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Q.5. a) Describe the inherent difficulties creation of profit centers may cause and
advantages possible?
Ans: When a responsibility center’s financial performance is measured in terms of
profit (i.e. the difference between the revenue and expenses), the centers is called a Profit
Center. Profit is a particularly useful performance measure since its allows senior manager to
use one comprehensive indicator rather than the several (some of which may be pointing in
different directions).
Difficulties in creation of Profit Centers:
• Decentralized decision making will force top management to rely more on
management control reports than on personal knowledge of an operation, entailing some loss
of control.

• If headquarters management is more capable or better informed than the average


profit center manager, the quality of decisions made at the unit level may be reduced.

• Friction may increase because of arguments over the appropriate transfer price, the
assignment of common sales, and the credit for revenues that were formerly generated jointly
by two or more business units working together.

• Organization units that once cooperated as financial units may now be in the
competition with one another. An increase in profits for one manager may mean decrease to
another. In such situations, manager may fail to refer sales leads to another business unit
better qualified to pursue them; may hoard personnel or equipment that, from the overall
company standpoint, would be better of used in another unit; or may make production
decision that have undesirable cost consequences for other units.

• Divisionalization may impose additional cost because of the additional management,


staff personnel, and record keeping required, and may lead to task redundancies at each profit
center.

• Competent general managers may not exist in a functional organization because there
may not have been sufficient opportunities for them to develop general management
competence.

• There may be too much emphasis on short run profitability at the expense of long run
profitability. In the desire to report high current profits, the profits center manager may skimp
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on R & D, training programs or maintenance. This tendency is especially prevalent when the
turnover of profit center managers is relatively high. In these circumstances, managers may
have good reason to believe that their actions may not affect profitability until they have
moved to other jobs.

• There is no completely satisfactory system for ensuring that optimizing the profits of
ach individual profit center will optimize the profits of the company as a whole.

Advantages of profit centers:


• The quality of decisions may improve because they are being made by managers
closest to the point of decision.

• The speed of operating decisions may be increased since they do not have to be
referred to corporate headquarters.

• Headquarters management, relieved of day-t0-day decision making, can concentrate


on broader issues.

• Managers, subject to fewer corporate restraints, are freer to use their imagination and
initiative.

• Because profit centers are similar to independent companies, they provide an


excellent training ground for general management. Their managers gain experience in
managing all functional areas, and upper management gains the opportunity to evaluate their
potential for higher – level jobs.

• Profit consciousness is enhanced since managers who are responsible for profits will
constantly seek ways to increase them. (A manager responsible for marketing activities, for
example, will tend to authorize promotion expenditures that increase sales, whereas a
manager responsible for profits will be motivated to make promotion expenditures increase
profits.)

• Profit centers provide top management with ready-made information on the


profitability of the company’s individual components.

• Because their output is so readily measured, profit centers are particularly responsive
to pressures to improve their competitive performance.
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Q.5.b) Under which situations creation of profit centers is not advisable.


Ans: The creation of profit centers is not advisable under the following situations:
One of the main problems occurs when profit units deal with one another. It is useful to
think of managing profit center in terms of control over three types of decisions:
1. The product decision (what goods and services to make and to sell)

2. The marketing decision (how, where and for how much are these goods and services
to be sold)

3. The procurement or the sourcing decision (how to obtain or manufacture the goods
and services).

If a profit center manager control all three activities, there is usually no difficulty in
assigning profit responsibility and measuring performance. In general, greater degree of
integration within a company, the more difficult it becomes to assign responsibility to a
single profit center for all three activities in a given product line; that is, if the production,
procurement, and marketing decision for a single product line are split among two or more
profit centers, separating the contribution of each profit centre to the overall success of the
product line may be difficult.
The constraints imposed by the corporate management can be grouped into three
types:
1. Those resulting from the strategic considerations

2. Those resulting because uniformity required

3. Those resulting from the economies of centralization.

Most of the companies retain certain decisions, especially financial decisions, at the
corporate level, at least for domestic activities. Consequently, one of the major constraints on
profit centers results from corporate control over new investments. Profit centers must
compete with one another for the share of the available funds. The maintenance of the proper
corporate image may require constraints in the quality of the products or in the public
relations activities.
Companies impose some constraints on profit centers because for the necessity for
uniformity. One constraint is that profit centre must confirm to the corporate accounting
management control systems. This constraint is especially troublesome for units that have
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been acquired from the another company and that have been accustomed to using different
systems.
Corporate headquarters may also impose uniform pay and other personnel policies, as
well as uniform policies on ethics, vendor selection, computers and communication
equipment, and even the design of the business unit letterhead. The major problems seem to
resolve around corporate service activities.

