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MANAGEMENT CONTROL SYSTEM

Submitted to professor M.A.Ganachari

Group No- 4 Rakshit Shetty Razak Shaikh Reena Gupta Rishikant JakhotiyaRizwana Kagzi75 76 77 78 79

Q1. How a profit centre is differs from investment centre? What are the different methods of judging their performance? Which is the better method?
Profit Center A profit center is any business segment whose manager has control over both cost and revenue. A profit center generally does not have control over investment funds. Profit center managers are often evaluated by comparing actual profit to targeted or budgeted profit. Segmented income statements should be used to evaluate the performance of profit center managers.

Profit centre includes marketing, production and service functions. Examples include a manufacturing plant or product line. Evaluation of their performance is done by Gross profit or contribution margin, operating income and net income plus the variances for sales and cost. A responsibility centre is called a profit centre when the manager is held responsible for both costs (inputs) and revenues (outputs) and thus for profit. Despite the name, a profit centre can exist in nonprofits organizations (though it might not be referred to as such) when a responsibility centre receives revenues for its services. A centre, whose performance is measured in terms of both - the expense it incurs and revenue it earns, is termed as a profit centre. The output of a responsibility centre may either be meant for internal consumption or for outside customers. In the latter case, the revenue is realized when the sales are made. That is, when the output is meant for outsiders, then the revenue will be measured from the price charged from customers. If the output is meant for other Responsibility centre, then management takes a decision whether to treat the centre as profit centre or not. In fact, any responsibility centre can be turned into a profit centre by determining a selling price for its outputs.

A profit centre is like a separate company with its own profit and loss account and the managers decisions relate to the revenue and costs that make up the divisions profit statement. From a management accounting perspective, key performance appraisal measures used would be cost and revenue variances to budget, as well as the preparation of key profit ratios such as gross profit percentage, operating profit percentage and expenses to sales percentages. Divisional profit statements are commonly used in profit centre and mainly distinguish between costs that are controlled by the division and costs that are controlled by head-office.

In addition to the authority to acquire short term assets, to hire temporary or contract personnel, and to manage inventories, profit center managers are usually given the authority to make long term hires, set salary and promotion schedules (subject to organization wide standards), organize their units, and acquire long lived assets costing less than some specified amount. Note, however, real revenue can be earned only on sales outside the organization -AFMC's sales of services to foreign governments and private firms earns revenue, for example; services performed for other elements of the Air Force would merely earn notational revenues or transfer prices.

Investment center An investment center is any segment of an organization whose manager has control over cost, revenue and investments in operating assets. Investment centers are usually evaluated using return on investment or residual income measures. Investment Centers - segments such as divisions of a company where the managers control the acquisition and utilization of assets, as well as revenue and costs. Investment center includes all the functions above plus the managers control what to produce and how to produce, i.e., have autonomy or more

autonomy than profit center managers. Typically, investment centers are divisions of large companies. Return on Investment: = (Return on Sales)(Capital Turnover) = (Net income Sales)(Sales Total assets) = Net income Total assets also Residual Income. This is essentially the same as economic value added (EVA). An investment centre is where the manager has responsibility for not just the revenues and costs relating to the centre, but also the assets that generate these costs and revenues and the investment decisions relating to disposal and acquisition of assets. Investment centre are profit centre that are accountable for cost, revenues and net assets for capital investment. This unit is assessed by return on investment and is a cost centre. Managers in an investment centre are responsible for purchasing capital or non-current assets and making investment decisions with capital.

Investment center managers are responsible for both profit and the assets used in generating profit. Thus, an investment center adds more to a manager's scope of responsibility than does a profit center, just as a profit center involves more than a cost center. Investment center managers are typically evaluated in terms of return on assets (ROA), which is the ratio of profit to assets employed, where the former is expressed as a percentage of the latter. In recent years many have turned to economic value added (EVA), net operating "profit" less an appropriate capital charge, which is a dollar amount rather than a ratio. If, for example, the logistics center described earlier had assets of $7.5 billion ($5 billion in fixed assets and $2.5 in current assets, primarily work-in-progress and parts inventories) and the federal government's cost of capital were 5 percent, its quasi-EVA would have been $50 million ($425 million - $375 million); its ROA would have been 5.7 percent.

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 capital, as in a ratio of income to the value of the capital employed. In practice, the term investment centre is not widely used. Instead, the term profit centre is used indiscriminately to describe centers those are always assigned responsibility for revenues and expenses, but may or may not be assigned responsibility for the capital investment. It is defined as a responsibility centre in which inputs are measured in terms of cost / expenses and outputs are measured in terms of revenues and in which assets employed are also measured. The Vice President (Investments) of a mutual funds company may be in charge of an Investment Centre. In the Investment Centre, the manager in charge is held responsible for the proper utilization of assets. He is expected 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. Some of the assets are in the physical possession of the responsibility centre while for some assets it may depend upon other responsibility centers or the Head Office of the company. This is particularly true of cash or heavy plant and equipment. Whether such assets should be included in the figure of assets employed of the responsibility centre and if included, at how much value, is a difficult question. On account of these difficulties, investment centers are generally used only for relatively large units, which have independent divisions, both manufacturing and marketing, for their individual products.

Different Methods of judging the performance of Profit Center and Investment center A profit center's economic performance is always measured by net income (i.e., the income remaining after all costs, including a fair share of the corporate overhead, have been allocated to the profit center). The performance of the profit center manager, however, may be evaluated by five different measures of profitability: (1) Contribution Margin: Contribution margin reflects the spread between revenue and variable expenses. The principal argument in favor of using it to measure the performance of profit center managers is that since fixed expenses are beyond their control, managers should focus their attention on maximizing contribution. The problem with this argument is that its premises are inaccurate; in fact, almost all fixed expenses are at least partially controllable by the manager, and some are entirely controllable. Many expense items are discretionary; that is, they can be changed at the discretion of the profit center manager. Presumably, senior management wants the
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profit center to keep these discretionary expenses in line with amounts agreed on in the budget formulation process. A focus on the contribution margin tends to direct attention away from this responsibility. Further, even if an expense, such as administrative salaries, cannot be changed in the short run, the profit center manager is still responsible for controlling employees' efficiency and productivity.

