measured in terms of profit2 )hich is the difference bet)een the revenues and e+penses2 the responsibility center is called a profit center.9rofit 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. "here are t)o types of profitability measurements in a profit center2 just as there are for the organization as a )hole. "here is2 first2 a measure of management performance< in )hich the focus is on ho) )ell the manager is doing. "his measure is used for planning2 coordinating and controlling the day@to@day activities of the profit center. 'econd2 there is a measure of economic performance2 in )hich the focus is on ho) )ell the profit center is doing as an economic entity. "he message given by these t)o measures may be /uite different.

1 #ypes of .rofitability measures)

In order to evaluate the economic performance of a profit center2 one must use net income after allocating all costs. Lo)ever2 in evaluating the performance of manager2 any of five different measures of profitability can be used.

1< $ontribution

argin) "he logic behind using contribution margin as a measure is that fi+ed e+penses are

not controllable by the manager2 and therefore he should focus on ma+imizing the spread bet)een revenue and e+penses. 0ut the problem )ith this is that some fi+ed costs are controllable and all fi+ed costs are partially controllable. A focus on the contribution margin tends to direct attention a)ay from this responsibility.

*< Direct .rofit) "his measure sho)s the amount that the profit center contributes to the general overhead and
profit of the corporation. It incorporates all e+penses incurred in or directly traced to the profit center2 regardless of )hether these items are entirely controllable by the profit center manager. A )ea3ness of this measure is that it does not recognize the motivational benefit of charging head/uarters costs.

,< $ontrollable .rofit) Lead/uarters e+penses are divided into t)o categoriesF controllable and non@
controllable. "he controllable e+penses are controlled by business unit manager. #onse/uently2 if these costs are included in the management system2 the profit )ill be after the deduction of all e+penses that are influenced by profit center manager.

-< Income before #axes) In this measure2 all corporate overhead is allocated to profit centers. "he basis of
allocation reflects the relative amount of e+pense that is incurred for each profit center. If corporate

overheads are allocated to profit centers2 budgeted costs2 not actual costs2 should be allocated. "hen the performance report )ill sho) an identical amount in the HbudgetJ and HactualJ columns for such overheads. .< !et Income) Lere2 companies measure performance of domestic profit centers at the bottom line2 the amount of net income after income ta+. "here are t)o arguments 1< Income after ta+ is constant percentage of the preta+ income2 so there is no advantage in incorporating income ta+es *< many decisions that have impact on income ta+es are made at head/uarters2 and it is believed that profit center manager should not be judged by the conse/uences of these decisions. Q/) Explain special characteristics of professional organi:ations (hich impact interacti,e controls? anagement $ontrol. 0hat are

Special $haracteristic of a .rofessional %rgani:ation) 1. "oals A goal of a manufacturing company is to earn a satisfactory profit specially a satisfaction profit2 specially a satisfactory return on assets its principle assets is the s3ill of its professional staff )hich doesnt appear on its balance sheet .return on assets employed therefore is essential meaningless in such organization .their financial goal is to provide ade/uate compensation to the professional. 6. .rofessionals 9rofessional organization is labour intensive and the labour is of a special type. %esearch and development organization use in setting selling price and for other management purposes .standard cost system 2separation of fi+ed and variable cost and analyses of variance )ere built on the foundation are e+ample of organization )hose product are professional service. 9rofessional tends to give in ade/uate )eight to the financial implication of their decision they )ant to do the best job they can regardless of its cost. 0ecause 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 1648s many boo3s and articles )ere )ritten on this subject but fe) comp actually such a system and )e do not 3no) of any that one current .the problem of measuring the value of human assets is intractable. /. %utput an* input measurement "he output of a profession organisation cannot be measured in physical terms2 use in setting selling price and for other management purposes .standard cost system2 seperstion of fi+ed and variable cost and analyses of variance )ere built on the foundation. Ke 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 e/uivalent to measuring the amt or /uality earned is one measures of output in some professional organization but these monetary amts at most relate to the /uantity of service rendered not to their /uality. 'ome profession notably scientist engineer2 and professional are reluctant to 3eep trac3 of ho) they spend their time and this complicate the trac3 of measuring performance .this reluctant seems to have its root in tradition usually it can be overcome if senior management is )illing to put appropriate emphasis on the necessity for accurate time reporting .nevertheless difficult problem arise in deciding ho) time should be charged to clients .if the normal )or3 )ee3 is -8

hrs should a job be charged for 1D-8th of a )ee3 compensation for each other spent on itI If so ho) should )or3 done on evening and )ee3end be counted ho) to account for time spent reading literature 2going to meeting 2and other)ise 3eeping up to dateI =. Small Si:e Kith a fe) e+ception such as some la) firm and accounting firms 2professional organisations are relatively small and operate at a single location .senior management in such organisations can personally observe )hat is going on and personally motivate employee .thus there is less need for a sophisticated management control system 2)ith profit centres and formal performance reports nevertheless even a small organisations need a budget a regular comparison of performance against budget 2and a )ay relating compensation to performance. 3. ar-eting

In a manufacturing company there is a dividing line bet)een mar3eting activities and production activities only senior management is concerned )ith both .such a clean separation does not e+ist in most 9rofessional organisation2 ho)ever their time and this complicate the trac3 of measuring performance .this reluctant seems to have its root in tradition usually it can be overcome if senior management is )illing to put appropriate emphasis on the necessity for accurate time reporting. Nevertheless difficult problem arise in deciding ho) time should be charged to clients .if the normal )or3. "hese mar3eting activities are conducted by professional usually by professional2 usually by professional )ho spend much of their time in production )or3 that is )or3ing for clients. In such situation it is difficult to assign appropriate credit to the person responsible for selling a ne) customerB in a consulting firm for e+ample a ne) engagement may result from a conversation bet)een a member of the firm or from the reputation of one of the firm professional as an outgro)th of speeches or articles. Moreover the profession al )ho is responsible for obtaining the engagement may not personally involved in carrying it out .until fairly recently these mar3eting contribution )ere re)arded subjectively Athat is they )ere ta3en into account in promotion and compensation decisions .some organisation no) give e+plicit credit2 perhaps as a percentage of the project revenue2 if the person revenue2 if the person )ho hold sold the project can be identified.

1 0hat is Interacti,e $ontrol?

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 thin3ing about ne) strategies.

1. A subset of the management control information that has a bearing on the strategic uncertainties facing
the buss becomes the focal point.

*. 'enior e+ecutive ta3e such information seriously. ,. Managers at all levels of the org focus attention on the information produced by the system.

Q3) Shan*ilya Lt*. 4 $S56778) !umerical 'handilya &td. has adopted !conomic Ralue Added ;!RA< techni/ue for the appraisal of performance of its three divisions A20 and #. #ompany charges 1N for current assets and 5 N for :i+ed Assets2 )hile computing !RA relevant data are given belo) F@

10

Di, A

Di, 1

Di, $

#otal

1u*gete * 9rofit #urrent Assets :i+ed Assets ,18 -88 1188

Actu al ,*8 ,18 1188

1u*gete * **8 588 1188

Actua l *-8 418 1588

1u*gete * *88 1*88 *888

Actua l *88 1-88 **88

1u*get e* 458 *-88 .*88

Actual 418 *.*8 .188

'olutionF .articulars Di, A 1u*gete * 15N *85 Actu al 11N 148.Di, 1 1u*gete * 6N -Actua l 6N .8.Di, $ 1u*gete * 1N @,* Actu al 1N @18 #otal 1u*get e* 18N **8

Actual 6N 118.5

%$A !RA

b) $omment upon both metho*s< base* on results. "here are three apparent benefits of an %$A measure. :irst2 it is a comprehensive measure in that anything that effects the financial statements is reflected in this ratio. 'econdly2 %$A is easy to calculate2 easy to understand2 and meaningful in absolute sense. :inally2 it is a common denominator that may be applied to any organizational units responsible for profitability2 no matter )hat its size or )hat business it practices. "he performance of different units may be compared directly to each other. Also2 %$I data is available for competitors that can be used as a basis for comparison. Nevertheless2 the !RA approach has some inherent advantages over %$A. "here are three compelling reasons to use !RA over %$I. +irst2 )ith !RA all business units have the same profit objective for comparable investments. "he %$I approach2 on the other hand2 provides different incentives for investment across business units. :or e+ample2 a business unit that is currently achieving ,8N %$A )ould be most reluctant to e+pand unless it is able to earn a %$I of ,8N or more on additional assets. 'econd2 decision that increase a centres %$I may decrease its overall profits. "hird advantage of !RA is that different interest rates may be used for different types of assets. :or e+ample2 a relatively lo) rate May be used for inventories )hile a higher rate may be used for different types of fi+ed assets.

SE# ./
MANAGEMENT CONTROL SYSTEM

Q.1) Describe *ifferences in bu*geting perspecti,e of engineere* an* *iscretionary expense centre

1.Expense centers) !+penses center are responsibility centers for )hich input or e+penses are measured in monetary terms2 but for )hich outputs are not measured in monetary terms. "here are t)o general typesF engineered e+pense

11

center and discretionary e+pense center. "hey correspond to t)o types of costs.. !ngineered costs are elements of cost for )hich the right or proper amount of costs that should be incurred can be estimated )ith a reasonable degree of reliability. #osts incurred in factory for direct labour direct material component supplies and utilities are e+amples.

6.Engineere* expense centers) !ngineered e+pense center have the follo)ing characteristicsF

1. "heir inputs can be measured in monetary terms. *. "heir output can be measured in physical terms. ,. "he optimal dollar amount of input re/uired to produce one unit of output can be established
!ngineered e+pense center usually are found in manufacturing operations. Karehousing2 distribution2 truc3ing and similar units in the mar3eting organization also may be engineered e+pense center and so many certain responsibility center )ithin administrative and support department. !+amples 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. 'uch units perform repetitive tas3 for )hich standard cost can be developed In an engineered e+pense center the output multiplied by the standard cost or each unit produced represents )hat the finished product should have cost. Khen this cost is compared to actual costs2 the difference bet)een the t)o represents the efficiency of the organization unit being measured. Ke emphasize that engineered e+pense centers have other important tas3s not measured by cast alone. "he effectiveness of these aspects of performance should be controlled. :or e+ample e+penses center supervisor are responsible for the /uality of good and for the volume of production in addition to their responsibility for cost efficiency. "herefore the type and amount of production is prescribed and specific /uality standards are set so that manufacturing costs are not minimized at the e+pense of /uality. Moreover manager of engineered e+pense 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 ho) )ell they carry out these responsibilities.

"here are fe) if any responsibility center in )hich all cost items are engineered. !ven in highly automated production department the amount of indirect labour and of various services used can vary )ith management discretion.

"hus2 the term engineered costs center refers to responsibility center in )hich engineered cost predominate but it does not imply that valid engineering estimates can be made for each and every cost item.

/.Discretionary expense center) "he output of discretionary e+penses center cannot be measured in monetary terms. "hey include administration and support units research and development organization and most mar3eting activities. "he 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. $ne company may have a small head/uarter staff another company of similar size and in the same industry may have a staff that is 18 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 )ay judging )hich decision )as actually better

12

manager are hired and paid to ma3e such decision after such a drastic change the level of discretionary e+penses generally has a similar pattern from one year to the ne+t. "he difference bet)een budgeted and actual e+pense is not a measure of efficiency in a discretionary e+pense centre it is simply the difference bet)een the budgeted input and the actual input. It in no )ay measures the value of the output2 if actual e+pense do not e+ceed the budget amount2 the manager has Slived )ithin the budget S ho)ever 2because by definition the budget does not purport to measure the optimum amount of spending )e cannot say that living )ithin the budget is efficient performance . =.Differences in bu*geting perspecti,e of engineere* an* *iscretionary expense centre

1 1u*get preparation "he decision that management ma3e about a discretionary e+pense budget are different from the decisions that it
ma3es about the budget for an engineered e+pense center. :or the latter2 management decides )hether the proposed operating budget represent the cost of performing tas3 efficiently for the coming period. Management is not so much concerned )ith the magnitude of the tas3 because this is largely determined by the actions of other responsibility centers2 such as the mar3eting departments ability to generate sales. In formulating the budget for a discretionary e+pense center2 ho)ever management principal tas3 is to decide on the magnitude of the job that should be done.

1 Incremental bu*geting)
Lere the current level e+penses in a discretionary e+pense center is ta3en as a starting points this amount is adjusted for inflation for anticipated changes in the )or3load of continuing tas3s for special tas3s and if the data are readily available for the cost of comparable )or3 in similar units. "here are t)o dra)bac3s to incremental budgeting. :irst because managers of these centers typically )ant to provide more service they tend to re/uest additional resources in the budgeting process and if they ma3e a sufficiently strong case these re/uest )ill be granted. "his tendency is e+pressed in 9ar3insons second la)F overhead costs tend to increase period. "here is ample evidence that not all this up)ard creep in cost is necessary.

"his problem is especially compounded by the fact that the current level of e+penditure in the discretionary e+penses center is ta3en for granted and is not re@e+amined during the budget preparation process. 'econd )hen a company faces a crises or )hen a ne) management ta3es over overhead costs are sometimes drastically reduced )ithout any adverse conse/uences. 7espite this limitation most budgeting in discretionary e+pense centers is incremental. "ime does not permit the more thorough analysis described in the ne+t section.

13

An alternative approach is to ma3e a thorough analysis of each discretionary e+pense center on a schedule that )ill cover all of them over a period of five year or so. "hat analysis provides a ne) base. "here is a li3elihood that e+penses )ill creep up gradually over the ne+t five years and this is tolerated at the end of five years2 another ne) base is established. 'uch an analysis is often called a zero base revie). In contrast )ith incremental budgeting )hich ta3es the current level of spending as the starting point this more intensive revie) attempts to build up de no) the resources that actually are needed by the activity. 0asic /uestion are raisedB;1< should use customerI;*< )hat should the /uality level be Iare )e doing too much;,<should the function be performed in this )ay ;-< ho) much should it costI

1 $ost ,ariability)
In discretionary e+pense center costs tend to vary )ith volume from one year to the ne+t but they tend not to vary )ith short run fluctuation in volume )ithin a given year. 0y contrast costs in engineering e+pense center are e+pected to vary )ith 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 B 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 e+pense item in most discretionary e+pense center the annual budget for these center tend to be a constant percentage of budgeted sales volume.

1 Q.6)

Explain some factors (hich may influence top management style an* the implication of the top management style on management control.

"he management control function in an organization is influenced by the style of senior management. "he style of the chief e+ecutive officer affects the management control process in the entire organization. 'imilarly2 the style of the business unit manager affects the unitQs management control process2 and the style of functional department managers affects the management control process in their functional areas.

1 Differences in anagement Styles

Managers manage differently. 'ome rely heavily on reports and certain formal documentsB others prefer conversations and informal contacts. 'ome are analyticalB others use trial and error. 'ome are ris3 ta3ersB others are ris3 averse. 'ome are process orientedB others are results oriented. 'ome are long@term orientedB others are short@term oriented. 'ome emphasize monetary re)ardsB others emphasize a broader set of re)ards.

Management style is influenced by the managerQs bac3ground and personality. 0ac3ground includes things li3e age2 formal education2 and e+perience in a given function2 such as manufacturing2 technology2 mar3eting2 or finance. 9ersonality characteristics include such variables as the managerQs )illingness to ta3e ris3s and his or her tolerance for ambiguity.

1 Implications for anagement $ontrol "he various dimensions of management style significantly influence the operation of the control systems. !ven if the
same reports )ith the same set of data go )ith the same fre/uency to the #!$2 t)o #!$s )ith different styles )ould use these reports very differently to manage the business units. 'tyle affects the management control process A ho) the #!$ prefers to use the information2 conducts performance revie) meetings2 and so on A )hich in turn affects ho) the control system actually operates2

14

even if the formal structure does not change under a ne) #!$. In fact2 )hen #!$s change2 subordinates typically infer )hat the ne) #!$ really )ants based on ho) he or she interacts during the management control process.

15

.ersonal ,ersus Impersonal $ontrols 9resence of personal versus impersonal controls in organizations is an aspect of managerial style. Managers differ on ho) much importance they attach to formal budgets and reports as )ell as informal conversations and other personal contacts. 'ome managers are Enumbers orientedEB they )ant a large flo) of /uantitative information2 and they spend much time analyzing this information and deriving tentative conclusions from it. $ther managers are Epeople orientedEB they loo3 at a fe) numbers2 but they usually arrive at their conclusions by tal3ing )ith people2 judging the relevance and importance of )hat they learn partly on their appraisal of the other person. "hey visit various locations and spend time tal3ing )ith both supervisors and staff to get a sense of ho) )ell things are going.

ManagersQ attitudes to)ard formal reports affect the amount of detail they )ant2 the fre/uency of these reports2 and even their preference for graphs rather than tables of numbers2 and )hether they )ant numerical reports supplemented )ith )ritten comments. 7esigners of management control systems need to identify these preferences and accommodate them.

1 #ight ,ersus Loose $ontrols

A managerQs style affects the degree of tight versus loose control in any situation. "he manager of a routine production responsibility center can be controlled relatively tightly or loosely2 and the actual control reflects the style of the managerQs superior. "hus2 the degree of tightness or looseness often is not revealed by the content of the forms or aspects of the formal control documents2 rules2 or procedures. It is a factor of ho) these formal devices are used. "he degree of looseness tends to increase at successively higher levels in the organization hierarchyF higher@level managers typically tend to pay less attention to details and more to overall results.

"he style of the #!$ has a profound impact on management control. If a ne) senior manager )ith a different style ta3es over2 the system tends to change correspondingly. It might happen that the managerQs style is not a good fit )ith the organizationQs management control re/uirements. If the manager recognizes this incongruity and adapts his or her style accordingly2 the problem disappears. If2 ho)ever2 the manager is un)illing or unable to change2 the organization )ill e+perience performance problems. "he solution in this case might be to change the manager.

Q./) Explain a*,antages an* *isa*,antages of t(o step transfer pricing an* profit sharing metho*s

1 #ransfer pricing) If t)o or more profit center is jointly responsible for product development
manufacturing and mar3eting each should share in the revenue that is generated )hen the product is finally sold. "he transfer price is not primarily an accounting toolB rather2 it is a behavioral tool that motivates manager to ma3e the right decisions. In particular the transfer price should be designed so that it accomplishes the follo)ing ob>ecti,e) It should provide each segment )ith the relevant information re/uired to determine the optimum tradeoff bet)een 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

* #(o step pricing) :irst2 a charge is made for each unit sold that is e/ual to the standard variable
cost of production. 'econd a periodic charge is made for the buying unit. $ne or both of these components should include a profit margin. "he t)o step pricing method

16

correct this problem by transferring variable cost on a per unit basis2 and transferring fi+ed cost and profit on a lump sum basis under this method the transfer price for product A )ould be .= for each unit that unit ( purchases plus =*8888 per month for fi+ed cost. 9lus =18888 per month for profitF if transfer of product A in a certain month are at the e+pected amount .888 units then under the t)o step method unit y )ill pay the variable cost of =*.888 plus =,8888 for the fi+ed cost and profit a total of =..888 .this is the same amount as the amount it )ould pay unit + if the transfer price is less than .888 units say -888unoits.unit y )ould pay =.8888 under the t)o step methods compared )ith the =--888 it )ould pay if the transfer price )ere =11 per unit. "he difference is their transfer prices )ere for not using a portion of unit P capacity that it has reserved. Note that under t)o step method the company variable cost for product A is identifiable to unit ( variable cost for the product2 and unit ( )ill ma3e the correct short term mar3eting decisions. Mnit ( also has information on upstream fi+ed costs and profit related to product A and it can use these data for long term decision."he fi+ed cost calculation in the t)o step pricing method is based on the capacity that is reserved for the production of product A that is sold to unit ( the investment represented by this capacity is allocated to product A. "he return on investment that unit P earns on competitive product is calculated and multiplied by the investment assigned to the product. In the e+ample )e calculated the profit allo)ance as a fi+ed monthly amount. It )ould be appropriate under some circumstance to divide the investment into variable and fi+ed component. "hen2 a profit allo)ance based on a return on investment on variable assets )ould be added to the standard variable cost for each unit sold.

17

.rofit sharing) If the t)o step pricing system just described is not feasible2 a profit sharing system might be used to ensure congruence of business unit interest )ith company interest. "his system operates some)hat as follo)s.

8. "he product is transferred to the mar3eting unit at standard variable cost. 1. After the product is sold2 the business units share the contribution earned )hich is selling price minus the variable
manufacturing and mar3eting costs. "his method of pricing may be appropriate if the demand for the manufactured product is not steady enough to )arrant the permanent assignment of facilities as in the t)o step method. In general2 this method accomplished the purpose of ma3ing the mar3eting units interest congruent )ith the companies. "here are several practical problems in implementing such profit sharing system. :irst2 there can be arguments over the )ay contribution is divided bet)een the t)o profit centers. Khich is costly2 time consuming and )or3 against basic reason for decentralization namely autonomy of the business units mangers. 'econd2 arbitrarily divided up the profit bet)een units does not give valid information on the profitability of each segment of the organization.

