Escolar Documentos
Profissional Documentos
Cultura Documentos
Management Control
Systems
FMG404
NOTES
Management Control Systems
:1
Introduction to
Management Control
Systems
NOTES
Authors Editor
Production
:2
Unit 1: Introduction to Management Control Systems 4 Introduction to
Management Control
Unit 2: Approach to Management Control 21 Systems
The book focuses on how to make control systems effective by balancing the internal
and the external environment.
Units 4 and 5 discuss the critical success factors which relate the control
environment in an organization to the externally driven factors and how goal
congruence is of critical importance in balancing conflicts within and with respect to
external environment.
Responsibility Centers
:4
Introduction to
Unit 1: Introduction to Management Control Systems Management Control
Systems
Structure
NOTES
1.0 Introduction
1.1 Unit objectives
1.2 Meaning
1.3 Evolution of Management Control Theories
1.4 Purpose of Management Control System
1.5 Elements of Control Systems
1.5.1 Detector
1.5.2 Assessor
1.5.3 Effector
1.5.4 Communication network
1.6 Need for Control
1.7 Complexities in designing management control
1.8 Activities in Management Control
1.9 Scope of Management Control
1.10 Strategic Planning
1.11 Operational Control
1.12 Management Control
1.13 Output of Management Control Systems
1.14 Summary
1.15 Key Terms
1.16 Questions
1.16.1 Multiple choice questions
1.16.2 State whether true or false
1.16.3 Theory questions
1.16.4 Business cases
1.17 Further Reading and References :5
Introduction to 1.0 Introduction
Management Control
Systems In this unit we get an overview of what control systems are all about. We discuss the
elements of control, why organisations need control and why designing control is not a
NOTES
simple and straightforward process. We also identify the activities involved in the control
process and the scope of management control.
1.2 Meaning
Control is perceived as the ability to wield considerable influence on something or
someone. When we say that things are under control we imply that nothing untoward
has happened. Simply put, it means that things are happening as planned. Therefore
control can be viewed as everything that happens between planning and achieving planned
objectives. What could happen between plan and result? Well, for starters, plans could
simply go wrong. You might be planning for a hot summer picnic and it might begin to
rain! A company may plan to launch a revolutionary feature in the key board and touch
screen may hit the market before the key board variant does. So while a good plan is a
good start, a good control system needs to be in place to ensure success in organisations.
The definition of control has evolved over years from one focussing on quantifiable
information to assist management decisions to include a much broader scope of information
that links the organisation to the external environment. From being passive tools which
merely provided information, newer approaches embracing sociological orientation make
management control systems dynamic and interactive.
a) Organizational theory - the strongest influences are the organizational chart, the line
and staff relationships, and the role of the controller in the organization. Management
accounting followed organizational theory evolution through classical, neoclassical (behavior
or human relations), systems, and contingency approaches.
b) Behavioral approaches capture the effect of motivation, habits and culture on the
behavior of individuals. For example, incentive plans can affect different people in the
organisation in different ways.While for some roles monetary incentives help in better
performance, certain other roles may require different kind of motivation. Similarly, while
sales team can be incentivized by commission on volumes, an audit team may need different
kind of incentives. Management control systems’ explicit aim is to positively affect the
behavior of individuals through identifying the behavioural impact of decisions. :7
Introduction to
Management Control
1.4 Purpose of Management Control System
Systems
The purpose of management control system is to assist the management in the coordination
NOTES of the parts of an organisation and the steering of the parts towards the achievement of
its overall purposes, goals and objectives. A control system is designed to bring unity out
of the diverse activities of an organisation as it seeks to fulfil its overall purpose.
Management Control Systems enables various parts of an organisation to function as
one and ensure that the sum of all parts is greater than the parts themselves.
· Management Control System plays the role of bringing about unity of purpose
to these diverse parts of the organisation.
1.5.2 Assessor
1.5.3 Effector
When the actual performance is measured and compared against the desired or expected
performance, then the actual performance may exceed expectations or fall short. In
case performance falls short of expectations, then the effector alters behaviour if assessor
so desires.To continue with the same sales example, if the sales of biscuits has come
down, the advertisement can be modified to reach out to the children as target audience.
The transmission of information between the detector and the assessor and between the
assessor and the effector is achieved by Communication network. For example, the
sales team may decide to meet once in two weeks to review performance and take
desired corrective actions. This can be achieved only if a meeting is organized and members
of the team communicate with each other.
Do these difficulties make a case for absence of controls in organizations? Not at all!
Despite the difficulties associated with framing and maintaining controls in organizations,
several factors are at play in the current business environment. Globalised nature of
competition, availability of real time information, accelerated technological changes and
shorter life cycles of products and technology have made the business environment
extremely complex, thereby making effective controls inevitable. Some of the advantages
that good control systems can bring to organizations are as follows:
: 10
· Controls provide strategic advantages for a business. Good controls systems Introduction to
Management Control
are usually designed in the context of each organization’s uniqueexternal Systems
environment, technology, strategy, orga-nization structure, culture, and top
NOTES
management style.
The reasons why management control may be more complex as compared to simpler,
mechanic controls are discussed as follows: Check Your Progress
Why do you think
management control is self
· Difficulties in setting standards .Standards are not objective in real business - control ? Can you think of
an example ?
environment. While it is easy to set an ideal room temperature and get your
machine to give the desired level of cooling, there are no such ideal standards
readily available in several areas of business. For example, if an organization
: 11
Introduction to wants to exceed the preceding years sales by ten percentage points that may
Management Control
Systems be a subjective decision of the management. It may not be the ideal or standard.
· The connection from perceiving the need for action to determining the
action required for the desired result may not be clear. While driving a car,
when the driver senses an obstacle ahead, he pulls the brake and the car stops
or slows down. Once the obstacle is cleared speed can be restored. Therefore
the driver knows clearly that pulling the brakes will slow down the car. However
in a business environment, suppose a manager senses obstacles in terms of
increased competition, then he may decide to increase marketing efforts.
However increasing marketing efforts is no guarantee that sales will not decline.
Therefore the need is to face competition; but the course of action is not as fool
proof as pulling the brakes in the car.
: 12
1.8 Activities in Management Control Introduction to
Management Control
There are several activities involved in the management control process. Systems
NOTES
· Planning- Management Control begins with planning. Planning is closely linked
to the strategic theme of the organization. Once the planning process is kick
started, the various agencies involved in implementing the plan are identified
and their role is defined.
One must remember that the control process is not finite, does not have definitive
boundaries or a clear starting and an end point. It is an ongoing process that has
to run as long as the business is running.
: 13
Introduction to
Management Control
1.9 Scope of Management Control
Systems
The scope of management control includes strategic planning, management control and
NOTES operational control. Strategic planning involves drawing a road map covering the medium
to the long term of the business. Management control converts these plans into action
points and communicates them downwards to the operational team and also reports the
results from operation back to the top management. Operational control involves
implementation of the plans so that themes envisioned in the strategy are realised as
planned.
: 14
Introduction to
1.12 Management Control Management Control
Systems
Indirect activities come under the purview of management control. Indirect activities
involve staff functions such as human resources, marketing etc. However management NOTES
control also involves line activities. As such, management control involves a combination
of long term and short term. The strategy of the top management is broken down into
functional budgets and communicated to the operational teams. This is a function of
management control.Hence management control involves line and staff functions.
Management control is also a two way process where communication happens from
top management to the operational teams and vice versa. Also management control
function is all pervasive since it spans across all levels of management. Otley, Broadbent
and Berry (1995) consider management control as an activity that links operational
control and strategic planning.
The scope of management control is also not limited since it involves reciprocal functions
of conveying instructions to the lower management and reporting the operational results
to the top management.
Management control occurs between the top and the lower levels because it involves
communication of strategies to lower level and reporting operational efficiencies to the
top management. Strategy has long run focus and operations have short run focus.
Management control is a combination of both planning and control.
1.14 Summary
A set of interrelated communication structures that facilitates the processing of information
for the purpose of assisting managers in coordinating the parts and attaining the purpose
of an organisation on a continuous basis is called as Management Control System. The
purpose of management control system is to assist the management in the coordination
of the parts of an organisation and the steering of the parts towards the achievement of
its overall purposes, goals and objectives. The elements of a control system are detector
which measures what is happening in the process; assessor which determines the
significance of what is happening by comparing it with the expected performance or the
standard performance; in case performance falls short of expectations, then the effector
alters behaviour if assessor so desires; the transmission of information between the
detector and the assessor and between the assessor and the effector is achieved by
communication network. Developing control systems in organization is extremely
complicated and involves coordination between several people, several functions, several
time frames and several aspirations. Yet Controls are important because they provide
strategic advantages for a business, facilitate “management by exception”, facilitate
efficient functioning in the business and provide for a self correcting mechanism.
Management control is more complex because unlike automatic machines where all
Strategic plan covers some aspects or part of business at any given time and is
infrequent and need based. Strategy is more a function of the external environment
and is closely linked to external environment.
1.16 Questions
1.16.1 Multiple choice questions
1. Management Control is different from operational control because:
ii. Management Control includes both short term tasks as well as long
term activities
NOTES i. Control process is not finite, does not have definitive boundaries or
a clear starting and an end point
ii. It involves the control of all activities by not allowing any external
influences
iii. It is very expensive to implement and does not justify the cost
involved
i. Assessor
ii. Detector
iii. Effector
5. This involves drawing a road map covering the medium to the long
term of the business
i. Strategic planning
1. Controls are not necessary because they are expensive to design and
cumbersome to maintain.
: 18
3. The output of management control is always measured by the financial Introduction to
Management Control
measures. Systems
4. Operational control relates to the near term activities of the business. NOTES
Identify the major elements in their control system, the set of activities that may
be involved and set out a scope for the control system to be designed.
7. MSM Himachal Limited manufactures fruit juices and syrups. The sales have
decreased since the last three years and there has been serious competition in : 19
Introduction to this segment making survival difficult. They have been operating with informal
Management Control
Systems control systems since a formal system of controls may be difficult and expensive
to install.
NOTES
Can a good control system improve things for the company? How will it help?
Anthony and Govindarajan, Management Control Systems, 12th Edition, Tata McGraw
Hill
Hanzlick and Bruhl, Management control systems as a package, CIMA Journal, Volume
13, Issue 2, April 2013
Maciariello and Kirby, Management Control Systems- Using Adaptive Systems to Attain
Control, 2nd Edition, Prentice Hall India, pp-1
Simons, R. Levers of Control: How Managers Use Innovative Control Systems to Drive
Strategic Renewal. Boston: Harvard Business School Press, 1995.
: 20
Introduction to
Unit 2: Approach to Management Control Management Control
Structure Systems
: 21
Introduction to
Management Control 2.0 Introduction
Systems
So far, we discussed themeaning and purpose of Management Control Systems, elements
NOTES
of control systems, need for control in organizations, complexities in designing
management controls, activities in management control and the scope of management
control. In this Unit we discuss the approaches to management control. We learn the
evolution of each of the approaches and the role of business strategy in control systems.
Controls in organisation are not made to order. There is no organisation that has a
perfect control system in place, to begin with. A good control system begins with planning.
Examples of failed enterprises on account of lack of planning are several. Studies have
shown that lack of planning is a key factor in explaining failure of a start-up business
(Lussier, 1995).1
(Footnotes)
1Lussier, R. N. (1995). ¯A ,Nonfinancial Business Success
Versus Failure Prediction, Model for Young Firms,Journal of Small Business
Management , 33(1), 8-20.
: 22
Approaches to management control are varied in perspective. In fact, one of the most Introduction to
Management Control
popular approaches to management control is that there is no best approach to controls. Systems
This is popularly known as the Contingency approach or contingency theory, which
NOTES
would be discussed later in this Unit.
Merchant and Otley (2007) opine that “MCS is designed to help an organization adapt to
the environment in which it is set and to deliver the key results desired by stakeholder
groups”
Contingency theory approach is reactive in its broad approach and the other popular
approach is the cybernetic paradigm which is proactive.
: 23
Introduction to
Management Control
2.3 Contingency Theory
Systems
The name simply means that structure and process depend, or are contingent upon
NOTES various internal and external factors. This theory was developed in the 1960s by Tom
Burns and G. M. Stalker in Britain and Paul Lawrence and Jay Lorsch in the United
States.
Contingency theory is a core-element and assumes that the environment or the internal
and external context of a system or an organization has a strong impact on the
performance and efficiency of the system. It is assumed that there is no such thing as
universally applicable systems but often the situation that systems have to adapt to a
specific context to be efficient (Schreyögg& Steinmann, 1987).
their situation-specific demands will achieve the best adaptation. (Scott, 2005)
Referring to MCS, contingency theory argues that the design of control systems is
contingent upon the context of the organizational setting and the strategic focus in which
these controls operate. A better match between the control system and the contingency
variables is hypothesized to result in increased organizational and individual performance.
Contingency theory in this context arose in response to a broad approach which argued
that optimal control design can be applied in all settings and firms.
to achieve efficiency and consistency. Certainty and predictability permit the use of
policies, rules, and procedures to guide decision making for routine tasks and problems.
One can easily imagine some structures that have the characteristics of mechanistic
structures. State owned businesses, monopolistic businesses etc., would have certainty
and predictability. This also results in rule based organisations resulting in what is commonly
called as “red tape” or delayed decision making owing to such rigid structures.
Small organisations may have informal structures. Owner driven organisations might
have random controls and power centres while large organisations might have more
layers and have more formalized structures. Hence organizational size is another
contingency variable thought to impact the effectiveness of different organizational forms.
The contingency approach in strategy literature holds that the appropriateness of differ-
ent strategies are contingent on competitive settings of businesses. The competitive
setting is typically defined in terms of environmental and/or organizational contingen-
cies. Firms operating in highly competitive business environment needs to have differ-
ent types of controls. They need to have controls which are external to the organization
such as customer feedback, competing product analysis etc. However, firms operating
in less competitive environments need to have internal controls such as inventory man-
agement, performance management etc.
Organizations operating within a country may have to adapt to variations in local, state,
Check Your Progress and federal laws and regulations. Organizations operating internationally may have to
How does organisation size adapt their organizational structures, managerial practices, and products or services to
influence the control system
? differing cultural values, expectations, and preferences. The availability of support
institutions and the availability and cost of financial resources may influence an
organization’s decision to produce or purchase new products.
Each of the above variables discussed have an influence on the control systems designed
by the organisation.
NOTES
Meaning of cybernetics
• Cybernetics is the science of communication and control, dealing with the self-
regulating properties in different systems (machines, human body).
4) Computing variances
Check Your Progress The next step in this process is to compare the actual number of additional units
What is the role of feedback
in the cybemetic paradigm? produced by the equipment and comparing it with the anticipated increase.
4) Computing variances
In case the actual number of units exceeded the expected output, then there
would be positive variances. In case the expected output exceeded the actual
output, then there is an unfavourable variance. Computation of variance is an
important step because it is at this stage that the organisation is alerted about
need for corrective action.
The reasons for the variance could be several. One of the possible reason
could be the performance of the equipment itself, but other reasons could be
improper installation, handling, improper inputs or scale inefficiencies which do
: 28
not necessarily relate to the equipment. Once the reasons have been identified, Introduction to
Management Control
then corrective actions can be taken. Systems
The corrective action would depend upon the root causes identified. There could
be several corrective measures possible including training the staff to handle
the equipment so that the results are optimized, or re-evaluate the performance
and get the vendor’s inputs on improving the performance.
variances would mean that the causes are identified and corrected immediately.
Once the corrective action is taken, the loop goes back to Stage 3- that is
comparing actual achievements with the goals.
From the analysis of the essential elements we can say that the cybernetic paradigm
starts with the assumptions that decision are made after the interaction between the
manager (decision makers) and the external environment. The manager scans and
observes the external environment from the data collected by the “sensors” through
reports and informal discussion with the members of the organization. The managers
build up their perceptions based on the “factual premises” drawn from the data collected.
In the next process, the factual premises are compared with the goals and objectives set
by the organization. Every possible step is taken by the management to eliminate/ minimize
the gap between value premises of the managers and the factual premises drawn from
the external environment, by analyzing the variance between the actual performance
and the desired result. In case of the adverse variance or shortfall in performance, the
managers take appropriate course of action as implementation process, to eliminate the
variances.
In the implementation stage, the managers put in practice the desired control mechanisms.
In the next stage which is called the “feedback stage”, the required feedbacks are
gathered to find out the reaction of the implementation action. If there is a positive
: 29
feedback, same action is repeated again in similar situation in future.
Introduction to
Management Control
Systems
NOTES
Organisational contingencies usually is the position of the organization vis a vis its
competitors. Mobile Handset manufacturers, for example face severe threat from
competitors forcing them to evaluate their competitive strategies periodically.
Strategies for high market share businesses; low market share businesses; effective
low market share businesses; market leaders, challengers, followers and nichers may
: 30
be different from one another. An entrant into an untested market may have different Introduction to
Management Control
strategies as compared to players who enter a mature market. An extremely interesting Systems
example of late entrant into a market is being witnessed in the Indian market today-
NOTES
Patanjali products which have used competitive pricing to acquire rapid growth in the
Indian fast moving consumer goods (FMCG) category.
The kind of controls that organisations would devise would depend upon each of the
variables as discussed above.
Hence the control process depends upon the hierarchical structure present in the
organization.
Concept in Action
: 31
Introduction to
2.11 Summary
Management Control
Systems
This Unit gives an overview of the basic approaches to management control. Controls
NOTES could be reactive and dependent on the external environment, or proactive and follow a
systematic approach. The former, known as contingency theory also proposes that control
depends upon the contingency variables such as organisation environment, size, and
work force technologies etc. Cybernetic paradigm suggests an eight step approach in
controls beginning with establishing goals and performance standards, measuring and
assessing the actual achievements, comparing actual achievements with the goals,
computing variances, inform the variances by way of reporting, identifying the reasons
for variances, taking appropriate action to stop adverse variances in future and constant
follow up actions to ensure compliance of the goals or objectives. Controls also vary
depending upon the business strategies and organisational hierarchy.
Cyberneticsis the science of communication and control, dealing with the self-regulating
properties in different systems (machines, human body).
: 35
Introduction to
Management Control Unit 3: Designing Management Controls
Systems
Structure
NOTES
3.0 Introduction
3.1 Unit objectives
3.2 Designing Management Controls
3.3 Steps in designing Management Control System
3.4 Role of Information Technology in Management
Control Design
3.5 Application of Information Technology in Organization
3.5.1 ERP Software
3.5.2 Email
3.5.3 CRM Software
3.5.4 Inventory management Software
3.6 Summary
3.7 Key Terms
3.8 Questions
3.8.1 State whether true or false
3.8.2 Theory questions
3.8.3 Business case
3.9 Further Reading and References
: 36
Introduction to
3.0 Introduction Management Control
Systems
In this Unit we look at designing managing controls and the important factors that
influence the design of management controls. We also understand the role of information NOTES
If organisations are left to their own devices, there is resultant disorder and chaos. A
Check Your Progress
Give an example of key
managerial control system seeks to reduce this chaos by bringing unity out of the diverse result and its measurement.
efforts of the various parts of the organisation. A purely mechanical control system can
achieve control only within the range of disturbance that it was designed to handle. An
air conditioner for example will regulate the temperature of air at the set parameters -
not more, not less. However, managerial control systems, on the other hand must be
designed to handle problems which are not known at the time of design. Therefore
managerial controls should be adaptive.