(2) Direct Profit: This measure reflects a profit center's contribution to the general overhead and profit of the corporation. It incorporates all expenses either incurred by or directly traceable to the profit center, regardless of whether or not these items are within the profit center manager's control. Expenses incurred at headquarters, however, are not included in this calculation. A weakness of the direct profit measure is that it does not recognize the motivational benefit of charging headquarters costs.

(3) Controllable Profit: Headquarters expenses can be divided into two categories: controllable and non controllable. The former category includes expenses that are controllable, at least to a degree, by the business unit manager-information technology services, for example. If these costs are included in the measurement system, profit will be what remains after the deduction of all expenses that may be influenced by the profit center manager. A major disadvantage of this measure is that because it excludes non controllable headquarters expenses it cannot be directly compared with either published data or trade association data reporting the profits of other companies in the industry.

(4) Income before Taxes: In this measure, all corporate overhead is allocated to profit centers based on the relative amount of expense each profit center incurs. There are two arguments against such allocations. First, since the costs incurred by corporate staff departments such as finance, accounting, and human resource management are not controllable by profit center managers, these managers should not be held accountable for them. Second, it may be difficult to allocate corporate staff services in a manner that would properly reflect the amount of costs incurred by each profit center. There are, however, three arguments in favor of incorporating a portion of corporate overhead into the profit centers' performance reports. First, corporate service units have a tendency to increase their power base and to enhance their own
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excellence without regard to their effect on the company as a whole. Allocating corporate overhead costs to profit centers increases the likelihood that profit center manager will question these costs, thus serving to keep head office spending in check. (Some companies have actually been known to sell their corporate jets because of complaints from profit center managers about the cost of these expensive items.) Second, the performance of each profit center will become more realistic and more readily comparable to the performance of competitors who pay for similar services. Finally, when managers know that their respective centers will not show a profit unless all-costs, including the allocated share of corporate overhead, are recovered, they are motivated to make optimum long-term marketing decisions as to pricing, product mix, and so forth, that will ultimately benefit (and even ensure the viability of) the company as a whole. If profit centers are to be charged for a portion of corporate overhead, this item should be calculated on the basis of budgeted, rather than actual, costs, in which case the "budget" and "actual" columns in the profit center's performance report will show identical amounts for this particular item. This ensures that profit center managers will not complain about either the arbitrariness of the allocation or their lack of control over these costs, since their performance reports will show no variance in the overhead allocation. Instead, such variances would appear in the reports of the responsibility center that actually incurred these costs.

(5) Net Income: Here, companies measure the performance of domestic profit centers according to the bottom line, the amount of net income after income tax. There are two principal arguments against using this measure: (1) After tax income is often a constant percentage of the pretax income, in which case there would be no advantage in incorporating income taxes (2) Since many of the decisions that affect income taxes are made at headquarters, it is not appropriate to judge profit center managers on the consequences of these decisions. There are situations, however, in which the effective income tax rate does vary among profit centers. For example, foreign subsidiaries or business units with foreign operations may have different effective income tax rates. In other cases, profit centers may influence income taxes through their installment credit policies, their decisions on acquiring or disposing of equipment, and their use of other generally accepted accounting procedures to distinguish gross income from taxable income. In these situations, it may be desirable to allocate income

tax expenses to profit centers not only to measure their economic profitability but also to motivate managers to minimize tax liability. The following techniques are useful in evaluating the performance of an investment centre: 1. Return on investment (ROI): The rate of return on investment is determined by dividing net profit or income by the capital employed or investment made to achieve that profit. ROI = Profit / Invested capital * 100 ROI = Net profit / Investment = (Net profit / Sales) * (Sales / Investment in assets) It will be seen from the above formula that ROI can be improved by increasing one or both of its components the profit margin and the investment turnover in any of the following ways: y y y Increasing the profit margin Increasing the investment turnover Increasing both profit margin and investment turnover

Capital employed is taken to be the total of shareholders funds, loans etc. The profit figure used is in calculating ROI is usually taken from the profit and loss account, profit arising out of the normal activities of the company should only be taken. Capital employed for the company as a whole can be arrived at as follows: Share capital of the company xxx Reserves and surplus xxx Loans (secured/unsecured) xxx Less: a. Investment outside the business xxx b. Preliminary expenses xxx c. Debit balance of P & L A/c xxx xxx ROI = (Capital turnover ratio)(Profit Margin on Sales) = (Sales Investment)(Net Income Sales) The Capital Turnover Ratio reflects management's ability to generate sales from a given investment base and reflects the overall productivity of the segment. Note that the source of the investment (i.e., debt or stockholders equity) is usually considered irrelevant, but see the alternatives below. Productivity is generally defined as some measure of output per input. In the ROI measurement, output is defined in terms of sales dollars and inputs are typically represented by total assets.

The Profit Margin is the rate of return on sales (ROS) and measures management's ability to control the spread between prices and costs. Efficiency and cost control are reflected in this measure as well as other factors such as productivity and the sales level. Productivity in this measurement refers to the quantity of products or services produced per input, such as per headcount. ROI may be increased in various ways. Some possibilities include the following. A. Increasing Capital Turnover Increase sales with the same investment base. Decrease the investment base with the same sales level.

B. Increasing Profit Margin: Increase prices with no unfavorable effects on sales. Decrease cost with no unfavorable effects on quality or increase in assets employed. Increase sales with no changes in prices or costs. Using ROI as a performance measurement may cause many managers to reject profitable projects if the projects would tend to lower the ROI. As a result, a conflict arises between the goals of the manager and the goal of the organization, i.e., goal congruence is not obtained. Assume that a division has a cost of capital, or minimum desired rate of return, of 10 percent, income of 13.5 million and 100 million in capital. ROI = 13.5/100 = .135 or 13.5% RI or EVA = 13.5 - .1(100) = 3.5 million Would a manager evaluated on the basis of the ROI accept a new project with an expected return of 11, 12 or 13 percent? Probably not, since it would reduce the division's overall ROI below the current 13.5%.