"hird since the contribution is not allocated until after the sale has been made the manufacturing units contribution depends upon the mar3eting units ability to sell and on the actual selling price. Manufacturing units may perceive this situation to be unfair

1 #(o set of price) in this method2 the manufacturing units revenue is credited at the outside sales price2 and
the buying unit is charged the total standard costs. "he difference is changed to a head/uarter account and eliminated )hen the business unit statement are consolidated2 this transfer pricing method is sometimes used )hen there are fre/uent conflict bet)een the buying and selling units that cannot be resolved by one of the other method both the buying and selling

* #here are se,eral *isa*,antages to the system of ha,ing t(o set of transaction prices< ho(e,er the sum
of the business unit profit is greater than overall company profits2 senior management must be a)are of this situation in approved budget for the business units and in subse/uent evaluation of performance against these budget. Also2 this system create an illusion feeling that business units are ma3ing money )hile in fact the overall company might be losing after ta3ing account of the debits to head/uarter. :urther this system might motivate business unit to concentrate more on internal transfers at the e+pense of outside sales

, #he fact that the conflict bet(een the business units (oul* be lessene* un*er this system coul* be
,ie(e* as a (ea-ness. 'ometime2 it is better for the head/uarter to be a)are of the conflict arising out of transfer prices because such conflict may signal problem in either the organizational structure or In other management systems. Mnder the t)o sets of prices method these conflicts are smoothed over thereby not alerting senior management to these problems. Q.=) Discuss special challenges face* in controlling & ? D acti,ities an* possible management initiati,es

1 #ype of financial control) "he financial control e+ercised in a discretionary e+pense center is /uite different from
that in engineered center the latter attempts to minimize operating cost by

18

setting a standard and reporting actual costs against this standards. "he main purpose of a discretionary e+pense budget on the other hand is to allo) the manager to control #ost for particular in the planning. #osts are controlled primarily by deciding )hat tas3 should be underta3en and )hat level of effort is appropriate for each. "hus in a discretionary e+pense center financial control is primary e+ercised at the planning stage before the amount are incurred.

easurement of performance) "he primary job of the manager of a discretionary e+pense center is to accomplish the desired output spending an amount that is on budget is satisfactory. "his is in contrast )ith the report in an engineered e+pense center )hich helps higher management to evaluate the manger efficiency. If these t)o types of responsibility center are carefully distinguished management may treat the performance report for the discretionary e+pense center as if it )ere an indication of efficiency #ontrol over spending can be e+ercised by re/uiring that the manger approved be obtain before the budget is over sometimes a certain percentage of overrun is permitted )ithout additional approval if the budget really set forth the best estimate of actual cost there is .8 percent probability that it )ill overrun and this is the reason that some latitude is often permitted.

* $ontrol problems) "he control of % T 7 centers2 )hich are also discretionary e+pense center is
follo)ing at least a semi tangible output reasons.

difficult for the

1. %esults are difficult to measure /uantitatively. As contrasted )ith administrative activities2 %T7 usually has at
least a semi tangible output in patent2 ne) products2 or ne) processes. Nevertheless2 the relationship of these outputs to inputs is difficult to measure and appraise. A complete product of an %T7 group may re/uire several year of effortB conse/uently input as stated in an annual budget may be unrelated to outputs. !ven if an output can be identified a reliable estimate of its value often cannot be made. !ven if the value of the output can be calculated2 it is usually not possible for management to evaluate the efficiency of the %T7 effort because of its technical nature. A brilliant effort may come up against an insuperable obstacle2 )hereas a mediocre effort may2 by luc3 result in a bonanza.

*. "he goal congruence problem in %T7 center is similar to that in administrative centers. "he research managers
typically )ant to build the best research organization that money can buy2 even though this is more e+pensive than the company can afford. A further problem is that research people often may not have sufficient 3no)ledge of the business to determine the optimum direction of the research efforts.

,. %esearch and development can seldom be controlled effectively on an annual basis. A research project may ta3e
year s to reach fruition2 and the organization must be built up slo)ly over a long time period. "he principal cost is for the )or3 force obtaining highly s3illed scientific talented is often difficult2 and short term fluctuation in the )or3 force are in efficient. It is not reasonable2 therefore to reduce %T7 costs in years )hen profits are lo) and increase them in year )hen profits are high. %T7 should be loo3ed at as a long term investment not as an activity that varies )ith short run corporate profitability.

1 #he &?D continuum)Activities conducted by %T7 organization lie along a continuum. At one e+treme
is basic researchB the other e+treme is product testing. 0asic research has t)o characteristicsF first2 it is unplanned management at most can specify the general area that is to be e+plored second there is often a very long time lag before basic research result in successful

19

ne) product introductions. :inancial control system has little value in managing basic research activities. In some companies2 basic research in included as a lump sum in the research program and budget. In others2 no specific allo)ance is made for basic research as suchB there is an understanding that scientists and engineers can devote part of their time to e+plorations in )hatever direction they find most interesting2 subject only to informal agreement )ith their supervisor.:or product testing projects2 on the other hand2 the time and financial re/uirement can be estimated2 not as accurately as production activities. Q.3) Explain problems face* in pricing corporate ser,ices pro,i*e* to business units organi:e* as .rofit $enters 'ervices are intangible in nature. "his characteristic of services ma3es it difficult for pricing. #harging business units for services furnished by corporate staff units becomes challenging )or3 due to intangibility of services. Khile pricing corporate services2 )e e+clude the cost of central service staff units over )hich business units have no control ;e.g.2 central accounting2 public relations2 and administration<. If these costs are charged at all2 they are allocated2 and the allocations do not include a profit component. "he allocations are not transfer prices.

1 0e nee* to consi*er t(o types of transfers) 1$ :or central services that the receiving unit must accept but can at least partially control the amount
used.

*$ :or central services that the business unit can decide )hether or not to use.
0usiness units may be re/uired to use company staffs for services such as information technology and research and development. In these situations2 the business unit manager cannot control the efficiency )ith )hich these activities are performed but can control the amount of the service received. "here are three schools of thought about such services. $ne school holds that a business unit should pay the standard variable cost of the discretionary services. If it pays less than this2 it )ill be motivated to use more of the service than is economically justified. $n the other hand2 if business unit managers are re/uired to pay more than the variable cost2 they might not elect to use certain services that senior management believes )orth)hile from the companyQs vie)point. "his possibility is most li3ely )hen senior management introduces a ne) service2 such as a ne) project analysis program. "he lo) price is analogous to the introductory price that companies sometimes use for ne) products.

A second school of thought advocates a price e/ual to the standard variable cost plus a fair share of the standard fi+ed costs@that is2 the full cost. 9roponents argue that if the business units do not believe the services are )orth at least this amount2 something is )rong )ith either the /uality or the efficiency of the service unit. :ull cost represents the companyQs long run costs2 and this is the amount that should be paid. A third school advocates a price that is e/uivalent to the mar3et price2 or to standard full cost plus a profit margin. "he mar3et price )ould be used if available ;e.g.2 costs charged by a computer service bureau<B if not2 the price )ould be full cost plus a return on investment. "he 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. Also2 the business units )ould incur the investment if they provided their o)n service.

1 %ptional @se of Ser,ices

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In some cases2 management may decide that business units can choose )hether to use central service units. 0usiness

In some cases2 management may decide that business units can choose )hether to use central service units. 0usiness

*8

*82882888

**288288 8

&%I A .rofitBIn,estment

*8N

*8N

7espite of increase in investment by 18N2 there is negligible difference in transfer price. Also the sales have decreased by -88 units. "herefore )e can say that additional investment has not achieved any positive results.

SE#5=
U.1< A<!+plain the concept of %$I. Khat are its advantagesI %eturn on investment ;%$I< is the ratio of profit before ta+ to the gross investment. %$I is calculated )ith the help of the follo)ing formulaF %$I > ;9re@"a+ 9rofitD'ales< P ;'alesDNet Assets< or ;9re@"a+ 9rofitsDNet Assets< "he numerator is profit before ta+ as reported in the 9T& account. "he profit should include only the profits arising out of the normal activities of the division. Mnusual items of receipts and e+penses should be e+cluded from the profit figure. $ne should also ignore )indfalls and income from investments not related to the operations of the division. "a+ is e+cluded from the numerator because the marginal of the '0M is not responsible for or in control of the ta+ paid. #apital employed can be ascertained from the balance sheet by including fi+ed and current assets. Assets not currently put to divisional use should be e+cluded from the investment base. $ne also needs to e+clude their relative earnings if any. "he company should also e+clude intangible assets li3e good)ill2 deferred revenue e+penses2 preliminary e+penses2 etc. %$I can be improved byF

1o Increasing the profit margin on sales. *o Increasing the capital turnover ,o Increasing both profit margin and capital turnover. -o %educing cost as that adds to the total earnings of the firm. .o Increasing the profits by e+panding present operations or developing ne) product line2 increasing
mar3et share2 etc.

1o 7iversifying2 introducing productivity imporevement measures2 e+pansion2 replacement of old

e/uipments Advantages of %$I

4o %$I relates return to the level of investment and not sales as the rate of return is more realistic. 5o %$I can be decomposed into other variables as sho)n. "hese variables have tremendous analytical value. 6o %$I is an effective tool for inter@firm comparison.
Uuestion 1 ;b<F

22

Many e+perts regard !RA as a concept superior to %$I and yet in certain cases2 !RA does not do justice to the evaluation of investment center. !+plain this phenomenon )ith as illustration. !RA does not solve all the problems of measuring profitability in an investment center. In particular2 it does not solve the problem of accounting for fi+ed assets discussed above unless annuity depreciation is also used2 and this is rarely done in practice. If gross boo3 value is used2 a business unit can increase its !RA by ta3ing actions contrary to the interests of the company2 as sho)n in !+hibit 4@,. If net boo3 value is used2 !RA )ill increase simply due to the passage of time. :urthermore2 !RA )ill be temporarily depressed by ne) investments because of the high net boo3 value in the early years. !RA does solve the problem created by differing profit potentials. All business units2 regardless of profitability2 )ill be motivated to increase investments if the rate of return from a potential investment e+ceeds the re/uired rate prescribed by the measurement system. Moreover2 some assets may be undervalued )hen they are capitalized2 and others )hen they are e+pensed. Although the purchase cost of fi+ed assets is ordinarily capitalized2 a substantial amount of investment in start@up costs2 ne) product development2 dealer organization2 and so forth may be )ritten off as e+penses2 and2 therefore2 not appear in the investment base. "his situation applies especially in mar3eting units. In these units the investment amount may be limited to inventories2 receivables2 and office furniture and e/uipment. Khen a group of units )ith varying degrees of mar3eting responsibility are ran3ed2 the unit )ith the relatively larger mar3eting operations )ill tend to have the highest !RA. In vie) of all these problems2 some companies have decided to e+clude fi+ed assets from the investment base. "hese companies ma3e an interest charge for controllable assets only2 and they control fi+ed assets by separate devices. #on@ trollable assets are2 essentially2 receivables and inventory. 0usiness unit management can ma3e day@to@day decisions that affect the level of these assets. If these decisions are )rong2 serious conse/uences can occur@/uic3ly. :or e+am@ ple2 if inventories are too high2 unnecessary capital is tied up2 and the ris3 of obsolescence is increasedB )hereas2 if inventories are too lo)2 production interruptions or lost customer business can result from the stoc3outs. "o focus attention on these important controllable items2 some companies2 such as Uua3er $ats2 14 include a capital charge for the items as an element of cost in the business unit income statement. "his acts both to motivate business unit management properly and also to measure the real cost of resources committed to these items. Investments in fi+ed assets are controlled by the capital budgeting process before the fact and by post completion audits to determine )hether the anticipated cash flo)s2 in fact2 materialized. "his is far from being completely satis@ factory because actual savings or revenues from a fi+ed asset ac/uisition may not be identifiable. :or e+ample2 if a ne) machine produces a variety of products2 the cost accounting system usually )ill not identify the savings attribut@able to each product. "he argument for evaluating profits and capital investments separately is that this often is consistent )ith )hat senior management )ants the business unit manager to accomplishB namely2 to obtain the ma+imum long@run cash flo) from the capital investments the business unit manager controls and to add capital investments only )hen they )ill provide a net return in e+cess of the companyQs cost of funding that investment. Investment decisions2 then2 are controlled at the point )here these decisions are made. #onse/uently2 the capital investment analysis procedure is of primary importance in investment control. $nce the investment has been made2 it is largely a sun3 cost and should not influence future decisions. Nevertheless2 management )ants to 3no) )hen capital investment decisions have been made incorrectly2 not only because some action may be appropriate )ith respect to the person responsible for the mis@ta3es but also because safeguards to prevent a recurrence may be appropriate. U.* Khat are the different methods to evaluate the performance of an investment centreI 7iscuss the merits and demerits of eachI Khich method )ould you recommendI "he follo)ing techni/ues are useful in evaluating the performance of an investment centreF 1. %eturn on investment ;%$I<F "he rate of return on investment is determined by dividing net profit or income by the capital employed or investment made to achieve that profit. %$I > 9rofit D Invested capital O 188

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%$I consists of t)o components viz. 9rofit margin Investment turnover %$I > Net profit D Investment > ;Net profit D 'ales< O ;'ales D Investment in assets< It )ill be seen from the above formula that %$I can be improved by increasing one or both of its components viz. the profit margin and the investment turnover in any of the follo)ing )aysF Increasing the profit margin Increasing the investment turnover Increasing both profit margin and investment turnover #apital employed is ta3en to be the total of shareholders funds2 loans etc "he profit figure used is in calculating %$I is usually ta3en from the profit and loss account2 profit arising out of the normal activities of the company should only be ta3en. #apital employed for the company as a )hole can be arrived at as follo)sF 'hare capital of the company %eserves and surplus +++ +++

&oans ;securedDunsecured<+++ @@@@@@ +++ &essF a. Investment outside the business b. 9reliminary e+penses +++ +++ @@@@@@@ ++++ +++

c. 7ebit balance of 9 T & ADc+++

MeritsF %eturn on investment analysis provides a strong incentive for optimum utilization of the assets of the company. "his encourages managers to obtain assets that )ill provide a satisfactory return on investment and to dispose off assets that are not providing an acceptable return. In selecting amongst alternative long@term investment proposals2 %$I provides a suitable measure for assessment of profitability of each proposal. 7emeritsF %$I analysis is not very suitable for short@term projects and performances. In the initial stages a ne) investment may yield a small %$I )hich may mislead the management. Most li3ely the rate )ould improve in course of time )hen the initial difficulties are overcome.

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"he boo3 value of assets decline due to depreciation2 the investment base )ill continuously decrease in value2 causing the rate of return to increase. *. %esidual incomeF %esidual income can be defined as the operating profit ;or income< of the company less the imputed interest on the assets used by the company. In other )ords2 interest on the capital invested in the company is treated as a cost and any surplus is the residual income. %esidual income is profit minus notional interest charge on capital employed. %esidual income is affected by the size of the organization and therefore )ill not provide a basis for evaluation of organizational performance. "his is probably the main reason )hy the management continues to ma3e use of %$I )hich is relative measure. Not all projects start off )ith positive or sufficiently large positive profits in the early years of a project to produce a positive increment to residual income. It has been argued that a more suitable measure of performance for investment centres2 )hich could encourage managers to be more )illing to underta3e marginally profitable projects2 is residual income. Ke recommend %I as a method of evaluating performance of an investment centre. 0ecause )hen %I is adopted for evaluation purposes2 emphasis is placed on marginal profit amount above the cost of capital rather than on the rate itself. U., Khat are the objectives of "ransfer 9ricingI "ransfer price if designed appropriately has the follo)ing objectivesF It should provide each segment )ith the relevant information re/uired to determine the optimum trade@off bet)een company costs and revenues.It should induce goal congruent decisions@i.e. the system should be so designed that decisions that improve business unit profits )ill also improve company profits. It should help measure the economic performance of the individual profit centers. "he system should be simple to understand and easy to administer.

Khat is ideal transfer price in the situations of &imited Mar3et 'hortage of #apacity in the industry
"he ideal transfer price in the situations of &imited Mar3et 0y limited mar3et it means that the mar3ets for buying and selling profit centers may be limited. !ven in case of limited mar3et the transfer price that is ideal or satisfies the re/uirement of a profit center system is the competitive price. In case if a company is not buying or selling its product in an outside mar3et there are some )ays to find the competitive price. "hey are as follo)sF If published mar3et prices are available2 they can be used to establish transfer prices. Lo)ever2 these should be prices actually paid in the mar3et@place and the conditions that e+ist in the outside mar3et should be consistent )ith those e+isting )ithin the company. :or e+ample2 mar3et prices that are applicable to relatively small purchases are not valid in this case. Mar3et prices are set by bids. "his generally can be done only if the lo) bidder has a reasonable chance of obtaining the business. $ne company accomplishes this by buying about one@half of a particular group of products outside the company and one@half inside the company. "he company then puts all of the products out to bid2 but selects one@half to stay inside. "he company obtains valid bids2 because lo) bidders can e+pect to get some of the business. 0y contrast2 if a company re/uests bids solely to obtain a competitive price and does not a)ard the contracts to the lo) bidder2 it )ill soon find that either no one bids or that the bids are of /uestionable value.
If the production profit center sells similar products in outside mar3ets2 it is often possible to replicate a competitive price on the basis of the outside price. If the buying profit center purchases similar products from the outside mar3et2

25

it may be possible to replicate competitive prices for its proprietary products. "his can be done by calculating the cost of the difference in design and other conditions of sale bet)een the competitive products and the proprietary products.

'hortage of #apacity in the industry In this case2 the output of the buying profit center is constrained and again company profits may not be optimum. 'ome companies allo) either buying profit center to appeal a sourcing decision to a central person or committee. In this scenario a buying profit center could appeal a selling profit centers decision to sell outside.
"he personDgroup )ould then ma3e a sourcing decision on the basis of the companys best interests. In every case the transfer price )ould be the competitive price. In other )ords2 the profit center is appealing only the sourcing decision.

!ven if there are constraints on sourcing2 the mar3et price is the best transfer price. If the mar3et price can be appro+imated2 it is ideal transfer price. Khen do you use #ost 0ased "ransfer 9ricingI Ke use cost@based transfer pricing if there is no )ay of appro+imating valid competitive price. "ransfer prices may be set up on the basis of cost plus a profit2 even though such transfer prices may be comple+ to calculate and the results less satisfactory than a mar3et@based price. ")o aspects need to be considered for cost@based transfer pricingF "he cost basisF "he usual basis is the standard cost. Actual costs should not be used because production inefficiencies )ill then be passed on to the buying profit center. If the standard costs are used2 there is a need to provide an incentive to set tight standards and to improve standards. "he profit mar3upF In calculating the profit mar3up2 there also are t)o decisionsF

Khat is the profit mar3up to be basedI "he simplest and most )idely used base is percentage of costs. If this base is used2 ho)ever2 no account is ta3en of capital re/uired. A conceptually better base is a percentage of investment. 0ut there may be a major practical problem in calculating the investment applicable to a given product. If the historical cost of the fi+ed assets is used2 ne) facilities designed to reduce prices could actually increase costs because old assets are undervalued Khat is the level of profit allo)edI "he second problem )ith the profit allo)ance is the amount of the profit. "he conceptual solution is to base the profit allo)ance on the investment re/uired to meet the volume needed by the buying profit centers. "he investment )ould be calculated at a HstandardJ level2 )ith fi+ed assets and inventories at current replacement costs. "his solution is complicated and2 therefore2 rarely used in practice. U.- ;a< H"ransfer 9ricing is not an accounting toolJ comment )ith an illustration If a group has subsidiaries that operate in different countries )ith different ta+ rates2 manipulating the transfer prices bet)een the subsidiaries can scale do)n the overall ta+ bill of the group. :or e+ample the ta+ rate in #ountry A is *8N and is .8N in #ountry 0. In the larger interest of the group2 it )ould be advisable to sho) lo)er profits in #ountry 0 and higher profits in #ountry A. :or this2 the group can adjust the transfer price in such a )ay that the profits in #ountry A increase and that in #ountry 0 get reduced. :or this the group should fi+ a very high transfer price if the 7ivision in #ountry A provides goods to the 7ivision in #ountry 0. "his )ill ma+imize the profits in #ountry A and minimize the profits in #ountry 0. "he reverse )ill be true if the 7ivision in #ountry A ac/uires goods from the 7ivision in #ountry 0. "here is also a temptation to set up mar3eting subsidiaries in countries )ith lo) ta+ rates and transfer products to them at a relatively lo) transfer price.

26

"here have been instances )here companies have fi+ed unrealistic transfer prices. "he first case relates to Loffman &a %oche that imported t)o drugs &ibrium and Ralium into MV at prices of -,4 pounds and 646 pounds per 3ilo respectively. Khile the ta+ authorities in MV accepted the price2 the Monopolies #ommission did not accept the companyQs argument2 since the same drugs )ere available from an Italian firm for 6 pounds and *5 pounds per 3ilo.

"he companyQs la)yers argued the case before the #ommission on t)o grounds viz.

1. "he price )as not set on cost but on )hat the mar3et )ould bear and *. "he company had incurred an %T7 cost that )as included in the price.
"hese arguments did not go )ell )ith the #ommission and the company )as fined 1.5. million pounds for the manipulative practices adopted )hile fi+ing the transfer price. "he second case is of Nissan. "he company had falsely inflated freight charges by -8@18N to reduce the profits. "he manipulation helped the company to hide ta+ to the tune of *,4 million dollars. "he ne+t year Nissan )as made to pay 181 million dollars in unpaid ta+ in the M'A because the authorities felt that part of their M' mar3eting profits )ere being transferred to Wapan2 as transfer prices on import of cars and truc3s )ere too high. Interestingly the Wapanese ta+ authorities too3 a different vie) and returned the double ta+. Kith a vie) to avoid such cases from recurring2 $rganisation for !conomic #ooperation and 7evelopment issued some guidelines in 166.. "hese guidelines aim at encouraging )orld trade. "hey evolved )hat came to be 3no)n as the armQs length price. "he principle states that the transfer price )ould be arrived at on the basis as if the t)o . companies are independent and unrelated. "he price is determined throughF #omparable 9rice Method )here the price is fi+ed on the basis of prices of similar products or an appro+imation to one. ross Margin Method )here a gross margin is established and applied to the sellerQs manufacturing cost. In spite of all these efforts2 it has to be admitted that setting a fair transfer price is not easy. 'o the onus of proving the price has been put on the ta+payer )ho is re/uired to produce supporting documents. If the ta+payer fails to do this he is re/uired to pay heavy penalty. :or e+ample2 in M'A2 failure to provide documentary evidence results in a -8N penalty on the armQs length price. In MV the penalty is to the tune of 188N of any ta+ adjustment. $ther countries are also in the process of evolving tight norms for the same. #ountries across the globe also allo) the ta+payer to enter into an Advance 9ricing Agreement )hereby dispute can be avoided and so also the costly penalty of double ta+ation and penalty. U.-.; b< Mar3et 9rice is ideal transfer price even in limited mar3ets. #omments 0y limited mar3et it means that the mar3ets for buying and selling profit centers may be limited. !ven in case of limited mar3et the transfer price that is ideal or satisfies the re/uirement of a profit center system is the competitive price. In case if a company is not buying or selling its product in an outside mar3et there are some )ays to find the competitive price. "hey are as follo)sF 1. If published mar3et prices are available2 they can be used to establish transfer prices. Lo)ever2 these should be prices actually paid in the mar3et@place and the conditions that e+ist in the outside mar3et should be consistent )ith those e+isting )ithin the company. :or e+ample2 mar3et prices that are applicable to relatively small purchases are not valid in this case. *.Mar3et prices are set by bids. "his generally can be done only if the lo) bidder has a reasonable chance of obtaining the business. $ne company accomplishes this by buying about one@half of a particular group of products outside the company and one@half inside the company.