: 37
Introduction to Management Control design should reflect the basic elements of control namely proper
Management Control
Systems goal setting, timely control and a good corrective and feedback mechanism.
NOTES
Some key factors which are of paramount importance while designing a management
control system are discussed as follows:
Punitive controls on the other hand are more focused on deviations and are
mechanisms which seek to punish errors or deviation. Late attendance record
is an example of punitive control.
While punitive controls have their place, organizations should strive to minimize
Check Your Progress punitive controls and establish constructive control to induce the desired
What is the role of
behaviour from the participants. Therefore while designing controls incentives
accountability in
management control ? could be built into the feedback that creates a healthy environment for the
controls to achieve the desired purpose.
: 38
2. Measurable Objectives: Control processes should have variables that are Introduction to
Management Control
measurable. If the variables are not measurable then the outcome is also not Systems
likely to be measurable and the control process is bound to fail. Let us assume
NOTES
that a company is tracking the sales performance of a new product that it has
launched in the market. Then the variables will have to be broken down as daily
sales off take, region wise, depot wise break up of daily sales etc. Otherwise it
would be impossible to track the sales performance of the product. When the
variables are more specific and measurable, the control also tends to be more
effective. Hence, wherever feasible, the objectives must be broken down into
measurable variables.
3. Key results: Controls must focus upon a few defined and specific key results
of an activity. If we continue with the example of the new product launch, some
of the key variables would be region wise sales figures and percentage increase
in sales volume for a given period. These would be the key result areas on
which the company would focus with respect to the new product. Significantly,
key results must be limited in number. Otherwise there is the danger of losing
the significant results and having a lot of unwanted data in hand.
and long term measures, strategic and tactical measures etc. should be aimed
for while designing a control process.
NOTES 6. Goals to be set pre activity: Goals or the projected performance should be set
ahead of the activity. Only when pre-established goals are in place there can be
comparison between the actual and the goals or the actual performance and the
projected performance. In the example of the new product launch expected
sales or projected sales should have been drawn up prior to the commencement
of sales. That would help the management to know which region matched the
projections, which of them exceeded expectations and which of the regions
could not meet the projected sales.
While designing a control system, the design should identify the role of the
employees cutting across all levels of the organisation. It should factor in the
levels of control, the reporting design and most importantly, the employee
responsible for the results of a process.
All controls have key action areas as well as key result areas. For example, if
the revenue on sales of a product is a key result area, then the key action area
would be region wise fortnightly sales report. The key action areas and the
frequency of monitoring will depend upon the criticality of the process chosen.
The expected outcome from each process and the process owner should be
identified while designing control systems. Identification of key action areas
leads to identification of the role demands. For example if revenue is to be
increased then the regional sales heads will be owners as far as the key action
area is concerned. The key result is the sales revenue.
The next step in designing the control is the understanding of likely result of role
demands. The control should be designed so that each level of facilitator in the
control system understands what the desired results are and the control system
delivers these results. A control would be successful only when the goals are
understood and the results are as close to the goals as possible.
5. Choice of controls
Check Your Progress
How does action control
The next step in designing the control system is to choose the appropriate control. differ from result control ?
Controls usually are aimed at attaining work efficiency which are called action
control or to control employee behaviour which is called result control. : 41
Introduction to Action controls work on the standard set of procedures and are directly linked
Management Control
Systems to the tasks to be performed. Number of calls attended per hour, number of
units produced per hour or number of customers serviced per day etc., fall
NOTES
under the purview of action control.
Result control, on the other hand, seeks to modify the behaviour of employees
by incentivising employees for achieving the desired goals. The controls in this
case are broader and require frequent communication between various levels
of management to ensure that the desired goal is achieved. Fixing higher incentive
slabs for selling new products, for example, will motivate the sales force to
aggressively push the new product.
Action controls are useful in case of repetitive jobs or tasks, while result control
is useful when the output cannot be defined objectively.
Choice of controls depends upon the type of organisation and the level of
innovation required in the processes.
Attempt to design a control system, using the above steps in the following
situation-
Managing responsibilities within a business entails many of the basic management NOTES
functions, like budgeting, staffing, and organizing and controlling, along with other aspects
that are unique to technology, like change management, software design, network planning,
technology support etc. Overall, the more complex a process is, the more likely the
MCS will be organic and less traditional. This implies that the complex processes will
also require technology intervention for effective management. Technology enablers
encompass software, hardware and telecommunication networks used for managing
information.
NOTES significantly better than its competition and information technology gives this
competitive advantage to businesses. One only needs to look at how banking
has been brought into the palm of the customer to understand the differentiation
advantage that technology provides. Several banks now focus on giving a mobile
phone enabled application to enhance customer experience and save the travel
time to the bank.
Some of the business applications for which software support is available are as follows:
Customer Service
Online customer-service software saves time in much the same way as automated
phone systems. Examples of software for online customer service include Kayako,
Parature and Zoho. Several companies now adopt online customer service which not
only helps in acquisition of new customers but also helps in retention of existing customers.
This software contains different modules designed to handle a particular facet of the
Check Your Progress business. Enterprise Resource Planning (ERP) examples include 3i InfoTech, Oracle
Technology is a key enable E-Business Suite and Sage ERP X3. True to its name, this software helps in planning
in designing and maintaining
an efficient control mecha- enterprise resources. By aligning various functions of the business, these software help
nism in organisation.
in optimising resources and help better planning and control. For example, a completely
Justify.
integrated software will help the manger to identify how much purchases can be made
in cash and how much through credit. So when a purchase transaction is triggered the
effect of the transaction on inventory, payables and cash position can be identified.
Similarly
3.5.2 Email
Businesses use email to disseminate information to anyone in the world with an Internet
connection. Bulk e-mail is used for cheaper and better reach. The costs of these have
dropped making it a more affordable as well as preferred solution for businesses.
: 44
3.5.3 CRM Software Introduction to
Management Control
Systems
Software for customer relationship management, or CRM, streamlines the sales process.
This saves time on data processing. CRM examples include Oracle’s Siebel and Microsoft NOTES
Dynamics.
This system also helps in managing inventories when Purchase Orders are raised or
receipts are created. With efficient and comprehensive reports Inventory Management
System provides businesses a new perspective on handling stock.
Good inventory management system helps the business in the following ways:
2 Web hosted application keeps data safe in the Internet and facilitates remote
management of inventory.
3.6 Summary
Control systems should be designed for organisations, because there is no self driven
mechanism which would automatically steer organisations towards achieving their
: 45
purpose. Controls in business Management Control design should reflect the basic
Introduction to elements of control namely proper goal setting, timely control and a good corrective and
Management Control feedback mechanism. Key factors while designing a management control system are
Systems
that controls must be constructive; objectives should be measurable; Controls must
NOTES
focus upon a few defined and specific key results; controls must have balance between
various aspects of the activity being controlled; accountability must be created; there
must be pre established goals;. Controls should have early warning predictors and
sampling must be done of control variables. The important steps in designing a good
control system are Identification of role of employees; Identification of key actions;
Identification of role demands and KRAs; Understanding likely results of role demands
and Choice of controls. Also with increasing levels of complexity, information technology
plays a major role in designing controls.
Punitive controls are more focused on deviations and are mechanisms which
seek to punish errors or deviation
Action controls work on the standard set of procedures and are directly
linked to the tasks to be performed.
3.8 Questions
NOTES
6. Early warning predictors help the management to understand whether
the existing set of activities are executed as per plan.
8. The more complex a process is, the more likely the Control Systems
will be organic and less traditional.
9. Result control, work on the standard set of procedures and are directly
linked to the tasks to be performed
10. While punitive controls have their place, organizations should strive to
minimize punitive controls and establish constructive control to induce
the desired behavior from the participants.
1. What are the key factors to be borne in mind while designing a control system?
: 47
Introduction to they would like to design a control system for production to sale of the new
Management Control
Systems model.
NOTES Required:
Maciariello and Kirby, Management Control Systems- Using Adaptive Systems to Attain
Control, 2nd Edition, Prentice Hall India, pp 38-76
Katz Daniel and Robert L Kahn, The Social Psychology of Organisations, 2nd Ed.
New York, John Wiley and Sons,1986
: 48
Introduction to
Unit 4: Key Success Variables and Performance Management Control
Measurement Systems
Structure NOTES
4.0 Introduction
4.1 Unit Objectives
4.2 Meaning of Key Success Variables
4.3 Process for identification of critical success factors
4.4 Source of Key Success Variables
4.5 Types of key success variables
4.6 Examples of Key Success variables in Industries
4.6.1 Restaurant Chain
4.6.2 Magazine Publishing firm
4.6.3 Health care Sector
4.7 Performance Measurement Framework
4.7.1 Importance of Performance Measurement
4.7.2 Role of performance Measurement in Organisation
4.7.3 Prerequisites of a good Performance Measurement
framework
4.8 Key Steps in Performance Measurement
4.9 Summary
4.10 Key Terms
4.11 Questions
4.11.1 State whether true or false
4.11.2 Substitute the statements with a single word
4.11.3 Theory questions
4.11.4 Business cases
4.12 Further Reading and References
: 49
Introduction to
Management Control
4.0 Introduction
Systems
Control systems are designed to achieve certain outcomes for organisations. Such
NOTES outcomes or goals can be achieved only when the critical attributes required for
success is identified. These critical attributes are known as key success variables.
We will examine why these key success variables are important in performance
measurement of organisations.
Key Success Variable is the term for an element that is necessary for an organization or
project to achieve its mission and is a critical factor or activity required for ensuring the
success of your business. They usually encompass those few things that must go well to
ensure success for a manager or an organization, and, therefore, they represent those
managerial or enterprise area, that must be given special and continual attention to bring
about high performance. Key Success Variables include issues vital to an organization’s
current operating activities and to its future success.
Critical success factors represent performance areas that must meet expectations if
Key success factors are usually a combination ofinternal as well as external factors.
They could be influenced by the strategy of the business, cost models, customer
segmentation or product differentiation.
Deliberations among top management team regarding the importance of the factors
identified and their impact analysis on the desired results, may bring out the real critical
success factors to the fore front. Also deliberations regarding obstacles that can be
foreseen in the way of accomplishing the business objectives of the company may
provide insights into the understanding of critical success factors.
Consequently, critical success factors are an important link between strategic plans and
performance measurement systems.
: 51
Introduction to
Management Control 4.4 Source of Key Success Variables
Systems
Key success variables can reliably be derived from five sources:
NOTES
1. Industry Characteristics
There are several characteristics peculiar to an industry and therefore key
success variables would vary according to industry characteristics. Costs are
often critical for manufacturing organisations; advertisement revenues are
very important for newspapers and television channels; investment performance
is critical for insurance companies; demand for value added services is crucial
for telecom companies. Transactions, customer expectations, performance
metrics, dependence on debt and several other factors lead to great diversity
between several industries and key success variables also differ accordingly.
2. Competitive Strategy
The choice of strategy further determines the variables that must be monitored
and emphasized. If a business has decided to be a low cost producer then the
focus would be upon detailed cost analysis. If a business is high on innovation
Check YourProgress
How do environmental then the focus might be on cutting edge technology. Hence the strategy is an
forces help in identifying important determinant to key success variables.
key success variables?
3. Environment forces
The environment in which a business operates often determines the key success
variables. Economic and political climate are key components of the business
environment. Fluctuation currency exchange rates, changes in interest rate
and the outlook of economy are key determinants of success factors. Similarly
a stable political and regulatory environment can result in a different set of
key variables as compared to an unstable or uncertain political environment.
During periods of political instability, businesses may not venture into new
products, new territories or heavy capital investment. Success factors tend to
be defined as a function of the environment in which the business functions.
4. Significant problems
: 52
Introduction to
Unusual problems having to do with key stakeholders such as customers, Management Control
executives, suppliers or creditors also changes business outlook. An example Systems
for this was the experience of Tata Motors at Singur, West Bengal when the NOTES
government could not assure safe operations for the business. Tata Motors had
to relocate the business and restate several of its success variables on account
of this significant problem.
5. Functional issues
Business has several functional units and each of the functional manager would
define key variables relating to their function. For the human Resources
Department, it might pertain to bringing down attrition rates while for the
marketing department it might be to increase product visibility. The most important
thing however, is that the functions should work for common organisational
goal even if each of them define success differently.
1. Strategy variables
Check Your Progress
Strategy variables refer to the variables linked to the long term choices of a How is structural variable
different from process
firm. A firm may decide to be a differentiated producer in which case the variables variable ?
2. Structural variables
Structural variables would depend upon the structure of the organisation. If the
organisation is vertically divided then the SBU (Strategic Business Units) would
have goals for their respective divisions. In a functionally divided organisation,
the variables would depend on the function performed by the Divisions. For
: 53
Introduction to example, the human resource function would identify quality of personnel,
Management Control
Systems employee satisfaction and attrition rate as key variables.
NOTES
3. Process variables
Process variables refer to the processes that influence the behaviour of the
employees towards achievement of organisational goals. They could be the
performance measurement variables which could be the rewards, responsibilities
and the powers and authority to be given to employees.
4. Environmental variables
Environmental variables help in understanding the scope, diversity and uncertainty
with regard to a firm. Key variables and performance have a positive correlation
if these variables induce goal congruent behaviour among stake holders.
Calfas (1990) designed a financial simulation model of growing restaurant chains and
the model identified the following critical success factors for restaurants:
Customer focus:
Growing restaurant chains need a growing number of competent managers. The success
of these chains is contingent upon recruiting and retaining competent store managers.
This requires good recruitment techniques as well as good incentive programmes to
motivate the employees.
: 54
Adaptability: Introduction to
Management Control
Systems
This business requires constant reinvention and keeping track of changing tastes and
sensibilities of customers. This is a very fundamental requirement of this business NOTES
Value
The ratio of value to price is a key success variable because customers need to leave
the restaurant with the feeling that the restaurant delivered value.
Roger Hall (1973) developed a model after empirically testing 20 years’ data of Saturday
Evening Post magazine. The key success variables that were identified were:
· Advertising Sales
· Advertising expenses
· Trial subscriptions
The inter relationship between the above variables were studied to understand how
these ultimately affected the profitability of the business.
A Survey had been conducted in USA during 2012-13, on behalf of a healthcare sector,
to identify the success factors for a change initiative. Based on the responses of 64
leaders in health care sector, the top three success factors are identified as given below
: 55
Introduction to · Culture and values
Management Control
Systems
· Business processes and
NOTES
· People and engagement
Two unique success factors were also identified only pertaining to the healthcare sector
and not common in the literature of change models. They were service quality & client
satisfaction, and access to information.
2. To Control how managers can ensure their subordinates are doing the right thing.
4. To Motivate Giving people significant goals to achieve and then use performance
measures, including interim targets, to focus people’s thinking and work, and to
provide periodic sense of accomplishment.
7. To Learn Learning is involved with some process, of analysis of information provided NOTES
from evaluating corporate performance and identifying what works and what does
not.
A good performance measurement framework will focus on the customer and measure
the right things. Performance measures must be:
Initially, the firm needs to focus on a few key goals that are critical to the success of
the organization or business, and ensure they are SMART, i.e.:
Specific
Measurable
Achievable
Relevant
Timely
Organisational objectives could be long term goals- for example, to attain market
leadership. Such objectives, however, cannot fructify unless they are converted into
desired standards of performance. A contemporary example to understand this could
: 58
Introduction to
be the initiative of the Ministry of Power of the Government of India. In order to shift Management Control
towards conservation of energy the Government decided to distribute LED bulbs. Targets Systems
have been set towards the same. Note that the objective of conservation has been NOTES
converted into something more measurable, namely LED bulbs. Use of these over
conventional bulbs should theoretically result in energy conservation.
Now the target is both specific and measurable. The website of the Government of
India has a dashboard which displays on a real-time basis, the number of LEDs that
have been distributed. It also shows a state wise break-up of the same. Note that LED
is a relevant measure for energy conservation and it is also measurable. To see how the
entire system works, one can log on to the portal of the Ministry of Power. Several
measures such as the number of villages electrified, the number of grids electrified etc.,
are available giving a glimpse into how objectives can be broken down into meaningful
and measurable indicators.
2. Development of performance metrics
Goals by themselves would not serve any purpose unless followed up with definite
outcome metrics. Outcome metrics are the translation of goals into measurable attributes.
The outcome measure for an effective Human Resources process, for example could
be reduction in attrition rate, while the goal could be happier employees. If it is difficult
to define outcome metrics for a particular goal, it is possible that the goal is either not
“SMART” or critical to the success of the business.
Good or bad performance cannot be established unless clear cut metrics are developed
to measure performance. Let us assume that a firm is selling in a competitive, but
growing market. If the market is growing at the rate of 20% the firm has to set the
desired target accordingly. Once the metrics are developed either region wise or product
wise, it becomes easier to compare it with the actual performance.
The Performance Measurement system:
(1) assesses the effectiveness of the Strategy and its supporting programs,
(2) Provides information to the entire organization on what needs to be done to refine
policy and programmatic directions, and
: 59
Introduction to The Performance Measurement system fulfills guidelines that the organization contains
Management Control
Systems measurable objectives and specific targets to accomplish long-term quantifiable goals.
These targets and annual reports are intended to inform appropriations and authorizing
NOTES
committees as they restructure appropriations in support of the Strategy to ensure that
resources necessary to attain ambitious long-term performance goals are provided.
3. Identification of gaps
Gaps are identified by comparing the budgeted performance or the targeted performance
with the actual performance. For example the projected income statement is compared
to the actual income statement to identify the gaps in anticipated performance to the
actual performance. Variances are calculated and the major variances are identified.
It is certainly neither necessary nor possible that all standards will be achieved. Gaps
are bound to occur and can be both positive as well as negative. Identification of gap is
not to be a fault finding exercise, but to understand the source of the variance or the
cause of the gap. This exercise helps the firm in either correcting the standards if the
standards are unrealistic or significant changes have occurred in the business environment
since the standards were first set, or to embark on a course correction in case there
have been major deviations from the set course.
4. Improvement Actions
Once the gaps are identified, improvement action plan is put in place. The entire process
of control is meaningless without a standard or goal in place. The reason why
Check Your Progress organisations set standards is because that gives a clear action plan. Improvement actions
How do improvement
are initiated depending upon the stated goals of the business. Even though all businesses
actions help inactieving
goals of business ? exist to maximise wealth through increase in profits, near term goals could be technology
improvement, customer delight or increase in product profile. Therefore any improvement
measures are suggested keeping in mind both the long term as well as short term objectives
of the business.
In conclusion one can say that processes can be measured effectively and measurements
may be applied to many aspects and attributes of processes. Some of the critical measures
are could be quality of output, timeliness, cost (financial), and scale. These measures
act hierarchically within all organizations at three levels of performance.The three levels
of hierarchy are organisation level, process level and the individual manager level. This
: 60
combination of measuring different attributes of the organization within a hierarchical Introduction to
Management Control
structure is called an integrated performance measurement framework (PMF). The Systems
most important aspect of this for management accountants is that measurement of
NOTES
performance of all attributes can be directly traced to financial goals and results, and
vice versa. Therefore, if the purpose of all commercial organizations is to increase
wealth, the establishment of a tightly integrated PMF is highly desirable. This is not to
say that only financial goals need to be measurable or can be measured. However
every objective has to ultimately be linked to performance and therebytg5 value
maximisation.