2. Residual income: Residual 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 words, interest on the capital invested in the company is treated as a cost and any surplus is the residual income. Residual income is profit minus notional interest charge on capital employed. Residual income is affected by the size of the organization and therefore will not provide a basis for evaluation of organizational performance. This is probably the main reason why the management continues to make use of ROI which is relative measure. Not all projects start off with 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
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for investment centre, which could encourage managers to be more willing to undertake marginally profitable projects, is residual income.

So the better method of judging the performance of both the center is ROI Return on investment

Q2. How does a service organization differ from a manufacturing organization? How is a professional service organization differ from a normal service organization? How is the pricing and marketing done by professional service organizations?
Manufacturing organization engaged in the production of goods (finished products) and market tangible goods that have value in the marketplace. These industries are further classified into two as Process Industries (Flow production or continuous process production industries) and Discrete Manufacturing Industries.

Service organization include those industries that do not produce goods, and market intangible services The peculiarity of these industries is that often the consumption of the service takes place while it is in the generation. Typically, this sector includes hospitality, advertising, banking, insurance, consultancy, logistics, etc.

The significant difference between the various types of organization is observed when we analyze the manufacturing or service environment in which they operate. Elements of the manufacturing environment include external environmental forces, corporate strategy, business unit strategy, other functional strategies (marketing, engineering, finance, etc.), product selection, product/process design, product/process technology and management of competencies. Manufacturers, unlike service firms, can automate production. There are five main differences between service and manufacturing organizations: the tangibility of their output; production on demand or for inventory; customer-specific production; labor-intensive or automated operations; and the need for a physical production location. However, in practice, service and manufacturing organizations share many characteristics. Many manufacturers offer their own service operations and both require skilled people to create a profitable business.
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1. Goods: The key difference between service firms and manufacturers is the tangibility of their output. The output of a service firm, such as consultancy, training or maintenance, for example, is intangible. Manufacturers produce physical goods that customers can see and touch.

2. Inventory: Service firms, unlike manufacturers, do not hold inventory; they create a service when a client requires it. Manufacturers produce goods for stock, with inventory levels aligned to forecasts of market demand. Some manufacturers maintain minimum stock levels, relying on the accuracy of demand forecasts and their production capacity to meet demand on a just-intime basis. Inventory also represents a cost for a manufacturing organization.

3. Customers: Service firms do not produce a service unless a customer requires it, although they design and develop the scope and content of services in advance of any orders. Service firms generally produce a service tailored to customers' needs, such as 12 hours of consultancy, plus 14 hours of design and 10 hours of installation. Manufacturers can produce goods without a customer order or forecast of customer demand. However, producing goods that do not meet market needs is a poor strategy.

4. Labor: A service firm recruits people with specific knowledge and skills in the service disciplines that it offers. Service delivery is labor intensive and cannot be easily automated, although knowledge management systems enable a degree of knowledge capture and sharing. Manufacturers can automate many of their production processes to reduce their labor requirements, although some manufacturing organizations are labor intensive, particularly in countries where labor costs are low.

5. Location: Service firms do not require a physical production site. The people creating and delivering the service can be located anywhere. For example, global firms such as consultants Deloitte use communication networks to access the most appropriate service skills and knowledge from offices around the world. Manufacturers must have a physical location for their

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production and stock holding operations. Production does not necessarily take place on the manufacturer's own site; it can take place at any point in the supply chain

Professional Service organization differ from normal service organization The term "professional services" is also used frequently by corporations such as banks and retailers that offer infrequent or ongoing services for their customers. A professional service is an industry of infrequent, technical, or unique functions performed by independent contractors or by consultants whose occupation is the rendering of such services. Eg: accountants, actuaries, appraisers, architects, attorneys, copywriters, engineers, funeral directors, law firms, public relations professionals, recruiters, researchers, real estate, brokers, translators, business development managers and business consultants, While not limited to licentiates (individuals holding professional licenses), the services are consider professional" and the contract may run to partnerships, firms, or corporations as well as to individuals

The special characteristics of professional organization which would have a bearing on their control system. 1. Goals: A dominant goal of a manufacturing company is to earn a satisfactory profit, specifically a satisfactory return on assets employed. A professional organization has relatively few tangible assets; its principal asset is the skill of its professional staff, which doesn't appear on its balance sheet. Return on assets employed, therefore, is essentially meaningless in such organizations. Their financial goal is to provide adequate compensation to the professionals. In many organizations, a related goal is to increase their size. In part, this reflects the natural tendency to associate success with large size. In part, it reflects economies of scale in using the efforts of a central personnel staff and units responsible for keeping the organization up to- date. Large public accounting firms need to have enough local offices to enable them to audit clients who have facilities located throughout the world.

2. Professionals: Professional organizations are labor intensive, and the labor is of a special type. Many professionals prefer to work independently, rather than as part of a team. Professionals who are also managers tend to work only part time on management activities; senior partners in an accounting firm participate actively in audit engagements ;senior partners in law firms have
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clients. Education for most professions does not include education in management, but quite naturally stresses the skills of the profession, rather than management; for this and other reasons, professionals tend to look down on managers. Professionals tend to give inadequate weight to the financial implications of their decisions; they want to do the best job they can, re- I regardless of its cost. This attitude affects the attitude of support staffs and nonprofessionals in the organization; it leads to inadequate cost control.

3. Output and Input Measurement: The output of a professional organization cannot be measured in physical terms, such as units, tons, or gallons. We can measure the number of hours a lawyer spends on a case, but this is a measure of input, not output. Output is the effectiveness of the lawyer's work, and this is not measured by the number of pages in a brief or the number of hours in the courtroom. We can measure the number of patients a physician treats in a day, and even classify these visits by type of complaint; but this is by no means equivalent to measuring the amount or quality of service the physician has provided. At most, what is measured is the physician's efficiency in treating patients, which is of some use in identifying slackers and hard workers. Revenues earned is one measure of output in some professional organizations, but these monetary amounts, at most, relate to the quantity of services rendered, not to their quality (although poor quality is reflected in reduced revenues in the long run). Furthermore, the work done by many professionals is non repetitive. No two consulting jobs or research and development projects are quite the same. This makes it difficult to plan the time required for a task, to set reasonable standards for task performance, and to judge how satisfactory the performance was. Some tasks are essentially repetitive: the drafting of simple wills, deeds, sales contracts, and similar documents; the taking of a physical inventory by an auditor; and certain medical and surgical procedures. The development of standards for such tasks may be worthwhile, although in using these standards, unusual circumstances that affect a specific job must be taken into account.