Q.6) Which management control practices, if followed, in performance measurement


of Investment Centers are likely to induce Goal Congruence, in respect of following
assets:-
(a) i) Idle ii) Intangible iii) Leased
(b) i) Cash ii) Receivables iii) Inventories
Ans: The following is the explanation of the terms:
Q.6.(a)
1. IDLE ASSETS: If a business unit has idle assets that can be used by the other units,
it may be permitted to exclude them from the investment base if it classifies them as
available. The purpose of this permission is to encourage business unit managers to realize
underutilized assets to units that may have better use for them. However, if the fixed assets
cannot be used by the other units, permitting the business unit manager to remove them from
the investment base could result in dysfunctional actions. For example, it could encourage the
business unit manager to idle partially utilized assets that are not earning a return equal to the
business unit’s profit objective. If there is no alternative use for the equipment, any
contribution form this equipment will improve the company profits.

2. INTANGIBLE ASSETS: Some companies tend to be R&D intensive; others tend to


be marketing intensive. There are advantages to capitalizing intangible assets such as R&D
marketing and then amortizing them over a selected life. This method should change how the
business unit manager views these expenditures. By accounting for these assets as long terms
investments, the business unit manager will gain less short term benefit from reducing outlays
on such items. For instance, if R&D expenditures are expensed immediately, each dollar of
R&D cut would be a dollar more in pretax profits. On the other hand if R&D costs are
capitalized, each dollar cut will reduce the assets employed by a dollar; the capital charge is
thus reduced only by one dollar times the cost of capital, which has a much smaller positive
impact on economic valued added.
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3. LEASED ASSETS: Many leases are financing arrangements – that is, they provide
an alternative way of getting to use assets that otherwise would be acquired by funds obtained
from the debt and equity financing. Financial leases (i.e. long term leases equivalent to the
present value of the stream of the lease charges) are similar to the debt and are so reported on
the balance sheet. Financing decisions usually are made by corporate headquarters. For these
reasons, restrictions usually are placed on the business unit manager’s freedom to lease
assets.

Q6(b)
1. CASH: Most companies control cash centrally because central control permits use of
the smaller cash balance than would be the case if each business unit held the cash balance it
needed to whether the unevenness of its cash inflows and outflows. Business unit cash
balances may well be only the “float” between daily receipts and daily disbursements.
Consequently, the actual cash balances at the business unit level tend to much smaller than
would be required

If the business unit were an independent company. Many companies then use a formula to
calculate the cash to be included in the investment base. For example, General Motors was
reported to use 4.5% of annual sales; Du Pont was reported to use two months cost of sales
minus depreciation. One reason to include cash at higher amount than the balance normally
carried by a business unit is that the higher amount is necessary to allow comparisons to
outside companies. If only the actual cash were shown, the return by internal units would
appear abnormally high and might mislead senior management. Some companies cash from
the investment base. These companies reason that the amount of cash approximates the
current liabilities. If this is so, the sum of accounts receivable and inventories will
approximate the amount of working capital.

2. RECEIVABLES: Business unit managers can influence the level of receivables


indirectly, by their ability to generate sales, and directly, by establishing credit terms and
approving individual credit accounts and credit limits, and by their vigor in collecting
overdue amounts. In the interest of simplicity, receivables often are included at the actual end
of period balances, although the average of intraperiod balances is conceptually a better
measure of the amount that should be related to profits. Whether to include accounts
receivables at selling prices or at cost of goods sold are debatable. One could argue that the
business unit’s real investment in accounts receivables is only the cost of goods sold and that
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a satisfactory return on this investment is probably enough. On the other hand, it is possible
to argue that the business unit could reinvest the money collected from accounts receivable,
and, therefore, accounts receivable should be included at selling prices. The usual practice is
to take the simpler alternative – that is, to include receivables at the book amount, which is
the selling price less an allowance of bad debts. If the business unit does not credits and
collections, receivables may be calculated on the formula basis. This formula should be
consistent with the normal payment period – for example 30 days’ sales where payment
normally made 30 days after the shipment of the goods.