4.9 Summary
Key success variables are those variables in the external environment to which the
goals, objectives and strategy of managers are most sensitive. Identification of key
success factors is not a simple job. The complexity increases because of the
interrelationship between various variables. Critical success factors are an important
link between strategic plans and performance measurement systems. Key success
variables can reliably be derived from five sources-Industry Characteristics, Competitive
Strategy, Environment forces, significant problems and Functional issues. Key success
variables can be classified as strategy variables, structural variables, process variables
and environmental variables. Performance Measurement is the process whereby an
organization establishes the parameters within which programs, investments, and
acquisitions are reaching the desired results. A good performance measurement
framework will focus on the customer and measure the right things. There are four key
steps in a performance measurement framework - strategic objectives of the organization
are converted into desired standards of performance, metrics are developed to compare
the desired performance with the actual achieved standards, gaps are identified, and
improvement actions are initiated.
4.11 Questions
3. Even though business has several functional units and key variables
are common across all functions
3. This refers to the variables linked to the long term choices of a firm
1. What do you mean by Key Success Variables? Explain with simple examples.
Calfas, Robert A., Why Growing restaurant Chains can Fail: A computer Simulation
Model, Ph D Dissertation , Claremont Calif:, Clarimont Graduate School,1991 : 63
Introduction to De Vasconcellos E Sá, J. A. S. and Hambrick, D. C. (1989), Key success factors: Test
Management Control
Systems of a general theory in the mature industrial-product sector. Strat. Mgmt. J., 10: 367–
382.
NOTES
: 64
Introduction to
Unit 5 : Behaviour in Organisations Management Control
Systems
NOTES
Structure
5.0 Introduction
5.1 Unit Objectives
5.2 Meaning of Goal Congruence
5.3 Importance of Goal Congruence
5.4 How Conflict arises in organisations
5.5 Role of Controls in Goal congruence
5.6 Factors affecting goal congruence
5.6.1 External factors
5.6.2 Internal factors
5.7 Formal Control process
5.8 Types of organisations
5.8.1 Functional Structure
5.8.2 Divisional Structure
5.8.3 Adaptive Structure
5.9 Functions of the controller
5.10 Management controls for differentiated strategies
5.11 Summary
5.12 Key terms
5.13 Questions
5.13.1 Multiple choice questions
5.13.2 Theory questions
5.13.3 Business cases
5.14 Further Reading and References
: 65
Introduction to
Management Control 5.0 Introduction
Systems
We saw how controls are designed differently for different organisations. In order to
NOTES
have effective controls organisations need to have well defined and clear focus. Individual
focus should be subservient to organisation focus. In this Unit we see how a common
focus or goal congruence contributes to better outcomes in organisations. We also
understand how controls are designed for differentiated strategies.
consistent with the organisational goals. Goal congruence is the process of integrating individual NOTES
goals to the organisational goals and ensuring that individuals or groups within the organisation
do not work at cross purposes. To ensure goal congruence is the central purpose of a
management control system.
Goal congruence is achieved when individuals in the organization strive or are induced
to strive towards the company goals. This assumes, of course, individuals are aware of
company goals and the derivative performance criteria. The essence of company’s
goals is conveyed by planning process, which expresses these goals in terms of budgets,
standards and other formal measures of performance. Management must tailor the
planning activities to encourage goal congruence at various levels of management. To
achieve goal congruence the following ideas are important –
· The firm should be viewed as pluralist entity where coalitions of individual seek
Check Your Progress
to express their own aspirations within the structure of the firm.
Why is it difficult to achieve
goal congruence ?
· Personnel cannot be viewed as people sharing the same goal, but also as people
striving for such rewards such as power, security, survival, and autonomy.
Example 1– The HR manager has devised a HR training program to enhance the skills
of its sales personnel, with an objective to enhance their productivity. But if company is
in strategic need of attaining a certain sales volume in a given quarter, it cannot do so on
account of non-availability of personnel.
: 67
Introduction to organisation may also conflict with one another, with individuals and group objectives. A
Management Control
Systems bargaining process may be necessary to reduce these conflicts in the goal setting process.
NOTES Goal Congruence is achieved when the same goals are shared by top managers and their
subordinates. This is one of the many criteria used to judge the performance of an accounting
system. The system can achieve its goal more effectively and perform better when
organizational goals can be well aligned with the personal and group goals of subordinates
and superiors. The goals of the company should be the same as the goals of the individual
business segments. Corporate goals can be communicated by budgets, organization charts,
and job descriptions. In fact the budget may be considered as the key mechanism for stabilization
Check Your Progress of that process, that is, a bargaining medium through which individuals and groups try to
How does goal congruence
help in motivating the further their own goals.
employees ?
Needless to say achieving goal congruence is very important for organisations. In the absence
of goal congruence, organisations will be conflict ridden and it would be impossible to achieve
the organisational objectives. Goal congruence helps the organisation in the following ways:
(i)profitability, (ii) market position, (iii) productivity, (iv) product leadership, (v) personnel
development (vi) employee attitude, (vii) public responsibility, and (viii) a balance between
short-range and long-range goals.
: 68
Introduction to
· The marketing Department will be concerned about market position, but not Management Control
necessarily about productivity. Systems
NOTES
· The Human Resources Department may be concerned about employee attitudes,
but not profitability.
· Hence it is obvious that the concern of a set of people is not necessarily the
concern of a different set of people.
To achieve the goals of each of the Departments, they all may need resources. Check Your Progress
What is problem of shared
Organisations may have limited resources. Therefore problems of shared resources
resources ?
could be as follows:
1. All the various stakeholders who might be performing different functions will
first meet to agree on the common goals.
2. Each of the objectives, namely (i)profitability, (ii) market position, (iii) productivity,
(iv) product leadership, (v) personnel development (vi) employee attitude, (vii) public
responsibility, and (viii) a balance between short-range and long-range goals must
be discussed with all the stakeholders namely the marketing department, production
department and the human resources department.
: 69
Introduction to 3. A budget process must be put in place so that the amount of resources available
Management Control
Systems to various departments to fulfill their respective objectives is clearly
communicated to them. This way, neither would there be mismanagement of
NOTES
resources, nor will conflicts arise owing to limited resources.
Hence in order to achieve goal congruence, the organization has to work in a way that
it reviews its operations and activities to ensure that none of them limit or inhibit the
organization’s ability to reach its goals, whatever they may be. Any system can achieve
its goals more effectively when the organizational goals are well aligned with the personal
and group goals of the subordinates and superiors. Essentially, the goals of the organisation
should be the same as the goals at individual business segment levels. These corporate
goals can be communicated by budgets, organization charts, and job descriptions.
Thus, the system should not encourage the individual to act against the best interests of
the company. The management control system may suggest that it is extremely crucial
and critical that costs be reduced, however if a manager responds by reducing costs at
the expense of minimum quality requirement or if he responds by reducing costs in his
own responsibility centre by measures that leads to an effect which increased costs in
some other responsibility centre, it means that although motivated, his action is not
towards organizational goal congruence.
There is a possibility for anyone to relate goal congruence with motivation. There is a
close link, however, as motivation involves desire for a selected goal and the drive or
pursuit towards the goal, it has two aspects, namely congruence and effort. The
: 70 achievement of goal congruence may also be affected by the degree of freedom to
make decisions, i.e., autonomy given to the managers. Therefore, while designing a Introduction to
Management Control
control system, the three important aspects related to goal congruence, managerial effort Systems
and autonomy should be given due consideration, with a view to motivating managers to
NOTES
achieve organizational goals.
Goal congruence is present when individuals, departments and divisions focus their efforts
on meeting organisational goals. To ensure as far as possible that managers and their
subordinates work toward the achievement of organisational goals requires attention
being paid to their levels of motivation.
The degree of goal congruence that exists between the goals of the subunits and the
overall organisational goals will be much or little, depending upon the rationality of the
control structure including responsibility centre designations and the efficiency with which
the sub unit manager attends to key success factors affecting his or her goals.
Factors affecting goal congruence are classified into external and internal factors.
External factors are norms of desirable behaviour that exists in a society of which the
organisation is a part. These norms include a set of attitudes, often collectively referred
to as the work ethic, which is manifested in the employees’ loyalty to the organisation.
Example:
Indian businesses, especially the non-corporate ones often function on the basis of faith
and goodwill. The World Development Report 2001 reveals as to how the majority
community of Tirupur was able to succeed in the knitted garment industry due to the
transfer of capital through community networks. In the Indian context, community
relationships provide certain benefits and cost advantages in business. Such communities
: 71
Introduction to festered high degree of entrepreneurship, high ambition and used community based
Management Control
Systems relationships to increase efficiency and reduce costs.
NOTES Being part of such business infuses the work force with certain work ethic which is
derived from the external environment.
: 72
Introduction to
5.8 Types of organisations Management Control
Systems
Different types of Organization structure can be created on the basis of arrangement of
activities. Accordingly, three broad types of structural forms are: NOTES
When units and sub-units of activities are created in organization on the basis of functions,
it is known as functional structure. All activities connected with each such function are
placed in the same unit.
The divisional organization structure is more suited to every large enterprise particularly
those which deal in multiple products to serve more than one distinctive markets. The
organization is then divided into smaller business units which are entrusted with the
business related to different products or different market territories. Each divisional
manager is given autonomy to run all functions relating to the product or market segment
or regional market.
: 73
Introduction to
Management Control
Systems
NOTES
Organizational structures are often designed to cope with the unique nature of undertaking
and the situation. This type of structure is known as adaptive structure. There are two
types in structures.
manage
: 74
Introduction to
Management Control
Systems
NOTES
· Designing and operating information and control systems. Check Your Progress
Identify any two important
· To regulate, supervise and implement a timely, full and accurate accounting set of functions of a controller ?
books of the firm reflecting all its activities subject to internal guidelines set from
time to time by the BOD.
· Preparing and analyzing performance reports, interpreting those reports for managers
and analyzing the program and budget proposals from various segments of the
company.
· Supervising internal audit and accounting control procedures to ensure the validity
of information, establishing adequate safeguards against theft and fraud, and
performing operational audits.
· To monitor the performance of the firm, its flow of funds, the loyalty to the budget,
the expenditures, the income, the cost of sales and other budgetary items.
· To prepare and present for the approval of the BOD an annual budget, other budgets,
: 75
Introduction to financial plans, feasibility studies, investment memoranda and all other financial and
Management Control
Systems business documents.
NOTES · To meet the terms with all the accounting, reporting and audit requirements imposed
by capital markets or regulatory bodies of the capital markets in which the securities
of the firm are traded or are about to be traded or otherwise listed.
· To initiate and engage in all manner of activities, whether financial or other, conducive
to the financial health, the growing prospect and the fulfilment of investment plans
of the firm.
Differentiation Strategy
An integrated set of actions to produce or deliver goods/ services that customers perceive
as being different in many ways that are important to them.
A focus strategy exploits a narrow target’s difference between the balances in the
industry by isolating a particular buyer group, isolating a unique segment of product line
The logic for linking controls to strategy is based on the following line of thinking:
Thus, a continuing concern in the design of control system should be whether the behaviour
induced by the system is consistent with the strategy. Specific tendencies in the design
of control systems corresponding to varia-tions in corporate strategies are:
Strategic Planning
Given the low level of interdependencies, conglomerates tend to use a vertical strategic
planning system. Business units prepare strategic plans and submit them to senior
management for review and approval.
Budgeting
Transfer Pricing
Transfers of goods and services between business units are more frequent in single
industry and related diversified firms than between business units in conglomerates. In
: 77
Introduction to a conglomerate, the usual transfer pricing policy is to give sourcing flexibility to business
Management Control
Systems units and to use arm’s-length market prices.
Incentive Compensation
NOTES
The incentive compensation policy tends to differ across corporate strategies in the following
ways:
5.11 Summary
In the real scenario, senior management wants the organization to attain its goals whereas
members of the organization have personal goals, and these are not in all respects consistent
with the organization’s goals. The central purpose of the management control system is
to assure goal congruence; that is, the systems should be designed in such a way that
actions it leads people to take in their perceived self-interest are also in the best interest
of the organization.Informal factors have an important influence on goal congruence.
The most important of these is an organization’s culture or climate.Designers of
management control systems should take explicit notice of the strategic context in which
the controls are being applied. The strategies that a firm selects can be arrayed along a
continuum, with single industry firms at one extreme and unrelated diversified firms
(conglomerates) at the other. The management control process differs according to the
firm’s strategy in this dimension.Business units have missions that can be classified as
“build,” “hold,” or “harvest,” and their managers can also decide to build competitive
advantage based on low cost or differentiation. The appropriate management control
pro-cess is influenced by which of these strategies is selected for a given business unit.The
: 79
Introduction to concept of linking controls to strategies should not be used in a mechanistic manner; the
Management Control
Systems suggestions made in our report are tendencies, not universal truths. The control systems
should be designed in the context of each organization’s unique external environment,
NOTES
technology, strategy, orga-nization structure, culture, and top management style.
When units and sub-units of activities are created in organization on the basis of functions,
it is known as functional structure.
5.13 Questions
a. Budgets, organization charts, job descriptions and such other control designs
: 80
a. Designing and operating information and control systems. Introduction to
Management Control
Systems
b. Regulate, supervise and implement a timely, full and accurate accounting
set of books of the firm reflecting all its activities subject to internal NOTES
guidelines
c. Setting goals for the functional teams and ensuring proper performance
of the teams
b. Sub units are responsible for end to end delivery, cutting across various
functions of the business
b. To ensure that decisions made in self-interest are also in the best interest
of the organization
: 81
Introduction to 5.13.2 Theory questions
Management Control
Systems
1. Explain the meaning of Goal Congruence with situational examples.
NOTES
2. Why is goal congruence important in an organization?
They want to identify the strategy that would make their product successful
and also help them create controls on the basis of the strategy. You are required
to advise YRC.
2. Red Rose manufactures gift articles and sell to both retail customers and
corporate clients. They are awaiting the Diwali season when corporate place
bulk orders to distribute gifts to their customers and employees. The demand
for differentiated gifts is very high in the corporate sector and hence they cannot
mass produce gifts.
Gifts are made to order and customized according to the customer requirements
in case of corporate gifts. Retail items, in contrast are mass produced. The
Sales team which handles the Corporate Clients wants to offer the clients a
: 82
discount in price so as to push sales volumes. The Production team however Introduction to
Management Control
informs the Sales team that the rising input costs and the need to customize Systems
gifts results in increased costs.
NOTES
What are the goal congruence issues that you can identify in this case? How
would you ensure that everybody at Red Rose work towards common goals?
: 83
Introduction to
Unit 6: Responsibility Centres
Management Control
Systems Structure
NOTES 6.0 Introduction
6.1 Unit Objectives
6.2 Meaning of Responsibility Centre
6.3 Types of Responsibility Centers
6.3.1 Cost Centre
6.3.2 Revenue centre
6.3.3 Profit Centre
6.3.4 Investment Centre
6.4 Summary
6.5 Key Terms
6.6 Questions
6.6.1 State whether True or False
6.6.2 Theory questions
6.6.3 Business case
6.7 Further Reading and References
: 84
Introduction to
6.0 Introduction
Management Control
Organisations have to align to the vision and function as goal congruent entities. While Systems
organisation sub units perform for organisation goals, the functions performed by each NOTES
vary. Consequently the deliverables for each sub unit in the organisation varies. In this
Unit, we identify these sub units, popularly known as responsibility centres and identify
the roles, functions and performance measures of each of the responsibility centre in an
organisation.
In order to maximise the organisation efficiency and performance, Ionaºcu I., Filip A.T.,
Stere M., (2007) propose a three tier structure in organisations:
(ii) At the base, are the operational staff that reiteratively fulfil current tasks?
(iii) An intermediary link between the top and the base, namely, responsibility centres,
In a manufacturing company, for instance, the lowest level of hierarchy might be the
workshops or production units. These units are responsible for production or output. At
the higher levels are departments or Strategic Business Units that consist of the smaller : 85
Introduction to
Management Control units, staff and management. They are usually responsible for middle management
Systems functions such as budgeting, marketing and human resource management. At the level
NOTES of senior management and Board of Directors, they are responsible for the functioning
of the whole of the enterprise.
An entity within an organization that holds responsibility for the management of revenue,
expenses, and investment funds is known as Responsibility Center. This center is
controlled by a responsibility manager that works with other individuals in the organization
to establish procedures and accounting practices to ensure that the necessary expense
and revenue information is reported accurately. The responsibility center will also work
with accountants to make sure that the organization is meeting requirements set by the
Internal Revenue Service.
Cost Centre
A cost center is a part of the company that does not generate any profit for the company,
but they add cost to the company. The manager of a cost center incurs costs and the
center is evaluated on how well they control their costs. In any business enterprise, an
example of a cost center would be the Research and Development department. They
add to the costs of the enterprise and in an indirect way add profit to the company.
Revenue Centre
The revenue center is responsible for generating revenue for the company by selling
goods or services. A good example of a revenue center is the Sales department. The
sales department is responsible for knowing the product and being able to sell it to the
customers.
: 86
Profit Centre Introduction to
Management Control
A profit center is a department that directly adds to its profit. Profit centers measure the Systems
profitability of business units or departments. Profit centers are responsible for revenue NOTES
and costs. A good example of a profit center is the business unit as a whole. There are
many companies that are a division of the corporation. Each business unit is responsible
for maintaining their costs and revenues and generating profit for the corporation.
Investment Centre
Investment centers are a part of responsibility center involved in utilising the capital
directly to contribute to the profits of the organization. An investment center is responsible
for both profits and investments.
Responsibility centres are similar to small businesses. Each manager in charge for the
individual responsibility centre is asked to run effectively to maximise the output of the
respective responsibility centre while still keeping the interests of the organization in
mind.
Let us now discuss each of the above responsibility centres in detail. Consider a
hypothetical company ABCD Corporation. ABCD Corporation manufactures steel pipes
for various applications such as industries, construction, automobiles and infrastructure.
They procure steel and cut it to various sizes and shapes depending upon the requirement
of the customer. They have several equipment varying in levels of sophistication
depending upon the output. For example, automobile applications and industrial applications
require far more inputs in terms of product design and quality control compared to
construction and infrastructure. Let us understand how responsibility centres would
apply to ABCD Corporation.
: 87
Introduction to Engineered costs are usually expressed as standard costs. Standards can be set because
Management Control
Systems the input is usually relatable to the output.
NOTES
Standard cost centres are responsible for controllable costs, efficiency, timeliness of
delivery and quality of output.
In the context of responsibility centres, costs can be divided into controllable and
uncontrollable cost. Standard cost centres are usually responsible for the controllable
cost in the responsibility centre.
Check Your Progress person, at a given level of authority has no control. Suppose the factory is operating out
Can you think of some of rented premises, and management decides the place out of which factories operate
examples of discretionary
expenses ? and the factory head has no authority in that decision, then factory rent will be
uncontrollable cost as far as the factory head is concerned.
It must be remembered that every cost that is uncontrollable at some level is controllable
at a higher management level. So for the business as a whole, no cost will be classified
as uncontrollable for the purpose of responsibility accounting.
· They arise from periodic (usually yearly) decisions regarding the maximum NOTES
outlay to be incurred.
· They are not tied to a clear cause and effect relationship between inputs and
outputs
We can think of several examples to illustrate a discretionary expense centre. For ABCD
Corporation, the design department could be a discretionary expense centre. This is Check Your Progress
Can you think of some
because depending upon the number of new designs or requirement for designs the
examples of discretionary
output of this division may vary. There is no specific input output ratio. There could be expenses ?
several other examples for the Discretionary expense centre. Marketing Department
could be another example. There are expenses incurred for marketing but there is no
defined output that is relatable to the expenses incurred.