4. Small Size: With a few exceptions, such as some law firms and accounting firms, professional organizations are relatively small and operate at a single location. Senior management in such organizations can personally observe what is going on and personally motivate employees. Thus, there is less need for a sophisticated management control system, with profit centers and formal performance reports. Nevertheless, even a small organization needs a budget, a
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regular comparison of performance against budget, and a way of relating compensation to performance.

5. Marketing: In a manufacturing company there is a clear dividing line between marketing activities and production activities; only senior management is concerned with both. Such a clean separation does not exist in most professional organizations. In some, such as law, medicine, and accounting, the profession's ethical code limits the amount and character of overt marketing efforts by professionals (although these restrictions have been relaxed in recent years). Marketing is an essential activity in almost all organizations, however. If it can't be conducted openly, it takes the form of personal contacts, speeches, articles, conversations on the golf course, and so on. These marketing activities are conducted by professionals, usually by professionals who spend much of their time in production work-that is, working for clients. In this situation, it is difficult to assign appropriate credit to the person responsible for "selling" a new customer. In a consulting firm, for example, a new engagement may result from a conversation between a member of the firm and an acquaintance in a company, or from the reputation of one of the firm's professionals as an outgrowth of speeches or articles. Moreover, the professional who is responsible for obtaining the engagement may not be personally involved in carrying it out. Until fairly recently, these marketing contributions were rewarded subjectively- that is, they were taken into account in promotion and compensation decisions. Some organizations now give explicit credit, perhaps as a percentage of the project's revenue, if the person who "sold" the project can be identified.

Service organization include those industries that do not produce goods, and market intangible services The peculiarity of these industries is that often the consumption of the service takes place while it is in the generation. Typically, this sector includes hospitality, Barber service etc. The characteristics of normal service organization are as follows:

1. Absence of Inventory Buffer: Goods can be held as inventory, which is a buffer that dampens the impact on production activity of fluctuations in sales volume. Services cannot be stored. The airplane seat, hotel room, hospital operating room, or the hours of lawyers, physicians, scientists, and other professionals that are not used today are gone forever. Thus, although a manufacturing
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company can earn revenue in the future from products that are on hand today, a service company cannot do so. It must try to minimize its unused capacity. Moreover, the costs of many service organizations are essentially fixed in the short run. In the short run, a hotel cannot reduce its costs substantially by closing off some of its rooms. Accounting firms, law firms, and other professional organizations are reluctant to layoff professional personnel in times of low sales volume because of the effect on morale and the costs of rehiring and training.

2. Difficulty in Controlling Quality: A manufacturing company can inspect its products before they are shipped to the consumer, and their quality can be measured visually or with instruments (tolerances, purity, weight, color, and so on). A service company cannot judge product quality until the moment the service is rendered, and then the judgments are often subjective. Restaurant management can examine the food in the kitchen, but customer satisfaction depends to a considerable extent on the way it is served. The quality of education is so difficult to measure that few educational organizations have a formal quality control system.

3. Labor Intensive: Manufacturing companies add equipment and automate production lines, thereby replacing labor and reducing costs. Most service companies are labor intensive and cannot do this. Hospitals do add expensive equipment, but mostly to provide better treatment, and this increases costs. A law firm expands by adding partners and new support personnel. 4. Multi-Unit Organizations: Some service organizations operate many units in various locations; each unit relatively small. These organizations are fast-food restaurant chains, auto rental companies, gasoline service stations, and many others. Some of the units are owned; others operate under a franchise. The similarity of the separate units provides a common basis for analyzing budgets and evaluating performance not available to the manufacturing company. The information for each unit can be compared with system wide or regional averages, and high performers and low performers can be identified. However because units differ in the mix of services they provide, in the resources that they use, and in other ways, care must be taken in making such comparisons

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The pricing and marketing done in professional service organization are as follows Pricing The selling price of work is set in a traditional way in many professional firms. If the profession is one in which members are accustomed to keeping track of their time, fees generally are related to professional time spent on the engagement. The hourly billing rate typically is based on the compensation of the grade of the professional plus a loading for overhead costs and profit. In other professions, such as investment banking, the fee typically is based on the monetary size of the security issue. In still others, there is a fixed price for the project. Prices vary widely among professional, they are relatively low for research scientists and relatively high for accountants and physicians. As noted the principal asset of a professional organization is the skill of its professional which is nit measurable. Actually the total value of the whole organization is greater than the sum of what the value of the individuals would be if they worked separately.

Marketing The selection of an independent contractor or consultant providing professional services usually depends on skill, knowledge, reputation, ethics, and creativity. Prices for services, even within the same field, vary greatly. Some professional-service providers are able to give fixed rates for projects, while others define the price only after assessing the work involved. For this reason, it is common to hire professionals on the basis of an hourly fee and of an estimated length of project In the past, independent contractors for professional services were located and hired by various means, including recommendation and directories (e.g. yellow pages). The popularity of the Internet has led to a new crop of professional-services sites that allow independent contractors to offer their services to a larger audience, while allowing individuals or companies to find professionals quickly and easily.

Q3. Transfer pricing is not an accounting tool? Comment with illustration?


Transfer pricing refer to the amount used in accounting for any transfer of goods and services between responsibility centers. This is what a narrow definition and limit the term transfer price to the value placed on a transfer of goods or services in transaction in which at least one of the two parties involved in the profit center. Such a price typically includes a profit element because an independent company normally would not transfer goods or services to

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another independent company at cost or less. Therefore, the mechanism for allocating cost in an accounting system; such cost do not include a profit element. The term price as used here has the same meaning as it has when used in connection transaction between independent companies.

