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Q.1. (a):-
Internal Audit is one of the techniques of control available to the top management for
ensuring continuous improvement for better performance. Comment upon this statement
analyzing it highlighting benefits accruing to the top management.
Ans:-
Internal audit can be viewed from two different perspectives-the traditional perspective
and the modern perspective. Viewed from a Traditional perspective, internal audit is
found to play the following roles:
The Traditional concept of internal auditing has a narrow scope whereas the Modern
concept has wider scope. The fact that the modern internal auditing is wider is reflected
in the new definition of internal auditing given by the Institute of Internal Auditors,
An independent appraisal function established within an organization to examine and
evaluate its activities as a service to the organization. The objective of internal auditing is
to assist members of the organization in the effective discharge of their responsibilities.
To this end, internal audit furnishes them with analyses, appraisals, recommendations,
counsel and information concerning the activities reviewed.
This definition implies that an internal auditor has to go beyond checking the books of
account and related records. He has to appraise the various operational functions of an
organization and provide recommendations about these.
Thus, according to the modern concept of internal auditing, the internal auditor is
involved in conduction a review of operations, and internal audit and operational audit
are almost synonymous.
For example, if a company has a strategic objective to raise Rs.20 million in loans to
build a new facility there are a number of risks that may prevent that from occurring. One
risk may be the external factor of increased interest rates. Another risk may be internal
risk that management does not qualify for credit because of covenants they will not be
able to meet.
Financial costs of internal audit will vary based upon the size and goal of the internal
audit function. Additionally, the cost will be based upon the resources used to perform the
work (outsource, co-source, in-house). The most significant non-financial cost may be a
negative reputation of the internal audit role throughout the organization. If the function
is not properly established, socialized and executed then the validity of the function could
be jeopardized.
Internal audit can be a value-add activity but often times it is strictly a policing function,
which is sadly an example when the cost of internal audit usually does not exceed its
benefit.
Q.1. (b):-
What are the considerations involved in regulating R&D function by the top management
especially in view of challenges faced on account of Globalization?
Ans:-
Research & Development Programme:
There is no scientific way of determining the optimum size of and R&D Budget. Many
companies simply use a percentage of average revenue as a base (preferring an average to
a percentage of specific revenues in a given year because the size of an R&D operation
ought to be affected by short term revenue swings). The specific percentage applied is
determined in part by a comparison with competitors R&D expenditures and in part by
the companys own spending history. Depending on circumstances, other factors may
also come into play.
For Example:
Senior Management may authorize a large and rapid increase in the budget if it appears
that there has been a significant breakthrough.
The R&D program consists of a list of programs plus a blanket allowance for unplanned
work; it is usually reviewed annually b y senior management. This research view is often
conducted by a research committee consisting of the CEO, the research director, and the
production and marketing managers. This committee makes broad decision as to which
projects to undertake, which to expand, which to cut back on, and which to discontinue.
These decisions, of course, are highly subjective, but they are within the established
policy limits on total research spending. Thus, the research program is determined not by
calculating the total amount of approved projects, but rather by dividing the research
pie into what seem to be the most worthwhile slices.
Annual Budgets:
If the company has decided on a long-range R&D program and has implemented program
with a system of project approval, the preparation of the annual R&D budget is a fairly
simple matter, involving mainly the Calendarization of the expected expenses for the
budget period. If the budget is in line with the strategic plan, approval is routine- it
primarily serves to assist in cash and personnel planning. Preparation of the budget
allows management to take another look at the R&D program with this question in mind:
In view of what we now knew, is this the best way to use our resources next year?
The annual budget process also ensures that actual costs will not exceed budgeted
amounts without managements knowledge. Significant variances from the budget should
be approved by management before they are incurred.
Measurement of Performance:
At regular intervals, usually monthly or quarterly, most companies actual expenses with
budgeted expenses for all responsibility centers and ongoing projects. These comparisons
are summarized for managers at progressively higher levels to assist the managers of
responsibility centers in planning their expenses and to assure their superiors that those
expenses are remaining at approved levels.
Ans:
Two step pricing Approach
It includes 2 charges:
First, for each unit sold, a charge is made that is equal to the standard variable cost of
production. Second, a periodic (usually monthly) charge is made that is equal to the fixed
cost associated with the facilities reserved for the buying unit. One or both of these
components should include a profit margin.
This method of pricing may be app. If demand for the manufactured product is not steady
enough to warrant the permanent assignment of facilities, as in the 2step pricing method.
In general, this method does make the marketing units interest congruent with the
companys.
Q3 (b):
Adopting Profit Center Approach may not be appropriate solution always`. Do you agree
with this statement? Give reason for your answer quoting various situations in business.
Ans:
Establishing organization units as profit centers provides the following advantages:
The quality of decisions may improve because they are being made by managers
closest to the point of decision.
The speed of operating decision may be increased since the do not have to be
referred to corporate headquarters.
Headquarters management, relieved of day-to-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 manger responsible for profits will be motivated to make
promotion expenditures that increase profits.)
Profit center provide top management with ready-made information on
profitability of the companys individual components.
Because their output is so readily measured, profit centers are particularly
responsive to pressures to improve their competitive performance.
Many Japanese companies use profit centre. The Kyocera Corporation, a technology
company divided itself into 800 small companies (nick named amoebas), which were
expected to trade both internally and externally. HIgashimaru Shoya, a soy sauce maker,
turned each stage in production process into a separate profit centre, instructing these
separate units to buy and sell to any other. Matsushita, consumer electronics giant,
operated its divisions as profit centers and focus managers attention on two numbers-
profit margin and the bottom line. The consumer electronic industries were
characterized by two factors: product life cycles tended to be short and profit margins
were higher in the initial stages of the product life cycle than in the later stages. The focus
on profit margins motivated managers to introduce new products, and the focus on the
bottom line motivated managers to extract the minimum profits from current products.