Because of the nature of Discretionary Expense centres, it is difficult to evaluate the
performance of these responsibility centres. A detailed discussion on the difficulties in
evaluation of Discretionary expense centres is discussed in the next Unit.
The following illustration demonstrates how each action results in bringing accountability
down to a Division level when the organisation is divided as responsibility centres.
Illustration 6.1
1. Mr. Arun had to catch a flight to Singapore to attend a “Strategic Selling Conference”
organized by Oasis Corporation, which operates across 14 countries in the world.
Mr.Arun is the marketing manager handling the India region, headquartered at
Mumbai. Oasis Corporation is decentralised and each Division operates
independently.
On the expected date of departure, riots broke out in the city and Arun was unable
to reach the airport. The ticket could not be rescheduled on the same date and
: 89
Introduction to hence had to be cancelled. The airline does not allow return flight if the onward
Management Control
Systems journey is not undertaken on the same airline.
NOTES Although the firm has a policy of booking tickets on refundable basis for all foreign
travel, this was a non-refundable ticket owing to the oversight of the Department in
charge of booking the tickets. The loss on account of this transaction amounted to
Rs.30,000/-
a. Suppose the marketing department had an annual budget for foreign travel and
all expenses had to be met out of that account, how will this loss be treated?
Solution
The situation has resulted in a loss of Rs.30,000/- and the problem is to whom this
a. This means the marketing department is responsible for all travels done by
them. This loss will be charged to the marketing department and they will have
to explain the budget variance caused by this mistake.
b. In this case, the Administration Department is responsible for the loss and the
ticket cost will be charged to marketing, but the loss of Rs.30,000/- will be
charged to the Administration department.
c. In this case, the Travel is a separate department and is responsible for the loss.
: 90
d. Since the external travel agency is a different organisation, the loss will not be Introduction to
Management Control
borne by any department of Oasis Corporation. It will be borne by the travel Systems
agency.
NOTES
A revenue centre is the part of organization in which organization gets revenue from sales
of products or providing of services. It is the business operation responsible for generating
usually break down their business operations into revenue centres to determine the
profitability of each good or service it produces. The size of the business, the number of
product or service lines and industry standards are all factors companies use when choosing
While retail and wholesale companies are traditional revenue centre businesses, service
companies may also add revenue centres to improve the profitability of current business
operations. For example, hotels may add a small restaurant or snack bar for guests, gas
stations may add convenience stores stocked with various food and sundry items, and
gyms or health clubs may add small shops marketing trendy workout clothes or vitamin
supplements. Each revenue centre addition adds a potential profit line to the company’s
overall profit potential.
Companies may add revenue centres as a means to enter new markets or industries.
Starting small is usually a better way to build and expand business operations without
incurring large amounts of debt or other expenses. Revenue centres may also take time to
become profitable and recover the initial start-up expenses. For this reason, starting multiple
revenue centres may exacerbate the potential downside to these new business operations.
For ABCD Corporation Sales Division which understands customer requirements and
carries out the final selling process is the revenue centre. Revenue centres are responsible
for revenue generation, increase in sales volume, adding new customers etc.
: 91
Introduction to Concept in Action
Management Control
Systems
In the highly competitive call centre industry environment of 2004, some companies
NOTES successfully differentiated themselves by converting their service centres into revenue
centres. The revenue streams were generated through “after sale service”. The call
centre agents would address the calling customer needs and request, provide the
necessary services, and then offer some type of new product or services that would
further meet the needs of the customer. To do so, the companies reworked their hiring
process, expanded training the encompass sales, and changed their incentive structure
from fixed pay to acombination of fixed pay and sales commission for their service
agents.
Businesses can also be divided vertically along geographic lines. For example if ABCD
Corporation had businesses in North, South, East and West of India, then they could
operate each of these zones as profit centres. For a responsibility centre to operate as
a profit centre, the following conditions should be met:
While profit centres help businesses to improve quality of decision and speed, they may
also result in friction within organization and focus on short run decisions.
: 92
Introduction to
Concept in Action Management Control
Systems
Nokia Corporation faced a considerable slowdown in sales in 2001. As part of turnaround
NOTES
strategy, Nokia Corporation split its $21 billion mobile phone unit into nine profit centres,
each with responsibility for a specific market segment. Profit centres helped the company
to break itself into smaller and accountable units each of which had an entrepreneurial
thrust. ABB(Asea Brown Bovery), a European multinational in the business of power
generation, transmission and distribution, was organized into 4500 profit centres-each
with profit/ loss responsibility and meaningful autonomy.
Investment centres are a part of responsibility centre involved in utilising the capital
directly to contribute to the profits of the organization. An investment centre is
responsible for both profits and investments. The investment centre manager has
control over revenues, expenses and the amounts invested in assets. He also
formulates the credit policy which has a direct influence on debt collection, and the
inventory policy which determines the investment in inventory
The focus is on increasing this return, both in total dollars and as a percentage of
sales. This can be achieved with a combination of increasing sales, reducing expenses,
and reducing the investment in assets. The investment centre concept is most useful in
situations where there is a large investment by a business unit in fixed assets and/or
working capital.
Cost Centre
(Concern for cost)
It compares Division’s profits with assets employed to earn that profit. The prime
concern of an investment centre is how efficiently it uses its assets. Profit centres
measure the profit in absolute terms whereas investment centre measure it in terms of
assets utilization efficiency. Thus investment centre acts as special type of profit centre.
This approach satisfies both the goals of business organizations i.e. to earn adequate
profit and profits earned and assets employed must have optimal relationship. Usually
the business unit manager has two performance objectives, first to generate adequate
profits from the assets/ resources at his disposal and second he should invest in additional
assets/resources, which provide the desired returns.
Ø Measuring the asset base for assessing the performance of the investment Check Your Progress
centre i.e. Tangible and/or intangible assets, controllable uncontrollable and/or What are the difficulties in
measuring the performance
partially controllable assets, Total assets and/or total assets minus liabilities etc. of investment centres ?
Illustration 6.2
Radio Masala is an extremely hip and happening channel and has a large listener base,
predominantly the youth. The radio channel is constantly on the lookout for programmes
and product offerings for the young generation.
The organisation has several popular radio jockeys who present various programmes.
Each of the programme, depending on the popularity, gets advertisement revenues. The
: 95
Introduction to advertisement revenues are directly traceable to the programmes and programmes are
Management Control
Systems taken off the air if they do not attract sufficient advertisement revenues.
NOTES There are support staffs that arrange music and handle other administrative functions
like fixing appointment with celebrities, arranging interview schedules, etc.
All of the above departments have support assistants who perform most of the errand
functions.
Trace each of the above mentioned function to its responsibility centre and justify your
choice.
Solution
: 96
Introduction to
6.4 Summary
Management Control
Systems
Responsibility Centre is an organizational unit that is headed by a responsible manager.
Responsibility Centres are classified into cost centre, revenue centre, profit centre and NOTES
investment centre. A cost centre is a part of the company that does not generate any
profit for the company, but they add cost to the company. The revenue centre is
responsible for generating revenue for the company by selling goods or services. A
profit centre is a department that directly adds to the profit of an organization. Investment
centres are a part of responsibility centre involved in utilising the capital directly to
contribute to the profits of the organization. Different Responsibility centres are
responsible for different outcomes and the evaluation parameters for each of them
vary.
A cost center is a part of the company that does not generate any profit for the
company, but they add cost to the company.
The revenue center is responsible for generating revenue for the company by
selling goods or services.
A profit center is a department that is responsible for the profit earned by the
organisation.
Investment centres are a part of responsibility centre involved in utilising the
capital directly to contribute to the profits of the organization.
6.6 Questions
The company is concerned that the operations, integrated as they may seem, do
not give them an idea about their strong areas or the weaknesses in their
production processes. To address this concern and also to assess opportunities
for outsourcing, as well as in sourcing, they have decided to create responsibility
centres within the organisation and define the goals of each of these individually.
: 98
There is no machining facility available around the vicinity, hence there is lot of Introduction to
Management Control
demand for machined products (Machining). These are demanded by both end Systems
users as well as producers. The finished and unpolished units do not have a
NOTES
ready market.
The Administration Department takes care of all other functions such as payroll,
accounts, payment follow up from retail stores and payment processing to
suppliers.
Ionascu I., Filip A.T., Stere M., Control de gestiune [Management control],
Publishing House Economica, Bucuresti, 2007.
: 99
Introduction to
Management Control Unit 7: Performance Evaluation of Responsibility
Systems Centres
NOTES
Structure
7.1 Introduction
7.2 Unit Objectives
7.3 Overview of Responsibility Centres
7.4 Measuring performance of Engineered Expense
Centers/Standard Cost Centers
7.5 Performance Evaluation in Discretionary Expense
Centre
7.6 Difficulties in evaluating Discretionary Expense Centre
7.7 Zero Based Budgeting
7.8 Balanced Scorecard (BSC)
7.9 Activity Based Costing
7.10 Summary
7.11 Key Terms
7.12 Questions
7.12.1 State whether true or false:
: 100
Introduction to
7.1 Introduction Management Control
Systems
We understood the type of responsibility centres in the previous Unit. We will now
understand how the performance of various responsibility centres are evaluated. We NOTES
will understand that not every responsibility centre can be evaluated using similar
measures because the function performed by each of them is different.
Engineered costs are usually expressed as standard costs. Standards can be set because
the input is usually relatable to the output.
: 101
Introduction to
Management Control Discretionary expense centres cannot be expressed as standard costs since the output
Systems cannot be measured reliably as a function of input.
NOTES
7.4 Measuring performance of Engineered Expense
Centers/Standard Cost Centers
“Standard costs” are costs that are established in advance to serve as targets to be
met and, after the fact, to determine how well those targets were actually met. They
are the predetermined cost based on the estimates for materials, labour and overheads
for a particular period of time. One of the most important uses of standard costing is to
compare the actual costs with the standard costs and analyze the reasons for the variations
with the view of maximizing efficiency of production. Variation is the difference between
standard cost and actual cost.
Variance analysis based on standard costs and flexible budgets would be a typical tool
for control of a cost center such as a production department.
Two general types of variances can be calculated for most cost items-
a. Price variance
Check Your Progress b. Quantity variance.
How is the performance of
a profit centre measured ? [a] Price Varianceis calculated as:
Price variance = AQ x (AP - SP) Price variance = (AQ x AP) - (AQ • SP) (2)
Table 7.1 shows a general model [a three-column model] for variance analysis that
incorporates items (1), (2), and (3) from the above equations.
Actual Quantity of Inputs, Actual Quantity of Inputs at Standard Quantity allowed for
Illustration 7.1
Calculate material cost variance from the information given below:
Particulars Units(kg)
Solution:
The actual production (output) is 1,000 units. So, entire calculation is to be made for
1,000 units.
Standard output (production) = 1,200 units
Check Your Progress
Standard quantity to be used = 1,200 kg
What is Material Usage
So, for one unit of production (output), standard quantity to be used is one kg. Variance? Why is it
calculated ?
Actual Output = 1,000 units
Standard quantity to be used = 1,000 kg
Actual quantity used = 1,100 kg
Material cost variance =
Standard cost – Actual cost or
Standard Quantity x Standard Rate - Actual quantity x Actual Rate
MCV = (SQ × SR) – (AQ × AR)
: 103
Introduction to = (1,000 × 7) – (1,100 × 7.50) = 7,000 – 8,250
Management Control
Systems = 1,250 (U)
The calculation is for actual production and not for planned production.
NOTES
So here the Material Cost Variance is Rs.1250
Material Price variance= Actual Quantity used× (Standard Rate-Actual Rate)
=1100× (7-7.5)
=550(U)
Material usage Variance= Standard Rate× (Standard Quantity-Actual Quantity)
=7× (1000-1100)
=700(U)
Material cost variance is the sum of Material quantity (usage) variance and Material
price Variance.
Similarly, variances can be calculated for wages and overheads and these variances are
analysed to evaluate the performance of a Standard Cost Centre.
1. A price variance and a quantity variance can be calculated for all three variable cost
items—direct materials, direct labor, and the variable portion of factory overhead. The
variance is not called by the same name, however. For example, a price variance is
called a materials price variance in the case of direct materials, but a labor rate variance
in the case of direct labor and a variable overhead spending variance in the case of
variable factory overhead.
2. A cost variance is “unfavorable (U) “if the actual price (AP) or actual quantity (AQ)
exceeds the standard price (SP) or standard quantity SQ; a variance is “favorable (F)”
if the actual price or actual quantity is less than the standard price or standard quantity.
3. The standard quantity allowed for output—item (3)—is the key concept in variance
analysis. This is the standard quantity that should have been used to produce actual
output. It is computed by multiplying the actual output by the number of input units
allowed.
4. Variances for fixed overhead are of questionable usefulness for control purposes,
: 104
since these variances are usually beyond the control of the production department.
7.5 Performance Evaluation in Discretionary Expense Introduction to
Management Control
Centre Systems
In discretionary cost center the budgets are given to improve the working of different NOTES
departments but there is no variance analysis for these budgets, only control systems
are implemented.
Budget Preparation
Management formulates the budget here by determining the magnitude of the job that
needs to be done, and not the volumes of the output. The work done here falls into two
general categories:
Continuing work- This is workwhich is done consistently from year to year, such as
preparation of financial statements.
Special work, which is a one shot project – for example, developing and installing a
system in a newly acquired division.
Check Your Progress
What is Material Usage
The technique used in this budgeting is Management By Objectives (MBO) and a formal variance? Why is it
process in the department ask for the budget on the basis to accomplish the specific jobs calculated?
The planning function for discretionary expense centre is usually carried out in one of
the two ways- Incremental budgeting and Zero base review
1. Incremental budgeting
NOTES
2. Zero base review:
An alternative budgeting approach is to make a thorough analysis of each of
discretionary expense centre on a rolling schedule so that all are reviewed at
least once every five years. This is called zero base review. In contrast with
incremental budgeting, this review attempts to ascertain from the scratch the
resources actually required to carry out each activity within the expense centre.
This is discussed detail in the later part of this Unit.
Check Your Progress Each responsibility centre has different evaluation measures, which are summarised as
How is the performance of follows:
a profit centre measured ?
Responsibility Centre Responsible for Evaluation measure
Organizations often have difficulty managing discretionary cost, which may include
those for R&D & accounting systems, because costs do not clearly relate to output. For
the same reason, firms have difficulty evaluating the performance of a discretionary
manager. Companies have tried many methods of identifying appropriate relation between
discretionary costs & activity levels & comparison with other firms. But relating costs
to activity levels remains primarily a matter of management judgment or discretion.
: 106
Consequently, companies typically give managers of discretionary cost centres a budget Introduction to
Management Control
and instruct them not to exceed it without higher level of authorization. Systems
NOTES
The word discretionary means that management has decided on certain policies that
should govern the operations of the company. By definition therefore, no relationship
can be reliably established between the input and output.
Some of the salient features of Discretionary Expense Centres are listed below:
2. Some functions for which output is not easily measurable or where the outputs
are not causally and deterministically related to the inputs expended cannot be
controlled by the use of traditional techniques such as standard cost or budgets.
4. The output from these units is not easily measured in financial terms, and the
relationship between the resources they expend (inputs) and the outcomes they
produce is weak.
1. First, the management control system helps only in expense control. The budget : 107
Introduction to for this type of expense centres represents the planned inputs to the expenses
Management Control
centre.
Systems
NOTES
2. Second, the difference between budgeted and actual expense is not a measure
of efficiency. It is simply the difference between the budgeted input and actual
input.
3. Third, the financial control system measures neither the efficiency nor the
effectiveness of these responsibility centres. It is necessary therefore, that
nonfinancial measures and judgments be employed in evaluating their
performance.
Several techniques have been evolved in the past few decades to evaluate performance
when there is a problem of output measurement or when there are no quantitative
output measures. Some such techniques are Zero Based Budgeting, Balanced Score
Card and Activity Based Costing. A brief understanding of these concepts follows.
The practical application of ZBB involves the use of the “Decision Package”. All
Check Your Progress
budgetary procedures involve an identification of organizational objectives. Where it is
What is Zero Based
Budgeting ? difficult to compare the resources allocation with output, ZBB is more appropriate in
controlling. If the past projects were allowed to continue, without justification, the past
inefficiencies would continue, automatically. So, manager has to justify, why he wants
to continue to spend.
Advantages of ZBB:
: 108
· Zero based budgeting is used to help justify expenses throughout each budget Introduction to
Management Control
cycles. This prevents programs that are ineffective from continually getting Systems
funded without justification for their expenses.
NOTES
· It also helps prevent waste, fraud and abuse within the system. This is because
the budget starts at zero and each charge is accounted for.
In 2010, Nokia was asked to cut spending from their IT department while continuing to
meet demand for new business. In order to accomplish this, they began a Zero Based
Budgeting program. This helped them analyze the benefits of the management framework
and determine which demands and supplies should be prioritized. Once this was
accomplished, they were able to decide which IT processes were critical to the success
of the company and should be continued.
· Customer perspective: This stands for identifying the customer and market
segments in which they are going to compete, as they are the basic pillars for
gaining revenue components of the company’s financial objectives. It mainly
focuses on gaining high customer satisfaction and leveraging customer
relationships
· Internal process perspective: This stands for identifying key business processes
by which an organization has to excel to meet the objectives of customers and
shareholders
Nerolac Paints Limited: It adopted the concept of BSC for deploying its business
strategy and managing enterprise performance. The very purpose of implementing the
BSC in the Company is its endeavour to grow its business profitability over the next few
years. The scorecard framework addresses the decorative and industrial paints business
of Nerolac and creates a strategy deployment system which will monitor month-on-
month achievement against defined strategic objectives.
Infosys Technologies: Infosys also implemented the concept of BSC. It helps this
organization to track its initiatives and also measure the impact it has on the organization’s
growth and profitability. It also enables Infosys to move towards a data-based decision
making culture.
: 110
7.9 Activity Based Costing Introduction to
Management Control
The concepts of Activity Based Costing (ABC) were developed in the manufacturing Systems
sector of the United States during the 1970s and 1980s.It is a practice in which activities NOTES
are identified and all related costs of performing them are calculated, providing actual
costs chargeable. The focus of activity based costing is activities. The basis of activity
based costing is that activities, rather than products, add to cost. Thus identifying activities
is a logical first step in designing an activity based costing. An activity is an event, task
or unit of work with a specified purpose. Some examples are designing products, setting
up machines, operating machines and distributing products.
Peter F. Drucker in the book Management Challenges of the 21st Century defines
ABC as that traditional cost accounting focuses on what it costs to do something, for
example, to cut a screw thread; activity-based costing also records the cost of not
doing, such as the cost of waiting for a needed part. Activity-based costing helps to
record the costs that traditional cost accounting does not do. The overhead costs assigned
to each activity comprise an activity cost pool.
: 111
Introduction to ABC has proven its applicability beyond academic discussion. ABC is applicable
Management Control
throughout company financing, costing and accounting:
Systems
· ABC is a modelling process applicable for full scope as well as for partial
NOTES
views.
· ABC helps to identify inefficient products, departments and activities.
· ABC helps to allocate more resources on profitable products, departments and activities.