If a group has subsidiaries that operate in different countries with different tax rates, manipulating the transfer prices between the subsidiaries can scale down the overall tax bill of the group. For example the tax rate in Country A is 20% and is 50% in Country B. In the larger interest of the group, it would be advisable to show lower profits in Country B and higher profits in Country A. For this, the group can adjust the transfer price in such a way that the profits in Country A increase and that in Country B get reduced. For this the group should fix a very high transfer price if the Division in Country A provides goods to the Division in Country B. This will maximize the profits in Country A and minimize the profits in Country B. The reverse will be true if the Division in Country A acquires goods from the Division in Country B.

There is also a temptation to set up marketing subsidiaries in countries with low tax rates and transfer products to them at a relatively low transfer price. Transfer price is viewed as a major international tax issue. While companies indulge in all types of activities to lower their tax liability, the tax authorities monitor transfer prices closely in an attempt to collect the full amount of tax due. For this they enter into agreements whereby tax is paid on specific transactions in one country only. But if companies set unrealistic transfer price to minimize their tax liabilities and the same is spotted by the tax authority, then the company is forced to pay tax in both countries leading to double taxation. There have been instances where companies have fixed unrealistic transfer prices. The first case relates to Hoffman La Roche that imported two drugs Librium and Valium into UK at prices of 437 pounds and 979 pounds per kilo respectively. While the tax authorities in UK accepted the price, the Monopolies Commission did not accept the company's argument, since the same drugs were available from an Italian firm for 9 pounds and 28 pounds per kilo. The company's lawyers argued the case before the Commission on two grounds viz. 1. The price was not set on cost but on what the market would bear and 2. The company had incurred an R&D cost that was included in the price.
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These arguments did not go well with the Commission and the company was fined 1.85 million pounds for the manipulative practices adopted while fixing the transfer price.

The second case is of Nissan. The company had falsely inflated freight charges by 40-60% to reduce the profits. The manipulation helped the company to hide tax to the tune of 237 million dollars. The next year Nissan was made to pay 106 million dollars in unpaid tax in the USA because the authorities felt that part of their US marketing profits were being transferred to Japan, as transfer prices on import of cars and trucks were too high. Interestingly the Japanese tax authorities took a different view and returned the double tax. With a view to avoid such cases from recurring, Organization for Economic Cooperation and Development Issued some guidelines in 1995. These guidelines aim at encouraging world trade. They evolved what came to be known as the arm's length price. The principle states that the transfer price would be arrived at on the basis as if the two Companies are independent and unrelated. The price is determined through: y Comparable Price Method where the price is fixed on the basis of prices of similar products or an approximation to one. y Gross Margin Method where a gross margin is established and applied to the seller's manufacturing cost. In spite of all these efforts, it has to be admitted that setting a fair transfer price is not easy. So the onus of proving the price has been put on the taxpayer who is required to produce supporting documents. If the tax payer fails to do this he is required to pay heavy penalty. For example, in USA, failure to provide documentary evidence results in a 40% penalty on the arm's length price. In UK the penalty is to the tune of 100% of any tax adjustment. Other countries are also in the process of evolving tight norms for the same. Countries across the globe also allow the taxpayer to enter into an Advance Pricing Agreement whereby dispute Can be avoided and so also the costly penalty of double taxation and penalty.

Q4. Write Short notes on the following 1. Cost Audit


Cost audit is an examination of cost accounting records and verification of the facts to ascertain that the cost of the product under reference has been arrived at in accordance with principles of Cost Accounting and evaluation of adequacy of proper Cost Accounting Records and their maintenance. The cost audit is performed by an independent, professionally
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qualified Cost and Management Accountant or Chartered Accountant. Cost audit is carried out to evaluate cost performance of the entity for which Cost Accounting Records have been prescribed by the Securities and Exchange Commission of Pakistan (SECP). The Cost Auditor, therefore, carries out such tests and makes such inquiries which enable him to give a professional, independent, unprejudiced opinion on the cost performance of the entity, as reflected in the cost information provided in the schedules which are prepared by the entity in accordance with the cost accounting records maintained. The verification of cost records and accounts, and a check on adherence to prescribed cost accounting procedures and their continuing relevance. Cost audit refers to the detailed checking of the costing system, the techniques used and the accounts to verify their accuracy. It also ensures that the company is adhering to the objective of cost accountancy. Special attention is given to verification of cost records and adherence to acceptable cost accounting procedures. Legal Provisions: The Companies Ordinance 1984 while providing for the books of accounts to be kept by a company under Section 230, makes an additional provision in sub-section (1) (e) of that Section which reads: in the case of company engaged in production, processing, manufacturing or mining activities, such particulars relating to utilization of material or labor or to other inputs or items of cost as may be prescribed, if such class of companies is required by the Authority by a general or special order to include such particulars in the books of accounts

The Companies Ordinance 1984 provides for Audit of Cost Accounts vide Section 258 which reads:-258. Audit of Cost Accounts. Where any company or class of companies is required under clause (e) of subsection (1) of Section 230 to include in its books of accounts the particulars referred to therein, the Federal Government may direct that an audit of cost accounts of the company shall be conducted in such manner and with such stipulations as may be specified in the order by an auditor who is a chartered accountant within the meaning of the Chartered Accountants Ordinance,1961 (X of 1961), or a cost and management accountant within the meaning of the Cost and Management Accountants Act, 1966 (XIV of 1966); and such auditor shall have the same powers, duties and liabilities as an auditor of a company and such other powers, duties and liabilities as may be prescribed.