27

"he company then puts all of the products out to bid2 but selects one@half to stay inside. "he company obtains valid

"he company then puts all of the products out to bid2 but selects one@half to stay inside. "he company obtains valid

behavior and assumptions that are implicitly and e+plicitly manifested throughout the organization. #ultural norms

The Informal Organization "he lines on an organization chart depict the formal relationships@that is2 the official authority and responsibilities@of each manager. "he chart may sho)2 for e+ample2 that the production manager of 7ivision A reports to the general manager of 7ivision A. 0ut in the course of fulfilling his or her responsibilities2 the production manager of 7ivision A actually communicates )ith many other people in the organization2 as )ell as )ith other managers2 support units2 the head/uarters staff2 and people )ho are simply friends and ac/uaintances. In e+treme situations2 the production manager2 )ith all these other communication sources available2 may not pay ade/uate attention to messages received from the general managerB this is especially li3ely to occur )hen the production manager is evaluated on production efficiency rather than on overall performance. "he realities of the management control process cannot be understood )ithout recognizing the importance of the relationships that constitute the informal organization.

1 Perception and Communication

In )or3ing to)ard the goals of the organization2 operating managers must 3no) )hat these goals are and )hat actions they are supposed to ta3e in order to achieve them. "hey receive this information through various channels2 both formal ;e.g.2 budgets and other official documents< and informal ;e.g.2 conversations<. 7espite this range of channels2 it is not al)ays clear )hat senior management )ants done. An organization is a complicated entity2 and the actions that should be ta3en by anyone part to further the common goals cannot be stated )ith absolute clarity even in the best of circumstances. Moreover2 the messages received from different sources may conflict )ith one another2 or be subject to differing interpretations. :or e+ample2 the budget mechanism may convey the impression that managers are supposed to aim for the highest profits possible in a given year2 )hereas senior management does not actually )ant them to s3imp on maintenance or employee training since such actions2 although increasing current profits2 might reduce future prof@ itability. "he informal factors discussed above have a major influence on the effectiveness of an organizations management control. "he other major influence is the formal systems. "hese systems can be classified into t)o typesF ;1< the management control system itself and ;*< rules2 )hich are described in this section. #he +ormal $ontrol System &ules Ke use the )ord rules as shorthand for all types of formal instructions and controls2 includingF standing instructions2 job descriptions2 standard operating procedures2 manuals2 and ethical guidelines. %ules range from the most trivial ;e.g.2 paper clips )ill be issued only on the basis of a signed re/uisition< to the most important<Fe.g.2 capital e+penditures of over =. million must be approved by the boardQ of directors<. 'ome rules are guidesB that is2 organization members are permitted2 and indeed e+pected2 to depart from them2 either under specified circumstances or )hen their o)n best judgment indicates that a departure )ould be in the best interests of the organization. 'ome rules are positive re/uirements that certain actions be ta3en ;e.g.2 fire drills at prescribed intervals<. $thers are prohibitions against unethical2 illegal2 or other undesirable actions. :inally2 there are rules that should never be bro3en under any circumstancesF a rule prohibiting the payment of bribes2 for e+ample2 or a rule that airline pilots must never ta3e off )ithout permission from the air traffic controller. 'ome specific types of rules are listed belo)F

1 Physical Controls
30

'ecurity guards2 loc3ed storerooms2 vaults2 computer pass)ords2 television surveillance2 and other physical controls may be part of the control structure.

1 Manuals
Much judgment is involved in deciding )hich rules should be )ritten into a manual2 )hich should be considered to be guidelines rather than fiats2 ho) much discretion should be allo)ed2 and a host of other considerations. Manuals in bureaucratic organizations are more detailed than are those in other organizationsB large organizations have more manuals and rules than small onesB centralized organizations have more than decentralized onesB and organizations )ith geographically dispersed units performing similar functions ;such as fast@food restaurant chains< have more than do single@site organizations

* System Safeguards
Rarious safeguards are built into the information processing system to ensure that the information flo)ing through the system is accurate2 and to prevent ;or at least minimize< fraud of every sort. "hese includeF cross@ chec3ing totals )ith details2 re/uiring signatures and other evidence that a transaction has been authorized2 separating duties2 counting cash and other portable assets fre/uently2 and a number of other procedures described in te+ts on auditing.

, Task Control Systems

"as3 control is the process of assuring that specific tas3s are carried out efficiently and effectively. Many of these tas3s are controlled by rules. If a tas3 is automated2 the automated system itself provides the control. Q.6) 0rite short notes on

1. $oncept of profit centre in non5profit organi:ation *.

anagement control in matrix structures

,. Implications of *ifferentiate* strategies on controls.

Ans. a) $oncept of profit centre in !.% 0y la) N9$ are allo)ed to ma3e profit but are restrained from distributing it to o)ners and management "his )ay they are non profit ma3ing organizations ;from the o)nerQs point of vie)<. 'uch organizations include religious2 charitable and educational trusts. 9rime goal of management control systems in such organization is enhancing the service spread first and if possible then cost control rather and than operating efficiency. $n the financial front2 they enjoy many concessions from the government such as ta+es2 subsidies2 grants etc so also they attract special control from these assisting institutes. #haracteristicsF 1. Absent of profit performance measure lea*s to problems in assessing the efficiency of the organi:ation. If the organization sho)s large net income it may be because that N9$ may not be providing the services to the e+tent possibleD e+pected. If the organization sho)s net losses it may sho) the N9$ facing ris3 of ban3ruptcy. Lence non availability of clear@cut performance yardstic3 ma3es the problem of control )orst.

31

!.%Cs ha,e contribute* capital .lant) N9$s do not have shareholder as its sta3eholder. "he capital contribution to the business comes by )ay of contributions to assets such as building and e/uipments. 'econd 3ind of contribution could be in the form of monetary assistance2 )hich entitles the organization to reap the interest on it 3eeping the principal amount intact.

*. %perating Assets represents the resources use* for running *ay to *ay acti,ities. And the contributed assets
are not allo)ed to mi+ up )ith the operating assets.

,. +un* accounting) N9$ need to 3eep t)o types of financial statements one set for contributed capital and another
for operating capital. "he nature of the contributed capital is beyond control of the management and therefore management concentrates on controlling the operating assetsDinvestments.

-. "o,ernance) Msually N9$ are managed by trusts2 )ho e+ercise less control on operational matters. Lence
performance control is less demanding from o)nersQ point of vie) and difficult from the point of vie) of management.

"hese characteristics pose difficulty in pricing of the productDservices @ )hat could be appropriate priceI Msually it is set at totalDfull cost. "he more stress e+pected on allocation of scare resources. "hough not stricter control2 but a sense of control can be built among the managers by )ay of using budgets for various activities and e+penses. Non profit basis ma3es performance evaluation /uite impossible. 0ut one can ma3e the things easier by concentrating on adherence to costs budgets2 and enhancing the service base.

b)

anagement control in matrix structures

Matri+ organizational structure assigns multiple responsibilities to the functional heads. !valuation of performance of such organizational entities is very difficult. "hough they offer economies of using scares functional staff2 it poses problems of casting the individual responsibility. "his form of organization is very comple+2 from the point of vie) of management control system. At the end )e must not forget that the management control system is for the organization and not the organization e+ists for management control system. $ne has to mold and remold the management control system to suit the given organization structure A citation by Anthony is )orth noting in this regard. Msually in an advertisement agency2 account supervisors are shifted from one account to another on periodic basis2 this practice allo)s the agency to loo3 at the account from the perspectives of different e+ecutives. Lo)ever ta3ing in to consideration the time lag of result realization in such services is /uite large. And this may pose problem of performance assessment of a particular e+ecutive. "his does not mean a control system designer should insist on abandoning the rotation system of the e+ecutives. Matri+ structure offers advantages such as faster decision ma3ing process2 efficiency and effectiveness but simultaneously it may pose problems such as added comple+ity in control function2 assignment of responsibility and authority etc. c) Implications of *ifferentiate* strategies on controls 7ifferent corporate strategies imply the follo)ing differences in the conte+t in )hich control systems need to be designedF As firms become more diversified2 corporate@level managers may not have significant 3no)ledge of2 or

32

e+perience in2 the activities of the companyQs various business units. If so2 corporate@level managers for highly diversified firms cannot e+pect to control the different businesses on the basis of intimate 3no)ledge of their activities2 and performance evaluation tends to be carried out at armQs length. 'ingle@industry and related diversified firms possess corporate)ide core competencies ;on )hich the strategies of most of the business units are based. #ommunication channels and transfer of competencies across business units2 therefore2 are critical in such firms. In contrast2 there are lo) levels of interdependence among the business units of unrelated diversified firms. "his implies that as firms become more diversified2 it may be desirable to change the balance in control systems from an emphasis on fostering cooperation to an emphasis on encouraging entrepreneurial spirit.

1 Strategic planning) given the lo) level of interdependencies2 conglomerates tend to use vertical strategic
planning systems@that is2 business units prepare strategic plans T submit to senior management to revie) T approve. "he horizontal dimension might be incorporated into the strategic planning process in a number of different )ays. :irst2 a group e+ecutive might be given the responsibility to develop a strategic plan for the group as a )hole that e+plicitly identifies synergies across individual business units )ithin the group. 'econd2 strategic plans of individual business units could have an interdependence section2 in )hich the general manager of the business unit identifies the focal lin3ages )ith other business units and ho) those lin3ages )ill be e+ploited. "hird2 the corporate office could re/uire joint strategic plans for interdependent business units. :inally2 strategic plans of individual business units could be circulated to managers of similar business units to criti/ue and revie). "hese methods are not mutually e+clusive. In fact2 several of them could be pursued fruit. fully at the same time.

* 1u*geting) "he chief e+ecutives of single@industry firms may be able to control the operations of subordinates
through informal and personally oriented mechanisms2 such as fre/uent personal interactions. "his lessens the need to rely as heavily on the budgeting system as the tool of control. $n the other hand2 in a conglomerate it is nearly impossible for the chief e+ecutive to rely on informal interpersonal interactions as a control toolB much of the communication and control has to be achieved through the formal budgeting stem. "his implies the follo)ing budgeting system characteristics in a conglomerate. 0usiness unit managers have some)hat greater influence in developing their budgets since they2 not the corporate office2 possess most of the information about their respec@ tive productDmar3et environments. reater emphasis is often placed on meeting the budget since the chief e+ecutive has no other informal controls available.

, #ransfer .ricing) "ransfers of goods and services bet)een business units are more fre/uent in single@industry
and related diversified firms than in conglomerates. "he usual transfer pricing policy in a conglomerate is to give sourcing fle+ibility to business units and use armQs@length mar3et prices. Lo)ever2 in a single@industry or a related diversified firm2 synergies may be important2 and business units may not be given the freedom to ma3e sourcing decisions.

- Incenti,e $ompensation) "he incentive compensation policy tends to differ across corporate strategies in the
follo)ing )ays@

. @se of formulas) #onglomerates2 in general2 are more li3ely to use formulas to determine business unit
managersQ bonusesB that is2 they may base a larger portion of the bonus on /uantitative2 financial measures2 such as P percent bonus on actual economic value added ;!RA< in e+cess of budgeted !RA. "hese formula@based bonus plans are employed because senior management typically is not familiar )ith )hat goes on in a variety of disparate businesses. 'enior managers of single@industry and related diversified firms tend to base a larger fraction of the business unit managers bonus on subjective factors. In many related diversified firms2 greater

33

degrees of interrelationships imply that one unitQs performance can be affected by the decisions and actions of other units. "herefore2 for companies )ith highly interdependent business units2 formula@based plans that are tied strictly to financial performance criteria could be counterproductive. 1 .rofitability measures) In the case of unrelated diversified firms2 the incentive bonus of the Qbusiness unit managers tend to be determined primarily by the profitabi1ity of that unit2 rather than the profitability of the firmX Its purpose is to motivate managers to act as though the business unit )ere their o)n company. In contrast2 single@industry and related diversified firms tend to base the incentive bonus of a business unit manager on both the performance of that unit and the performance of a larger organizational unit ;such as the product group to )hich the business unit belongs or perhaps even .the overall corporation<. Khen business units are interdependent2 the more the incentive bonus of general managers emphasizes the separate performance of each unit2 the greater the possibility of interunit conflict. $n the other hand2 basing the bonus of general managers more on the overall corporate performance is li3ely to encourage greater interunit cooperation2 thereby increasing managersQ motivation to e+ploit interdependencies rather than their individual results.

* 1usiness @nit Strategy) 7iversified corporations segment themselves into business units and typically assign
different strategies to the individual business units. Many chief e+ecutive officers of multi business organizations do not adopt a standardized2 uniform approach to controlling their business unitsB instead2 they tailor the approach to each business unitQs strategy."he strategy of a business unit depends on t)o interrelated aspectsF ;1< Its mission ;EKhat are its overall objectivesIE< and ;*< its competitive advantage. ;ELo) should the business unit compete in its industry to accomplish its missionIE<. "ypically business units choose from four missionsF build2 hold2 harvest2 and divest. "he business unit has t)o generic )ays to compete and develop a sustainable competitive advantageF lo) cost and differentiation.

ission "he mission for e+isting business units could be either build2 hold2 or harvest. "hese missions constitute a continuum2 )ith Epure buildE at one end and Epure harvestE at the other end. "o implement the strategy effectively2 there should be congruence bet)een the mission chosen and the types of controls used. "he mission of the business unit influences the uncertainties that general managers face and the short@term versus long@term trade@offs they ma3e. Management control systems can be systematically varied to help motivate the man ager to cope effectively )ith uncertainty and ma3e appropriate short@term versus long term trade@offs. "hus2 different missions often re/uire systematically different management control systems.

ission an* @ncertainty E0uildE units tend to face greater environmental uncertainty than EharvestE units for several reasonsF 0uild strategies typically are underta3en in the gro)th stage of the product life cycle2 )hereas harvest strategies typically are underta3en in the mature decline stage of the product life cycle. 'uch factors as manufacturing processB product technologyB mar3et demandB relations )ith suppliers2 buyers2 and distribution channelsB number of competitorsB and competitive structure change more rapidly and are more unpredictable in the gro)th stage than in the matureDdecline stage. An objective of a build business unit is to increase mar3et share. 0ecause the total mar3et share of all firms in an industry is 188 percent2 the .battle for mar3et share is a zero@sum gameB thus2 a build strategy puts a business unit in greater conflict )ith its competitors than does a harvest strategy. #ompetitorsQ actions are li3ely to be unpredictable2 and this contributes to the uncertainty that build business units face. $n both the input side and the output side2 build managers tend to e+perience greater dependencies on e+ternal individuals and organizations than do harvest managers. :or instance2 a build mission signifies additional capital investment ;greater dependence on capital mar3ets<2 e+pansion of capacity ;greater dependence on the technological environment<2 increase in mar3et share ;greater dependence on customers and

34

competitors<2 increase in production volume ;greater dependence on ra) material suppliers and labor mar3ets<2 and so on. "he greater the e+ternal dependencies a business unit faces2 the greater the uncertainty it confronts.0uild business units are often in ne) and evolving industriesB thus2 build managers are li3ely to have less e+perience in their industries. "his also contributes to the greater uncertainty that managers of build units face in dealing )ith e+ternal constituencies. 1 ission an* #ime Span "he choice of build versus harvest strategies has implications for short@term versus long@term profit trade@offs. "he share@building strategy includes (a) price Qcutting2 (b) major %T7 e+penditures ;to introduce ne) products<2 and (c) major mar3et development e+penditures. "hese actions are aimed at establishing mar3et leadership2 but they depress short@term profits. "hus2 many decisions that a build unit manager ma3es2 today may not result in profits until some future period. A harvest strategy2 on the other hand2 concentrates on ma+imizing short@term profits.

* Strategic

.lanning Khen the environment is uncertain2 the strategic planning process is especially important

management needs to thin3 about ho) to cope )ith the uncertainties2 and this usually re/ull1 longer@range vie) of planning than is possible in the annual budget. If the environment is stable2 there may be no strategic planning process at all or only a broad@brush strategic plan. "hus2 the strategic planning process is more critical and more important for build2 as compared )ith harvest2 business units. Nevertheless2 some strategic planning of the harvest business units may be necessary because the companyQs overall strategic plan must encompass all of its businesses to effectively balance cash flo)s. In screening capital investments and allocating resources2 the system may be more /uantitative and financial for harvest units. A harvest business unit operates in a mature industry and does not offer tremendous ne) investment possibilities. Lence2 the re/uired earnings rate for such a business unit may be relatively high to motivate the manager to search for project )ith truly e+ceptional returns. 0ecause harvest units tend to e+perience stable environments )ith predictable products2 technologies2 competitors2 and customers<2 discounted cash flo) 9#:< analysis often can be used more confidently. "he re/uired information used to evaluate investments from harvest units is primarily financial. A build unit2 ho)ever2 is positioned on the gro)th stage of the product life cycle. 'ince the corporate office )ants to ta3e advantage of the opportunities in a gro)ing mar3et2 senior management may set a relatively lo) discount rate2 thereby motivating build managers to for)ard more investment ideas to corporate office. iven the productDmar3et uncertainties2 financial analysis of some projects from build units may be unreliable. :or such projects2 nonfinancial data are more important.

, 1u*geting "he calculational aspects of variance analysis comparing actual results )ith the budget identify
variances as either favorable or unfavorable. Lo)ever2 a favorable variance does not necessarily imply favorable performance2 nor does an unfavorable variance imply unfavorable performance. "he lin3 bet)een a favorable or unfavorable variance2 on the one hand2 and favorable or unfavorable performance2 on the other hand2 depends on the strategic conte+t of the business unit under evaluation.

- Incenti,e $ompensation Syste In designing an incentive compensation pac3age for business unit managers2 the
follo)ing /uestions need to be resolvedF

1. 1. Khat should the size of incentive bonus payments be relative to the general managerQs base salaryI 'hould
the incentive bonus payments have upper limitsI

*. Khat measures of performance ;e.g.2 profit2 !RA2 sales volume2 mar3et share2 product
development< should be used )hen deciding the general managerQs incentive bonus a)ardsI If multiple performance measures are employed2 ho) should they be )eightedI

,. Lo) much reliance should be placed on subjective judgments in deciding on the bonus amountI
35

Lo) fre/uently ;semiannual2 annual2 biennial2 etc.< should incentive a)ards be madeI Kith respect to the first 2uestion2 many firms use the principle that the ris3ier the strategy2 the greater the proportion of the general managerQs compensation in bonus compared to salary ;the Eris3DreturnE principle<. "hey maintain that because managers in charge of more uncertain tas3 situations should be )illing.to ta3e greater ris3s2 they should have a higher percentage of their remuneration in the form of an incentive bonus. "hus2 EbuildE managers are more li3ely than EharvestE managers to rely on bonuses. As to the secon* 2uestion2 )hen re)ards are tied to certain performance criteria2 behaviour ls influenced by the desire to optimize performance )ith respect to those criteria. 'ome performance criteria ;cost control2 operating profits2 and cash flo) from operations< focus more on short@term results2 )hereas other performance criteria ;mar3et share2 ne) product development2 mar3et development2 and people development< focus on long@term profitability. "hus2 lin3ing incentive bonus to short@term criteria tends to promote a short@term focus on the part of the general manager and2 similarly2 lin3ing incentive bonus to long@term criteria is li3ely to promote long@term focus. #onsidering the relative differences in time horizons of build and harvest managers2 it may not be appropriate to use a single2 uniform financial criterion2 such as operating profits2 to evaluate the performance of every business unit. A better idea )ould be louse multiple performance criteria2 )ith differential )eights for each criterion depending on the business unitQs mission. "he third /uestion as3s ho) much subjective judgment should affect bonus amounts. At one e+treme2 a managerQs bonus might be a strict formula@based plan2 )ith the bonus tied to performance on /uantifiable criteria ;e.g.2 P percent bonus on actual profits in e+cess of budgeted profits<. At the other e+treme2 a managerQs incentive bonus amounts might be based solely on the superiorQs subjective judgment or discretion. Alternatively2 incentive bonus amounts might also be based on a combination of formula@based and subjective approaches. 9erformance on most long@term criteria ;mar3et development2 ne)@product development2 and people development< is harder to measure objectively than is performance along most short@run criteria ;operating profits2 cash flo) from operations2 and return on investment<.As already noted2 build managers@ in contrast )ith harvest managers2 should concentrate more on the long run2 so they typically are evaluated more subjectively than are harvest managers. As to the final /uestion2 the fre/uency of bonus a)ards does influence the time horizon of managers. More fre/uent bonus a)ards encourage managers to concentrate on short@term performance since they have the effect of motivating managers to focus on those facets of the business they can affect in the short run.