· ABC helps to control the costs at any per-product-level level and on a
departmental level.
· ABC helps to find unnecessary costs that may be eliminated.
Check Your Progress
Identify any two advantages · ABC helps fixing the price of a product or service with any desired analytical
of Activity Based Costing.
resolution.
Furthermore, time-driven ABC systems can measure the unit costs of the repetitive
processes done within HR (training, employee benefit counseling, and performance
management appraisals) and IT (providing CPU capacity, storage capacity, and connect
time). The ABC innovation enables the resource costs of corporate support departments
to be charged out to operating units just as the outputs from manufacturing units are
charged out, via standard costs, to marketing and sales units.
In effect, ABC enables discretionary expense centers to become cost centers with a
financial goal to break even—to recover their expenses through cost-recovery pricing
schemes based on the actual demands made by operating units on the support units’
resources.
Illustration 7.2
XYZ Company is considering Activity based costing to allocate Overheads. Following
Information is given for the production of two products A and B.
Activity Cost
Set-up 200000
product A B Total
In above case company performs two activity i.e. Setup and maintenance of
machine.
1. Setup Cost:
100
2. Machine Maintenance:
Since, we have calculated the Allocation Rate; next step is to allocation of cost to
each product,
per Setup
: 113
Introduction to In the above illustration we see that costs are allocated according to the activities
Management Control
Systems performed instead of a traditional volume based approach.
NOTES Activity based costing is hence very useful when different products are
manufactured and when there is a mix of simple and complex products. Activity
Based Costing would also be helpful in identifying costs which do not necessarily add
value to any process or activity and hence does not get allocated directly to any
activity. These costs have to be ultimately weeded out. Hence the application of
Activity Based Costing is wide and vast.
7.10 Summary
For a Standard Cost Centre the expected outcomes are cost control, efficiency, quality
of output and timeliness of delivery. The evaluation measure is the Variance Analysis
which is the comparison of Actual with Standard. For a discretionary expense centre,
Quality of Output is necessary and performance is measured by checking compliance
with pre-approved budget spending limits. For a revenue centre the desired outcome is
increase in sales volume and addition of new customers and the performance is mea-
sured by compare budgeted output to actual output. A profit centre has to aim for profit
maximisation and performance is evaluated by comparing budgeted income statement
with actual income statement. An Investment Centre has to ensure investment of re-
sources to achieve organisation goals and performance is measured by calculating Re-
turn on Investment and Economic Value Added. Of all responsibility centres it is most
difficult to evaluate the performance of Discretionary expense centre. So techniques
like Balanced Score card, Zero based budgeting and Activity Based Costing are used.
: 114
Introduction to
Activity Based Costing is a method for developing cost estimates in which the Management Control
project is subdivided into discrete, quantifiable activities or a work unit. Systems
f. Pricing distortions can happen when costs are distributed without tracing
the activity drivers.
g. When most of the costs are direct, Activity based costing is very useful.
Activity Based Costing helps in bringing down product costs in the long run
by identifying non value added costs.
: 116
Introduction to
8.0 Introduction
Management Control
Systems
In the previous Unit we understood the meaning of responsibility centre. The organisation
unit responsible for generation of profit is called a profit centre. In this Unit we take a NOTES
detailed look at profit centres, why and how they are created and the evaluation of
performance of profit centres.
8.2 Meaning
A responsibility centre whose financial performance is measured in terms of profits
(i.e., by the difference between the revenue and expense), is called a profit centre. This
is a sub unit or a Division which is accountable for generation of profits.
Each profit centre is a relatively independent unit and the manager must have significant
control over the operating decisions that affect profit. Some examples for these kinds of
decisions are selling price, sales mix, production volume, sourcing of inputs etc. Simply
put, the profit centre head is responsible for cost control as well as revenue generation.
Therefore he must have control over cost and revenue decisions.
Financial control systems for profit centres should measure inputs, outputs and profit
versus a standard performance.
However, let us assume that the Division was extremely effective and they reached
out to a lot of people and consequently a new business area was developed and a new
branch was opened there. This branch will bring in measurable revenues and have
Check Your Progress
measurable cost. Therefore while it is possible to evaluate the branch as profit centre, it
Can an R & D division in an
is still not possible to evaluate the public relation Division as a profit centre. FMCG be assessed as a
profit centre ?
Therefore in order to create a profit center:
1. Quality of decisions
: 119
Introduction to The decisions in a profit centre are usually guided by profit motive. Therefore every
Management Control
Systems situation is evaluated to ensure that the overall profitability of the Division increases on
account of that decision. This ensures that not only the Division but the organization as
NOTES
a whole benefits because of that decision. For example, the Division may be considering
up gradation of technology which is recommended by production department. In a profit
centre such a decision may be taken only after the marketing department confirms that
there is demand for the product and it is worthwhile to upgrade technology and that this
will bring in additional revenues.
Check Your Progress In any organization, there may be several issues requiring the urgent attention of the top
What is management by
management. However, when the organization is decentralized and lower down units
exception ?
are empowered, then several issues and problems are solved at that level itself. The top
management can focus its attention on critical issues alone. This is known as
“management by exception”-that is the top management only focuses on exceptional
issues and the day to day problems are handled by the middle and lower management.
5. Initiative
When managers are responsible for generation of profits, they tend to be more
entrepreneurial in their thinking and look for newer opportunities to improve revenues or
innovative ways to manage cost. Therefore managers tend to take initiative rather than
wait for things to happen.
: 120
6. Innovation Introduction to
Management Control
When there are constraints on resources and profits have to be improved, then the Systems
managers need to be more innovative and creative. As the old saying goes, “Necessity is
NOTES
the mother of invention”, managers will need to come up with better ideas for improving
profit since they need to keep improving profits in order to be favourably evaluated as
compared to other Divisions.
A B C Total
The manager of Division A is unhappy that his profitability is about the same as Division
B’s and much less than Division C’s even though his sales are much higher than either
of these other two divisions. The manager knows that he is carrying one line of products
with very low profitably. He was going to replace this line of business as soon as more
profitable product opportunities became available but has retained it until now, because
the line was still marginally profitable and used facilities that would otherwise be idle.
: 122
The manager now realizes, however, that the sales from this product line are attracting a Introduction to
Management Control
fair amount of corporate overhead, which is allocated at the rate of 20% of net sales, and Systems
maybe the line is already unprofitable for him.
NOTES
This low margin line of products had the following characteristics for the quarter:
Thus the product line accounted for 40% of the divisional sales but less than 15% of
divisional profit.
Required
1. Prepare the operating statement for Bharat Company for the second quarter of
2013 assuming that sales and operating results are identical to the first quarter
except that the manager of Division A drops the low margin product entirely
from his product group. Is the Division A manager better off from this action? Is
the Bharat Company better off from this action?
Solution
: 123
Introduction to Current After dropping the product
Management Control
Systems Net Sales 4,800 4,000
Therefore Division A will decide to drop the product. However the margin of Division
A has reduced from 700 to 600. The income has increased because the allocated
corporate expenses have reduced. However since these expenses are only allocated-
that is these are corporate expenses which are unavoidable, so the total expenses for
the organisation as a whole has not decreased. Only the allocation has changed thereby
increasing the reported income of a Division.
If A drops the product, the income of the organisation as a whole will go down by
Rs.100,000 as is evident from the income statement of Bharat Company.
Revenue
(Variable costs)
Contribution Margin
Direct Profit
Controllable Profit
Less: Taxes
NOTES
Contribution margin
Contribution margin is the spread between revenue and variable expenses. Therefore
Check Your Progress
What is contribution the question is, whether the Division earning the highest contribution be evaluated most
margin ?
favourably. The answer to this question would be in the negative because contribution is
a function of revenue. Increase in revenue would automatically result in increased
contribution. Therefore that would only be the function of the revenue centre. Profit
centre also needs to effectively control fixed expenses to increase profits. If we evaluated
a revenue centre by the contribution generated, then the Division could always show
increased contribution by keeping variable costs low and incurring higher fixed costs
than required.
Direct profit
Direct profit is calculated by netting off the direct fixed expenses incurred in the Division.
If direct profit is to be used as a measure to evaluate performance of the Division, then
Division, then that might be an incentive for the Division to reduce costs incurred at the
Division and transfer all expenses to the Corporate Headquarters.
Controllable profit
The profit earned by the division after adjusting for direct fixed costs incurred in the
Check Your Progress Division and the expenses incurred on behalf of the Division by the Corporate
What are the various Headquarters. Many a times, expenses are common across several Divisions and the
measures of profit evaluation
in profit centres ? Corporate Headquarter incurs these expenses on behalf of all the Divisions. Some of
these expenses are traceable to Divisions. For instance, if the Headquarter has defended
a suit pending against the product of a particular Division, the legal expenses should be
allocated to that Division. These are called as “Controllable Corporate Charges”, wherein
: 126
the Corporate Headquarter incurs certain overheads on behalf of the Division. These Introduction to
Management Control
costs are then allocated to the respective Division. The income earned after adjusting for Systems
Controllable Corporate Charges is called as Controllable profit.
NOTES
If controllable profit is used as performance evaluation measure for the Divisions then it
means that there is no ownership of costs incurred at the Headquarter level which are not
This is the profit after adjusting for “Other corporate allocations”. These are expenses
incurred at the Corporate Headquarters which are allocated to Divisions on the basis of
certain logical assumptions. However, these are not so easy to apportion and are mostly
done on some approximations.
This is the profit after adjusting for taxes. This may not be the most appropriate evaluation
Check Your Progress
because taxes are a corporate function and are usually levied on the entire organization’s What is controllable profit ?
profits. Also some Divisions may operate in tax free zones because of which it may
Considering the factors discussed above, Income before Taxes is the better measure of
evaluation of income for Divisions since it makes managers accountable for all the costs
incurred whether at the Divisional level or at the Headquarter level. Therefore Divisions
can be reliably evaluated on the income they earn before taxes.
Illustration 8.2
The following is the Income Statement of SBUs of Hindustan Company Ltd. The income
statement forms the basis for the incentive plan for the head of the SBUs. There is some
thinking about what the ideal measure for rewarding the SBU heads should be.
: 127
Introduction to Particulars SBU1 SBU2 SBU3
Management Control
Systems (All figures in Rs.000’s)
Required:
Rank the profit centres as per the performance on each of the parameters indicated in
bold.
Solution:
Rank 3 2 1
Rank 1 2 3
Rank 2 1 3
Rank 2 1 3
As is evident from the solution given above, each of the SBUs gets ranked differently
: 128 according to each parameter.
Illustration 8.3 Introduction to
Management Control
Systems
The following is the Income Statement of SBUs of M ltd. The income statement forms
the basis for the incentive plan for the head of the SBUs. There is some thinking about NOTES
what the ideal measure for rewarding the SBU heads should be.
*** Other Corporate Allocations consist of corporate charges allocated to SBUs. Rural
branches get a lesser share of these allocations because several initiatives of M Ltd. are
urban based. Hence SBU 2 is charged a lesser share of the corporate allocations.
Required:
: 129
Introduction to appropriate for the purpose of judging the efficiency of the SBUs and
Management Control
Systems attribute appropriate reasons for the same.
Solution:
Direct Profit does not include the expenses incurred by the Corporate Headquarters.
So it is not an appropriate measure.
Controllable profit does not include other expenses incurred at Headquarters. If profit
centers are not made accountable for these costs, eventually these costs will not be
controlled at any level and there would be no accountability for costs incurred in this
head.
Income before Taxes is the better measure of evaluation of income for Divisions
since it makes managers accountable for all the costs incurred whether at the Divisional
level or at the Headquarter level. Therefore Divisions can be reliably evaluated on the
income they earn before taxes.
b. Taxes should not be considered because taxes are a corporate function and are
usually levied on the entire organization’s profits. Also some Divisions may
operate in tax free zones because of which it may become difficult to evaluate
after tax profits of Divisions.
Can Expense centres be converted to profit centres?
: 130 department, for example input of raw material become part of finished goods, hence,
Introduction to
the control focus on using the minimum input necessary to produce the required output
Management Control
according to the correct specification and quality standards. Systems
Not all units are capable of being evaluated on the same basis. Some units do not generate NOTES
any revenue; they only incur costs in support of some necessary function. Other units that
deliver goods and services have the potential to be assessed on the basis of profit generation.
Can Divisions that operate as cost or expense center be converted to profit center?
Cost centre may actually provide services that could generate profits if they were offered
outside the organisation. Companies may want to convert their cost centres to profit
centres since that may improve the efficiency of a Division and help the overall growth of
the business. Sometimes it may also help them to gain competitive advantage over
competitors.
Let us consider another example of a hospital. Flower Hospital is a reputed hospital in the
city and has a several famous surgeons visiting the hospital to perform surgeries as also in
house doctors. The Hospital has State of art facilities for pathological testing, surgery and
recovery post-surgery. The Hospital was reputed for its humane care and the success
rate of surgeries and the recovery rates post-surgery were very high. The Hospital however
was highly renowned for its testing services of the pathology department. There were
several tests for which facilities were not available anywhere else in the city.
Flower Hospital therefore, decided to operate the pathology department as a profit centre
with operational autonomy. This has contributed to the bottom line of the Hospital and
helped the Division to fund newer equipment and technology.
: 131
Introduction to
From the discussion above, it follows that here are two very important criteria for an
Management Control
Systems expense centre to be converted as profit centre:
NOTES 1. The output should be measurable- in the example above, the IT Division should
be able to quantify the service rendered in monetary terms.
2. The Division should be free to sell its products or services outside the organisation
also.
The profit centre approach gives an opportunity to expand both revenue and profit, as
well as build the leverage base.
8.8 Summary
A responsibility centre whose financial performance is measured in terms of profits
(i.e., by the difference between the revenue and expense), is called a profit centre.
Profit centres can usually be created or carved out of businesses on the basis of Products;
Clientele; Geographic Location or other criteria such as function. In order to create a
profit centre the output should be measurable. Some of the advantages or benefits of
having a profit centre approach to business are better quality of decisions; quicker
decision making; facilitation of management by exception; better information systems;
more initiative from lower management; innovation. However there are some limitations
of profit center like loss of control for top management; pursuit of short term goals
which may impact the organization adversely in the long term; generalist outlook for the
specialist and pursuing divisional goals at the expense of organisational goals. While
profit centres could be evaluated at many levels such as contribution, direct profit,
controllable profit or profit before taxes, the most comprehensive evaluation would be
the profit before taxes. Sometimes cost centre may actually provide services that could
generate profits if they were offered outside the organisation. Companies may want to
convert their cost centres to profit centres since that may improve the efficiency of a
division and help the overall growth of the business.
: 132
Introduction to
8.9 Key Terms Management Control
Systems
A responsibility centre whose financial performance is measured in terms of
NOTES
profits (i.e., by the difference between the revenue and expense), is called a
profit centre
Direct profit is calculated by netting off the direct fixed expenses incurred in the
Division
The profit earned by the division after adjusting for direct fixed costs incurred in the
Division and the expenses incurred on behalf of the Division by the Corporate
Headquarters is called controllable profit.
8.10 Questions
1. In a belt tightening measure, the Blueberry Company is taking a close look at its
four divisions with an eye toward closing any unprofitable ones. Common costs
incurred at the corporate level have been distributed to each division in proportion
to sales revenue. Division level costs are considered to be avoidable if a Division
is shut down. The Corporate costs, however cannot be avoided as long as some
: 133
Introduction to of the Divisions continue operation. The Corporate headquarters costs amount
Management Control
Systems to 995,000 (semi-annual). The following data represents semi-annual results:
and allocated)
Required:
costs
costs
: 134
Introduction to
8.11 Further Reading and References Management Control
Systems
Lemke, K. W. (1970), In Defence of the ‘Profit Centre’Concept. Abacus, 6: 182–189.
NOTES
Mottis, N., & Ponssard, J. P. (2001). Value based management and the corporate profit
centre. In European Business Forum (Vol. 8, pp. 141-7). Prentice Hall.
: 135
Introduction to
Management Control Unit 9: Transfer Pricing
Systems
Structure
NOTES
9.0 Introduction
9.1 Unit Objectives
9.2 Background
9.3 Definition of Transfer price
9.4 Objectives of Transfer Pricing
9.5 Implementation of transfer pricing
9.6 Methods of transfer price
9.6.1 Market based
9.6.2 Cost plus
9.6.3 Negotiated Transfer Pricing:
9.7 Pricing Corporate Services
9.8 Control over amount of service
9.9 Summary
9.10 Key Terms
9.11 Questions
9.11.1 State whether True or False:
9.11.2 Theory questions
9.12 Further Readings and References
: 136
9.0 Introduction Introduction to
Management Control
In the previous Unit we understood all about profit centres. In this Unit we understand Systems
how responsibility centres transact with each other. The pricing mechanism for internal NOTES
9.2 Background
We have heard of number of business enterprises which have multiple products. We also
know businesses which produce raw material as well as finished products. Some of the
businesses that you might quickly recall are Tata who produce iron and steel as well as
automobiles. So the output of one business becomes input for another. Another Indian
business house that we all know is Reliance Industries who have interest in number of
businesses from oil to plastic, many of which are fully integrated. So integrated business
Check Your Progress
simply means that they produce from raw material to finished goods (though it is possible Can you define transfer
that they may not be producing all of them). pricing ?
Such integrated businesses usually transact within each other. These inter business
transactions may not be necessarily market driven. However if each of the transacting
unit is a profit centre, then they need to maximise their divisional profits. Transactions
between two autonomous business units give rise to two questions:
1. Would the transaction have been similar if the units were not autonomous, but
were part of a centralized organisation?
: 137
Introduction to
2. Had the transacting units been unrelated to each other, would the transactions
Management Control
Systems have been similar?
NOTES The questions above result in an interesting situation, wherein the transacting entities
have to arrive at a consideration for transacting with each other, usually called transfer
price.
Transfer price can be described as the value placed on goods or services between two
entities, of which at least one is a profit centre. The reason is simple. The pricing
resembles a transaction conducted with an unrelated entity. Such pricing involves analysis
of the transactions and adjustment of charges between related parties for goods or
services, whether tangible or intangible.
Some issues arise in transfer pricing because of such adjustments. We will discuss them
in detail in the forthcoming sections.
If two or more profit centres are jointly responsible for product development,
manufacturing and marketing, each should share in the revenue generated when the
product is finally sold. The transfer price is the mechanism for distributing this revenue.
: 138
Introduction to
Fundamentals of transfer pricing
Management Control
Systems
Transfer price should be similar to the price charged if the buying or selling were done to
outside units. NOTES
· Sourcing Decision
Sourcing decision is taken to determine whether the sourcing should be done from within
or from any other external vendor.
In case the sourcing is sought to be done from within the organization, then what might be
the price at which the transfer might happen is called the transfer price decision.
1. Distribution of revenue between Division when they are responsible for jointly
developing and marketing a product
2. To induce goal congruent decisions to improve profits of the profit centre as well
as organization as a whole
3. Autonomy to Divisions
Check Your Progress Transfer pricing requires that Divisions function in a reasonably autonomous
Why is autonomy required
for implementation of environment. If the central leadership is negotiating in all transfer pricing
transfer pricing?
transactions, it is counterproductive. Guidelines can be stipulated for transfer
pricing transactions where there is similar nature of transactions.
Basically we identify three methods of fixing transfer price. It can be fixed on the basis
of market price or cost plus margin or on the basis of negotiation with transacting
Divisions.