3. INVENTORIES: They are ordinarily treated in an manner similar to receivables –


that is, they are often recorded at the end of period amounts even though intraperiod averages
would be preferable conceptually. If the company uses LIFO for the financial accounting
purposes, a different valuation method usually is used for business unit profit reporting
because LIFO inventory balances tend to be unrealistically low in the periods of inflation. In
these circumstances, inventories should be valued at standard or average cost, and these same
costs should be used to measure cost of sales on the business unit income statement. If work
in progress inventory is financed by advanced payments or by progress payments from the
customers, as is typically the case with goods that require a long manufacturing period, these
payments either are subtracted from the gross inventory amounts or reported as liabilities.
Some companies subtract accounts payable from the inventory on the grounds that accounts
payable represent financing of part of the inventory by vendors, at zero cost of the business
unit. The corporate capital required for inventories is only the difference between the gross
inventory amount and accounts payables. If the business can influence the payment period
allowed by vendors, then including accounts payable in the calculations encourages the
manager to seek the most favorable terms. In times of high interest on credit stringency,
managers might be encouraged to consider forgoing the cash discount to have, in effect,
additional financing provided by vendors. On the other hand, delaying payments unduly to
reduce net current assets may not be in the company’s best interest since this may hurt its
credit rating.

Q10. Pritam engineering manufactures variety of metal products at many factories.


Currently it is experiencing crisis. Management has therefore decided to install detailed
expense control system including responsibility budgets for overheads expense items to
each factory. from historical data controller developed a standard for each overheads
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exp. Item. Summarized expenses for Nov 2005. Given to concerned productions
supervisor for comments is tabulated.

Particulars Standard at Budgeted at


normal volume actual volume (2) Actual
(1)
Management supervision 720 720 582
Indirect Labour 12706 11322 12552
Idle time 420 361 711
Material & Tools 3600 3096 3114
Maintenance & scrap 14840 13909 17329
Allocation exp. 21040 21040 21218
Total per tune 2133.04 2103.39 2413.30

(a) Explain with justification which of the 2 standards 1 or 2 is more meaningful for
expense control
(b) Can the supervisor be held responsible for all overhead expenses included?
Why / why not?

Table 1
Table for total Expenses Rupee in 000

Particulars Standard at normal Budgeted at actual


volume (1) volume (2)
Management supervision 720 720
Indirect Labour 12706 11322
Idle time 420 361
Material & Tools 3600 3096
Maintenance & scrap 14840 13909
Allocation exp. 21040 21040
Total exp. 53326 50448

Table 2
Total Exp. Per Ton. 2133.04 2103.39
Unit Produce 56626/2133.04 50448/2103.39
Unit Produce 25 24

Table 3
If no of unit produce is same as 25000
Unit produce 25000 25000
Total expenses 53326 50448 * 25 / 24
53326 52550
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If we consider total expenditure then obviously we select standard (2) because standard at
normal volume (1) total exp. rupee 53326 and Budgeted at actual volume (2) rupees 50448
(from table 1) & if we consider individual expenses then we can say as under
,stander volume(1) expenses more than propagated actual volume(2) as shown as under.

Indirect labor 12706 > 11322


Idle time 420 > 361
Material & Tools 3600 > 3096
Maintenance & scrap 14840 > 13909
Allocation exp. 21040 > 21040

If we consider relationship of expenses and output then we also select the standard (2)
because output is more in the standard (1) is 25000 but expenses are also more as compare to
budgeted actual volume. This can we understand from table 2 & table 3. In that total expense
of standard (1) are Rs. 53326000 & standard (2) is Rs. 52550000 with same level of output.