1 $ompetiti,e A*,antage A business unit can choose to compete. !ither as a differentiated player or as a lo)@cost
player2 #hoosing a differentiation Qapproach2 rather than a lo)@cost approach2 increases uncertainty of a business unitQs tas3 environment for three reasons.

1. 9roduct innovation is more critical for differentiation business units than for lo) cost business units. "his is
partly because a lo)@cost business unit2 )ith primary emphasis on cost reduction2 typically prefers to 3eep its product offerings stable over timeB a differentiation business unit2 )ith its primary focus on uni/ueness T e+clusivity2 is li3ely to engage in greater product innovation.

*. A lo) cost business unit typically tend to have narro) product lines to minimize the inventory carry costs as
36

)ell as to benefit from scale economies. 7ifferentiation business units on the other hand tend to have a broader set of products to create uni/ueness.

,. &o) cost business units typically produce no@frill commodity productsT these products succeed primarily
because they have lo)er prices than competing products. Lo)ever product differentiation business units succeed if customers perceive that the products have advantages over competing products. 'ince the customer perception is difficult to learn about2 T since customer loyalty is subject to change resulting from actions of competitors or other reasons2 the demand for differentiated products is typically more difficult to predict than the demand for commodities. Q./) 0hich management control practices< if follo(e*< in performance measurement of in,estment centres are li-ely to in*uce goal congruence< in respect of follo(ing assets 4ii) Intangible 4iii) Lease*

*.

4i) I*le

e.

4i) $ash

4ii) &ecei,ables

4iii) In,entories

Ans. In some business units2 the focus is on profit as measured by the difference bet)een revenues and e+penses. In other business units2 profit is compared )ith the assets employed in earning it. Ke refer to the latter group of responsibility centers as investment centers. easuring Assets Employe* In deciding )hat investment base to use to evaluate investment center managers2 head/uarters as3s t)o /uestionsF :irst2 )hat practices )ill induce business unit managers to use their assets most efficiently and to ac/uire the proper amount and 3ind of ne) assetsI 9resumably2 )hen their profits are related to assets employed2 business unit managers )ill try to improve their performance as measured in this )ay. Y'enior management )ants the actions that they ta3e to)ard this end to be in the best interest of the )hole corporation. 'econd2 )hat practices best measure the performance of the unit as an economic entityI

1 $ash
Most companies control cash centrally because central control permits use of a smaller cash balance than )ould be the case if each business unit held the cash balances it needed to )eather the unevenness of its cash inflo)s and outflo)s. 0usiness unit cash balances may )ell be only the EfloatE bet)een daily receipts and daily disbursements. #onse/uently2 the actual cash balances at the business unit level tend to be much smaller than )ould be re/uired if the business unit )ere an independent company. Many companies therefore use a formula to calculate the cash to be included in the investment base. :or e+ample2 eneral Motors )as reported to use -.. percent of annual salesB 7u 9ont )as reported to use t)o monthsQ costs of sales minus depreciation. $ne reason to include cash at a higher amount than the balance carried by a business unit is that the higher amount is necessary to allo) comparisons to outside companies. If only the actual cash )ere sho)nF by internal units )ould

37

appear abnormally high and might mislead senior management. 'ome companies omit cash from the investment base. "hese companies reason that the amount of cash appro+imates the current liabilitiesB if this is so2 the sum of accounts receivable and inventories )ill appro+imate the )or3ing capital.

1 &ecei,ables
0usiness unit managers can influence the level of receivables2 not only indirectly by their ability to generate sales2 and directly2 by establishing credit terms by approving individual credit accounts and credit limits2 and by the collecting overdue amount. In the interest of simplicity2 receivable included at the actual end@.of@period balances2 although the average of intraperiod balances is conceptually a better measure of the am should be related to profits. Khether to include accounts receivable at selling prices or at cost of goods sold is debatable. $ne could argue that the business unitQs real investment in accounts receivable is only the cost of goods sold and that a satisfactory return on this investment is probably enough. $n the other hand2 it is possible to argue that the business unit could reinvest the money collected from accounts receivable2 and2 therefore2 accounts receivable should be included at selling prices. "he usual practice is to ta3e the simpler alternative@that is2 receivables at the boo3 amount2 )hich is the selling price less an allo)ance for bad debts. If the business unit does not control credits and collections2 receivables may be calculated on a formula basis. "his formula should be consistent )ith the normal payment period@for e+ample2 ,8 daysQ sales )here payment is made ,8 days after the shipment of goods.

1 In,entories
Inventories ordinarily are treated in a manner similar to receivables Athat is they are often recorded at end@of@period amounts even though intraperiod averages )ould be preferable conceptually. If the company uses &I:$ ;last in first out< for financial accounting purposes2 a different valuation method usually is used for business unit profit reporting because &I:$ inventory balances tend to be unrealistically lo) in periods of inflation. In these circumstances2 inventories should be valued at standard or average costs2 and these same costs should be used to measure cost of sales on the business unit income statement If )or3@in@process inventory is financed by advance payments or by progress payments from the customer2 as is typically the case )ith goods that re/uire a long manufacturing period2 these payments either are subtracted from the gross inventory amounts or reported as liabilities. :or e.g. )ith manufacturing periods a year or greater2 0oeing received progress payments for its airplanes and recorded them as liabilities. 'ome companies subtract accounts payable from inventory on the grounds that accounts payable represent financing of part of the inventory by vendors2 at zero cost to the business unit. "he corporate capital re/uired for inventories is only the difference bet)een the gross inventory amount and accounts payable. If the business unit can influence the payment period allo)ed by vendors2 then including accounts payable in the calculation encourages the manager to see3 the most favorable terms. In times of high interest rates or credit stringency2 managers might be encouraged to consider forgoing the cash discount to have2 in effect2 additional financing provided by vendors. $n the other hand2 delaying payments unduly to reduce net current assets may not be in the companyQs best interest since this may hurt its credit rating.

38

Lease* Assets 'uppose the business unit )hose financial statements are sho)n in !+hibit 1 ;see page *1< sold its fi+ed assets for their boo3 value of =,8828882 returned the proceeds of the sale to corporate head/uarters2 and then leased bac3 the assets at a rental rate of =182888 per year. As !+hibit * ;see page *1< sho)s2 the business unitQs income before ta+es )ould decrease because the ne) rental e+pense )ould be higher than the depreciation charge that )as eliminated. Nevertheless2 economic valued added )ould increase because the higher cost )ould be more than offset by the decrease in the capital charge. 0ecause of this2 business unit managers are induced to lease2 rather than o)n2 assets )henever the interest charge that is built into the rental cost is less than the capital charge that is applied to the business unitQs investment base. ;Lere2 as else)here2 this generalization oversimplifies because2 in the real )orld2 the impact of income ta+es must also be ta3en into account.< Many leases are financing arrangements@that is2 they provide an alternative )ay of getting to use assets that other)ise )ould be ac/uired by funds obtained from debt and e/uity financing. :inancial leases ;i.e.2 long@term leases e/uivalent to the present value of the stream of lease charges< are similar to debt and are so reported on the balance sheet. :inancing decisions usually are made by corporate head/uarters. :or these reasons2 restrictions usually are placed on the business unit managerQs freedom to lease assets.

1 I*le Assets
If a business unit has idle asset that can be used by other units2 the business unit may be permitted to e+clude them from the investment base if it classifies them as available. "he purpose of this permission is to encourage business unit managers to release underutilized assets to units that may have better use for them. Lo)ever2 if the fi+ed assets cannot be used by other units2 permitting the business unit manager to remove them from the investment base could result in dysfunctional actions :or e+ampleB it could encourage the business unit manager to idle partially utilized assets that are not earning a return e/ual to the business unitQs profit objective. If there is no alternative use for the e/uipment2 any contribution from this e/uipment )ill improve company profits.

1 Intangible Assets
'ome companies tend to be %T7 intensive ;e.g.2 pharmaceutical firms such as Novartis spend huge amounts on developing ne) products<B others tend to be mar3eting intensive ;e.g.2 consumer products firms such as Mnilever spend huge amounts on advertising<. "here are advantages to capitalizing intangible assets such as %T7 and mar3eting and then amortizing them over a selected life. "his method should change ho) the business unit manager vie)s these e+penditures. 0y accounting for these assets as long@term investments2 the business unit manager )ill gain less short@term benefit from reducing out lays on such item2 :or instance2 if %T7 e+penditures are e+pensed immediately2 each dollar of %T7 cut )ould be a dollar more in preta+ profits. $n the other hand2 if %T7 costs are capitalized2 each dollar cut )ill reduce the assets employed by a dollarB the capital charge is thus reduced only by one dollar times the cost of capital2 )hich has a much smaller positive impact on economic valued added.

SE#.D
Q.1) 0hat *o you un*erstan* by "oal $ongruence? 0hat are the informal factors that influence goal congruence?

AnsF "his term is used )hen the same goals are shared by top managers and their subordinates. "his is one of the many criteria used to judge the performance of an accounting system. "he system can achieve its goal more

39

effectively and perform better )hen organizational goals can be )ell aligned )ith the personal and group goals of subordinates and superiors. "he goals of the company should be the same as the goals of the individual business segments. #orporate goals can be communicated by budgets2 organization charts2 and job descriptions.

1 "oal $ongruence5
spea3 #os language.<

eaning Individuals )or3 in different hierarchies and handle different responsibilities T

may have different goals. 0ut they must come together as far as #ompanys oal is concerned ;there action must

"oal $ongruence !+ample 1A "he L% manager has devised a L% training program to enhance the s3ills of its sales personnel2 )ith an objective to enhance their productivity 0ut if company is in strategic need of attaining a certain sales volume in a given /uarter2 it can not do so on account of non availability of personnel. !+ample *A "he mar3eting department has planned an impressive advertising campaign2 )hich promises good returns2 0ut say due to cash crunch #ompanys current financial position may not let to lose the strings !+ample , A 9roduction Manager may get a good applause for reducing cycle timeB 0ut at )hat costI 0uilding up the high inventory i.e. higher investment in current assets. Khile doing so he just overloo3ed the financial interest of the company. Z After completing the given activity in more efficient manner the concerned manager scores the pointDs on his score card. Z Khether his actions are leading to scoring of points on the organizations score card tooI if it is so then only one can say the organization is marching to)ards a common goal. !very individual )or3ing in an organization has got his o)n motive to do the )or3. Individuals act in their o)n interest2 based on their o)n motivations. And it is al)ays not necessarily consistent )ith the #os goal. In a goal congruence process2 the actions the people are led to ta3e in accordance )ith their perceived self interest are also in the best interest of the organization i.e. oal congruence ensures that the action of manager ta3en in their best interest is also in the best interest of the organization.

Informal factors that influence goal congruenceF Informal :actors A !+ternal factors A set of attitudes of the society2 )or3 ethics of the society Internal factors A ;:actors )ithin the organization<

1G #ulture@#ommon beliefs2 shared values2 norms of behavior T assumptions *G Implicitly accepted and e+plicitly built into. ,G Mgt. 'tyle A InformalD:ormal -G "he #ommunication #hannels .G 9erception and #ommunication A e.g. 0udget ;meaning< strict profit.
40

1 %rgani:ations (ith 1usiness Di,isions 4.rofit $entre) format ha,e obser,e* that Di,isional $ontrollers
experience *i,i*e* loyalty in carrying out their functions< causing a possible *ysfunction. Eo( coul* such a situation be resol,e*? Define role of controller (hich suits your suggestion.

"o the e+tent the decision are decentralized top management may lose some control. %elying on control reports is not as effective as personal 3no)ledge of an operation. Kith profit center2 top management must change its approach to control. Instead of personal direction senior management must rely to a considerable e+tent on management control reports. #ompetent units that )ere once cooperating as functional units may no) compete )ith one another dis advantageously. An increase in one managers profit may decrease those of another. "his decrease in cooperation may manifest itself in a manager un)illingness to refer sales lead to another business unit2 even though that unit is better /ualified to follo) up on the lead in production decision that have undesirable cost conse/uence on other units or in the hoarding of personnel or e/uipment that from the overall company standpoint )ould be better off used in another units. "here may be too much emphasis on short run profitability at the e+pense of long run profitability. In the desire to report high current profits2 the profit center manager may s3ip on %T72 training2 maintenance. "his tendency is especially prevalent )hen the turnover of profit center managers is relatively high. In these circumstances2 manager may have good reason to believe that their action may not affect profitability until after they have moved to other job. "here is no complete satisfactory system for ensuring that each profit center by optimizing its o)n profit 2 )ill optimize company profits. If head/uarter management is more capable or has better information then the average profit center manager the /uality of some of the decision may be reduced. 7ivisionalization may cause additional cost because it may re/uire additional management staff personnel and record3eeping and may lead to redundant at each profit center. 0usiness units as profit centersF 0usiness units are usually set up at profit centers. 0usiness unit managers tend to control product development2 manufacturing2 and mar3eting resources. "hey are in a position to influence revenue and cost and as such can be held accountable for the bottom line. Lo)ever as pointed out in the ne+t section a business unit manager authority may be constrained such constrained should be incorporated in designing and operating profit center. #onstraint on business unit authority "o realize fully the advantage of the profit center concept the business unit manger )ould have to be as autonomous as the president of the independent company. As a practical matter ho)ever such autonomy is not feasible. If a company )ere divided into completely independent units the organization )ould be giving up the advantage of size and synergism. Also senior management authority that a board of director gives to the chief e+ecutive. #onse/uently business unit structure represents trade off bet)een business unit autonomy and corporate constraint. "he effectiveness of a business units organization is largely dependent on ho) )ell these trade off are made.

41

"he performance of a profit center is appraised by comparing actual results for one or more orf these measures )ith budgeting amounts. In addition2 data on competitors and the industry provide a good cross chec3 on the appropriate of the budget. 7ata for individual companies are available from the securities and e+change commission for about 3ey business ratiosB standard T poor computer services2 IncB %obert Morris associates annual statement studiesB and annual survey published in fortune2 business )ee32 and :orbes. "rade associations publish data for the companies in their industries. %evenuesF choosing the appropriate revenue recognition method is important. 'hould revenue be recognized at the time as order is received2 at the time an order is shipped2 or at the time cash is receivedI In addition to that decision2 issues related to common revenues may need to be considered. "here are some situations in )hich t)o or more profit centers participate in the sales effort that results in a saleB ideally2 each should be given appropriate credit for its part in this transaction. Many companies have not given much attention to the solution of these common revenue problems. "hey ta3e the position that the identification of price responsibility for revenue generation is too complicated to be practical and that sale personnel must recognize they are )or3ing not only for their o)n profit center but also for the overall good of the company. "hey for e+ample2 may credit the business unit that ta3es an order for a product handled by the another unit )ith the e/uivalent of a bro3erage commission or a finder fee. In the case of a ban3 the branch performing a service may be given e+plicit credit for that service even though the customer account is maintained in another branch. %ole of controller

1G It should publish procedure and forms for the preparation of the budget. *G It should provide assistance to budgetees in the preparation of their budget. ,G It should administer the process of ma3ing budget revision during the year. -G It should coordinate the )or3 of budget departments in lo)er echelons .G It should analyze reported performance against budget2 interprets the result2 and prepares summary report for
senior management.

1 .art of a multinational group< Sun*aram Shoe $ompany4SS$)< establishe* its o(n facilities in In*ia o,er
F3 years ago an* en>oye* an excellent recor*5high mar-et share for its *i,erse range of shoes< gro(th an* profits. S$ mar-ets its pro*ucts through company o(ne* shops an* its o(n personnel. %rgani:ation structure is functional. Since 6771< profitability< mar-et share are slipping. .ressure from cheap $hinese shoes an* also premium shoes li-e !i-e has ma*e the company thin-G of organi:ational restructuring an* intro*ucing $omensurate $ontrol System to regain its position. Although SS$ outsources< /7H of pro*ucts< it is seen as a pro*uction oriente* company. SS$ (ants to a*opt measures to re*uce costs< strengthen mar-eting an* be in a position to pro*uce an* meet unexpecte* an* unusual customer *eman*s. Eo( shoul* the company reorgani:e to achie,e "oal $ongruence. Define .erformance etric?

In a goal congruent process2 the actions people are led to ta3e in accordance )ith their perceived self@interest are also in the best interest of the organization. A firms strategy has a major influence on its structure. "he type of structure in turn influences the design of the organizations management control systems. 'undaram 'hoe #ompanys ;''#<

42

organization structure is functional )hich involves the notion of a manager )ho brings specialized 3no)ledge to bear on decisions related to a specific function2 vis@[@vis a general purpose manager )ho lac3s the specialized 3no)ledge. A s3illed mar3eting and production manager )ould be able to ma3e better decisions in their respective fields. Le )ould also be able to supervise )or3ers in the same function better than the generalist )ould. "hus an important advantage of the functional structure is efficiency. A major disadvantage of this structure is that there is no unambiguous )ay of determining the effectiveness of the separate functional managers because each function contributes jointly to the organizations final output. "herefore2 there is no )ay of determining ho) much of the profit )as earned respectively by the several production departments. 'undaram 'hoe #ompany )hich )as a mar3et leader for a period of over 4. years has been losing mar3et share2 )hich has impacted its profitability. Also it needs to be seen that the company outsources about ,8N of its products. "he company aims to strengthen mar3eting2 reduce costs and )ants to be in a position to customize products as per the demands of the customer. "hus2 'undaram needs to re@organize its organization structure )hich is functional to a 0usiness Mnit form of organization. "he benefits of the re@organization )ould be that the business unit or the division )ould be responsible for all the functions involved in producing and mar3eting a specified product line. "he business managers act almost as if their units are separate companies. "hey are responsible for planning and co@coordinating the )or3 of the separate functions. "heir performance is measured by the profitability of the business unit. "his is a valid criterion because profit reflects the activities of both mar3eting and production. "hough business unit managers e+ercise broad authority over their units2 head/uarters reserves certain 3ey prerogatives. Lead/uarters are responsible for obtaining funds for the company as a )hole and allocating it to the business unit2 as )ell as approving budgets and judging the performance of business unit managers2 setting their compensation. A major advantage of the 0usiness unit structure of organization is that because it is close to the mar3et for its products than the head/uarters2 its manager may ma3e sounder production and mar3eting decisions than head/uarters might and the unit as a )hole reacts to ne) threats or opportunities /uic3ly. "his re@organization )ould help in achieving goal congruence in the organization. 9erformance Metrics are high@level measures what you are doingB that is2 they assess your overall performance in the areas you are measuring. "hey are e+ternal in nature and are most closely tied to outputs2 customer re/uirements2 and business needs for the process. "he performance measurement system should cover the follo)ing areas at a minimumF $@S#% E&S

1. 9erformance against customer re/uirements *. #ustomer 'atisfaction

.E&+%& A!$E %+ I!#E&!AL 0%&I .&%$ESSES

1. #ycle times *. 9roduct and service /uality ,. #ost performance ;could be productivity measures2 inventory2 etc.<
S@..LIE&S

43

1. 9erformance of suppliers against your re/uirements

+I!A!$IAL

1. 9rofitability ;could be at the company2 product line2 or individual level< *. Mar3et share gro)th and other standard financial measures
E .L%'EE

1. Associate satisfaction

SE# .F
Q) 1) 4A) Describe the factors (hich impact ser,ice organi:ation Ans) +actors (hich impact ser,ice organi:ation)

1 Absence of In,entory 1uffer)

oods can be held as inventory2 )hich is a buffer that dampens the impact on production activity of fluctuations in sales volume. 'ervices cannot be stored. "he airplane seat2 hotel room2 hospital operating room2 or the hours of la)yers2 physicians2 scientists2 and other professionals that are not used today are gone forever. "hus2 although a manufacturing company can earn revenue in the future from products that are on hand today2 a service company cannot do so. It must try to minimize its unused capacity. Moreover2 the costs of many service organizations are essentially fi+ed in the short run. In the short run2 a hotel cannot reduce its costs substantially by closing off some of its rooms. Accounting firms2 la) firms2 and other professional organizations are reluctant to layoff professional personnel in times of lo) sales volume because of the effect on morale and the costs of rehiring and training.

1 Difficulty in $ontrolling Quality)

A manufacturing company can inspect its products before they are shipped to the consumer2 and their /uality can be measured visually or )ith instruments ;tolerances2 purity2 )eight2 color2 and so on<. A service company cannot judge product /uality until the moment the service is rendered2 and then the judgments are often subjective. %estaurant management can e+amine the food in the 3itchen2 but customer satisfaction depends to a considerable e+tent on the )ay it is served. "he /uality of education is so difficult to measure that fe) educational organizations have a formal /uality control system.

1 Labor Intensi,e)
Manufacturing companies add e/uipment and automate production lines2 thereby replacing labor and reducing costs. Most service companies are labor intensive and cannot do this. Lospitals do add e+pensive e/uipment2 but mostly to provide better treatment2 and this increases costs. A la) firm e+pands by adding partners and ne) support personnel.

ulti5@nit %rgani:ations)

'ome service organizations operate many units in various locationsB each unit relatively small. "hese organizations are fast@food restaurant chains2 auto rental companies2 gasoline service stations2 and many others. 'ome of the units are o)nedB others operate under a franchise. "he similarity of the separate units provides a common basis for

44

Q)1) 41) Explain special characteristics of professional organi:ation (hich (oul* ha,e a bearing on their control system. Ans) Special $haracteristics of .rofessional %rgani:ation)

1 "oals)
A dominant goal of a manufacturing company is to earn a satisfactory profit2 specifically a satisfactory return on assets employed. A professional organization has relatively fe) tangible assetsB its principal asset is the s3ill of its professional staff2 )hich doesnQt appear on its balance sheet. %eturn on assets employed2 therefore2 is essentially meaningless in such organizations. "heir financial goal is to provide ade/uate compensation to the professionals. In many organizations2 a related goal is to increase their size. In part2 this reflects the natural tendency to associate success )ith large size. In part2 it reflects economies of scale in using the efforts of a central personnel staff and units responsible for 3eeping the organization up to@ date. &arge public accounting firms need to have enough local offices to enable them to audit clients )ho have facilities located throughout the )orld.