Market price serves the interest of both buying and selling division and maximises the NOTES
profits of the entity. Such transfer would become possible when the buying division does
not have a better supplier or all suppliers quote similar prices and hence the buying
division is indifferent between internal and external entities. Similarly the selling division
would be willing to sell at market price when all buyers are willing to offer market price
and the selling division is indifferent between the internal and external buyers
Illustration 9.1
Arnold Limited manufactures ball point pens and refills. They have two different profit
centres-one is the ball point division and another is the refill division. The refill division
sells refills directly in the market and also supplies to the ball point division. Similarly, the
ball
point division also buys refills either from within Arnold Limited or from external sources.
Currently the ball point division is able to source refills at Rs.400/- for 500 pieces. What
is the maximum price that they would be willing to pay for an order of 2000 units if they
buy from the refill division?
Solution:
1. The ball point division will not be willing to pay more than Rs.1,600/- for 2000
pieces. Similarly, the refill division will not be willing to sell at anything less than
Rs.1,600/-
2. This is because the buying division (ball point) has unlimited sellers and the selling
division (refill) has unlimited buyers.
3. Also the firm profit will not suffer if refill sold their output in the open market and
if ball point purchases from outside the firm.
: 141
Introduction to
9.6.2 Cost plus
Management Control
Systems
Another very common method of fixing transfer price is on the basis of cost plus standard
NOTES margin. One very important aspect to remember is that the basis of cost used to fix the
transfer price should be the standard cost and not the actual cost. The reason is that the
actual cost may factor in inefficiencies which might affect the competitiveness of the
final product.
· Market price is not available because the product might be customised and may
be produced as per requirements of the purchasing division.
· A Division creates capacity for another and is looking for a minimum margin
built over the cost of producing the product. The transfer price is based on the
production cost of the upstream division. A cost-based transfer price requires
that the following criteria be specified:
· Actual cost – Actual cost is the cost of producing the unit. Usually this
can be calculated only at the end of the accounting period.
· Full cost- This is the cost of producing a unit comprising fixed cost and
the variable cost
The amount of mark up, if any, is added to cost to allow the upstream division to earn a
profit on the transferred product. The choice of any of the above price will depend on
various factors. Suppose the product is new or is being developed for the first time, then
historical costs may not be available. The division may have to go with the budgeted or
projected cost. If the division produces only a single product then they may not be able
to spread their fixed costs across many units. Also if there are installed capacities that
the firm cannot minimise- for example they cannot operate the equipment for less than
: 142
Introduction to
a shift, then the division may want to be compensated for full cost. In case the division
Management Control
operates with flexible costing structure, (that is, they can hire equipment if they wanted) Systems
then they can charge on the variable cost. NOTES
Suppose the upstream division sells the intermediate product to external customers as well
as to the downstream division. In this situation, capacity constraints are crucial. In case
there is excess capacity, the upstream division can use a cost based transfer price. But
unless there is a mark up to the cost, the division will not be incentivised to sell it to the
downstream division.
Suppose there is no external market for the upstream division, and this division is to be
treated as a profit centre, it must be allowed the opportunity to recover its full cost of
production plus a reasonable profit. If the downstream division is charged the full cost of
production, there is still an incentive for the upstream division and the downstream division
will refuse the transfer under only two circumstances:
· First, if the downstream division can source the intermediate product for a
lower cost elsewhere
Illustration 9.2
X Ltd. has two divisions A and B. A produces output which is entirely consumed by
Division B. A’s produce has a market outside provided A makes considerable changes in
its output. This will increase the variable cost of A by at least 30%. Division B can
source the material from outside, but will again have to incur additional conversion costs
to make it suitable for their uses.
Which of the following, do you think is ideal for the organization so that any sourcing
decision taken by division B will be in the interest of the organization?
NOTES Solution:
If A is a cost centre, then they are motivated to reduce cost and B will be
motivated to buy from A.
In this case, A will initially supply at cost. Eventually they can start supplying
at cost plus when more buyers, other than Division B start entering the
market.
When divisions cannot agree on a common price, negotiation is resorted to. A negotiation
may not result in the best transfer price since the buying or selling division may have an
upper hand. While each of the division tries to maximise its own gains the process of
negotiation, the managers try to emulate a free market so as to create transactions that
closely resemble an arm’s length price. When divisions are not able to negotiate
successfully, or come to an agreement on the transfer price, the senior management
may intervene. Though such an intervention may benefit the company in the short run,
it may be counterproductive in the long run since divisions need to communicate efficiently
with each other in the true spirit of decentralisation.
When either the buying or the selling division has options, then negotiation takes place.
For example, assume that there are two Divisions A and B in an organisation and Division
A supplies to Division B. If Division A has more than one buyer, but Division B has only
one supplier namely Division A, then Division A might want to negotiate for better
: 144 prices with Division B.
Illustration 9.3 Introduction to
Management Control
The Sather Corporation manufactures and sells 10,000 boom boxes per year. The Assembly Systems
Division assembles the boom boxes. It buys the cassette deck for the boom box from the NOTES
Cassette Deck Division. The Cassette Deck Division can manufacture at most 12,000
cassette decks. The demand for cassette decks is strong. Any Cassette Deck not sold to
the Assembly Division can be sold in the outside market at $35 per unit. The Cassette
Deck Division currently sells 10,000 cassette decks to the Assembly Division and 2,000
cassette decks in the outside market. The incremental cost of manufacturing the cassette
deck is $25 per unit.
A crucial component for producing high-quality cassette decks is the cassette head
mechanism. The Cassette Deck Division manufactures the head mechanism for its cassette
decks. Many outside suppliers have offered to supply cassette decks to Sather. To ensure
quality, Sather requires that any outside supplier wanting to supply cassette decks to
Sather must purchase the head mechanism from the Cassette Deck Division. The Cassette
Deck Division will charge $18 per unit for the head mechanism. The incremental cost of
manufacturing the head mechanism is $12 per unit out of the total incremental costs of
$25 per unit to manufacture the cassette deck. The Cassette Deck Division has unused
capacity for manufacturing the head mechanism. That is, even if the Cassette Deck
Division manufactures the head mechanism for outside suppliers, it will still be able to
manufacture 12,000 cassette decks for sale in outside market at $35 per unit.
c. What transfer price for the Cassette Decks will result in the Cassette
Deck Division and the Assembly Division taking actions that are optimal
: 145
for Sather Corporation as a whole? Explain your answer.
Introduction to Solution:
Management Control
Systems
Q1. Yes, it is acceptable because they get the component at 34 and Cassette
NOTES Deck Division can sell it at the outside market for 35. Net gain
$1*10000=$10,000
Q2. Yes. For reasons above, In addition the Cassette Deck Division also earns
contribution of (18-12) = $6
Q3. Any price above $25 which is the variable cost. But two points to be noted:
b. But if price falls to 34 outside, eventually Cassette Deck has to drop to 34.
Students should note that the element of negotiation arises when there is a disruption.
Buying and selling divisions may have agreed on a given price and may be transacting
among themselves, but when a new player emerges, it disrupts the existing quilibrium
and results in negotiation. In the example that we saw, the entry of Johnson Corporation
is bringing down the price from $35 to $34 thus resulting in negotiations and change in
vendor.
Several issues could arise in fixing and administering transfer prices. These issues could
be broadly identified as follows:
All of these issues are discussed in significant detail in the following Unit.
On account of the issues and complexities in transfer pricing administration of the same
is not always simple or straight forward.Implementation of transfer pricing in organisations
: 146
Introduction to
happens through negotiated settlement, arbitration and conflict resolution and fixing thumb
Management Control
rules for repetitive transactions. A single department or division is usually not made Systems
responsible for the administration. Usually a committee is set up consisting of product NOTES
specialists as well as finance executives to arrive at acceptable solutions in transfer
pricing conflicts.
· Central services that the receiving unit must accept but can at least partially
control the amount used.
· Central services that the business unit can decide whether or not to use
Let us understand this in some detail. Regulatory or legal compliance is usually not a
matter of choice for a business. So the costs of these services will be passed on to all the
business units which receive these services. Information technology or business advisory
services, on the other hand offer scope for choosing as to whether and to what extent
these services need to be availed.
: 147
Introduction to Ø The first school of thought states that a business unit should pay the standard
Management Control
Systems variable cost for the discretionary services. If it pays less than this, then it will
be motivated to use more of the service than is economically justified and if it
NOTES
has to pay more than the standard variable cost, then it might not use the central
service that senior management believes worthwhile from the company’s
viewpoint.
Ø The second school of thought advocates that a price equal to standard variable
cost plus a fair share of the standard fixed costs that is full cost should be paid
for central service. If the business units feel that the services are not worth this
amount, then something is wrong with the quality or efficiency of the service
unit. Full cost represents the company’s long-run costs and therefore this is the
amount that must be paid.
Ø The third school of thought proposes a price equivalent to the market price if it
is available or standard full cost plus profit margin (return on investment) as it is
of the opinion that the capital employed by service units should earn a return
just as the capital employed by manufacturing units does.
Sometimes, business units may decide to obtain central services from outside or develop
their own capability or even choose not to use the service at all. In this situation, the
business unit managers control both the amount and efficiency of the central services.
The central service centres are independent and if they are found to be incompetent,
then either the scope of their activity will be contracted or their services may be
outsourced.
Transfer pricing fundamentals do not vary too much between products and services.
Transfer of services between divisions can happen on the basis of a transfer price
b. The buying division must have a choice to source services from outside. Similarly, NOTES
Some examples of services required that are purchased within the business organisation Check Your Progress
are Information Technology, Research and Development etc. Can services be priced like
products ?
Prices are fixed by the selling Division on the basis of variable cost, full cost or market
price.
Illustration 9.4
Taxation currently has 4 consultants, all of whom are fully engaged. They charge on
hourly basis and their billable hours are 140 per month per consultant. The charges are
Rs.5000/- per hour. The Consulting Division approaches the Taxation Division with a
work that requires 20 hours and offer them a consolidated remuneration of Rs.90,000/-
Solution:
1. The Taxation Division charges Rs.5000/- per hour. So the expected remuneration
is Rs.1,00,000/- Since all the consultants are fully occupied, it stands to reason
that the offer will be rejected unless they are paid at least Rs.1,00,000/-
2. The only situation when the offer is likely to be accepted is when there is surplus
capacity in the Taxation Division- that is there are some consultancy hours that
are unutilised. If there is not enough work available for the consultants then this
situation could arise. In this case, the Division may consider accepting the offer
in order to meet the establishment expenses or the fixed costs of the Division.
: 149
Introduction to
Management Control
Systems Students are advised to revisit this illustration after understanding the next Unit
9.9 Summary
Transfer pricing refers to the setting, analysis, documentation, and adjustment
of charges made between related parties for goods, services, or use of property
(including intangible property). Transfer prices among components of an
enterprise may be used to reflect allocation of resources among such
components, or for other purposes. Transfer price should be similar to the price
charged if the buying or selling were done to outside units. Objectives of transfer
pricing are distribution of revenue between Divisions, to induce goal congruent
decisions to improve profits of the profit centre as well as organization as a
whole and to measure the economic performance of individual Division.
Requirements in an organization for successful implementation of transfer pricing
are free flow of information, atmosphere of cooperation and Autonomy to
Divisions. Transfer prices can be fixed on the basis of market price or cost plus
margin or on the basis of negotiation with transacting Divisions. Issues that
arise in transfer pricing are problems on account of capacity utilization in
Divisions, problems of information exchange and problems of goal congruence.
Market based transfer prices are those that are fixed on market basis when the
products or services are commodities which have unlimited buyers and sellers and have
a market price.
Cost plus transfer price is the price fixed on the basis of cost plus standard margin.
: 150
Negotiated transfer price is fixed by the divisional managers who negotiate a mutually Introduction to
Management Control
agreeable price. Systems
NOTES
9.11 Questions
3. Market price as transfer price is ideal when the products have a market
outside the firm and the divisions are performing at optimum capacity.
4. Market price is not effective when a division produces exclusively for captive
consumption.
5. Transfer prices are highly dynamic and related more to the external
environment of the business.
7. Transfer price can never be below the variable cost of producing a unit.
3. Should cost based transfer price be based on actual or standard cost? Why?
Lexington Books.
: 152
Introduction to
10.0 Introduction Management Control
Systems
We understood the meaning of transfer pricing, the basis for fixing transfer prices and
also how corporate services are priced. We also understood that issues could arise in NOTES
transfer pricing due to various problems. We will discuss these problems and how they
are addressed in detail in this Unit.
Several issues could arise in fixing and administering transfer prices. These issues could
be broadly identified as follows:
Let us discuss these issues and understand how transfer price can be fixed in such a way
that these problems are addressed.
To understand the problems of capacity utilization and how it affects transfer pricing, let
us consider an illustration as follows:
: 153
Introduction to XY Limited has two Divisions, X and Y. Division X has a capacity to produce 5000 units
Management Control
Systems of output per month. Division Y wants to place an order for 5000 units from X. The cost
structure is as follows:
NOTES
Fixed cost-Rs.200,000/-
Division X cannot sell these units outside since it has no demand. They would like to
charge Rs.200/- per unit. This includes the variable cost of Rs.100/-, fixed expenses of
Rs.40/-(Rs.200,000/- allocated to 5000 units) and Rs.60/- towards profit.
Division Y can source a similar product from outside for Rs.160/- and spend an additional
Rs.100,000/- to modify the product to suit their requirements.
The total cost to Y in this case would be Rs.160/- and another Rs.20/-(Rs.100,000/-
allocated to 5000 units) totalling Rs.180/- Y would obviously choose to buy it from
outside rather than from Division X.
2. Division Y spends Rs.180/- to purchase a product that could have been sourced
from X at Rs.100/-
What should be done in this case? Should the top management force X to sell to
Y at a discounted price? Should they force Division Y to purchase at a price
higher than the market rate?
Both of these decisions will not augur well for the functioning of a decentralised
business. So how should transfer price be fixed so as to encourage the divisions
to take goal congruent decisions?
. This would also help X to recover a part of its fixed cost and therefore benefit the NOTES
organisation.
This concept of charging divisions on the basis of incremental or marginal cost was Check Your Progress
pioneered by Hirshleifer (1956). He demonstrated that when there is no separate market What problem does surplus
capacity cause ?
for intermediate inputs, the transfer price should be set to the marginal cost of the producing
division. In contrast, if there is a perfectly competitive market for intermediate inputs, the
transfer price should be set at the market price for the intermediates. Aside from these
simple cases, however, the optimal transfer price depends on a number of economic
fundamentals, including the nature of competition in intermediate and final good markets,
the structure of firm costs, and whether there is demand or technical dependence between
separate divisions of the firm.
Illustration 10.1
Division A of AB Limited produces and sells 10000 pairs of glasses to be used in spectacles.
Division sells its output at Rs.120/- a pair. They are able to sell their entire output to their
various customers, currently.
Division B of AB Limited has a requirement to use this glass in kaleidoscopes that they
produce and sell as toys.
Suppose Division B wants to purchase the glass from Division A, what is the minimum
price that Division A would charge?
Solution
In this case the minimum selling price that can be offered by Division A is Rs.120/- per
pair which is their market price.
This is because Division A has no surplus capacity and is able to sell their entire output at
Rs.120/-
: 155
Introduction to In case they want to supply to Division B they will have to divert capacity from their
Management Control
Systems existing orders which they could have sold at Rs.120/- per pair. So in case they sell at
any price below Rs.120/- their profit margins will drop.
NOTES
Illustration 10.2
Division B of AB Limited has a requirement to use this glass in kaleidoscopes that they
produce and sell as toys.
Suppose Division B wants to purchase 3000 pairs from Division A, what is the minimum
price that Division A would charge?
Solution
In this case the minimum selling price that can be offered by Division A is as follows:
We are using this formula here because Division A has surplus capacity.
Incremental Cost=Rs.90/-
Opportunity Cost=0
This is because Division A has surplus capacity and is not able to sell their entire output.
In case they want to supply to Division B they can do so from out of their current
capacity without incurring any additional fixed cost. So in case they sell at any price
above Rs.90/- their profit will increase.
Illustration 10.3
MM Ltd. has two Divisions R and D. The unit cost structure of Division R is as follows:
: 156
Material- 6/- Introduction to
Management Control
Systems
Labour- 7/-
NOTES
Variable overhead-9/-
Using the transfer price rule, what is the minimum price R should charge D if:
Solution
In Situation 1, Division R has surplus capacity. Usually surplus capacity indicates that the
Division has incurred fixed costs to create capacity and therefore will have unabsorbed
fixed costs.
This also indicates that the opportunity cost for the Division is Zero since they have no
market elsewhere.
Opportunity Cost=0
In Situation 2, Division R has no surplus capacity. This indicates that they have an adequate
market size to absorb their output, Hence minimum Transfer price= Rs.35/-
: 157
Introduction to
In Situation 3, Division R can produce 3000 additional units without incurring any additional
Management Control
Systems fixed cost. Hence incremental cost is Rs.22/-(as calculated above) However, there is
Illustration 10.4
Two divisions A and B of M&S Enterprises operate as profit centres. Division A normally
purchases 10,000 units of Component M12 from Division B, annually. Division B has
recently revised its price list and has fixed a selling price of Rs.1,100 per unit of M12. A
similar component is available in the market at Rs.1,000 per unit. The cost structure of
Division B is as follows:
Required:
2. If the market price reduces by Rs.80/- per unit, what would be the
effect of sourcing the component from the market?
Solution
: 158
If no alternate uses are available for capacity in Division B, then opportunity cost Introduction to
Management Control
to Division B is zero. This is because, there is no other opportunity available for Systems
Division B to earn profits.
NOTES
Therefore the component should be sourced from Division B at any price over
Rs.950/- but under Rs.1000/-
2. If the market price reduces by Rs.80/-, then the cost to Division A is Rs.920/-
However, the minimum cost of producing the unit is Rs.950/- Therefore there
would be a saving of Rs.30/- per unit if it is sourced from the market.
=950+37.5= Rs.987.5
: 159
Introduction to information to the divisions and the fixed cost that are included in the cost to the receiving
Management Control
Systems division is called the upstream fixed costs.
NOTES Let us look at a hypothetical situation to understand how the distortion happens.
Assume that Divisions X and Y are two divisions and X produces and transfers to Y.
The total cost to X is Rs.500/- of variable cost and Rs.200/- per unit of fixed cost and
margins. The number of units transferred to Division Y is 100. So X will fix a price of
Rs.700/- per unit and transfer the output to Y. Y might incur additional processing cost
of Rs.300/- This would add up to an incremental cost of Rs.1,000/- per unit plus the
divisional fixed cost of Y.
Suppose Division Y has excess capacity (that is, they can produce more units without
incurring additional fixed cost) and the market price for the output has dropped to Rs.900/
- per unit, Division Y will decide not to supply the product in the market. This is because
they would not even be able to recover their incremental cost of producing one unit.
Now assume that the Divisions are not functioning as independent profit centres. Then
the total variable cost of producing the product would be Rs.800/-(Rs.500/- for Division
X and Rs.300/- for Division Y). Now the selling division would compare the selling price
to this incremental cost of Rs.800/- and may decide to sell the product at the current
market price of Rs.900/- resulting in a contribution of Rs.100/- per unit.
The problem in the situation as described above was that the selling division was not
aware of the breakup of the cost of the product and could not therefore take the decisions
best suited to the organization at large.