B) Supervisor be held responsible for overhead expenses because of following reason:


1. He is professional person who have knowledge and skill
2. Supervisor has responsibilities of optimum utilization of organizational resource
3. He is responsible to manage cost and increase efficiently
4. He is responsible to allocate proper recourses in each area where it require
5. If manage each presses properly then it can idle-time and increase production
6. It manage things properly in production area in it will reduce scrap.

So supervisor play important role in manage each activity smoothly and effective

Q.11 (a) Given Facts


Turnover 225 crores – 2004-2005
Income Tax rate 40%
Plan to install new machinery of Rs. 45 cr.
Results
Turnover rise by 6% = 238.5 cr.
Variable expenses to turnover ratio
Old = 225 = 1.5
180

New = 238.5 = 1.47


162.2

( 162.2 = new variable expenses )


8.48% rise in fixed expenses
Old fixed expenses = 49.5 cr.
New = 53.7 cr.

Net working capital = 36 cr. Rise by 1.8 cr.


New working capital = 37.8 cr.
Solution
a)
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Return on equity = ____Profit____


Equity capital
Profit = 225 – expenses
= 225 – 150 – 49.5
= 25.5

ROE = _25.5_ turnover


51
= 0.5

Up explored = Fixed Asset + Working Capital


= 36 + 51
= 87 cr.

b) Pre Post
Installation Installation

Turnover 225 cr. 238.5 cr.


Variable Expenses 150 cr. 162.2 cr.
Fixed Expenses 49.5 cr. 53.70 cr.
New W. Capital 36 cr. 37.80 cr.

c) Parameters to be controlled for success of project

1. Pre – installation statement obtain.


2. Analysis of all expenses
3. Post installation statement obtain
4. Analysis of all expenses
5. Comparison of both statements
6. Turnover rise from 225 cr. To 238.5 cr. It means it rise by 6% but as compare to
that variable expenses rise by 8% i.e. from Rs. 150 cr. To 162.2 cr. Still there is
need to control variable expenses.
7. about fixed expenses it is rising by 8.48% If sales is rising by just 6% & expenses
are increasing by 8.48% I should control.

Q.12 For effective strategy implementation, Soniya Ltd. (SL) has been organized on
product decentralization basis and each division is headed by GM (General Manager).
GM is responsible for manufacturing, purchasing, finance and marketing activities for
his divisional product group. Performance measurement is Return on Investment (ROI)
of division. Annual budgets are split up into four quarters and at the beginning of each
quarter, performance of previous quarter is reviewed and budget for following quarter
may be revised in consultation with GM. Data for div P is as under. Figures in Rs.
Crores

Budget Actual
Quarter 1 Quarter 2 Quarter 1
Account 8 7.5 8.5
receivable
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Cash 4 4 2.0
Inventory 18 16.5 21.50
Fixed assets 20 20 20
Factory cost 21 19 17
Marketing Cost 7 6 3
Freight 1 0.90 0.80
Administrative 3 2.60 3.20
exp.
Sales 40 36 34
(a) Review the first-quarter performance on the basis of computation of various
Parameters.
(b) Would you suggest any revisions for the second quarters? why/why not.Justify.
Solution:
a) The first-quarter performance on the basis of computation of various parameters are as
follows:
1) Turnover of investment =__ Sales ___
Total Investment

= 40
50
= 0.8 times
2) Profit Margin = Profit*100
Sales
= 08*100
40
= 20%

3) Return on Investment = Operating profit


Total investment
= 08 *100
50
= 16%
Working note:

Calculation of operating profit

Particulars Amount(Rs.)
Sales 40
Less expenses:
Factory cost 21
Marketing cost 7
Freight 1
Administration expenses 3 (32)
Operating profit 8

Calculation of Total Investment

Particulars Amount (Rs.)


Account Receivable 8
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Cash 4
Inventory 18
Fixed Assets 20
Total Investment 50

4) Factory cost as percentage to sales = Factory cost * 100


Sales
= 21 / 40 *100
= 52.5%

5) Marketing cost as percentage to sales = Marketing cost *100


Sales
= 7/40 *100
= 17.5%

6) Freight as percentage to sales = Freight *100


Sales
=1/40 * 100
=2.5%

7) Administration exp. as percentage to sales = Administration exp. *100


Sales
=3/40 *100
=7.5%

8) Turnover of Fixed Asset = Sales


Fixed Asset
= 40/20
= 2 times

9) Turnover of Inventory = Sales


Inventory
=40/18
=2.22times

b) Suggestion for review for second quarter budget.