1 .rofessionals)
9rofessional organizations are labor intensive2 and the labor is of a special type. Many professionals prefer to )or3 independently2 rather than as part of a team. 9rofessionals )ho are also managers tend to )or3 only part time on management activitiesB senior partners in an accounting firm participate actively in audit engagementsB senior partners in la) firms have clients. !ducation for most professions does not include education in management2 but /uite naturally stresses the s3ills of the profession2 rather than managementB for this and other reasons2 professionals tend to loo3 do)n on managers. 9rofessionals tend to give inade/uate )eight to the financial implications of their decisionsB they )ant to do the best job they can2 re@ I regardless of its cost. "his attitude affects the attitude of support staffs and nonprofessionals in the organizationB it leads to inade/uate cost control.

1 %utput an* Input easurement)

"he output of a professional organization cannot be measured in physical terms2 such as units2 tons2 or gallons. Ke can measure the number of hours a la)yer spends on a case2 but this is a measure of input2 not output. $utput is the effectiveness of the la)yerQs )or32 and this is not measured by the number of pages in a brief or the number of hours in the courtroom. Ke can measure the number of patients a physician treats in a day2 and even classify these visits by type of complaintB but this is by no means e/uivalent to measuring the amount or /uality of service the physician has provided. At most2 )hat is measured is the physicianQs efficiency in treating patients2 )hich is of some use in identifying slac3ers and hard )or3ers. %evenues earned is one measure of output in some professional organizations2 but these monetary amounts2 at most2 relate to the /uantity of services rendered2 not to their /uality ;although poor /uality is reflected in reduced revenues in the long run<. :urthermore2 the )or3 done by many professionals is non repetitive. No t)o consulting jobs or research and development projects are /uite the same. "his ma3es it difficult to plan the time re/uired for a tas32 to set reasonable standards for tas3 performance2 and to judge ho) satisfactory the performance )as. 'ome tas3s are essentially

45

repetitiveF the drafting of simple )ills2 deeds2 sales contracts2 and similar documentsB the ta3ing of a physical

repetitiveF the drafting of simple )ills2 deeds2 sales contracts2 and similar documentsB the ta3ing of a physical

"here are t)o types of profitability measurements used in evaluating a profit center2 just as there are in evaluating an

is that because it e+cludes non controllable head/uarters e+penses it cannot be directly compared )ith either

"he /uality of decisions may improve because they are being made by managers closest to the point of decision. 1G "he speed of operating decisions may be increased since they do not have to be referred to corporate head/uarters. . Lead/uarters management2 relieved of day@to@day decision ma3ing2 can concentrate on broader issues.

*G Managers2 subject to fe)er corporate restraints2 are freer to use their imagination and initiative.0ecause
profit centers are similar to independent companies2 they provide an e+cellent training ground for general management. "heir managers gain e+perience in managing all functional areas2 and upper management gains the opportunity to evaluate their potential for higher@level jobs.

,G 9rofit consciousness is enhanced since managers )ho are responsibleQ for profits )ill constantly see3 )ays to
increase them. ;A manager responsible for mar3eting activities2 for e+ample2 )ill tend to authorize promotion e+penditures that increase sales2 )hereas a manager responsible for profits )ill be motivated to ma3e promotion e+penditures that increase profits.<.

-G 9rofit centers provide top management )ith ready@made information on the profitability of the companyQs
individual components. . 0ecause their output is so readily measured2 profit centers are particularly responsive to pressures to improve their competitive performance. Demerits)

1G 7ecentralized decision ma3ing )ill force top management to rely more on management control
reports than on personal 3no)ledge of an operation2 entailing some loss of control.

*G If head/uarters management is more capable or better informed than the average profit center
manager2 the /uality of decisions made at the unit level may be reduced.

,G :riction may increase because of arguments over the appropriate transfer price2 the assignment of
common costs2 and the credit for revenues that )ere formerly generated jointly by t)o or more business units )or3ing together.

-G $rganization units that once cooperated as functional units may no) be in competition )ith one
another. An increase in profits for one manager may mean a decrease for another. In such situations2 a manager may fail to refer sales leads to another business unit better /ualified to pursue themB may hoard personnel or e/uipment that2 from the overall company standpoint2 )ould be better off used in another unitB or may ma3e production decisions that have undesirable cost conse/uences for other units.

.G 7ivisionalization may impose additional costs because of the additional management2 staff personnel2
and record 3eeping re/uired2 and may lead to tas3 redundancies at each profit center. Q)/) (hat are *ifferent types of Strategic issions at S1@ le,el? Eo( *o these missions affect Strategic .lanning process an* 1u*geting at S1@ Le,el? Different #ypes of Strategic issions) 1usiness @nit ission) In a diversified firm one of the important tas3s of senior management is resource deployment2 that is2 ma3e decisions regarding the use of the cash generated from some business units to finance gro)th in other business units. 'everal planning models have been developed to help corporate level managers of diversified firms to effectively allocate

49

resources. "hese models suggest that a firm has business units in several categories2 identified by their missionB the appropriate strategies for each category differ. "ogether2 the several units ma3e up a portfolio2 the components of )hich differ as to their ris3Dre)ard characteristics just as the components of an investment portfolio differ. 0oth the corporate Qoffice and the business unit general manager are involved in identifying the missions of individual business units. $f the many planning models2 t)o of the most )idely used are 0oston #onsulting roupQs t)o@by@t)o gro)th@ share matri+ and eneral !lectric #ompanyDMcVinsey T #ompanyQs three@by@three industry attractiveness@business strength matri+. Khile these models differ in the methodologies they use to develop the most appropriate missions for the various business units2 they have the same set of missions from )hich to chooseF build2 hold2 harvest2 and divest. 1 1uil*) "his mission implies an objective of increased mar3et share2 even at the e+pense of short@term earnings and cash flo) ;e.g.2 Merc3Qs bio@technology2 0lac3 and 7ec3erQs handheld electric tools<.

* Eol*) "his strategic mission is geared to the protection of the business unitQs mar3et share and competitive
position ;e.g.F I0MQs mainframe computers<.

, Ear,est) "his mission has the objective of ma+imizing short@term earnings and cash flo)2 even at the e+pense of
mar3et share ;e.g.2 American 0randsQ tobacco products2 eneral !lectricQs and 'ylvaniaQs light bulbs<

- Di,est) "his mission indicates a decision to )ithdra) from the business either through a process of slo)
li/uidation or outright sale. Khile the planning models can aid in the formulation of missions2 they are not coo3 boo3s. A business unitQs position on a planning grid should not be the sole basis for deciding its mission.

. 1usiness @nit $ompetiti,e A*,antage) !very business unit should develop a competitive advantage in order to
accomplish its mission. "hree interrelated /uestions have to be considered in developing the business unitQs competitive> advantage. :irst2 )hat is the structure of the industry in )hich the business unit operatesI 'econd2 ho) should the business unit e+ploit the industryQs structureI "hird2 )hat )ill be the basis of the business unitQs competitive advantageI

1 In*ustry Analysis) %esearch has highlighted the important role industry conditions play in the performance of
individual firms. 'tudies have sho)n that average industry profitability is2 by far2 the most significant predictor of firm performance. According to 9orter2 the structure of an industry should be analyzed in terms of the collective strength of five competitive forces.

1. "he intensity of rivalry among e+isting competitors. :actors affecting direct rivalry are industry gro)th2 product
differentiability2 number and diversity of competitors2 level of fi+ed costs2 intermittent overcapacity2 and e+it barriers.

*. "he bargaining po)er of customers. :actors affecting buyer po)er are number of buyers2 buyerQs s)itching costs2
buyerQs ability to integrate bac3)ard2 impact of the business unitQs product on buyerQs total costs2 impact of the business unitQs product on buyerQs product /ualityD performance2 and significance of the business unitQs volume to buyers.

,. "he bargaining po)er of suppliers. :actors affecting supplier po)er are number of suppliers2 supplierQs ability to
integrate for)ard2 presence of substitute inputs2 and importance of the business unitQs volume to suppliers.

-. "hreat from substitutes. :actors affecting substitute threat are relative priceDperformance of substitutes2 buyerQs
s)itching costs2 and buyerQs propensity to substitute.

50

.. "he threat of ne) entry. :actors affecting entry barriers are capital re/uirements2 access to distribution channels2 economies of scale2 product differentiation2 technological comple+ity of product or process2 e+pected retaliation from e+isting firms2 and government policy.

1 0e ma-e three obser,ations (ith regar* to the in*ustry analysis) 1. "he more po)erful the five forces are2 the less profitable an industry is li3ely to be. In industries )here average
profitability is high ;such as soft drin3s and pharmaceuticals<2 the five forces are )ea3 ;e.g.2 in the soft drin3 industry2 entry barriers are high<. In industries )here the average profitability is lo) ;such as steel and coal<2 the five forces are strong ;e.g.2 in the steel industry2 threat from substitutes is high<.

*. 7epending on the relative strength of the five forces2 the 3ey strategic issues facing the business unit )ill differ
from one industry to another.

,. Mnderstanding the nature of each force helps the firm to formulate effective strategies. 'upplier selection ;a
strategic issue< is aided by the analysis of the relative po)er of several supplier groupsB the business unit should lin3 )ith the supplier group for )hich it has the best competitive advantage. 'imilarly2 analyzing the relative bargaining po)er of several buyer groups )ill facilitate selection of target customer segments. "eneric $ompetiti,e A*,antage) "he five@force analysis is the starting point for developing a competitive advantage since it helps to identify the opportunities and threats in the e+ternal environment. Kith this understanding2 9orter claims that the business unit has t)o generic )ays of responding to the opportunities in the e+ternal environment and developing a sustainable competitive advantageF lo) cost and differentiation.

1 Lo( $ost) #ost leadership can be achieved through such approaches as economies of scale in productionB
e+perience curve effects2 tight cost control2 and cost minimization ;in such areas as research and development2 service2 sales force2 or advertising<. 'ome firms follo)ing this strategy include #harles 'ch)ab in discount bro3erage2 Kal@Mart in discount retailing2 "e+as Instruments in consumer electronics2 !merson !lectric in electric motors2 Lyundai in automobiles2 7ell in computers2 0lac3 and 7ec3er in machine tools2 Nucor in steel2 &incoln !lectric in arc )elding e/uipment2 and 0I# in pens.

* DifferentiationF
"he primary focus of this strategy is to differentiate the product offering of the business unit2 creating something that is perceived by customers as being uni/ue. Approaches to product differentiation include brand loyalty ;#oca@#ola and 9epsi #ola in soft drin3s<2 superior customer service ;Nordstrom in retailing<2 dealer net)or3 ;#aterpillar "ractors in construction e/uipment<2 product design and product features ;Le)lett@9ac3ard in electronics<2 and technology ;#isco in communications infrastructure<. $ther e+amples of firms follo)ing a differentiation strategy include 0MK in automobilesB 'toufferQs in frozen foods2 Neiman@Marcus in retailing2 Mont 0lanc in pens2 and %ole+ in )rist)atches.

Jalue $hain AnalysisF

0usiness units can develop competitive advantage based on lo) cost2 differentiation2 or both. "he most attractive competitive position is to achieve cost@cum@differentiation.

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51

0hat is a responsibility centre? List an* explain *ifferent types of &esponsibility $enters (ith s-etches.

&esponsibility centers) A responsibility center is an organization unit that is headed by a manager )ho is responsible for its activities. In a sense2 a company is a collection of responsibility centers. !ach of )hich is represented by bo+ on the on the organization are responsibility centers for section )or3 shifts or other small organization units. At a higher level are departments or business units that consist of several of these smaller units plus staff and management people these larger units are also responsibility center. And from the stand point of senior management and the board of directors2 the )hole company is responsibility center although the term is usually used to refer to unit )ithin the company.

!ature of responsibility centers A responsibility center e+ist one or more purpose are its objectives. "he company as a )hole has goals2 and senior management has decided on a set of strategies to accomplish these goals. "he objectives of responsibility centers are to help implement these strategies. 0ecause the organization is the sum of its responsibility centers2 if the strategies are sound and if each responsibility center2 if the strategies are sound and if each responsibility center meets its objectives the )hole organization should achieve its goals. A responsibility center uses inputs2 and a variety of services. Its )or3 )ith these resources and it usually re/uire )or3ing capital2 e/uipment2 and other asset to do this )or3. As a result of this )or3 the responsibility center produces output )hich is classified either as goods if they are tangible or as services if they are intangible. !very responsibility center has output that is it does something. In a production plant2 the outputs are goods. In staff units2 such as human resources2 transportation2 engineering2 accounting2 and administration2 the output s are services. :or many responsibility centers2 especially staff units2 outputs are difficult to measureB nevertheless2 they e+ist. "he products produced by a responsibility center or to the outside mar3etplace. In the first case2 the product are inputs to the other responsibility center in the latter case2 they are output s of the )hole organization. #ypes of &esponsibility $enters $ost $enter #ost centers are divisions that add to the cost of the organization2 but only indirectly add to the profit of the company. "ypical e+amples include %esearch and 7evelopment2 Mar3eting and #ustomer service. #ompanies may choose to classify business units as cost centers2 profit centers2 or investment centers. "here are some significant advantages to classifying simple2 straightfor)ard divisions as cost centers2 since cost is easy to measure. Lo)ever2 cost centers create incentives for managers to underfund their units in order to benefit themselves2 and this underfunding may result in adverse conse/uences for the company as a )hole ;reduced sales because of bad customer service e+periences2 for e+ample<. 0ecause the cost centre has a negative impact on profit ;at least on the surface< it is a li3ely target for rollbac3s and layoffs )hen budgets are cut. $perational decisions in a contact centre2 for e+ample2 are typically driven by cost considerations. :inancial investments in ne) e/uipment2 technology and staff are often difficult to justify to management because indirect profitability is hard to translate to bottom@line figures. 0usiness metrics are sometimes employed to /uantify the benefits of a cost centre and relate costs and benefits to those of the organization as a )hole. In a contact centre2 for e+ample2 metrics such as average handle time2 service level and cost per call are used in conjunction )ith other calculations to justify current or improved funding.

52

.rofit $enter A responsibility centre is called a profit centre )hen the manager is held responsible for both costs ;inputs< and revenues ;outputs< and thus for profit. 7espite the name2 a profit centre can e+ist in nonprofits organizations ;though it might not be referred to as such< )hen a responsibility centre receives revenues for its services. A profit centre is a big segment of activity for )hich both revenues and costs are accumulatedF A centre2 )hose performance is measured in terms of both @ the e+pense it incurs and revenue it earns2 is termed as a profit centre. "he output of a responsibility centre may either be meant for internal consumption or for outside customers. In the latter case2 the revenue is realized )hen the sales are made. "hat is2 )hen the output is meant for outsiders2 then the revenue )ill be measured from the price charged from customers. If the output is meant for other responsibility centre2 then management ta3es a decision )hether to treat the centre as profit centre or not. In fact2 any responsibility centre can be turned into a profit centre by determining a selling price for its outputs. :or instance2 in case of a process industry2 the output of one process may be transferred to another process at a profit by ta3ing into account the mar3et price. 'uch transfers )ill give some profit to that responsibility centre. Although such transfers do not increase the #ompanys assets2 they help in management control process.

In,estment $entre An investment centre goes a step further than a profit centre does. Its success is measured not only by its income but also by relating that income to its invested capital2 as in a ratio of income to the value of the capital employed. In practice2 the term investment centre is not )idely used. Instead2 the term profit centre is used indiscriminately to describe centers that are al)ays assigned responsibility for revenues and e+penses2 but may or may not be assigned responsibility for the capital investment. It is defined as a responsibility centre in )hich inputs are measured in terms of cost D e+penses and outputs are measured in terms of revenues and in )hich assets employed are also measured. A responsibility centre is called an investment centre2 )hen its manager is responsible for costs and revenues as )ell as for the investment in assets used by his centre. Le is responsible for maintaining a satisfactory return on investment i.e. asset employed in his responsibility centre. "he investment centre manager has control over revenues2 e+penses and the amounts invested in the centres assets. "he manager of an investment centre is re/uired to earn a satisfactory return. "hus2 return on investment ; &%I< is used as the performance evaluation criterion in an investment centre. Le also formulates the credit policy2 )hich has a direct influence on debt collection2 and the inventory policy2 )hich determines the investment in inventory. "he Rice 9resident ;Investments< of a mutual funds company may be in charge of an Investment #entre. In the Investment #entre2 the manager in charge is held responsible for the proper utilization of assets. Le is e+pected to earn a satisfactory return on the assets employed in his responsibility centre. Measurement of assets employed poses many problems. It becomes difficult to determine the amount of assets employed in a particular responsibility centre. 'ome of the assets are in the physical possession of the responsibility centre )hile for some assets it may depend upon other responsibility centers or the Lead $ffice of the company. "his is particularly true of cash or heavy plant and e/uipment. Khether such assets should be included in the figure of assets employed of the responsibility centre and if included2 at ho) much value2 is a difficult /uestion. $n account of these difficulties2 investment centers are generally used only for relatively large units2 )hich have independent divisions2 both manufacturing and mar3eting2 for their individual products.

53

*. Explain the process of e,aluation of &esponsibility $enter from one stage to another (ith the help of
illustration5cum5experiences of the corporate. .rocess of e,aluation of &esponsibility $enter.

1. "he organization is divided into various responsibility centers. !ach responsibility centre is put under the
charge of a responsibility manager.

*. "he targets or budgets of each responsibility centre are set in consultation )ith the manager of responsibility
centre2 so that he may be able to give full information about his department. "he manager of responsibility centre should 3no) as )hat is e+pected of him @ each centre should have a clear set of goals. "he responsibility and authority of each centre should be )ell defined.

,. Managers are charged )ith the items and responsibility2 over )hich they can e+ercise a significant degree of
direct control.

-.

oals defined for each area of responsibility should be attainable )ith efficient and effective performance.

.. "he actual performance is communicated to the managers concerned. If it falls short of the standards2 the
variances are conveyed to the top management. "he names of persons responsible for the variances are also conveyed so that responsibility may be fi+ed. "he purpose of all these steps is to assign responsibility to different individuals so that their performance is improved and costs are controlled. "he personal factor in %esponsibility Accounting is most important. "he management may prepare the best plan or the budget and put up before its staff2 but its success depends upon the initiative and the )ill of the )or3ers to e+ecute it Example of &esponsibility $enter

"he 'arva 'hi3sha Abhiyan emphasizes /uality improvement in elementary education for )hich it deems necessary that resource groups and responsibility centers from national to sub@district levels are identified. "hese groups )ould oversee the policy2 planning2 implementation and monitoring of all /uality related interventions. "heir major role )ould be to advise and assist at various levels in curriculum development2 pedagogical improvement2 teacher educationDtraining and activities related to classroom transaction. In order to facilitate a decentralized mode of education2 these groups )ould need to be constituted at various operational levels2 namely @ national2 state2 district and sub district. "he follo)ing could be involved in the groupsF National level @ N#!%"2 NI!9A2 Mniversities2 N $s2 e+perts and eminent educationists. 'tate level @ '#!%"2 'I!MA"2 Mniversities2 IA'!sD#"!s2 N $s2 e+perts and eminent educationists. 7istrict level @ 7I!"s2 representatives from 79!9 7istrict %esource roup2 higher educational institutions2 innovative teachers from the districts2 N $s. 'ub@district @ 0%#D0!$2 representatives from #%#s2 innovative teachers.

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1riefly *efine Discretionary Expense $enter< Engineere* Expense $enter< .rofit $entre an* In,estment $entre? Eo( is bu*get prepare* in Discretionary Expenses $entre? Engineere* expense centers) !ngineered e+pense center have the follo)ing characteristicsF

1@ *@ ,@

"heir inputs can be measured in monetary terms. "heir output can be measured in physical terms. "he optimal dollar amount of input re/uired to produce one unit of output can be established.