Therefore there have to be systems in place to make all entities in the organization
aware of the various components of cost so that decisions can be taken that benefit the
organization. One of the methods that we use towards this end is called two step pricing.
Check Your Progress Two step pricing includes two charges. First, for each unit sold, a charge is made that is
How does two step pricing
help in resolving information equal to the standard variable cost of production. Second, a periodic (usually monthly),
asymmetry ?
charge is made that is equal to the fixed costs associated with the facilities reserved for
UV Enterprises operates a decentralized business unit with three divisions A,B and C.
Division A transfers output to Division B and Division B in turn transfers output to Division
C. Division C’s cost structure is as follows:
Particulars Amount
Division C has received an order for 1000 units at an expected selling price of
Rs.750/- per unit.
Required:
: 161
Introduction to b. Assuming that Divisions A, B and C were not profit centres, what
Management Control
Systems might be the expected contribution from the order?
NOTES c. Would you classify the issues arising between departments on account
of the order as:
d. What is the minimum selling price at which C can accept the order, on
the basis of your calculations in b as above assuming 100% capacity
utilization Division C?
Solution:
a. C is not likely to accept the order since their variable costs amount to
790/-(440+350) which is below the offer of 750/-
b. Cost to A:
: 162
Since all divisions have excess capacity, contribution from the order is Introduction to
Management Control
Rs.750-500=Rs.250/- Systems
Profit Sharing
The product is transferred to the marketing unit at Standard variable cost. After
the product is sold, the business units share the contribution earned, which is the
selling price minus the variable manufacturing and marketing costs.
Illustration 10.6
: 163
Introduction to ii. Transfer the output at cost by M to N
Management Control
Systems
iii. Transfer the output at cost, and then share profits after output is sold
NOTES between M and N
Solution
Since the market for the product is yet untested and success rate is not
known, Division N is reasonable in being reluctant. However, since M has
Check Your Progress proposed the product, they are already motivated to produce the same. In
What are the goal
congruence issues in order to incentivize Division N to produce it, a good beginning would be to
transfer pricing ? allow Division M to transfer at cost and then arrive at a profit sharing
between the Divisions. Option C seems to be the most reasonable.
Manufacturing unit is credited with market price and buying unit is debited with
standard cost. The differential is charged to the headquarters.
10.6 Summary
Issues that arise in transfer pricing are problems on account of capacity utilization in
Divisions, problems of information exchange and problems of goal congruence. To over-
come the problem of information exchange, there must be systems in place to make all
entities in the organization aware of the various components of cost so that decisions
can be taken that benefit the organization. One of the methods that we use towards this
end is called two step pricing. Two step pricing includes two 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 costs associated
with the facilities reserved for buying the unit. This gives the buying divisions an
understanding as to what component is fixed and what is variable. Some of the
negotiated methods of transfer pricing intended to overcome problems of goal
congruence are -facilitating agreement among Business units, profit Sharing between
: 164
divisions and having two Sets of Prices. Implementation of transfer pricing in organisations Introduction to
Management Control
happens through negotiated settlement, arbitration and conflict resolution and fixing thumb Systems
rules for repetitive transactions.
NOTES
10.7 Key Terms
Two step pricing includes two 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 costs associated with the facilities reserved for
buying the unit.
10.8 Questions
1. Large Scale operations Ltd., pursues the policy of permitting each of its Divisions
to operate essentially as an independent unit. Division managers are free to
determine their own sources of supply and to set their own prices.
The Component Division has a productive capacity of 8,00,000 labour hours per
year. It is operating at 80% capacity now. Total conversion cost in the division
amounts to Rs.6/- per labour hour plus Rs.17,50,000/- per annum.
Required:
: 165
Introduction to c. Suppose Component Division gets a special order to supply 50,000 units to
Management Control
Systems an outsider, at a price of Rs.28/- and their raw material cost in this case
goes down by Re.1/- what is the minimum price that Component Division
NOTES
should charge the manufacturing division so that they are not at a loss.
Assume that Manufacturing Division will source the entire 60,000 units
from a single supplier.
2. X Ltd. has two divisions A and B. A produces output which is entirely consumed
by Division B. A’s produce has a market outside provided A makes considerable
changes in its output. This will increase the variable cost of A by at least 30%.
Division B can source the material from outside, but will again have to incur
additional conversion costs to make it suitable for their uses.
Which of the following, do you think is ideal for the oragnisation so that any
sourcing decision taken by division B will be in the interest of the organisation?
c. Convert A into a cost centre and get them to transfer their output to B
at cost.
iii. Transfer the output at cost, and then share profits after output is sold
between M and N
: 166
Introduction to
iv. Compensate M for product development cost and transfer output of M Management Control
at cost Systems
NOTES
4. A company is organised into two large divisions. Division A produces a component
which is used by Division B in making a final product. The final product is sold at
Rs.400/- each. Division A has the capacity to produce 2000 units and Division B
can purchase the entire quantity.
Present a statement indicating the position of each Division and the company as a whole,
in each of the following situations:
a. If there are no alternative uses for the production facilities of A, will the company
benefit if Division B buys from outside suppliers at Rs.200/- per component?
b. If internal facilities of A are otherwise not idle and the alternative use of the
facilities will give an annual cash operating savings of Rs.30,000/- to Division A,
should Division B purchase the components from outside?
c. If there are no alternative use for the production facility at Division A and the
selling price for the component in the outside market drops by Rs.15/-, should
Division B purchase from outside suppliers?
d. What transfer price would you fix in each of the above circumstances?
5. Omega Co. has divisions-M and N. Products required by Division N are currently
outsourced at Rs.20/unit. Division M also makes these products and can sell
either to Division N or to outside markets. Current capacity of Division M is
: 167
Introduction to
50,000 units. Div. N sells its products at Rs.40 per unit in the market. Income
Management Control
Systems statement for both divisions and the company is as under:
Sales
Total 10 8 18
Expenses
Variable
Fixed 3 1 4
Gross Income 2 1 3
(a) What should be done by the company as a whole? Justify with figures.
(b) What would be the approach of Managers of Divisions M and N towards the
possible capacity increase? What should it be? Why?
(c) If you recommend inter unit sale, what would be the recommended selling price?
Why?
80 3000 NOTES
50 6000
(a) Define profit in this case and prepare a statement for both Division and
overall company.
(b) State the Selling price which maximizes profits for Division B and the
company as a whole. Comment on why the latter selling price is unlikely
to be selected by Division B.
The Johnson adhesive plant requires 10,000 barrels of T-bar per month and can
purchase it outside the firm at $150 per barrel. Johnson’s T-bar unit has a capacity
of 20,000 barrels per month and is presently selling that amount to outside buyers
at $165 per barrel. The difference between the T- Bar’s unit selling price and
the market price is due to short term pricing strategy only; the materials are
equivalent in quality and functionality. The T-Bar unit’s selling cost is $5 per
barrel and the unit variable cost is $90 per barrel.
Required:
a. Should the adhesive unit purchase T-Bar from outside the firm?
NOTES 8. Alpha, Beta and Gamma are three divisions in Chandra Ltd. All of them are
profit centres and follow an extremely market driven approach towards all inter
divisional transactions.
Alpha transfers its output to Beta, Gamma and several external businesses.
Beta’s output is mostly consumed by Gamma. The Alpha Division is working
under severe capacity constraints and cannot supply to anybody unless a firm
order is placed. They have a markup of 20% over their full cost. The Beta
Division is constrained only by the capacity of Alpha. Sometimes they source
from outside when Alpha declines to supply to them. Beta is always on the
lookout for new orders in order to fill their capacity.
Required:
Lexington Books.
: 171
Introduction to
Management Control Unit 11: Measuring and Controlling Assets
Systems Employed
NOTES Structure
11.0 Introduction
11.1 Learning Objectives
11.2 Meaning of Investment Centre
11.3 Historical Perspective to Investment Centre
11.4 Objectives of Investment Centre
11.5 Performance measurement of Investment Centers
11.5.1 Return on Investment
11.5.2 Residual Income- is the difference between operating
income and the minimum dollar return required on a
company’s operating assets.
11.5.3 Economic Value Added
11.6 ROI vs EVA
11.7 Precautions while using ROI
11.8 Choice of Depreciation method
11.9 Choice of Asset Base
11.10 Summary
11.11 Key Terms
11.12 Questions
11.12.1 Objective questions
11.12.2 Theory questions
11.12.3 Business cases
11.13 Further Reading and References
: 172
11.0 Introduction Introduction to
Management Control
We learnt that profit centres have to meet their expenses and generate a surplus. Now we Systems
raise the question-surplus on what? Is profit an absolute measure or is it relative? In this NOTES
The concept of measurement of return on asset is based on the philosophy that the true
test of whether the profit is too great or too small is the rate of return on the money
invested in the business and not the percent profit on the cost. Such measurement of profit
against the investment is the function of an investment center. The essential element of an
investment centre is that it is treated as a unit which is measured against its use of capital,
as opposed to a cost or profit centre, which are measured against raw costs or profits.
: 173
Introduction to Investment centres are a part of responsibility centres involved in utilising the capital
Management Control
Systems directly to contribute to the profits of the organization. This is a responsibility centre,
which aims at efficient utilization of the resources. To earn a satisfactory return on the
NOTES
investment made is an important objective of the profit oriented company, except in
some service organization where the capital investment is insignificant. The performance
of this centre is evaluated by comparing the profits earned i.e. output with the assets
employed to earn that profit i.e. input. Just focusing on the profits without concerning
about amount of resources being used will mislead the performance evaluation and lead
to ineffective control. Comparing the absolute profit performance of different business
units is meaningless unless one considers the amount of assets employed to generate
the profits.
In the 1900s businesses had single focus- textile or railroad or steel etc. For the business
to be profitable, costs needed to be controlled. Control of costs naturally resulted in
better profits. When businesses stabilized then the most important decision was that of
scale. As a business grew in size and produced more units of output, then it experienced
falling average costs of production (i.e. on average, each unit of output costs less to
produce). This came to be known as benefiting from economies of scale. In other
words, the business was becoming more efficient in its use of its inputs to produce a
given level of output.
Du Pont Powder Company, formed in 1903, had a new organizational challenge not
faced by the nineteenth century organizations- to coordinate and allocate resources to
the manufacturing and selling of units performing quite different activities. Integrated
: 174
Introduction to
business units created alternative uses for capital thus making it imperative that returns Management Control
generated from capital should exceed the cost of capital. The concept of measurement of Systems
return on asset was that “the true test of whether the profit is too great or too small is the NOTES
rate of return on the money invested in the business and not the percent profit on the
cost”. In order to know which of their activities returned maximum profits as percentage
of the capital employed, Du Pont developed a scale that is today popularly known as
“Return on Investment” to measure performance of their divisions.
Internal Capital was defined as the Standard Working Capital+ Fixed Assets-Reserves.
Interest charged for internal Capital was 1% per month, paid to Central Office, each
month. Central Office levied3% of Divisional Sales to cover headquarters expenses, paid
to Central Office each month. After deducting this payment, divisional net profit was
expected to be equal to 10% of sales which was the target goal for profit management.
If divisional funds fell short of required amounts, the division could borrow temporarily
from the Central Office. Any excess cash could be deposited in the Matsushita Bank,
where it earned a competitive rate of interest. When a division required large funds for a
major new investment, the proposal was submitted to the Central Office for approval and
funding.
Thus businesses had evolved from merely deciding the scale of production to allocating
capital to their various businesses based on the return generated on each of the business.
One of the most important objectives of the investment centre is to measure the
ofits not in absolute terms, but as a function of investment.
: 175
Introduction to For example, if Division A has earned a profit of Rs.1,00,000/- and the assets
Management Control
Systems relatable to Division A is Rs.50,00,000/-, then the profit in relation to the
investment is 2%. However, if Division B has earned Rs.1,00,000/- on an asset
NOTES
base of Rs.10,00,000/- then the profit earned by Division B is 10%. On a relative
basis, Division B would be more profitable even if the absolute profits earned
by both the Divisions are the same.
For a profit centre to perform well, the vital parameters are profitability and
Check Your Progress
What are internal and asset utilisation. Profitability is a function of cost control and revenue
external economic scale ?
eaximisation. However, an investment centre also seeks to measure the profit
against assets utilised. Hence the objective of an investment centre is not only
control of cost and maximisation of revenue but also proper asset utilisation.
When a business has an opportunity to invest into multiple projects, then the
project which promises the most return on the investment or assets deployed
will be the preferred investment. Also when there are multiple profit centres in
a business the capital will be used in that profit centre where the returns are
better than the other profit centres.
(ROI) measures profits earned per rupee of investment. ROI is calculated as:
OR
· Profitability to sales represents the margin which is the ratio of operating income
to sales
· Sales to Assets employed represents asset turnover which shows how productively
assets are being used to generate sales Advantages of using ROI-
: 177
Introduction to
Advantage of residual income:
Management Control
Systems
A manager will accept any project that earns above the minimum rate of return because
NOTES they will increase the company-wide profitability
Economic value added (EVA) is after-tax operating profit minus the total annual cost of
capital. EVA =After-tax operating income, that is:
Illustration 11.1
Calculate return on sales, asset turnover, return on investment and residual income from
the following data:
Sales 80,00,000/-
Solution
=640000/800000*100
=8%
=8000000/{(2500000+2800000)/2}
=3.01 times
: 178
Sales Assets employed Introduction to
Management Control
Systems
=8*3.01
NOTES
=24.08%
= 640000-(12%*2650000#)
=640000-318000
=Rs.322,000/-
Illustration 11.2
The following are the operating result of A Ltd. Calculate EVA assuming weighted average
cost of capital at 8%, 10% and 12%
Solution
EVA (Economic Value Added) = Post tax Profit- (Weighted average cost of capital
×Total capital employed)
8% 10% 12%
: 179
Introduction to Illustration 11.3
Management Control
Systems
Divisions M, P and C of Little Lotus Limited are respectively engaged in activities of
NOTES Marketing, Manufacturing and both. Control is through Return on Investment. Fixed
assets are depreciated on straight line basis assuming asset life of 10 years. The
performance of the divisions is as follows:
(b) Analyse and comment on relationship, if any, between ROI achieved and divisional
activities.
Solution
Depreciation 0 100 50
depreciation*100)
: 180
(b) Relationship between ROI and divisional activities Introduction to
Management Control
Systems
Division P which undertakes manufacturing activity has the least ROI whereas, Division
M which does only marketing activities reports the maximum ROI. The reason for this is NOTES
not difficult to guess because Division P employs more assets as compared to Division M
and Division C.
Therefore when the activity requires heavy investment ROI will be relatively less.
However, ROI is not a measure of efficiency for Division M. this is because service
activities will deploy lesser assets and the ROI is not a true measure of performance for
such Divisions.
For Division C however, ROI is an ideal measure of performance since there is sufficient
deployment of assets.
Illustration 11.4
Div A Div B
(b) Suppose the Manager of Division A were offered a one year project that would
increase the investment by Rs.1000 and generate a return of Rs.150, would the manager
accept the project if he were evaluated by the ROI he generates for his division?
(c) Would the decision take by the manager correct? Why/ Why not?
Solution
However, if the EVA is calculated, then the results of the divisions would appear as
follows:
: 181
Introduction to
Management Control DivisionA DivisionB
Systems
Capital invested 2400 4000
NOTES
Net Income 480 720
Income= 480+150=630/-
Investment=2400+1000=3,400/-
ROI=630/3400*100=18.53%
(b) The decision would be incorrect because the cost of capital is 12% and the new
project gives a return of 15% (150/1000*100). Since the cost of capital is less
than the return on the project, it should be accepted since it would increase the
profits of the business.
(c) The Divisions would be equally profitable when the cost of capital is 15%. This
is explained as follows:
: 182
Introduction to
11.6 ROI vs EVA Management Control
Systems
There are several differences between ROI and EVA. They are:
NOTES
1. Economic value added is an absolute measure, whereas ROI is a percentage
measure.
2. Since EVA is an absolute measure, it can account for scale differences. For
example, if ROI is 10%, then it can be Rs. 10 earned on 100 or Rs. 1 crore
earned on a base of 10 crore. ROI cannot account for the differences in scale,
whereas EVA can account for it. EVA of Rs.100,000/- would imply a certain
scale of activity, whereas EVA of Rs.100,00,000/- will imply a larger scale of
activity.
3. EVA represents the returns for the owner of the capital since it is interest adjusted,
whereas ROI represents the return for the specific project, since interest costs
are not deducted.
Check Your Progress
What is the difference
4. EVA is the measure of profits whereas ROI is a measure of efficiency since it between residual income
and Economic value added?
measures the return generated from an asset without reference to the source of
capital.
Even though EVA is a superior measure as compared to ROI, ROI is a preferred measure
by most of the managers for practical purposes. The reasons why ROI is preferred to
EVA are as follows:
1. The thrust for the manager is to maximise returns and not maximise accounting
based measures
2. The cost of capital was a figure that divisional managers are not willing to commit
on
: 183
Introduction to 5. Despite the long time lack of acceptance of EVA most of the bonus plans for
Management Control
Systems senior executives is based on EVA
ROI is a very useful method in calculating return of a division. It also has a wide appeal
because it is an easy measure to administer and understand. However, there are demerits
of the method which are discussed as follows:
Since ROI is a percentage measure, it does not account for scale differences.
When percentage is calculated, then a small return on a small asset base may
return a larger percentage than a large return on a large asset base. For example
if a business has an investment of Rs.10,00,000/- and the profit earned is
Rs.2,00,000/- then the ROI is 20%. However if the investment is Rs.100,00,000/
- (1 crore) and the profit earned is Rs.15,00,000/-. In this case the ROI would
be 15%.
Check Your Progress
Are absolute measures When 15% and 20% are compared, it does not give us an idea of the scale at
better than relative
measures ? Why/Why not? which the division operates. Hence the ROI percentages could be misleading.
Intangible expenses do not create assets. They create benefits for a Division for
the future period. For example, research expenses. For such expenses on
intangibles, discretion exists as to whether the expenditures should be capitalized
or expensed in the same year in which they are incurred. The division may decide
to write off the expense in a single year even though the benefits may accrue
over several future years. Such failure to capitalize expenses with future benefits
will penalize earnings in the short run until the steady state is reached and will
overstate the ROI in the steady state.
Leasing of Assets
Sometimes firms decide to lease assets rather than purchase them. The effect of
this on the ROI is that the profit will reduce because of the lease rentals paid, but
the asset base reduces disproportionately since the cost of the asset is not included
in the denominator. Therefore ROI may be grossly overstated thereby giving an
incentive to managers to lease assets rather than purchase them even if no
economic benefit arises on account of the same.
: 185
Introduction to
Illustration 11.5
Management Control
Systems
GR limited operates some of its divisions as Investment Centers and accordingly
NOTES their performance is measured by the ROI that they generate.
Typically they consider lot of projects that require capital investment and the
ROI generated by each of these investments will be a major factor in identifying
the favourable projects.
Alternatively, there is a proposal that the company need not own the assets but
lease them. Leasing has clear advantages in terms of the number of years for
which the asset needs to be held. The division can surrender the asset, provided
it is used for at least three years. Under these terms the company can pay a
lease rent of Rs.35,00,000/- per annum.
The Division manager is keen that in the initial years of the project, there must
be a higher ROI so that it will reflect positively in his appraisal.
Required:
Calculate the post-tax earnings under both purchase and lease options assuming
tax rate of 50%. Also calculate the ROI under both options for the years ending
2008,09,10 and 11 and 12 assuming that the division uses Straight line method(
for the full five years) to depreciate the assets of the Division.