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Companies (Audit of Cost Accounts) Rules, 1998: The basic structure of the Cost Audit has been laid down in the Companies (Audit of Cost Accounts) Rules, 1998.Cost Audit has to be carried out every year from 1997-98 in all industries to which Cost Account Records Orders issued by SECP apply. Cost audit ascertains compliance with Cost Accounting Record Orders. During cost audit, the cost accounting system is also studied, which should be proper and adequate for ascertaining cost of the product under reference and for providing all information required to complete the prescribed schedules and annexure given n the relevant cost accounting record orders/rules. Companies (Audit of Cost Accounts) Rules 1998 have been published as Appendix I. Cost Accounting Records Orders: Under Sub-section (I)(e) of Section 230 of the Companies Ordinance 1984, the SECP (former Corporate Law Authority) framed the Vegetable Ghee and Cooking Oil Companies (Cost Accounting Records) Order, 1990 which came into force from 1st January 1991. Subsequently the Cement Industry (Cost Accounting Records) Order 1994 and Sugar Industry (Cost Accounting Records) Order, 2001 were framed by SECP which came into force from 1stJuly 1994 and 13th February 2001 (Appendix III, IV and V). Under these three Orders, Vegetable Ghee and Cooking Oil Companies, units of Cement Industry and Sugar Industry are required to maintain cost accounting records to provide cost accounting information in a verifiable form, required to fill in the schedules and annexures prescribed in these orders. Other industries may be brought within the ambit of Cost Audit as and when relevant Cost Accounting Records Orders are issued. Principles of Cost Audit 1. Planning and Performing Cost Audit: There are certain principles that the cost auditor has to observe in planning and performing the cost audit. There are also principles that the cost auditor has to see are being observed by the company he is auditing. On the one hand, the cost auditor has to safeguard his independence and professional status in planning and performing the cost audit, ensuring quality and standard of cost audit, as required by his professional body, the ICMAP, as well as by the Companies Ordinance 1984, and the Companies (Audit of Cost Accounts) Rules
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1998, and other rules regulating his audit engagement and reporting. On the other hand, he has also to see that the client unit operates within the legal framework provided for the industry, maintaining cost accounting records, in accordance with the cost accounting records order rules applicable to the industry.

2. Code of Ethics: Cost Auditor should comply with the code of ethics for professional accountants. The fundamental principles governing the professional responsibility of the Cost Auditors are enumerated as follows: independence; integrity; objectivity; professional competence and due care, confidentiality, professional behavior; and technical standards. 3. Independence of Cost Auditor: The independence of the cost auditor is largely covered by the Companies (Audit of Cost Accounts) Rules 1998,under which a person who has or had specified relationships, which go to mar his independence, cannot be appointed as a cost auditor.

4. Integrity and Objectivity: Integrity implies not only honesty but fair dealings and truthfulness. The principle of objectivity imposes the obligation on all professional accountants to be fair, intellectually honest and free of conflict of interest. Financial involvement with the client effects independence and may lead a reasonable observer to conclude that it has been impaired. A professional cost and management accountant should be straightforward and honest in rendering professional services as a cost auditor. He has neither any ulterior motives nor any personal ends to serve. He should be fair and should not allow any prejudice or bias, conflict of interest or any other influence to override objectivity. Cost audit is to meet the management and the Government need for credibility in cost information and cost accounting systems.

5. Professional Competence and Due Care: A professional accountant should not project himself as having expertise or experience which he does not possess. Attainment of professional competence requires a high standard of general education followed by specific education, training and examination in professionally relevant subjects and a period of work experience, with which all ICMAP members are equipped. Professional competence requires to be maintained by a continuing awareness of developments in the accountancy profession, including relevant national and international
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pronouncements on accounting, auditing and other relevant regulations and statutory requirements. The cost and management accountant has to maintain professional knowledge and skill at a level required to ensure that a client or employer receives the advantage of competent professional service, based on up-to-date developments in practice, legislation and techniques.

6. Confidentiality: A cost and management accountant should respect the confidentiality of information acquired during the course of performing professional services and should not use or disclose any such information without proper and specific authority or unless there is a legal or professional right or duty to disclose. The duty of confidentiality continues seven after the end of the relationship between the cost auditor and the client or the cost and management accountant and the employer.

7. Professional Behaviors: A professional Cost and Management Accountant, being a member of the Institute of Cost and Management Accountants of Pakistan, should act in a manner consistent with the good reputation of the profession. He should meticulously avoid any such conduct or behavior as may cast an unfavorable aspersion on the profession. He has to ensure professional behavior while meeting his responsibilities to clients, third parties, other members of the cost and management accounting profession, staff, employers and the general public.

8. Technical Standards: A professional Cost and Management Accountant should carry out professional services in accordance with the relevant technical and professional standards. A Cost and Management Accountant has a duty to render professional services with care and skill, in accordance with the instructions of the clients or employers, insofar as they are compatible with the requirements of integrity, objectivity, and in the case of Cost and Management Accountants in public practice, independence. Moreover, they have to conform to the technical and professional standards laid down by the Institute of Cost and Management Accountants of Pakistan, IFAC, IASC and the relevant laws, orders ,rules and regulations.

9. Professional Code of Ethics:

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A distinguishing mark of a profession is its acceptance of responsibilities to the society. The Cost Auditor independence is to be judged by his clients, Government, employers, employees, investors in the business, the financial community and the consumers at large, who all rely on the objectivity and integrity of the Cost and Management Accountant. This reliance imposes a public interest responsibility on the professional cost and management accountant.

10. Engagement on other occupation: A professional accountant in public practice should not concurrently be engaged in any business occupation and activity which might impair his integrity, objectivity or independence or the good reputation of the profession. The code of professional ethics of the Institute of Cost and Management Accountants of Pakistan must be carefully observed.

2. Efficiency Audit
Efficiency audit is conducted to ensure that money is so utilized as to generate handsome returns. Efficiency audit is related to that whether corporate plans are effectively executed. In this, auditor investigates the reasons of variances in actual performance and planned performance. It also investigates that capital resources of company are properly utilized or not. A process of checking whether an organization is working as efficiently as possible. This may be done internally, as management tries to improve profitability, or externally by regulatory bodies.

Efficiency happens in all stages of the audit, from planning and scoping through reporting. Improving Audit Efficiency-Efficiency is the ratio of inputs per output: Hours spent per audit report, Years spent per audit report, highly efficient auditors and offices have traction to create audit yield with each hour of audit time invested. Core idea: Make each time investment count in your audit office The objectives of efficiency audit are: y y To invest the capital in areas that generates optimum returns. To plan and invest judiciously in various functions.