!ngineered e+pense center usually are found in manufacturing operations. Karehousing2 distribution2 truc3ing and similar units in the mar3eting organization also may be engineered e+pense center and so many certain responsibility center )ithin administrative and support department. !+amples 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. 'uch units perform repetitive tas3 for )hich standard cost can be developed. In an engineered e+pense center the output multiplied by the standard cost of each unit produced represents )hat the finished product should have cost. Khen this cost is compared to actual costs2 the difference bet)een the t)o represents the efficiency of the organization unit being measured. Ke emphasize that engineered e+pense centers have other important tas3s not measured by cast alone. "he effectiveness of this aspect of performance should be controlled. :or e+ample e+penses center supervisor are responsible for the /uality of good and for the volume of production in addition to their responsibility for cost efficiency. "herefore the type and amount of production is prescribed and specific /uality standards are set so that manufacturing costs are not minimized at the e+pense of /uality. Moreover manager of engineered e+pense 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 ho) )ell they carry out these responsibilities. "here are fe) if any responsibility center in )hich all cost items are engineered. !ven in highly automated production department the amount of indirect labor and of various services used can vary )ith management discretion. "hus2 the term engineered costs center refers to responsibility center in )hich engineered cost predominate but in does not imply that valid engineering estimates can be made for each and every cost item. Discretionary expense center) "he output of discretionary e+penses center cannot be measured in monitory terms. "hey include administration and support units research and development organization and most mar3eting activities. "he term discretionary does not mean that management judgment is capricious or haphazard. Management has decided on certain policies that should govern the operation of the company. Khether to match e+ceed or spend less than the mar3eting effort of its competitorB the level of service that the company provides to the customer. "he appropriate amount of spending for % T 72 financial planning public relation and many other activities. $ne company may have a small head/uarter staff another company of similar size and in the same industry may have a staff that is 18 times as large. the management of both companies may be concerned that they made the correct decision on staff size but there is no objective )ay judging )hich decision )as actually better manager are hired and paid to ma3e such decision. After such a drastic change the level of discretionary e+penses generally has a similar pattern from one year to the ne+t. "he difference bet)een budgeted and actual e+pense is not a measure of efficiency in a discretionary e+pense center it is simply the difference bet)een the budgeted input and the actual input. It in no )ay measures the value of the output. if actual e+pense do not e+ceed the budget amount2 the manager has Slived )ithin the budget S ho)ever 2because by definition the budget does not purport to measure the optimum amount of spending )e cannot say that living )ithin the budgeted is efficient performance. .rofit $enter A responsibility centre is called a profit centre )hen the manager is held responsible for both costs ;inputs< and revenues ;outputs< and thus for profit. 7espite the name2 a profit centre can e+ist in nonprofits organizations ;though it might not be referred to as such< )hen a responsibility centre receives revenues for its services. A profit centre is a big segment of activity for )hich both revenues and costs are accumulatedF A centre2 )hose performance is measured

55

in terms of both @ the e+pense it incurs and revenue it earns2 is termed as a profit centre. "he output of a responsibility centre may either be meant for internal consumption or for outside customers. In the latter case2 the revenue is realized )hen the sales are made. "hat is2 )hen the output is meant for outsiders2 then the revenue )ill be measured from the price charged from customers. If the output is meant for other responsibility centre2 then management ta3es a decision )hether to treat the centre as profit centre or not. In fact2 any responsibility centre can be turned into a profit centre by determining a selling price for its outputs. :or instance2 in case of a process industry2 the output of one process may be transferred to another process at a profit by ta3ing into account the mar3et price. 'uch transfers )ill give some profit to that responsibility centre. Although such transfers do not increase the #ompanys assets2 they help in management control process. In,estment $entre An investment centre goes a step further than a profit centre does. Its success is measured not only by its income but also by relating that income to its invested capital2 as in a ratio of income to the value of the capital employed. In practice2 the term investment centre is not )idely used. Instead2 the term profit centre is used indiscriminately to describe centers that are al)ays assigned responsibility for revenues and e+penses2 but may or may not be assigned responsibility for the capital investment. It is defined as a responsibility centre in )hich inputs are measured in terms of cost D e+penses and outputs are measured in terms of revenues and in )hich assets employed are also measured. A responsibility centre is called an investment centre2 )hen its manager is responsible for costs and revenues as )ell as for the investment in assets used by his centre. Le is responsible for maintaining a satisfactory return on investment i.e. asset employed in his responsibility centre. "he investment centre manager has control over revenues2 e+penses and the amounts invested in the centres assets. "he manager of an investment centre is re/uired to earn a satisfactory return. "hus2 return on investment ; &%I< is used as the performance evaluation criterion in an investment centre. Le also formulates the credit policy2 )hich has a direct influence on debt collection2 and the inventory policy2 )hich determines the investment in inventory. "he Rice 9resident ;Investments< of a mutual funds company may be in charge of an Investment #entre. In the Investment #entre2 the manager in charge is held responsible for the proper utilization of assets. Le is e+pected to earn a satisfactory return on the assets employed in his responsibility centre. 1u*get .reparation. "he decision that management ma3e about a discretionary e+pense budget are different from the decisions that it ma3es about the budget for an engineered e+pense center. :or the latter management decides )hether the proposed operating budget represent the cost of performing tas3 efficiently for the coming period. management is not so much concerned )ith the magnitude of the tas3 because this is largely determined by the actions of other responsibility centers2 such as the mar3eting departments ability to generate sales. In formulating the budget for a discretionary e+pense center2 ho)ever management principal tas3 is to decide on the magnitude of the job that should be done. "hese tas3s can be divided generally into t)o types continuing and special. #ontinuing tas3 are those that continue from year to year for e+ample financial statement preparation by the controllers office. 'pecial tas3s are one shot project for e+ample developing and installing a profit budgeting system in a ne)ly ac/uired division. "he techni/ue management by objective is often used in preparing the budget for a discretionary e+pense center. Management by objective is a formal process in )hich a budget purposes to accomplish specific tas3s and state a mean for measuring )hether these tas3s have been accomplished. "here are t)o different approach to planning for the discretionary e+pense center increment budgeting and zero based revie).

SE# .K
Q1. Describe inherent *ifficulties creation of profit centres may cause an* a*,antages possible? @n*er (hich situation creation of profit centre is not a*,isable. @n*er (hich situation creation of profit centre is not a*,isable 7ecentralized decision ma3ing )ill force top management to rely more on management control reports than on personal 3no)ledge of an operation2 entailing some loss of control. If head/uarters management is mere capable or better informed than the average profit center manager2 the /uality of decisions made at the unit level )ay be reduced. :riction may increase because of arguments over the appropriate transfer price2 the assignment of common costs2 and the credit for revenues that )ere formerly generated jointly by t)o or more business units )or3ing together. $rganization units that once cooperated as functional units may no) be in competition )ith one another. An increase in profits for one manager may mean a decrease for another. In such situation a manager may fail to refer sales leads to another business unit better /ualified to pursue themB may hoard personnel or e/uipment that2 from the overall

56

companys2 standpoint2 )ould be better off used in another unitB or may ma3e production decisions that have undesirable cost conse/uences for other units. 7ivisionalization may impose additional costs because of the additional management2 staff personnel2 and record 3eeping re/uired2 and may lead to tas3 redundancies at each profit center.#ompetent general managers may not e+ist in a functional organization because there may not have been sufficient opportunities for them to develop general management competence. "here may be too much emphasis on short@ run profitability at the e+pense of long@run profitability. In the desire to report high current profits2 the profit center manager may s3imp on %T72 training programs2 or maintenance. "his tendency is especially prevalent )hen the turnover of profit center managers is relatively high. In these circumstances2 managers may have good reason to believe that their actions may not affect profitability until after they have moved to other jobs. "here is no completely satisfactory system for ensuring that optimizing the profits of each individual profit center )ill optimize the profits of the company as a )hole. Q6.0hat are the challenges face* in pricing corporate ser,ices pro,i*e* to 1usiness @nits operating as Lprofit centers?M 1usiness @nits as .rofit $enters Most business units are created as profit centers since managers in charge of such units typically control product development2 manufacturing2 and mar3eting resources. "hese managers are in a position to influence revenues and costs and as such can be held accountable for the Ebottom line.E Lo)ever2 as pointed out in the ne+t section2 a business unit managerQs authority may be constrained in various )ays2 )hich ought to be reflected in a profit centerQs design and operation. $onstraints on 1usiness @nit Authority "o realize fully the benefits of the profit center concept2 the business unit manager )ould have to be as autonomous as the president of an independent company. As a practical matter2 ho)ever2 such autonomy is not feasible. If a company )ere divided into completely independent units2 the organization )ould lose the advantages of size and synergy. :urthermore in delegating to business unit management all the authority that the board of directors has given to the #!$2 senior management )ould be abdicating its o)n responsibility. #onse/uently2 business unit structures represent trade@offs bet)een business unit autonomy and corporate constraints. "he effectiveness of a business unit organization is largely dependent on ho) )ell these trade@offs are made. $onstraints from %ther 1usiness @nits. $ne of the main problems occurs )hen business units must deal )ith one another. It is useful to thin3 of managing a profit center in terms of control over three types of decisionsF ;1< "he product decision ;)hat goods or services to ma3e and sell<2 ;*< "he mar3eting decision ;ho)2 )here2 and for ho) much are these goods or services to be soldI<2 and ;,< "he procurement or sourcing decision ;ho) to obtain or manufacture the goods or services<. If a business unit manager controls all three activities2 there is usually no difficulty in assigning profit responsibility and measuring performance. In general2 the greater the degree of integration )ithin a company2 the more difficult it becomes to assign responsibility to a single profit center for all three activities in a given product lineB that is2 if the production2 procurement2 and mar3eting decisions for a single product line are split among t)o or more business units2 separating the contribution of each business unit to the overall success of the product line may be difficult. Constraints from Corporate Management "he constraints imposed by corporate management can be grouped into three typesF ;1< "hose resulting from strategic considerations2 ;*< "hose resulting because uniformity is re/uired2 and ;,< "hose resulting from the economies of centralization. Most companies retain certain decisions2 especially financial decisions2 at the corporate level2 at least for domestic activities. #onse/uently2 one of the major constraints on business units results from corporate control over ne) investments. 0usiness units must compete )ith one another for a share of the available funds. "hus2 a business unit could find its e+pansion plans th)arted because another unit has convinced senior management that it has a more Attractive program. #orporate management .also imposes other constraints. !ach business unit has a EcharterE that specifies the mar3eting andDor production activities that it is permitted to underta3e2 and it must refrain from operating beyond its charter2 even though it sees profit opportunities in doing so. Also2 the maintenance of the proper corporate image may re/uire constraints on the /uality of products or on public relations activities.

57

#ompanies impose some constraints on business units because of the necessity for Mniformity. $ne@constraint is that business Mnits must conform to corporate accounting and M#' "his constraint is especially troublesome for units that have been ac/uired from another company and that have been accustomed to using different systems. Q./) 0rite Short !otes on

1. Nero 1ase* 1u*geting *. Internal $ontrolO

Nero 1ase* 1u*geting) \ero@based budgeting is a techni/ue of planning and decision@ma3ing )hich reverses the )or3ing process of traditional budgeting. In traditional incremental budgeting2 departmental managers justify only increases over the previous year budget and )hat has been already spent is automatically sanctioned. No reference is made to the previous level of e+penditure. 0y contrast2 in zero@based budgeting2 every department function is revie)ed comprehensively and all e+penditures must be approved2 rather than only increases. ]1^ \ero@based budgeting re/uires the budget re/uest be justified in complete detail by each division manager starting from the zero@base. "he zero@base is indifferent to )hether the total budget is increasing or decreasing.
"he term Ezero@based budgetingE is sometimes used in personal finance to describe the practice of budgeting every dollar of income received2 and then adjusting some part of the budget do)n)ard for every other part that needs to be adjusted up)ard. It )ould be more technically correct to refer to this practice as Eactive@balanced budgetingE.

Advantages of \ero@0ased 0udgetingF

1. !fficient allocation of resources2 as it is based on needs and benefits. *. 7rives managers to find cost effective )ays to improve operations. ,. 7etects inflated budgets. -. Municipal planning departments are e+empt from this budgeting practice. .. Mseful for service departments )here the output is difficult to identify. 1. Increases staff motivation by providing greater initiative and responsibility in decision@ma3ing. 4. Increases communication and coordination )ithin the organization. 5. Identifies and eliminates )asteful and obsolete operations. 6. Identifies opportunities for outsourcing. 18. :orces cost centers to identify their mission and their relationship to overall goals.
7isadvantages of \ero@0ased 0udgetingF

1. 7ifficult to define decision units and decision pac3ages2 as it is time@consuming and e+haustive. *. :orced to justify every detail related to e+penditure. "he %T7 department is threatened )hereas the ,. -.
production department benefits. Necessary to train managers. \ero@based budgeting must be clearly understood by managers at various levels to be successfully implemented. 7ifficult to administer and communicate the budgeting because more managers are involved in the process.
In a large organization2 the volume of forms may be so large that no one person could read it all. #ompressing the information do)n to a usable size might remove critically important details.

.. Lonesty of the managers must be reliable and uniform. Any manager that e+aggerates s3e)s the results
Internal $ontrol)
Internal control is defined as a process affected by an organizationQs structure2 )or3 and authority flo)s2 people and management information systems2 designed to help the organization accomplish specific goals or objectives. ]1^ It is a means by )hich an organizationQs resources are directed2 monitored2 and measured. It plays an important role in preventing and detecting fraud and protecting the organizationQs resources2 both physical ;e.g.2 machinery and property< and intangible ;e.g.2 reputation or intellectual property such as trademar3s<. At the organizational level2 internal control

objectives relate to the reliability of financial reporting2 timely feedbac3 on the

58

achievement of operational or strategic goals2 and compliance )ith la)s and regulations. At the specific transaction level2 internal control refers to the actions ta3en to achieve a specific objective ;e.g.2 ho) to ensure the organizationQs payments to third parties are for valid services rendered.< Internal control procedures reduce process variation2 leading to more predictable outcomes escri!ing Internal Controls" Internal controls may be described in terms ofF a< the objective they pertain toB and b< the nature of the control activity itself. $bjective categorization Internal control activities are designed to provide reasonable assurance that particular objectives are achieved2 or related progress understood. "he specific target used to determine )hether a control is operating effectively is called the control objective. #ontrol objectives fall under several detailed categoriesB in financial auditing2 they relate to particular financial statement assertions2 ].^ but broader frame)or3s are helpful to also capture operational and compliance aspectsF

1. *. ,. -. .. 1. 4.

!+istence ;Ralidity<F $nly valid or authorized transactions are processed ;i.e.2 no invalid transactions< $ccurrence ;#utoff<F "ransactions occurred during the correct period or )ere processed timely. #ompletenessF All transactions are processed that should be ;i.e.2 no omissions< RaluationF "ransactions are calculated using an appropriate methodology or are computationally accurate. %ights T $bligationsF Assets represent the rights of the company2 and liabilities its obligations2 as of a given date. 9resentation T 7isclosure ;#lassification<F #omponents of financial statements ;or other reporting< are properly classified ;by type or account< and described. %easonableness@transactions or results appear reasonable relative to other data or trends.

Activity categorization #ontrol activities may also be described by the type or nature of activity. "hese include ;but are not limited to<F

1G *G ,G -G .G 1G 4G

'egregation of duties @ separating authorization2 custody2 and record 3eeping roles to limit ris3 of fraud or error by one person. Authorization of transactions @ revie) of particular transactions by an appropriate person. %etention of records @ maintaining documentation to substantiate transactions. 'upervision or monitoring of operations @ observation or revie) of ongoing operational activity. 9hysical safeguards @ usage of cameras2 loc3s2 physical barriers2 etc. to protect property. Analysis of results2 periodic and regular operational revie)s2 metrics2 and other 3ey performance indicators ;V9Is<. I" 'ecurity @ usage of pass)ords2 access logs2 etc. to ensure access restricted to authorized personnel. '

Q= .Jeena .,t. Lt*.< a small multipro*uct company is ta-en o,er by a multinational company 4 e.g. Ein*ustan Le,er.) 0hat changes in the control system (oul* you expect an* (hy? 'ince Reena is a small multiproduct company it )ould re/uire changes in control system )hich )ould be related to transfer pricing a2 as this company )ould generally provide inputs to LM&. "hus the domestic operations generally involve transfer of goods and services only In vie) of this difference many other considerations2 in addition to the criteria used in domestic operations for the determination of transfer price2 are involved. "hese includeF

;1< :air 9riceF "his is an important factor one needs to consider )hile determining the transfer price for foreign
operations. #ompanies that enter into joint ventures must ensure that the transfer price charged is fair. If such companies charge a higher transfer price2 it )ould reduce the profits of the joint venture and as a result reduce the foreign partnerQs share of profits.

;*< overnment %egulationsF All countries have a regulatory frame)or3 under )hich business units operate. Khere
government rules and regulations regarding transfer prices are lenient2 the parent company should fi+ a higher transfer price for all transfers to countries )ith high income ta+ rates. "his approach )ould enable the parent company to minimize ta+es in such countries.

59

;c< !+change #ontrol %estrictionsF !very country has foreign e+change control regulations. "hese regulations impose a limit on the amount of foreign e+change available for the import of certain goods. "o accommodate the foreign subsidiary the parent company may have a lo)er transfer price so that the subsidiary is able to import a larger /uantity of re/uired goods.

;-< Income "a+ %egulationsF "he rates of income ta+ vary from country to country. "o overcome this difference the
transfer price should be so fi+ed that countries )ith lo) ta+ rates sho) profits )hile others end up )ith a loss. "his helps the parent company to reduce its ta+es on a global basis.

;.< 7esire to accumulate fundsF A company that )ishes to accumulate funds in a particular country may fi+ the
transfer prices in such a manner that it facilitates shifting of funds into that country. ;I< "ariffs@ and 7utiesF No country li3es high imports. In order to restrict imports countries impose restrictions such as /uantitative restrictions2 high duties and tariffs and banning import of products. "he general practice is to charge import duties as a percentage of the value of products imported2 although a lo)er tariff may be levied if the import value is lo)er. It is seen that the impact of tariffs on the profitability of foreign operations is generally the reverse of the incidence of income ta+es in transfer pricing. As such a lo) transfer price )ould lead to lo) import duties on transfer2 the profit arising in that country )ould be high. "his results in high income ta+es in that country. It is therefore advisable that companies must compute the net effect of these factors )hile determining transfer prices. In designing performance evaluation systems for ac/uired Reena company2LM& could use the follo)ing guidelines 'ubsidiary managers should not be held responsible for translation effects. "he simplest )ay to achieve this objective is to compare budgets and actual results using the same metric and isolate inflation@related effects through variance analysis. It is pointless for managers to )orry about the appropriate metric. "he MN! should choose )hatever metric is more convenient. "ransaction effects are best handled through centralized coordination of the MN!Qs overall hedging needs. "his is li3ely to be cheaper and simpler2 and it prevents the subsidiary manager from becoming a foreign e+change rate forecaster and speculator. "he subsidiary manager should be held responsible for the dependence effects of e+change rates resulting from economic e+posure. !valuation of the subsidiary as a basis for a decision to locate operations in a country or to relocate operations from a country should reflect the conse/uences of translation. "ransaction and economic e+posures.

SE# 17
Q.1) Khat are the 'pecial #haracteristics of 9rofessional 'ervice $rganizationI Ans(er) "oals A dominant goal of a manufacturing company is to earn a satisfactory profit2 specifically a satisfactory return on assets employed. A professional organization has relatively fe) tangible assetsB its principal asset is the s3ill of its professional staff2 )hich QdoesnQt appear on its balance sheet. %eturn on assets employed2 therefore2 is essentially meaningless in such organizations. "heir financial goal is to provide ade/uate compensation to the professionals. In many organizations2 a related goal is to increase their size. In part2 this reflects the natural tendency to associate success )ith large size. In part2 it reflects economies of scale in using the efforts of a central personnel staff and units responsible for 3eeping the organization up@to@date. &arge public accounting firms need to have enough local offices to enable them to audit clients )ho have facilities located throughout the )orld. .rofessionals 9rofessional organizations are labor intensive2 and the labor is of a special type. Many professionals prefer to )or3 independently2 rather than as part of a team. 9rofessionals )ho are also managers tend to )or3 only part time on management activitiesB senior partners in an accounting firm participate actively in audit engagementsB senior partners in la) firms have clients. !ducation for most professions does not include education in management2 but /uite

60

naturally stresses the s3ills of the profession2 rather than managementB for this and other reasons2 professionals tend to loo3 do)n on managers. 9rofessionals tend to give inade/uate )eight to the financial implications of their decisionsB they )ant to do the best job they can2 regardless of its cost. "his attitude affects the attitude of support staffs and nonprofessionals in the organizationB it leads to inade/uate cost control. %utput an* Input easurement "he output of a professional organization cannot be measured in physical terms2 such as units2 tons2 or gallons. Ke can measure the number of hours a la)yer spends on a case2 out this is a measure of input2 not output. $utput is the effectiveness of the la)yerQs )or32 and this is not measured by the number of pages in a brief or the number of hours in the courtroom. Ke can measure the number of patients a physician "eats in a day2 and even classify these visits by type of complaintB but this is by no means e/uivalent to measuring the amount or /uality of service the physician has provided. At most2 )hat is measured is tl1e physicianQs efficiency in treating patients2 )hich is of some use in identifying slac3ers and hard )or3ers. %evenues earned is one measure of output in some professional organizations2 but these monetary amounts2 at most2 relate to the /uantity of services rendered2 not to their /uality ;although poor /uality is reflected in reduced revenues in the long run<. :urthermore2 the )or3 done by many professionals is non repetitive. No t)o consulting jobs or research and development projects are /uite the same. "his ma3es it difficult to plan the time re/uired for a tas32 to set reasonable standards for tas3 performance2 and to judge ho) satisfactory the performance )as. 'ome tas3s are essentially repetitiveF the drafting of simple )ills2 deeds2 sales contracts2 and similar documentsB the ta3ing of a physical inventory by an auditorB and certain medical and surgical procedures. "he development of standards for such tas3s may be )orth)hile2 although in using these standards2 usual circumstances that affect a specific job must be ta3en into account. 'ome professionals2 notably scientists2 engineers2 and professors2 are reluctant to 3eep trac3 of ho) they spend their time2 and this complicates the tas3 of measuring performance. "his reluctance seems to have its roots in traditionB usually2 it can be overcome if senior management is )illing to put appropriate emphasis on the necessity of accurate time reporting. Nevertheless2 difficult problems arise in deciding ho) time should be charged to clients. If the normal )or3 )ee3 is -8 hours2 should a job be charged for 11-8th of a )ee3Qs compensation for each hour spent on itI If so2 ho) should )or3 done on evenings and )ee3ends be countedI ;9rofessionals are Ee+emptE employees@ that is2 they are not subject to government re/uirements of overtime payments.< Lo) to account for time spent reading literature2 going to meetings2 and other)ise 3eeping up@to@dateI Small Si:e Kith a fe) e+ceptions2 such as some la) firms and accounting firms2 professional organizations are relatively small and operate at a single location. 'enior management in such organization can personally observe )hat is going on and personally motivate employees. "hus2 there is less need for a sophisticated management control system2 )ith profit centers and formal performance reports. Nevertheless2 even a small organization needs a budget2 a regular comparison of performance against budget2 and a )ay of relating compensation to performance. Eo( is ar-eting *one in them? In a manufacturing company there is a clear dividing line bet)een mar3eting activities and production activitiesB only senior management is concerned )ith both. 'uch a clean separation does not e+ist in most professional organizations. In some2 such as la)2 medicine2 and accounting2 the professionQs ethical code limits the amount and character of overt mar3eting efforts by professionals ;although these restrictions have been rela+ed in recent years<. Mar3eting is an essential activity in almost all organizations2 ho)ever. If it canQt be conducted openly2 it ta3es the form of personal contacts2 speeches2 articles2 conversations on the golf course2 and so on. "hese mar3eting activities are conducted by professionals2 usually by professionals )ho spend much of their time in production )or3@that is2 )or3ing for clients. In this situation2 it is difficult to assign appropriate credit to the person responsible for EsellingE a ne) customer. In a consulting firm2 for e+ample2 a ne) engagement may result from a conversation bet)een a member of the firm and an ac/uaintance in a company2 or from the reputation of one of the professionals as an outgro)th of speeches or articles. Moreover2 the professional )ho is responsible for obtaining the engagement may not be personally involved in carrying it out. Mntil fairly recently2 these mar3eting contributions )ere re)arded subjectively@that is2 they )ere ta3en into account in promotion and compensation decisions. 'ome organizations no) give e+plicit credit2 perhaps as a percentage of the projectQs revenue2 if the person )ho EsoldE the project can be identified. Eo( *o (e e,aluate the .erformance Appraisal? As noted earlier in regard to teachers2 at the e+tremes the performance of professionals is easy to judge. Appraisal of the large percentage of professionals )ho are )ithin the e+tremes is much more difficult. :or some professions2 objective measures of performance are sometimes unavailableF "he recommendations of an investment analyst can be compared )ith actual mar3et behavior of the securitiesB the accuracy of a surgeonQs diagnosis can be verified by an