Ans:-
(A) BALANCE SCORE CARD:-
The establishment, through data gathering of targets & comparators, through those
whose use relative levels of performance (and particularly areas of under performance)
can be identified. By the adoption of identified best practices it is hoped that performance
will improve.
-CIMA OFFICIAL TERMINOLOGY
The framework for action in implementing of BSC is shown in the following figure:
Business planning
Setting targets
Aligning strategic initiatives
Allocating resources
Establishing milestones
Benefits
It avoids management reliance on short term financial measures
It can successfully communicate corporate strategies to the functional heads &
organizations subunits & forcing them to develop there own goals to achive the
corporate mission & goals & to make consistent policies to corporate strategy.
In can assist stakeholders in evaluating the firm if measures are communicated
externally.
Limitations
There is no clear relationship between BSC & shareholder value
It does not leads to a single aggregate summary of control
The measures may give conflicting signals & confuse management
It involves substantial shifts in corporate culture.
Q5.
Economic Value Added (EVA) is a technique of management control, considered by
some as superior to that of ROI. Analyze the statement, and give your comments,
quoting illustrations/ situations prevailing in the Business World, in support of your
argument.
Ans.
Most companies employing investment centers evaluating business units on the basis of
ROI rather than EVA. Ther4e are three apparent benefits of an ROI measure. First, it is
comprehensive is that any thing that affects financial statements is reflected in this ratio.
Second, ROI is simple to calculate, easy to understand, meaningful in an absolute sense.
For example, an ROI of less than 5 percent is considered low on an absolute scale, and an
ROI of over 25 percent is considered high. Finally, it is a common denominator that may
be applied to any organizational unit responsible for profitability, regardless of size or
type of business. The performance of different units may be compared directly to one
another. Also ROI data are available for competitors and can be used as a basis for
comparison.
The dollar amount of EVA does not provide such a basis for comparison. Nevertheless,
the EVA approach has some inherent advantages. There are four compelling reasons to
use EVA over ROI>
First, with EVA all business units have the same profit objective for comparable
investments. The ROI approach, on the other hand, provides different incentives for
investments across business units. For example, a business unit that currently is achieving
an ROI of 30percent or more on additional assets; a lesser return would decrease its
overall ROI below its current 30 percent level. Thus, this business unit might forgo
investment opportunities whose ROI is above the cost of capital but below 30 percent.
Example. Based on ROI Wal-mart would have chosen to stop expanding since the late
1980s because its ROI on new stores slipped from 25% to 20% even though both rates
were substantially above its cost of capital.
Similarly, a business unit that currently is achieving a low ROI- say 5% would benefit
from anything over 5% on additional assets. As a consequence, ROI creates a bias
towards little or no expansion in high profit business units while, at the same time, low
profit units are making investments at rates on return well below those rejected by the
high profits units.
Second, decision that increase a centers ROI may decrease its overall profits. For
instance, in an investment centre whose current ROI is 30%, the manager can increase its
over all ROI by disposing of an assets whose ROI is 25%. However, if the cost of capital
tied up in the investment centre is less than 25%, the absolute dollar profit after deducting
capital cost will decrease for the centre.
The use of EVA as a measure deals with both these problems. They relate to assets
investment whose ROI falls between the cost of capital and the centers current ROI. If
an investment centers performance is measured by EVA, investments that produce a
profit in excess of the cost of capital will increase EVA and therefore be economically
attractive to the manager.
A third advantage of EVA is that different interest rates may be used for different types of
assets. For example, a low rate may be used for inventories while a relatively higher rate
may be used for investments in fixed assets. Furthermore, different rates may be used for
different types type of fixed assets to take into account different degrees of risk. In short,
management Control System can be made consistent with the framework used for
decision about investments and recourse allocation. It follows that the same type of assets
may be required to earn the same return throughout the company, regardless of the
particular business units profitability. Thus, business units managers should act
consistently when deciding to invest in new assets.
A fourth advantage is that EVA, in contrast to ROI, has a stronger positive correlation
with changes in companys market value. Shareholders are important stakeholders in a
company. There are several reasons why shareholder value creation is critical for the
firm. It (a) reduces the risk of takeover, (b) creates currency for aggressiveness in mergers
and acquisitions, and (c) reduces cost of capital, which allows faster investment for future
growth.
Thus, optimizing shareholding value is an important goal of an enterprise. However,
because shareholder value measures the worth of consolidated enterprise as a whole, it is
nearly impossible to use it as a performance criterion for an organizations individual
responsibility centers. The best proxy for shareholder value at a business unit level is to
ask business unit managers to create and grow EVA.
How EVA is understood is as under:
the following action can increase EVA as shown in equation (2): (i) increase in ROI
through business process reengineering and productivity gains, without increasing the
asset base; (ii) divestment of assets, products, and/or businesses whose ROI is less than
the cost of capital; (iii) aggressive new investments in assets, products, and/or businesses
whose ROI exceeds the cost of capital; and (iv) increase in sales, profit margins, or
capital efficiency (ratio of sales to capital employed), or decrease in cost of capital
percentage, without affecting the other variables in equation (2). These actions clearly are
in the best interests of shareholders.
Ans.:-
Strategy Formulation Task Control