3. Management Audit

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A management audit is a periodic assessment conducted by company managers to determine the effectiveness or efficiency of business operations. Audits test a variety of business functions, including production operations, resource procurement, employee hiring practices and financial reporting. These audits may be less formal if conducted by internal managers or employees rather than a public accounting firm or third-party management consultant. A management audit may be described as a systematic and objective appraisal of the quality of management, aimed both at individual managers and toward the management team as an interlocking system of decision makers. Management audit concerned with the ways and means to perform specific task. For e.g. it involves the decision taken by the management, reporting and follow up Procedures, direction given by the management to the company, leadership etc are examined in the management audit. It is a complex task closely related with the process of management. It is highly result oriented. It requires inter/multi-disciplinary approach as it involves examination, review and appraisal of various policies and actions of management on the basis of certain norms/standards. It undertakes comprehensive and critical review of all organizational activities with wider perspective. It goes beyond conventional audit and audits the efficacy of the management itself. It's a comprehensive and constructive examination of an organization, the structure of a company, institution or branch of government or of any components thereof, such as division or department and its plans, objectives, its means of operations and its use of human and physical facilities.

William P. Leonard It's an investigation of a business from the higher level downwards in order to ascertain whether sound management prevails throughout, thus facilitating the most effective relationship with the outside world and the most efficient and smooth running internally. Leslie Howard It is an audit performed with the object of examining the efficacy of the institution/control systems, management procedures towards the achievement of enterprise goals. Churchill & Cyert 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 existing and potential management weaknesses within an organization and to recommend ways to rectify these weaknesses.
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Objectives To ascertain the provision of proper control at different levels and their effectiveness in accomplishing management goals. Critically analyze and evaluate management performance. To detect and overcome existing management deficiencies and resulting operational problems. To evaluate the methods and processes used by the management to accomplish its organizational objectives. It helps to determine the effectiveness of the management in PODC the organization activities. It helps to ascertain the appropriateness of the managements decisions for achieving the organization objectiveness. Ascertain objectives of the organization are properly communicated and understood at all levels. To reveal defects or irregularities in any of the elements examined and to indicate what improvements are possible to obtain the best results of the operations of the company. To assist the management to achieve the most efficient administration of its operations. To suggests to the management the ways and means to achieve the objectives if the management of the organization itself lacks the knowledge of efficient management. It aims to achieve the efficiency of management and assess the strength and weaknesses of the organization structure, its management team and its corporate culture

To reveal defects or irregularities in any of the elements examined and to indicate what improvements are possible to obtain the best results of the operations of the company. To assist the management to achieve the most efficient administration of its operations. To suggest to the management the ways and means to achieve the objectives if the management of the organization itself lacks the knowledge of efficient management. It aims to achieve the efficiency of management and assess the strength and weaknesses of the organization structure, its management team and its corporate culture. To help the management at all levels in the effective and efficient discharge of their duties and responsibilities. The auditor must apprise managerial performance at all levels of the organization. The audit starts right at the top level of the management. It studies the managerial performance at all the levels of management. The audit has to study the decision-making system of the organization and also the level of autonomy granted to the managers at different levels of the organization. The authority and responsibility given at the different levels of the management. One of the most

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important things that the audit must study is that the mangers at various levels use the authority.

Conducting Management Audit Management audit requires an interdisciplinary approach since it involves a review of all aspects of management functions. It has to be conducted by a team of experts because this requires 3 varieties of skills, which one individual may not possess. The team may consist of management experts, accountants, and the operation research specialists, the industry experts and even social scientists.

The auditors must have analytical mind and ability to look at a management function form the point of view of the organization as a whole. They therefore have to be properly trained in this aspect. They need to have through knowledge of the management science and they should be acquainted with the salient features of various functional areas. Under financial audit, the entire emphasis is on macro-aspect, the individual transactions being- scrutinized for check of the aggregates. It is concerned with examination of transactions recorded in the books of account. It reviews the procedure and internal checks, and scrutinizes individual transactions for the purpose of verification, of Profit and Loss Account and Balance Sheet. Financial audit is not concerned with ~ avoidance of profiteering motive. It indicates the financial position and over~ performance of the business, regardless of its performance in various segments. Financial audit is applicable to all classes of companies and industries irrespective of size and Dan of operations.

Instead of serving the interest of the management and the Government, it serves interest of shareholders. Financial audit is organization - oriented. It is conducted under Sections 224 232 of the Companies Act 1956. It is concerned with the review of the past Performance to ascertain whether it is in tune with the objectives, policies and procedures of the enterprise. The management auditor reports on performance of the management during a particular period and suggests ways to remedy the deficiencies, including modification of objectives, policies etc. No limit as to the period to be covered. There is legal compulsion as regards management audit. The auditor reports to the management

Types of management audit:


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Complete management audit, Compliance management audit, Program management audit, Functional management audit, Efficiency management audit, Propriety audit.

Organizing the management audit Devising the statement of policy, Allocation of personnel, Staff training program, Time and other aspects, Frequency.

4. MCS in Matrix Organization


In a Matrix organization, Project managers are responsible for dealing with the customers, and functional units provide resources to the projects. A project is ant task or group of tasks involved in reaching a specified end- objective. For e.g:- installation of a plant, new machine, setting a system, organizing an advertising campaign etc. Each project is set up for a specific purpose. Responsibility centers, on the other hand are arranged by functions such as purchase and procurement, operations, engineering, etc. The project managers use material, persons service from various functional units in accomplishing the objectives and when the objective is achieved the project is terminated. Organizations like consultancy firms, research and development units, construction companies, manufactures of complicated plant and machinery are examples of matrix structure. It is virtually a marriage between two types of organization structures one arranged by functions and the other arranged by projects.

Matrix organizational structure assigns multiple responsibilities to the functional heads. Evaluation of performance of such organizational entities is very difficult. Though they offer economies of using scares functional staff, it poses problems of casting the individual responsibility. This form of organization is very complex, from the point of view of management control system. At the end we must not forget that the management control system is for the organization and not the organization exists for management control system. One has to mold and remold the management control system to suit the given organization structure.

A citation by Anthony is worth noting in this regard. Usually in an advertisement agency, account supervisors are shifted from one account to another on periodic basis, this practice

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allows the agency to look at the account from the perspectives of different executives. However taking in to consideration the time lag of result realization in such services is quite large. And this may pose problem of performance assessment of a particular executive. This does not mean a control system designer should insist on abandoning the rotation system of the executives.