61

e+amination of the tissue that )as removedB and the doctorsQ s3ill can be measured by the success ratio of operations. "hese measures are2 of course2 subject to appropriate /ualifications2 and in most circumstances the assessment of performance is finally a matter of human judgment by superiors2 peers2 self2 subordinates2 and clients. Wudgments made by superiors are the most common. :or these2 professional organizations increasingly use formal systems to collect performance appraisals as a basis for personnel decisions and for discussion )ith the professional. 'ome systems re/uire numerical ratings of specified attributes of performance and provide for a )eighted average of these ratings. #ompensation may be tied2 in part2 to these numerical ratings. In a matri+ organization2 both the project leader and the head of the functional unit that is the professionalQs organizational EhomeE judge performance. E Appraisals by a professionalQs peers2 or by subordinates2 are sometimes part of a formal control system. In some organizations2 individuals may be as3ed to ma3e a self@appraisal. !+pressions of satisfaction or dissatisfaction from clients are also an important basis for judging performance2 although such e+pressions may not al)ays be readily forthcoming. "he budget can be used as the basis for measuring cost performance2 and the actual time ta3en can be compared )ith the planned time. 0udgeting and control of discretionary e+penses are as important in a professional firm as in a manufacturing company. 'uch financial measures are relatively unimportant in assessing a professionalQs contribution to the firmQs2 profitability2 ho)ever. "he professionalQs major contribution is related to /uantity and above all /uality of )or32 and its appraisal must be largely subjective. :urthermore2 the appraisal must be made currentlyB it cannot )ait until one learns )hether a ne) building is )ell designed2 a ne) control system actually )or3s )ell2 or a bond indenture has a fla). In some professions2 internal audit procedures are used to control /uality. In many accounting firms2 the report of an audit is revie)ed by a partner other than the one )ho is responsible for it2 and the )or3 of the )hole firm is Epeer revie)edE by another firm. "he proposed design of a building may be revie)ed by architects )ho are not actively involved in the project. Q.6) Khat is a Non @ 9rofit $rganizationI Lo) is the performance of this organization evaluatedI Ans(er) Intro*uction A nonprofit organization2 as defined by la)2 is an organization that cannot distribute assets or income to2 or for the benefit of2 its members2 officers2 or directors. "he organization can2 of course2 compensate its employees2 including officers and members2 for services rendered and for goods supplied. "his definition does not prohibit an organization from earning a profitB it prohibits only the distribution of profits. A nonprofit organization needs to earn a modest profit2 on average2 to provide funds for )or3ing capital and for possible Hrainy days.J .erformance e,aluation of nonprofit organi:ation :or any organization2 the most important reasons to measure performance are to improve effectiveness and to ac/uire information that )ill allo) the organization to drive its agenda for)ard. If the motivation for doing evaluation remains outside an organization2 the evaluation )ill have limited impact. "o do performance assessment effectively2 an organization must commit to adopting a culture of measurement2 because acceptance must come from senior management2 staff2 funders2 and board members ali3e.

1 1oar* self5e,aluation
Members of the 0oard of 7irectors should regularly evaluate the /uality of their activities on a regular basis. Activities might include staffing the 0oard )ith ne) members2 developing the members into )ell@trained and resourced members2 discussing and debating topics to ma3e )ise decisions2 and supervising the #!$. 9robably the biggest problem )ith 0oard self@evaluation is that it does not occur fre/uently enough. As a result2 0oard members have no clear impression of ho) they are performing as members of a governing 0oard. 9oor 0oard operations2 )hen undetected2 can adversely affect the entire organization. * Staff an* ,olunteer 4in*i,i*ual) performance e,aluation Most of us are familiar )ith employee performance appraisals2 )hich evaluate the /uality of an individuals performance in their position in the organization. Ideally2 those appraisals reference the individuals )ritten job description and performance goals to assess the /uality of the individuals progress to)ard achieving the desired results described in those documents. #ontinued problems in individual performance often are the results of poor strategic planning2 program planning and staff development. If overall planning is not done effectively2 individuals can e+perience continued frustration2 stress and lo) morale2 resulting in their poor overall performance. !+perienced

62

leaders have learned that continued problems in performance are not al)ays the result of a poor )or3 ethic A the recurring problems may be the result of larger2 more systemic problems in the organizations. 1 .rogram e,aluation 9rogram evaluations have become much more common2 particularly because donors demand them to ensure that their investments are ma3ing a difference in their communities. 9rogram evaluations are typically focused on the /uality of the programs process2 goals or outcomes. An ineffective program evaluation process often is the result of poor program planning A programs should be designed so they can be evaluated. It can also be the result of improper training about evaluation. 'ometimes2 leaders do not realize that they have the responsibility to verify to the public that the nonprofit is indeed ma3ing a positive impact in the community. Khen program evaluations are not performed )ell2 or at all2 there is little feedbac3 to the strategic and program planning activities. Khen strategic and program planning are done poorly2 the entire organization is adversely effected. * E,aluation of cross5functional processes #ross@functional processes are those that span several systems2 such as programs2 functions and projects. #ommon e+amples of major processes include information technology systems and /uality management of services. 0ecause these cross@functional processes span so many areas of the organization2 problems in these processes can be the result of any type of ineffective planning2 development and operating activities. , %rgani:ational e,aluation $ngoing evaluation of the entire organization is a major responsibility of all leaders in the organization. &eaders sometimes do not recognize the ongoing activities of management to actually include organizational evaluations A but they do. "he activities of organizational evaluation occur every day. Lo)ever2 those evaluations usually are not done systematically. As a result2 useful evaluation information is not provided to the strategic and program planning processes. #onse/uently2 both processes can be ineffective because they do not focus on improving the /uality of operations in the )or3place. Q./) A Kell 7iversified company A 9ritam International &td. sells one of its divisions to a group of its o)n company managers. !+plain )hat significant changes in systems and control procedures can be e+pectedI KhyI Ans(er) As2 )e 9ritam International is a )ell diversified company. 'ometimes2 e+cessive diversification and that too in unrelated lines of business causes failure in the business operations. $ne of the major reason for failures of many Mergers and 7iversification is e+cessive diversification. As2 e+cessive diversification is ominous especially2 in unrelated lines of business. As2 there may be no advantage of operating synergy. Neither throughF 'haring common resources nor 'haring common core competencies "herefore2 it may be a strategic decision by the promoters and directors of the company to sell one of its divisions. As2 this may be impacting their core business. 'ometimes2 your core business tends to get neglected mainily due to e+cesive diversification. As2 the division is being sold to its o)n company managers. "here2 might not be major changes in management control and systems. As2 most of its managers )ill be the same. 0ut2 they )ill have more autonomy to ta3e decisions independently after ac/uisition. No) there )ill be less red tapism and managers can ta3e more ris3. "he managers )ill manage the firm in their o)n style. As2 they are not ans)erable to their superiors. #urrently2 they are ans)erable to their sta3e@ holders. As2 the management is completely in their hands and that too )ith full autonomy. "he management might have identified the fla)s in the previous controls and systems of the company because of )hich the company might not be so effective and efficient. As2 they have been associated )ith the company over aperiod of time. "hey have a better understanding about the business dynamics and environment in )hich the firm operates. 'o2 they can ta3e necessary steps to overcome the fla)s and improve the management control and systems. 'o2 that is )hy there )ill be some significant changes in the management control and systems and procedures if there is further scope for improvement.

6< ,.<

SE# 11
Q.1)0hy 1alance Score $ar* is consi*ere* superior to other metho*s of .erformance Appraisal? .repare 1alance Score $ar* for any organi:ation you are familiar (ith. A!S0E&)

63

0hat is the 1alance* Scorecar*? "he rationale for the development of the 0alanced 'corecard )as a gro)ing dissatisfaction )ith traditional2 financial measures of performance. "hese measures suffer from a number of serious dra)bac3s in that they ta3e a short@term2 lagged ;i.e.2 historic< vie) of performance. "he shift to)ards fle+ible2 lean productionDservice systems in many firms has strengthened the re/uirement for performance measurement systems to become more broadly based2 incorporating both non@financial and e+ternal measures of performance. According to Vaplan and Norton2 the 0alanced 'corecard provides a better assessment of performance as it Eenables companies to trac3 financial results )hile simultaneously monitoring progress in building the capabilities and ac/uiring the intangible assets they need for future gro)thE. "he original scorecard designed by Vaplan and Norton contained four 3ey groupings of performance measures. "hese four groupings2 called Sperspectives by Vaplan and Norton2 )ere considered sufficient to trac3 the 3ey drivers of both current and future financial performance of the firm. "he perspectives focused on the achievements of the firm in four areasF namely the financial2 customer2 internal business process and innovationDlearning perspectives. "he four perspectives can be represented as an interlin3ed hierarchy. "he firms strategy underlies the )hole scorecard2 as the measures for each of the four perspectives are dra)n from this strategy.

"o obtain a satisfactory overvie) of performance2 the scorecard )ill re/uire a mi+ of lagging and leading ;for)ard loo3ing< measures. :inancial measures tend to be lagged and conse/uently2 the measures chosen for the other perspectives )ill need to include leading measures. In general2 outcome measures tend to be lagged2 for e+ample2 current mar3et share is the result of past decisions and conse/uently is a lagging measure. "hus the challenge in designing a 0alanced 'corecard is to choose driver measures )hich lead changes in the outcome measures in the non@financial perspectives and )hich ultimately drive the financial measures. $nce the firms objectives have been agreed and the appropriate outcome and driver measures chosen for each of the perspectives2 firm and managerial performance is assessed by comparing actual attainment on each measure )ith the target set for that measure. $bjective Measure "arget Act ual

64

1enefits from a*opting the 1alance* Scorecar* "here are several benefits from implementing a 0alanced 'corecard. $riginally the 0alanced 'corecard )as seen as a useful tool for performance measurement. In this role2 the 0alanced 'corecard )as seen as integrating financialDnon@financial2 internalDe+ternal and leading Dlagging information on firm performance in a coherent fashion. &ater it )as realised that the 0alanced 'corecard could play a pivotal role in the strategic management process. 0ecause the 0alanced 'corecard re/uires management to clarify and obtain consensus on the strategic objectives of the firm2 it can assist in the communication of the chosen strategy2 conse/uently aligning the efforts both of individuals and of departments. In this role2 there is a clear lin3 bet)een the 0alanced 'corecard and management by objectives ;M0$<. !ffective implementation of a 0alanced 'corecard project )ill generally involve the development of a series of hierarchical ;cascaded< scorecards. iven the overall corporate scorecard2 supporting scorecards can be developed for each department )ithin the firm. Kithin each department2 a scorecard can be developed for each manager ;or perhaps even for each individual member of staff< )hich lin3s the objectives on each perspective for that manager bac3 to the objectives for each perspective outlined in the scorecard for the department and finally2 bac3 to the objectives listed in the firms overall scorecard. "he 0alanced 'corecard could be used to assist in corporate restructuring. In recent years2 many firms have migrated a)ay from a traditional hierarchical structure to a flatter2 team@based organisational structure. "he 0alanced 'corecard can support such changes2 as it can help clarify the objectives and the critical success factors for the ne)ly formed teams. Apart from the communication and co@ordination roles of the 0alanced 'corecard in strategic implementation2 the 0alanced 'corecard can be used to lin3 strategy to specific critical success factors in the customer2 internal business process and gro)thDlearning perspectives. 0y setting both short and long@ term targets for driver and outcome measures and by comparing actual attainment against target2 feedbac3 is obtained on ho) )ell the strategy is being implemented and on )hether the strategy is )or3ing. 0uilding on the 0alanced 'corecards use as a strategic management tool2 it has been suggested that the 0alanced 'corecard can play a role in the investment appraisal process;.<. "raditional methods of investment appraisal such as discounted cash flo) do not cope )ell )ith investments )hich generate indirect rather than direct financial returns. !+amples of these include investments )hich enhance the future Sfle+ibility of a firm or investments in the firms infrastructure2 such as an enhanced management information system. "he 0alanced 'corecard can assist managements investment appraisal decisions as it provides managers )ith a mechanism to incorporate the strategic aspects of the investment into the appraisal process. "his could be achieved by using a )eighting system developed from a firms 0alanced 'corecard measures to evaluate ne) projects. An inde+ score )ould be calculated for each investment opportunity and projects )ould then be ran3ed and selected based on this score. 1alance Score $ar* of $re*it $ar* $ompany

65

Q .6) Soniya $ompany has t(o Di,isions) A ? 1. &eturn on In,estment for both *i,isions is 67H. Details are gi,en belo()5 .articulars Di,isional sales Di,isional In,estment .rofit Di, A =777777 6777777 =77777 Di, 1 KD777 77 /6777 77 D=77 77

Analyse an* comment on *i,isional performance of each. A!S0E& As .rofit Sales argin A .rofit P177

9rofit Margin for 7ivision SA> -2882888 D-82882888 O188 > 18N 9rofit Margin for 7ivision S0 > 12-82888D 612882888 O188 > 1.1N #urno,er of In,estment A Sales P 177 In,estment

66

"urnover of Investment for 7ivision SA > -82882888D*82882888 > * times "urnover of Investment for 7ivision S0 > 612882888D,*2882888 > , times As %eturn on investment for both 7ivisions A and 0 is *8N. $% E!#S)5

Di,ision QAR ; Although SA has more profit margin than 7ivision S0 that is 18N as compared to 1.1N of S02 so it has more profitability but inspite of it2 division SA has lo)er turnover of investment that its assets management is bad than 7ivision S02 it can be improved by increased sales or reducing investment. Di,ision Q1R ; Needs to improve profit margin by increasing sales and reduce variable cost and sales at same price or by reducing salesprice and increase the volume of sales so that its profit )ould improve. As it has good assets management sho)n by its turnoverof 7ivision S0 that is , times )hich is better than 7ivision SA. 'o it can become profitable organisation by improving 9rofit Margin. Q.=)Discuss an* illustrate *ifferences an* similarities bet(een

1@ *@

'trategy :ormulation and Management #ontrol Management #ontrol and "as3 #ontrol

AN'K!% 'ome 7istinction bet)een 'trategy :ormulation and management #ontrol

$haracteristics a< :ocus of plan b< #omple+ities c< Nature of information

Strategy +ormulation $n one aspect at a time Many variables hence comple+ "ailor@made for the issue2 more e+tern and al predictive2 less accura te. Mnstructured and irregular2 each problem being different of %elatively simple 'ho) e+pected results 'taff and top management 'mall #reative2 analytical 9lanni dominant

anagement $ontrol $n entire organisation &ess comple+ Integrated2 more internal historical2 more accurate. an d

d< 'tructure e< #ommunication information f< 9urpose of estimates g< 9ersons involved h< No. of persons involved i< Mental activity j< 9lanning and control

%hythmic2 definite pattern2 procedure %elatively difficult &ead to desired result &ine and top management &arge

se t

som

Administrative2 persuasive !mphasis on both planning and

ng

but

control

control

"ends to be long

"ends to be short

l< !nd result m< Appraisal of job done

9olicies and precedents !+tremely difficult

Action )ithin policies laid &ess difficult

68

b) Some Distinction bet(een $haracteristics a< :ocus of plan b< Nature of information

anagement $ontrol an* #as- $ontrol #as- $ontrol 'ingle tas3 or transaction "ailor@ operatio made to n2 specific2 often non@ financial2 real time 'uperviso rs :ollo) directives or none as in case of machines or set objective s 7ay to day !ngineer !+istenc ed@ e of standa objective rd against )hich actuals can be compared ma3es control easier. anagement control $n entire organisation Integrat internal ed2 more and historical2 more accurate

c< 9ersons involved d< Mental activity

&ine and top management Administrative2 persuasive

e< "ime horizon f< "ype of cost

"ends to be short 7iscretionary@ #ontrol is more due difficult to subjective consideration.

SE# 16 Q.6 Suresh Lt*. 4!umerical) 4 $S5677F)

;1< 7efine profit in this case and prepare a statement for both divisions and overall
company. 'olutionF i< 9rofitability statement of 7ivision AF@

9articulars 'elling price p.u. Rariable #ost p.u. #ontribution p.u.

Amount;% s.< ,. 11 *-

#ontribution p.u.

!+pected ;no. of

sales "otal contribution

"otal :i+ed cost ;%s.<

Net profit ;%s.<

units<

,888

4*888

18888

1*888

*-

1888

1--888

18888

5-888

ii< 9rofitability statement of 7ivision 0F@ 'elling p.u. #ontributio n p.u. -5 "otal :i+ed cost ;%s.< 68888 prof it

"otal variable cost p.u. -*

!+pected sales ;no. of units< *888

"otal contribution 61888

Net ;%s. <

188 8 *-8 58 -* ,5 ,888 11-888 68888 88 .8 -* 5 1888 -5888 68888 ;-*888< ]NoteF "otal Rariable cost p.u. > Rariable cost p.u. ;%s.4< ? "ransfer price of intermediate product ;%s.,.<^ 68

iii< 9rofitability statement of #ompany as a )holeF@

!+pected sales *888 ,888 1888

Net profit of division A ;%s.< ;1*888< 1*888 5-888

Net profit of 7ivision 0 ;%s.< 1888 *-888 ;-*888<

"otal Net profit ;1888< ,1888 -*888

;*< 'tate the selling price )hich ma+imizes profits for division 0 and company as a )hole. #omment
on )hy the latter price is unli3ely to be selected by division 0.

'olutionF

As per the calculation in part ;a<2 selling price p.u. of %s.58 ma+imizes profit for division 0 )hereas selling price p.u. of %s..8 ma+imizes profit for the #ompany as a )hole. Lo)ever2 if 7ivision 0 opts for selling price p.u. of %s..8 in order to ma+imize #ompanys profit2 it )ould suffer a loss of %s.-*888. "herefore2 7ivision 0 )ould not select 'elling price p.u. of %s..8.