1) Turnover of investment = __ Sales ___


Total Investment
Budgeted Actual
Particulars Quarter I Quarter II Quarter I
Turnover of investment 40/50 = 0.8 times 36/48 = 0.75 34/52 = 0.65
times times

2) Profit Margin = Profit*100


Sales
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Budgeted Actual
Particulars Quarter I Quarter II Quarter I
Profit Margin 08/40 * 100 = 7.5/36*100 = 10/34*100= 29.41
20% 20.83%

3) Return on Investment = Operating profit


Total investment
Budgeted Actual
Particulars Quarter I Quarter II Quarter I
Return on Investment 8/50 *100= 16% 7.5/48*100= 10/50*100 =
15.63% 19.23

Working note:

Calculation of operating profit

Budget Quarter I
Particulars Amount(Rs.)
Sales 40
Less expenses:
Factory cost 21
Marketing cost 7
Freight 1
Administration expenses 3 (32)
Operating profit 8

Budget Quarter II
Particulars Amount(Rs.)
Sales 36
Less expenses:
Factory cost 19.00
Marketing cost 6.00
Freight 0.90
Administration expenses 2.6 28.5
Operating profit 7.5

Actual Quarter I
Particulars Amount(Rs.)
Sales 34
Less expenses:
Factory cost
17.00
Marketing cost 3.00
Freight 0.80
Administration expenses 24
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3.20
Operating profit 10

Calculation of Total Investment

Budgeted Actual
Quarter I Quarter II Quarter I
Particulars Amount (Rs.) Amount (Rs.) Amount (Rs.)
Account Receivable 8 7.5 8.5
Cash 4 4 2.0
Inventory 18 16.5 21.5
Fixed Assets 20 20 20
Total Investment 50 48 52

4) Factory cost as percentage to sales = Factory cost * 100


Sales
Budgeted Actual
Particulars Quarter I Quarter II Quarter I
Factory cost as 21/40 *100= 19/36*100= 17/34*100= 50%
percentage to sales 52.5% 52.77%

5) Marketing cost as percentage to sales = Marketing cost *100


Sales
Budgeted Actual
Particulars Quarter I Quarter II Quarter I
Marketing cost as % to 7/40*100 = 6/36*100 =16.67% 3/34*100 =8.82%
sales 17.5%

6) Freight as percentage to sales = Freight *100


Sales
Budgeted Actual
Particulars Quarter I Quarter II Quarter I
Freight as percentage 1/40 * 100 0.90/36* 100 0.80/34*100=2.35%
to sales =2.5% =2.5%

7) Administration exp. as percentage to sales = Administration exp. *100


Sales
Budgeted Actual
Particulars Quarter I Quarter II Quarter I
Administration exp. as 03/40*100 =7.5% 2.6/36*100 =7.22% 3.2/34*100
percentage to sales =9.41%
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8) Turnover of Fixed Asset = Sales


Fixed Asset

Budgeted Actual
Particulars Quarter I Quarter II Quarter I
Turnover of Fixed 40/20 =2times 36/20 =1.8times 34/20 =1.7times
Asset

9) Turnover of Inventory = Sales


Inventory
Budgeted Actual
Particulars Quarter I Quarter II Quarter I
Turnover of Inventory 40/18= 2.22times 36/16.5= 2.18times 34/21.5=
1.58times

Return on Investment of Budgeted quarter I was less than Actual quarter I.


ROI is multiplication of Profit margin and turnover of Asset

There was difference in budgeted Quarter I and actual Quarter I due to:
Increase in profit margin.
Though sales have been reduced from budgeted but there is reduction in marketing cost and
freight. Quarter II sales have been increased from actual Quarter I. So there should be
decrease in cost as compared to actual. So this will lead to increase in profit margin.

Fixed asset invest is same in Quarter II but in turnover there is difference due to sales. But
inventory budgeted in Quarter I was less than actual quarter I. so instead of increasing
inventory it has reduced than actual. So there should be increase in inventory.