Advantages- Matrix of organization structure The number of products grows to be relatively large, products require close coordination among many specialized discipline and the market are too small to justify separate divisions for each product. Matrix structure offers advantages such as faster decision making process, efficiency and effectiveness but simultaneously it may pose problems such as added complexity in control function, assignment of responsibility and authority etc.

Disadvantages- Matrix of organization structure Management control in a matrix organization is obviously more difficult than the other two types because: Profitability is the joint responsibility of several managers, Planning must harmonize the requirement of the projects with the resources that are available at the functional units and perfect co-ordination is required in scheduling the activities, so that the projects are completed in time, but personnel are not idle at any time.

CASE STUDY SOLUTION QUALITY METAL SERVCE CENTER


Q1. Is the capital investment proposal described in Exhibit 3 an attractive one for Quality Metal Service Center? Yes, the purpose of a company is to maximum the profit, and as Elizabeth Barret suggested, it can help company to make more profit. So the capital investment proposal described in Exhibit 3 is an attractive on for QMSC.

Investment in machine $540,000 10 years cash inflow $286,000 PV of cash inflow $39,182

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Payback period = 4.5 years NPV= 286000 IRR= 2.8% Reasons for selection:    Positive cash flow IRR> COC Payback period is less than the standard

Q2. Should Ken Richards send that proposal to home office for approval? Ken need send this proposal to home office for approval, because this proposal is good for the company and can make a lot of profit for the company. And another reason is, capital expenditures in excess of $10,000 and all capital leasing decisions require corporate approval.

Q3. Comment on the general usefulness of ROA as the basis of evaluating district managers performance. Could this performance measure be made more effective? The Return on Assets (ROA) percentage shows how profitable a company's assets are in generating revenue. An indicator of how profitable a company is relative to its total assets. ROA gives an idea as to how efficient management is at using its assets to generate earnings. ROA can be computed as Net Income/ Total Assets. To make it more effective QMSC can use: Multiple performance measure, management service histories, or strategy paining.

Q4.In deciding the investment base for evaluating managers of investment centers, the general question is: What practices will motivate the district mangers to use their assets most efficiently and to acquire the proper amount and kind of new ssets? Presumably, when his redesire that the actions he takes toward this end be actions that are in the best interest of the whole corporation. Given this general line of reasoning, evaluate the way Quality computes the investment base for its districts. For each asset category, discuss whether the basis of measurement used by the company is the best for the purpose of measuring districts return on assets. What are the likely motivational problems that could arise in such a system? What can you recommend to overcome such dysfunctional effects?
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Yes, in the investment center. The managers are responsibility for the segments, investment and asset base as well as the profits. Usually, evaluate based on the return on assets employed, evaluation might include a variety of measures such as profit, return on investment, residual income, economical valued added and a range of non-financial measures. Hence the manager in the districts should consider about the acquisition of new equipment which is an investment for the segment. And also, they evaluated equipments and accounts receivable etc. based on the return on assets employed. May be it can also be the profit center because the managers usually evaluated in terms of effectiveness in raising segment profit level and controlling costs. QMSC should use EVA instead of ROA as the measure of district and manager performance. Since EVA is the best proxy for shareholder value at the business unit level, improving EVA will also improve the companys overall performance. The managers district objectives will then be congruent with the companys overall objectives. This will induce Mr. Richards to employ additional assets which will promote the growth of both the Columbus district and QMSC, such as the one in Ms. Barrets proposal. The purchase of the new processing equipment is also in line with the companys objective to develop techniques and marketing program that would increase market share in identified industries and geographic markets of specialty metal users. Having the equipment will allow QMSC to provide the demand for processed metals in the Columbus District with a short lead time, addressing the concern of potential customers.

Another aspect of the issue that needs to be looked into is the decision on what assets should be included in the investment base and what expenses should be charged from profits. QMSC includes land, warehouse buildings, and equipment at gross book value in its investment base. This results to an EVA that signals a decrease in profitability during the early years of the assets when in fact, profits increased. It will be better for the company to use annuity depreciation so that the profitability calculations will show the correct EVA. Leased buildings and equipment are also part of the asset base. This motivates managers to lease rather own assets whenever the interest charge that is built into the rental cost is less than the capital charge that is applied to the investment base. Thus, the head office must think carefully before approving the leases of the districts as the managers might just be using it to window dress their performance. QMSC also includes inventory and accounts receivables, without subtracting standard accounts payable, using average values for the period. This is a good practice because these are representative of the assets used during the period and thus, conceptually a satisfactory measure of the amount that should be related to profits.
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Q5. While computing district profits for performance evaluation purposes, should there be a charge for income taxes? Should corporate overheads be allocated to districts? Should profits be computed on the basis of historical costs or on the basis of replacement costs? Evaluate these issues from the standpoint of their motivational impact on the district managers? No, while computing district profits for performance evaluation purpose did not charge for income taxes, for each district was calculated based on current inventory replacement values. Expenses were separated into controllable and non controllable categories. No corporate overhead expenses were allocated to the districts. A few years earlier, the company had considered a proposal to allocate corporate overheads to the districts. However, the proposal had been rejected on the grounds that the allocation bases were arbitrary and that such expenses could not be controlled at the district level. So profit should be computed on the basis of historical costs and performance. The motivational impact on the district mangers that thing before taking corporate overheads.

Q6. Evaluate Qualitys incentive compensation system. Does the present system motivate district managers to make decisions which are consistent with the strategy of the firm? If not, make specific recommendations to improve the system? The key issue in the case is that the incentive compensation system does not motivate district managers to make decisions which are consistent with the strategy of Quality Metal Service Center (QMSC) because it is tied to the districts target ROA. Acquiring the new processing equipment reduces the incentive bonus of the Columbus District Manager, Mr. Ken Richards, from 11.1% to 4.28% of his base salary. This happens because the asset base increases with the new equipment and will exceed the target for 1992. This may motivate him to not proceed with the purchase even if the proposal of the Sales Manager, Ms. Elizabeth Barret, shows that the acquisition results to a positive NPV and thus, should be sent to the home office for approval.

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