70

71

Q./ Explain *ifferent organi:ational goals. $omment on goal of sharehol*er ,alue maximi:ation in particular. "oals Although )e often refer to the goals of a corporation2 a corporation does not have goalsB it is an artificial being )ith no mind or decision@ma3ing ability of its o)n. #orporate goals are determined by the chief e+ecutive officer ;#!$< of the corporation2 )ith the advice of other members of senior management2 and they are usually ratified by the board of directors. In many corporations2 the goals originally set by the founder persist for generations. !+amples are Lenry :ord2 :ord Motor #ompanyB Alfred 9. 'loan2 eneral Motors #orporationB Kalt 7isney2 Kalt 7isney #ompanyB eorge !astman2 !astman Voda3B and 'am Kalton2 Kal@Mart. Economic "oals 'hareholderQs value2 !arning per share and Mar3et value2 all relate to ma+imizing shareholderQs value2 )hich is not a desirable goal2 because )hat is Qma+imumQ is difficult to determine. Although optimizing shareholder value may be one goal2 but there are other sta3eholders in the business also such as customers2 employees2 creditors2 community and so on. Again2 shareholder value is usually e/uated )ith the mar3et value of the companyQs stoc3. 0ut mar3et value is not an accurate measure of the )orth of shareholdersQ investments. 0esides2 such value can be obtained only )hen the share is traded in the stoc3 e+change. It is interesting to note that Lenry :ordQs operating philosophy )as Qsatisfactory profitQ2 not Qma+imum profitQ. Le said2 EA reasonable profit is right2 but not too much. 'o2 it has been my policy to force the price of the car do)n as fast as production )ould permit and give the benefit to the user and laborers2 )ith resulting surprisingly enormous benefit to ourselvesE $ther goals such as adding ne) products2 or product@line or ne) business actually indicate normal organizational gro)th. Social "oals Lo)ever2 every organization has its share of responsibility to)ards the local community )here it is situated2 and the public at large. It is very difficult to incorporate in Management #ontrol 'ystem such goals as ta3ing pride in an organization )hich cares for the society and renders service to the public. $f course2 any concrete structural programme indicating its operational e+penses2 methods of providing service2 personnel involved in rendering service and the nature of the service in details can2 ho)ever2 be mentioned through an appropriate system. .rofitability In a business2 profitability is usually the most important goal. %eturn on investment can be found by simply dividing profit ;i.e.2 revenues minus e+penses< by in@ vestment2 but this method does not dra) attention to the t)o principal componentsF profit margin and investment turnover. In the basic form of this e/uation2 EinvestmentE refers to the shareholdersQ investment2 )hich consists of proceeds from the issuance of stoc32 plus retained earnings. $ne of managementQs responsibilities is to arrive at the right balance bet)een the t)o main sources of financingF debt and e/uity. "he shareholdersQ investment ;i.e.2 e/uity< is the amount of financing that )as not obtained by debt2 that is2 by borro)ing. :or many purposes2 the source of financing is not relevantB EinvestmentE thus means the total of debt capital and e/uity capital. E9rofitabilityE refers to profits in the long run2 rather than in the current /uarter or year. Many current e+penditure ;e.g.2 amounts spent on advertising or research and development< reduce current profits but increase profits over time. 'ome #!$s stress only part of the profitability e/uation. Wac3 Kelch2 former #!$ of eneral !lectric #ompany2 e+plicitly focused on revenueB he stated that eneral !lectric should not be in any business in 72

)hich its sales revenues )ere not the largest or the second largest of any company in that business. "his does not imply that Kelch neglected the other components of the e/uationB rather2 it suggests that in his mind there )as a close correlation bet)een mar3et share and return on investment. $ther #!$s2 ho)ever2 emphasize revenues for a different reasonF :or them2 company size is a goal. 'uch a priority can lead to problems. If e+penses are too high2 the profit margin )ill not give shareholders a good return on their investment. !ven if the profit margin is satisfactory2 the organization may still not earn a good return if the investment is too large. 'ome #!$s focus on profit either as a monetary amount or as a percentage of revenue. "his focus does not recognize the simple fact that if additional profits are obtained by a greater than proportional increase in investment2 each dollar of investment has earned less. aximi:ing Sharehol*er Jalue In the 1658s and 1668s the term shareholder value appeared fre/uently in the business literature. "his concept is that the appropriate goal of a for@profit corporation is to ma+imize shareholder value. Although the meaning of this term )as not al)ays clear2 it probably refers to the mar3et price of the corporationQs stoc3. Ke believe2 ho)ever2 that achieving satisfactory profit is a better )ay of stating a corporationQs goal2 for t)o reasons. :irst2 Ema+imizingE implies that there is a )ay of finding the ma+imum amount that a company can earn. "his is not the case. In deciding bet)een t)o courses of action2 management usually selects the one it believes )ill increase profitability the most. 0ut management rarely2 if ever2 identifies all the possible alternatives and their respective effects on profitability. :urthermore2 profit ma+imization re/uires that marginal costs and a demand curve be calculated2 and managers usually do not 3no) )hat these are. If ma+imization )ere the goal2 managers )ould spend every )or3ing hour ;and many sleepless nights< thin3ing about endless alternatives for increasing profitabilityB life is generally considered to be too short to )arrant such an effort. 'econd2 although optimizing shareholder value may be a major goal2 it is by no means the only goal for most organizations. #ertainly a business that does not earn a profit at least e/ual to its cost of capital is not doing its jobB unless it does so2 it cannot discharge any other responsibilities. 0ut economic performance is not the sole responsibility of a business2 nor is shareholder value. Most managers )ant to behave ethically2 and most feel an obligation to other sta3eholders in the organization in addition to shareholders. !+ampleF Lenry :ordQs operating philosophy )as satisfactory profit2 not ma+imum profit. Le )rote let me say right here that I do not believe that )e should ma3e such an a)ful profit on our cars. A reasonable profit is right2 but not too much. 'o it has been my policy to force the price of the car do)n as fast as production )ould permit2 and give the benefits to the users and laborers@)ith resulting surprisingly enormous benefits to ourselves. 0y rejecting the ma+imization concept2 )e do not mean to /uestion the validity of certain obvious principles. A course of action that decreases e+penses )ithout affecting another element2 such as mar3et share2 is sound. 'o is a course of action that increases e+penses )ith a greater than proportional increase in revenues2 such as e+panding the advertising budget. 'o2 too2 are actions that increase profit )ith a less than proportional increase in shareholder investment ;or2 of course2 )ith no such increase at all<2 such as purchasing a cost@saving machine. "hese principles assume2 in all cases2 that the course of action is ethical and consistent )ith the corporationQs other goals. An organizationQs pursuit of profitability is affected by managementQs )illingness to ta3e ris3s. "he degree of ris3@ta3ing varies )ith the personalities of individual managers. Nevertheless there is al)ays an upper limitB some organizations e+plicitly state that managementQs primary responsibility is to preserve the companyQs assets2 )ith profitability considered a secondary goal. "he Asian .financial crisis during 1661@ 1665 is traceable2 in large part2 to the fact that ban3s in AsiaQs emerging mar3ets made )hat appeared to be highly profitable loans )ithout paying ade/uate attention to the level of ris3 involved.

73

ultiple Sta-ehol*er Approach $rganizations participate in three mar3etsF the capital mar3et2 the product mar3et2 and the factor mar3et. A firm raises funds in the capital mar3et2 and the public stoc3holders are therefore an important constituency. "he firm sells its goods and services in the product mar3et2 and customers form a 3ey constituency. It competes for resources such as human capital and ra) materials in the factor mar3et and the prime constituencies are the companyQs employees and suppliers and the various communities in )hich the resources and the companyQs operations are located. "he firm has a responsibility to all these multiple sta3eholders@shareholders2 customers2 employees2 suppliers2 and communities. Ideally2 its management control system should identify the goals for each of these groups and develop scorecards to trac3 performance. !+ampleF In *88.2 the Acer roup2 head/uartered in "ai)an2 )as one of the largest computer companies "he #ompany subscribed to the multiple sta3eholder approach and managed its internal operations to satisfy the needs of several constituencies. "o /uote 'tan Q'hih2@the founder2 E"he customer is number 12 the employee is number *2 the shareholder is number ,. I 3eep this message consistent )ith all my colleagues. I even consider the companyQs ban3s2 suppliers2 and others )e do business )ith are our sta3eholdersB even society is sta3eholder. I do my best to run the company that )ay.E &incoln !lectric #ompany is )ell 3no)n for its philosophy that employee satisfaction )as more important than shareholder value. Wames &incoln )roteF E"he last group to be considered is the stoc3holders )ho o)n stoc3 because they thin3 it )ill be more profitable than investing more in any other )ay. "he absentee stoc3holder is notQ of any value to the customer or to the )or3er2 since he has no 3no)ledge of nor interest in the company other than greater dividends and advance in the price of his stoc3.E 7onald :. Lastings2 chairman and chief e+ecutive officer2 emphasized that this )as still the companyQs philosophy in 1661. Q.= Explain an* illustrate (ith one example *ifferences bet(een / forms of internal au*it5 +inancial< %perational ? anagement. +inancial Au*it5 :inancial Audit is a historically oriented2 independent evaluation performed by internal auditor or e+ternal auditor for the purpose of attesting to the fairness2 accuracy and reliability of the financial data2 providing protection for the entityQs assetsB evaluating the ade/uacy and accomplishment of the system ;internal control< designed2 provide for the aforementioned :airness and 9rotection2 :inancial data2 )hile not being the only source of evidence2 are the primary evidential source. "he evaluation is performed on a planned basis rather than a re/uestE. Institute of Internal AuditorF@ :inancial audit ta3es care of the protective aspect of the business and it does not normally carry out constructive appraisal function of the business operations. It helps in detection and prevention of fraud. It also verifies )hether documentation and flo) of activities arc in conformity )ith the internal control system introduced and developed )ithin the organization. It helps coordinating )ith statutory auditor to help them in proper discharge of their function. 0esides2 financial audit also ensures compliance )ith statutory la)s especially in financial and accounting matters. %b>ecti,es of +inancial Au*it) @"o see that established accounting systems and procedures have been complied )ith @"o see that proper records have been maintained for the fi+ed assets of the #oncern to loo3 into correctness of the financial data and records along )ith correctness of the accounting procedure follo)ed. 74

@"o see )hether scrap2 salvage and surplus materials have been properly accounted for etc. @"o see that internal control system has been )or3ing properly. @"o see that any abrupt variation in sales2 purchases etc.B )ith respect to immediate previous year are not due to any irregularity @"o see that the credit control has been strictly follo)ed. @"o see that all payments have been made )ith proper authorization and approval. . @"o see that preparation of salary and )age pay roll has been properly done. budgetary control system2 if any scope and performance of internal audit2 if any2 suggestions for improvements in performance2 if any2 and improved inventory policies. "he opinion e+pressed by the auditors shall be based on verified data2 reference to ich shall also be made here and2 if practicable2 included after the company has been forded on opportunity to comment on them. anagement Au*it It is a comple+ tas3 closely related )ith the process of management. It is highly result oriented. It re/uires interDmulti@disciplinary approach as it involves e+amination2 revie) and appraisal of various policies and actions of management on the basis of certain normsDstandards. It underta3es comprehensive and critical revie) of all organizational activities )ith )ider perspective. It goes beyond conventional audit and audits the efficacy of the management itself. Definition) ItQs a comprehensive and constructive e+amination of an organization2 the structure of a company2 institution or branch of government or of any components thereof2 such as division or department and its plans2 objectives2 its means of operations and its use of human and physical facilities. 0illiam .. Leonar* ItQs an investigation of a business from the higher level do)n)ards in order to ascertain )hether sound management prevails throughout2 thus facilitating the most effective relationship )ith the outside )orld and the most efficient and smooth running internally. Leslie Eo(ar* It is an audit performed )ith the object of e+amining the efficacy of the institutionDcontrol systems2 management procedures to)ards the achievement of enterprise goals. $hurchill ? $yert It is an objective and independent appraisal of the effectiveness of managers and the effectiveness of the corporate structure in the achievement of company objectives and policies. Its aim is to identify e+isting and potential management )ea3nesses )ithin an organization and to recommend )ays to rectify these )ea3nesses. $hartere* Institute of anagement Accountants Lon*on "hus it can be seen that management audit is an e+amination2 revie) and appraisal of the various policies and actions of the management. It is a tool for the evaluation of methods and performance in all the areas of the enterprise. %b>ecti,es)

1. "o ascertain the provision of proper control at different levels2 their effectiveness I in accomplishing
management goals.

*. Ascertain objectives of the organization are properly communicated and understood at all levels. ,. "o reveal defects or irregularities in any of the elements e+amined and to indicate )hat
improvements are possible to obtain the best results of the operations of the company. 75

"o assist the management to achieve the most efficient administration of its operations.

-. "o suggest to the management the )ays and means to achieve the objectives if the management of the
organization itself lac3s the 3no)ledge of efficient management.

.. It aims to achieve the efficiency of management and assess the strength and )ea3nesses of the
organization structure2 its management team and its corporate culture.

4. "o ascertain the provision of proper control at different levels2 their effectiveness
in accomplishing management goals.

5. Ascertain objectives of the organization are properly communicated and understood at all levels. 6. "o reveal defects or irregularities in any of the elements e+amined and to indicate )hat
improvements are possible to obtain the best results of the operations of the company.

18. "o assist the management to achieve the most efficient administration of its operations. 11. "o suggest to the management the )ays and means to achieve the objectives if the
management of the organization itself lac3s the 3no)ledge of efficient management.

1*. It aims to achieve the efficiency of management and assess the strength and )ea3nesses of the
organization structure2 its management team and its corporate culture.

1,. "o help the management at all levels in the effective and efficient discharge of their duties and
responsibilities. "he auditor must apprise managerial performance at all levels of the organization. "he audit starts right at the top level of the management. It studies the managerial performance at all the levels of management. "he audit has to study the decision@ma3ing system of the organization and also the level of autonomy granted to the managers at different levels of the organization. "he authority and responsibility given at the different levels of the management. $ne of the most important things that the audit must study is that the mangers at various levels use the authority. $on*ucting anagement Au*it

Management audit re/uires an interdisciplinary approach since it involves a revie) of all aspects of management functions. It has to be conducted by a team of e+perts because this re/uires , varieties of s3ills2 )hich one individual may not possess. "he team may consist of management e+perts2 accountants2 and the operation research specialists2 the industry e+perts and even social scientists. "he auditors must have analytical mind and ability to loo3 at a management function form the point of vie) of the organization as a )hole. "hey therefore have to be properly trained in this aspect. "hey need to have through 3no)ledge of the management science and they should be ac/uainted )ith the salient features of various functional areas. Mnder financial audit2 the entire emphasis is on macro@aspect2 the individual transactions being@ scrutinized for chec3 of the aggregates. It is concerned )ith e+amination of transactions recorded in the boo3s of account. It revie)s the procedure and internal chec3s2 and scrutinizes individual transactions for the purpose of verification2 of 9rofit and &oss Account and 0alance 'heet. :inancial audit is not concerned )ith X avoidance of profiteering motive. It indicates the financial position and overX performance of the business2 regardless of its performance in various segments. :inancial audit is applicable to all classes of companies and industries irrespective of size and 7an of operations. Instead of serving the interest of the management and the overnment2 it serves interest of shareholders. :inancial audit is organization @ oriented. It is conducted under 'ections **- @ *,* of the 76

#ompanies Act 16.1. +inancial Au*it It is concerned )ith financial aspects of business transactions of the year under audit "he auditor e+amines the past financial records to report his opinion on the truth and fairness of the representations made in the financial statements. !+amination of the performance of the management is beyond his scope 9ast year Q;:inancial< transactions are #overed !nterprises such as companies2 trust and societies etc. :inancial audit is compulsory in the case of certain enterprises such as companies2 trust and societies etc. "he auditor reports to the o)ner2 i.e. shareholders in the #ase of a company anagement Au*it It is concerned )ith the revie) of the past 9erformance to ascertain )hether it is in tune )ith the objectives2 policies and procedures of the enterprise. "he management auditor reports on performance of the management during a particular period and suggest )ays to remedy the deficiencies2 including modification of objectives2 policies etc.

No limit as to the period to be covered

"here is legal compulsion as regards management audit. "he auditor reports to the management

Q.3 Explain briefly ,arious stages of management control process citing salient features of each. Management control process involves communication of information to the managers at various levels of hierarchy and their interactions arising out of them. "hese communications aim to)ards attaining the organizationQs goals. 0ut individual managers have their personal goals also. :or e+ample2 a young manager )ith good education2 e+perience2 personality and social bac3ground joins a company li3e 0ritannia Industries or %eliance. "he company finds him fit for the position as per job specifications2 appoints him and ma3es him a)are of )hat the company e+pects of him. "he young manager sets his goals of gaining rich e+perience for his career progress besides ade/uate compensation pac3ages. Naturally2 his actions )ill be directed to)ards achieving his o)n objectives and goals )hile serving the company. "hus2 his self@interest and the best interest of the organization are apparently in conflict. 0ut the best results can be achieved by perfectly matching the t)o interests and this is called Qgoal congruenceQ. It is /uite apparent that perfect congruence bet)een the goals of the individual and the organization individualQs goals and the organizationQs goals can never happen. (et2 the main purpose of a management control system is to assure goal congruence bet)een the interest of the individual and the organization as far as practicable. anagement control systems +ormal an* Informal $ommunication As mentioned earlier2 all the communication of information may be either formal or informal. "he formal communication system involves strategic plan2 budgets2 standards and reports )hereas the informal communication is made through letters and memos2 verbally or even by facial e+pression. :ormal communications are all documented and addressed to the responsible managers for their information and actions2 if necessary. Lo)ever2 the actions depend on the perception of the individual managers. 77

Informal communication , on the other hand2 relates to some e+ternal factors@)or3 ethics2 management style and culture. Added to these factors is the e+istence of an informal organization )ithin the structured formal organization. Informality refers to the rela+ation of sharp differentiation and e+plicit description of behavior as indicated in the hierarchy and thereby2 moving a)ay from superiorDsubordinate relationship. Lo)ever2 such relations depend on the personal capabilities of the manager such as education2 e+perience2 e+pertise2 trust and cooperation. :or e+ample2 Accounts Manager of Nasi3 9lant ;see the organization chart in the diagram ,.*< reports to the eneral Manager of the 9lant. Khile visiting the #orporate $ffice for attending a "raining #ourse2 he meets other colleagues2 parallel officers and even the :inance 7irector. "he latter communicates some important matter to him verbally and )ants action thereon. Accounts Manager carried out the instructions so given. As per the organization chart2 he should inform his eneral Manager2 but it depends on his o)n perception of the situation2 and he mayor may not report to the eneral Manager. 0or- Ethics< anagement Style an* $ulture

!+ternal factors li3e )or3 ethics vary from place to place. "herefore2 organization )or3 culture depends on the general behavior of the people in the society )here the organization situates. Kor3 culture generally differs because of the life style and the attitude to)ards the )or3. :or e+ample2 people of Mumbai lead very fast life. "ime has more value at Mumbai as compared to Vol3ata2 )here people ta3e things easily and leisurely. Wapanese and Vorean people have reputation for their e+cellent )or3 culture. Lo)ever2 the most important internal factor is the organizationQs culture and climate. "he culture refers to the set of common beliefs2 attitudes2 norms2 relationships and assumptions that are e+plicitly or implicitly accepted and evidenced throughout the organization. "he )riter joined Mnion #arbide as an Assistant just three days before #hristmas !ve. $n the very second day2 )hen he attended #hristmas lunch2 his table )as shared by none other than the eneral 'ales Manager 7r. K.%. #orrea. Le 3ept us amused )ith various stories of his recent tour abroad and recited Mrdu QshairiesQ2 even sharing jo3es. 'uch a situation )as unthin3able in Wessop T #o.2 )here sharp differences )ere maintained at every level of hierarchy. anagement control systems #limate is used to designate the /uality of the internal environment that conditions the /uality of cooperation2 the development of individuals2 the e+tent of membersQ dedication or commitment to organizational purpose and the efficiency )ith )hich that purpose is translated into results. #limate is the atmosphere in )hich individuals )or3 help2 judge2 and re)ard2 constrain and find out about each other. It influences moral@the attitude of the individual to)ards hisDher )or3 and environment. #ulture differs bet)een the organizations2 but cultural norms are e+tremely important. "hey are not )ritten li3e formal communication. 0ut the e+istence of a good culture can be felt from the behavior of the members of the organization. $nce the )riter landed up )ith his family at Lyderabad in the early morning to discover that nobody had come to receive them at the station. Lis visit )as arranged through non other than the 7irector of the company himself. Lis unit being ne)2 telephone directory did not include any number of his unit2 but the parent organizationQs telephone number )as located. Khen an e+ecutive of the parent company )as contacted2 he immediately sent an officer of the company )ith a car to pic3 us up to their uest Louse2 entertain )ith coffee and then put up in a Lotel. Khat subse/uently happened is a different matter2 but the attitude and treatment of that member of organization spea3 volumes about their e+cellent culture. In any organization2 the culture remains unchanged as long as the #hief !+ecutive remains in position. Khen a ne) e+ecutive replaces him2 there is li3elihood of some change in the culture2 unless the ne) #hief follo)s the footsteps of his predecessor and maintains it. enerally2 if higher positions are filled in through promotion of internal e+ecutives2 the culture remains unchanged and the traditions are maintained. "he other important internal factor )hich influences management control system is management style@ that is the attitude of the superior to his subordinates and the latterQs reaction through their perception of the attitude of their superiors. Again2 the attitude ultimately stems from the temperament of the #hief !+ecutive2 )ho controls the entire organization. "hat is )hy %. K. !merson said Ean institute is the lengthened shado) of a manE.

Importance of Informal $ommunication 78

An organization indulges in informal control process )hen encountering non@routine decision@ma3ing or )hen see3ing ne) information to increase understanding of some problem areas. 7uring a very critical period in an organization2 the )riter found that the #hief !+ecutive used to call managers informally at his residence or club to e+tract information in a rela+ed manner rather than in a tense situation prevailing in the factory. +ormal $ontrol .rocess :ormal communication system is structured as per the Qhierarchy outlined in the organization chart. "he system has the follo)ing four componentsF

;1< 'trategic plan and programme ;*< 0udgeting ;,< $perations and measurement in responsibility centers ;d< %eporting
;a< 'trategic 9lan and 9rogramme "he foundation of management control process lies in the organizationQs goals and its strategies for attaining these goals. A strategic plan is prepared in order to implement the strategies2 after carefully considering opportunities and threats in the e+ternal environment as )ell as the strengths and )ea3nesses in the internal environment. "hus2 a strategic plan and programme is prepared as a guideline to budgeting. ;b< 0udgeting "he strategic plan is converted to an annual budget incorporating planned e+penditure and revenues for individual responsibility centers. !+penses and revenues are mar3ed for each responsibility centre period )ise2 say monthly2 /uarterly2 half yearly2 and annually. ;c< $perations and Measurement %esponsibility centers operate )ithin the frame)or3 of the budget2 established standards2 standing instructions2 practices and operating procedures embodied in QrulesQ2 and QmanualsQ. "hus2 besides budget2 the responsibility centers are also guided by a large number of rules. "hey record the resources actually used and revenue earned. "hey also classify the data by programmes as )ell as by responsibility centers for performance measurement. ;d< %eporting Actual performance is analyzed2 measured and reported against plan2 indicating variances and highlighting areas of )ea3nesses. If the performance is satisfactory2 feedbac3 information is sent to the responsibility centre concerned for praise or re)ard. If the same is unsatisfactory feedbac3 communication is sent to the responsibility centre concerned for corrective action. If such action re/uires to be included in the budget2 then the latter is revised to give effect to the changed position. If re/uired2 then the plan itself can be revised and a ne) basis of control may be established. "he aforesaid formal control process has been presented in the follo)ing diagramF

79