At a cost of capital of 5%, which of the options is better for Division R? You
may assume that the assets will be used for 5 years under both options.
: 186 What are the dysfunctions that the ROI approach throws up in this case?
Solution Introduction to
Management Control
In case Systems
equipment
is purchased NOTES
Cash Depreciation Income Tax (50%) Asset value ROI Cash flow
Flow (st.line dep
method) adjusted
In case
is leased
Cash Flow Lease Rent Net cash Tax adjusted Asset value ROI
flow cashflow
12117079
Since differential cash inflow is more than outflow, purchase is beneficial. : 187
Introduction to Note:
Management Control
Systems 1. Differential cash flow is calculated as cash inflows from purchase minus cash
NOTES inflows from lease. For example, it is Rs.40,00,000 in Year 1 in case of purchase
and Rs.250,000/- in case of lease. So the differential cash flow is
Rs.37,50,000/- in Year 1
2. These differential cash flows are discounted using a discount rate of 5%. For
better understanding of this concept, students are advised to go through
information on “time value of money”
3. The dysfunctions that arise on account of use of ROI is that the economic
benefit of the decision is overlooked. Purchase is a better economic decision,
whereas, leasing results in better ROI in Year 1 because the asset base is low.
Purchase decision looks better in the later years when the asset is depreciated.
So a manager who looks at a one or two year frame is likely to choose lease,
whereas in the long run it is not a good choice.
methods of depreciation can result in different ROI being reported. For example,
if sum of year digit method is used, then the ROI in the earlier years are likely
to be high and later years will reduce. So a manger wanting to increase the
near term profits of his division is likely to choose this method of depreciation
: 188
over others.
Introduction to
11.9 Choice of Asset Base Management Control
Systems
The choice of asset base for assessing the performance of the investment centre
could be tangible and/or intangible assets, controllable uncontrollable and/or partially NOTES
controllable assets, total assets and/or total assets minus liabilities etc. Each of
these will have the effect of changing the ROI. Similarly, the asset value could be
gross block or net block, book value or market value or replacement value etc.
When the gross block of asset is used to calculate ROI, then the choice of method
of depreciation does not affect the ROI.
When the net value of assets are used in the base to calculate ROI, it might result
in using a higher rate of depreciation or a method of depreciation that might result
in quick write off of asset values so that ROI is high.
1
Sum of the year digit method works as follows:
Suppose the equipment costs Rs.5000/- and the life of the equipment is 3 years,
depreciation for year 1 is 1/(3+2+1)*5000; Year 2 is 2/(3+2+1)*5000 and year 3 is 3/
(3+2+1)*5000. This method ensures that the depreciation in the initial years is faster
than the depreciation in the later years.
Illustration 11.6
The Division is currently operating on fairly old assets, some of which are run
down and nearing the end of useful life.
Replacement of such assets is expected to cost the Division an additional capital investment
of Rs.30,00,000 in the beginning of the year 2011. Additional cash flow on account of
savings in maintenance and enhanced productivity is expected to be Rs.10,00,000 every
: 189
Introduction to year for the next 5 years before tax. The company uses the sum of year digit method to
Management Control
provide depreciation of the asset for income tax purposes.
Systems
The cash flows and income statement of the Division appears as follows:
NOTES
Particulars Current After
Replacement(Projected)
On seeing the calculations as above, the Division manager is not too keen to work
with new assets; there are talks of melt down and downsizing all around and he was
not willing to take flak for lower ROI. He had his bonus at stake and therefore he
decided not to press for any asset replacement.
Required:
11.10 Summary
Investment centres are a part of responsibility centres involved in utilising the capital
directly to contribute to the profits of the organization. This is a responsibility centre,
which aims at efficient utilization of the resources. Integrated business units created
alternative uses for capital thus making it imperative that returns generated from capital
should exceed the cost of capital. The concept of measurement of return on asset was
that “the true test of whether the profit is too great or too small is the rate of return on the
money invested in the business and not the percent profit on the cost”. Objectives of
investment centre are measurement of profit against investment, Control on cost, revenue
and asset utilization and deciding the priority of deployment of capital. Return on Investment.
The performance of investment centre can be measured using Return on Investment
(ROI), Residual Income and Economic Value Added. Economic value added is an absolute
measure, whereas ROI is a percentage measure. Even though EVA is a superior measure
as compared to ROI, ROI is a preferred measure by most of the managers for practical
purposes ROI is a very useful method in calculating return of a division. It also has a wide
appeal because it is an easy measure to administer and understand. However, there are
also demerits of the method such as not accounting for differences in scale , not being
: 191
Introduction to
Management Control representative of future performance and also being susceptible to manipulation. Some
Systems of the specific instances where ROI could be adjusted by making accounting adjustments
NOTES are in the choice of Expensing versus capitalization, Leasing of Assets, Choice of
Depreciation method and Choice of Asset Base.
11.11Key Terms
Investment centre is concerned with costs, revenue and the assets
11.12 Questions
1. When ROI is 15% and cost of capital is 10%, then the project should be
rejected.(T/F)
2. When ROI is 15% and a new project yields 13%, the investment proposal can
be accepted or rejected on the basis of _______________________.
3. Inflation affects ROI by bringing down the percentage of ROI over a period
of time.(T/F)
4. Replacement value of the asset is used for ROI calculations when the division
is intended to be sold.(T/F)
5. If Return on sales is low and asset turnover is high, it means that profit can be
improved by increasing margin on sales.(T/F)
7. ROI will decrease if the incremental investment gives the same return as the
existing return.
NOTES
10. Interest is always included in calculation of ROI because the real return on
investment is after adjustment of interest.
12. Since input costs increase simultaneously with selling prices, the adjustment for
inflation happens automatically and therefore does not affect ROI calculations.
13. Capitalizing expenses with future benefits ensures that ROI is even and relatable
to the income earned.
14. Stating assets at historical costs gives an unrealistic ROI during inflationary period.
15. Since EVA is an absolute measure, it cannot even out differences in the scale of
operation.
17. Gross Book Value adjusts for the age of the asset and method of depreciation
used for the purposes of ROI calculation.
: 193
Introduction to
7. What precautions must be exercised while using ROI to measure the
Management Control
Systems performance of a Division?
NOTES
11.12.3 Business cases
CASE 1 There are four divisions located in various geographic locations of Western
India Components Limited. These divisions operate out of Mumbai, Nasik, Ahmedabad
and Goa. Each of these divisions have complete autonomy in most of the critical business
decisions. Capital requirement of these divisions is evaluated by the top management
and a project evaluation is made before approving funds for projects. When divisions
request for capital infusion at the same time, projects are ranked using various criteria
including NPV and Pay back period.
The following is a tabulation of the division wise assets and income for 2012.
Assets
Equipment(Gross) 40 45 45 30
Equipment(Net)* 20 10 30 27
Accounts Receivable 8 12 4 9
Inventory 12 13 8 6
EBIT 38 20 16 17
Return on Assets
Rank
Incentive
: 194
Required: Introduction to
Management Control
Systems
1. Rank the divisions by Return on Assets
NOTES
2. Assume that the minimum desired return on assets (gross) is 15%. Incentive is
calculated as 10% of base salary on every 1% of Return over and above the
minimum return. Calculate the return for each of the Divisional Manager as % of
his base salary.
3. Suppose the return is calculated on net value of assets this might result in:
b. Replacing assets just before quitting the Division, even if the replacement
was not entirely necessary
5. Suppose Land and Building are eliminated from the asset base in calculating the
return and gross value of assets are used instead of net value, it might indicate the
following(you can choose more than one answer in this case):
NOTES
d. Divisions operating with older assets look better in terms of returns
f. High cost of real estate pulls down the return of the Division
6. CASE 2 The Randolph Teweles Company (RTC) has decided to acquire a new
truck. One alternative is to lease the truck on a 4-year guideline contract for a
lease payment of Rs.10,000 per year, with payments to be made at the beginning
of each year. The lease would include maintenance. Alternatively, RTC could
purchase the truck outright for Rs.40,000, financing the purchase by a bank
loan for the net purchase price and amortizing the loan over a 4-year period at
an interest rate of 10 percent per year. Under the lease arrangement, RTC
would have to maintain the truck at a cost of $1,000 per year. The truck is
depreciated at 20% per annum using Straight Line Method. It has a residual
value of Rs.10,000, which is the expected market value after 4 years, when
RTC plans to replace the truck irrespective of whether it leases or buys. RTC
has a tax rate of 40 percent.
For convenience, you can assume that maintenance costs are incurred at the
beginning of the year (in case of lease).
: 196
Introduction to
11.13Further Reading and References Management Control
Systems
Anthony and Govindarajan, Management Control Systems, 12th Edition, Tata McGraw
Hill NOTES
Robert Kaplan, Anthony Atkinson, Advanced management Accounting 3rd Edition, Pearson
“An overview of the implementation of Economic Value Added (EVA™) performance
measures in South Africa “ by H.M. van der Poll, N.J. Booyse, A.J. Pienaar, S.
Büchner & J. Foot Hand Book(F-6) on EVA published by United States Postal
Service
: 197
Introduction to
Management Control
Unit 12: Budgets, Responsibility Accounting and
Systems Budgetary Control
NOTES Structure
12.0 Introduction
12.1 Unit Objectives
12.2 Meaning of Budgeting
12.3 Budget Preparation Process
12.4 Components of Budget
12.5 Classification of Budgets
12.6 Advantages of budgets
12.7 Limitations of budgets
12.8 Meaning of Responsibility Accounting
12.9 Principles of Responsibility Budget Management
12.10 Advantages of Responsibility Budget
12.11 Meaning of Budgetary control
12.12 Objectives of budgetary control
12.13 Budgetary control techniques
12.14 Budgetary variance using flexible budget
12.15 Reconciliation of Actual and Budgeted profits
12.16 Summary
12.17 Key Terms
12.18 Questions
12.18.1 State whether True or False
12.18.2 Theory questions
12.18.3 Practice Problems
12.19 Further Reading and References
: 198
Introduction to
12.0 Introduction Management Control
Systems
We have understood the meaning and importance of Responsibility centres in organisations.
We will understand how the concept of responsibility centre can be incorporated into the NOTES
budgeting process and such budgets help the process of control in organisations.
· Classification of Budgets
Budget is one of the important and powerful tools available to the organization to have
estimates about expenses and income for a definite period of time. In this present scenario
it is very necessary to reduce the cost in regard of all terms to sustain in the market.
The modern approach is towards a comprehensive budget plan and control. Of all business
activities, budgeting is one of the most important aspects and, therefore requires detailed
attention.
A budget is a financial and /or quantities a statement prepared prior to a definite period of
time, of the policy to be pursed during that period that for the purpose of attaining a given : 199
Introduction to objective. A budget is a pre-determined statement of management policy during a given
Management Control
Systems period which provides a standard for comparison with the results actuality achieved.
NOTES
12.3 Budget Preparation Process
There are certain essential components which are necessary for the successful
preparation and implementation of a budgeting system. They are discussed as follows:
1. Budget centers
2. Budget officer
3. Budget manual
4. Budget committee
5. Budget period
6. Determination of key factor.
1. Budget centers
A budget center is that part of the organization for which the budget is prepared.
A budget Centre may be a department, section of department or any other part
of the department.
2. Budget officer
The chief executive, who is at the top of the organization, appoints some persons
as budget officer. The budget officer is empowered to scrutinize the budgets
prepared by the various departmental heads and carry out changes in them, if
the situation so demands. The actual performance of different departments is
communicated to the budget officer. He determines the deviations in the budget
and takes necessary steps to rectify the deficiencies, if any.
3. Budget manual
A budget manual is a document which spells out the duties and also the
Check Your Progress responsibilities of the various executives concerned with the budgets. It specifies
What is meaning of budgets
? the relations among various functionaries.
4. Budget committee
In small scale concerns, the accountant is made responsible for preparation and
implementation of budget. In large scale concerns a committee known as a
: 200 budget committee is formed. The heads of all important departments are made
Introduction to
members of this committee. The committee is responsible for preparation and
Management Control
execution of budgets. The budget officer acts as coordinator of this committee Systems
A budget period is the length of time for which a budget is prepared. The budget
period depends upon a number of factors. It may be different for different industries
or even it may be different in the same industries or business
1. Operating Budgets
2. Financial Budgets
3. Capital budgets
Operating Budgets relate to the planning of operations or activities or operations of the
enterprise. Usually the starting point of such a budget is the anticipated demand. There
are two approaches to an operational budget- a budget of an activity or a programme or a
budget from the point of view of responsibility.
NOTES detailed discussion about responsibility budgeting follows later in this Unit.
Financial Budgets
Financial budgets are concerned with the financial implication of the operating budgets.
The important components of financial budgets are the cash budget, projected income
statement and the projected balance sheet. This helps the business for planning the
financial resources of the firm and the firm can accordingly decide the payment of
dividends and plan capital inflows and outflows.
Capital budgets
Capital Budgets involves planning for the long term and involves higher cash outlays.
The fundamental difference between operational budget and capital budget is that capital
budgets are prepared for activities that are expected to have longer life. Operational
budgets are meant for activities that usually commence and finish within the same
accounting period. Considering the significant cash outlay involved capital budgets usually
have a committee and the budget is prepared to ascertain whether a project should be
accepted or rejected.
: 202
Introduction to
On the basis of level of activity, budgets can be classified into static and flexible budgets.
Management Control
Static budgets are used to manage activities whose outcome is not dependent on the Systems
inputs and flexible budgets are useful when the output can be related to the input. NOTES
1. Budgets can be seen as pressure devices imposed by management, thus resulting in:
b) Inaccurate record-keeping.
4. Waste may arise as managers adopt the view, “we had better spend it or we will lose
it”. This is often coupled with “empire building” in order to enhance the prestige of
a department.
5. Responsibility versus controlling, i.e. some costs are under the influence of more
than one person. e.g. power costs.
6. Managers tend to overestimate costs so that they will not be blamed in the future
should the actual costs exceed the budgeted costs. This is called as building a
“slack” in the budget.
: 204
The essence of responsibility accounting is the collection of costs according to responsibility Introduction to
Management Control
centres in order that variances from standard cost and budgets can be identified with Systems
persons, based on the causes of variances corrective actions may be initiated. Suppose
NOTES
variance is calculated for material purchase, then the purchase department will have to
explain these variances. To be effective control must enable effective utilization of scarce
resources by identifying process owners and fixing responsibility. When responsibility is
fixed, there is more attention to details, ensuring proper utilization of resources and an
attempt to keep variances at its minimum.
Responsibility accounting usually involves the preparation of annual and monthly budgets
for each responsibility center -
· The most common responsibility centers are the departments within a company.
· When the manager of a responsibility center can control only costs, the
responsibility center is referred to as a cost center. Check Your Progress
What is responsibility
accounting ?
· If a manager can control both costs and revenues, the responsibility center is
known as a profit center.
· If a manager has authority and responsibility for costs, revenues, and investments
the responsibility center is referred to as an investment center.
: 205
Introduction to
· Then the company’s actual transactions are classified by responsibility center
Management Control
Systems and a monthly report is prepared.
NOTES · The reports will present the actual amounts for each budget line item and the
variance between the budget and actual amounts.
Illustration 12.1
The following information relates to the various departments of Kamal & Company,
who produce three different types of fans. The types of fans produced are table fans,
ceiling fans and exhaust fans.
Variable overheads 50 75 95
1. Head Office incurs brand promotion expenses of Rs.30,000/- per month which
is divided between the products in the proportion of sale units.
3. A special incentive of Rs.20/- per unit is paid for exhaust fans in addition to the
10% sales commission paid on the sales price of each unit of any product sold.
4. Book keeping and administration cost is divided between the products equally.
This amounts to Rs.15,000/- per month.
: 206
Introduction to
Table fans 50
Management Control
Systems
Ceiling fans 100
NOTES
Exhaust fans 50
6. Selling price of table fan is Rs.800/-; ceiling fan is Rs.1050; exhaust fan is
Rs.1050/-
Required:
a. Suppose each of this product is handled by different managers, how will you
prepare a performance budget?
c. How does the preparation of the budget help in fixing responsibility for each
manager?
Solution:
Sales(Units) 50 100 50
Variable overheads 50 75 95
: 207
Introduction to
Particulars Table Ceiling Exhaust
Management Control
Systems fans fans fans
c. The sales units, selling price, variable cost and fixed cost is reflected clearly in
the budget.
The respective managers will be responsible for all the controllable aspects in the budget.
For example, if the manager is allowed to give discount on selling price, he will be
responsible for variances in sale. Similarly, all costs that fall within the authority of the
managers will be controllable costs and hence they will be responsible for it.
Hence such a responsibility budget helps to fix the accountability for performance on a
single person and therefore the response time taken for any feedback or correction also
is quick.
7. The relationship of the parts to the whole should be reflected in the assignment
of responsibility
· In traditional responsibility budgets this also has the effect of keeping higher levels
of administration ignorant of operating details, thereby discouraging them from
meddling in the affairs of their responsibility center managers.
The concept and procedures under budget plan and control have wide application not
only in profit oriented enterprises but in every enterprise where the resource are limited
and have to be properly applied. This, in a sense is ‘managerial budgeting’. It applies to
public and private enterprises, government departments and charitable organizations.
a. Variance analysis
b. Budgetary variance using flexible budget
c. Reconciliation of Budgeted profit with actual profit
Variance Analysis
Variance is the difference in the actual result and the standard result. It is a controlling
technique in which the standard result is first set in the beginning of the month or year
according to the accounting rules or company standards. The actual results are processed
after the period. Then the actual results are compared with the expected or set standard
results. When there is a difference in the result, this difference is known as variance.
This difference is studied by the cost accountant to understand why this gap was formed
and the reasons for it.
This study or the reasons found out by the accountants on the basis of variance is known
as variance analysis, which is the most common budgetary control technique. This is
usually done on a monthly basis, with a summary closing process every quarter. Variances
(differences between the budget and actual results) are noted and accounted for. A decision
can be made to reduce expenses or reallocate resources. This technique greatly reduces
the need for comprehensive review cycles.
If the actual result is better than the set result then it is known as a favourable result and
if the actual result is worse than the standard result then it is unfavourable or adverse
result.
: 211
Introduction to
Management Control In accounting, a variance is defined as the difference between the expected amount
Systems and the actual amount of costs or revenues. From a revenue perspective, if actual
NOTES is more than expected then the resultant is a favourable variance and from a
cost perspective, if actual more than expected then the resultant is an
unfavourable variance.
Variance analysis uses this standard or expected amount versus the actual amount to
judge performance. The analysis includes an explanation of the difference between
actual and expected figures as well as an evaluation as to why the variance may have
occurred. The purpose of this detailed information is to assist managers in determining
what may have gone right or wrong and to help in future decision-making.
Favourable Variance
A variance can be put into the favourable category when the results are better than
expected. This means that revenues were more than the expected amount or costs
were below the budgeted amount. In accounting practice, a favourable variance is
shown by noting a letter F in parenthesis on the reports. A favourable variance might
earn a bonus for a manger, or perhaps a move up the corporate ladder.
Unfavourable Variance
In contrast, the variance can be judged as unfavourable if the results are worse than
expected. If the revenues were below expectations or the costs were higher than
standard, the variance would be termed unfavourable or adverse. This would be denoted
on the reports with the letter A or U. Consistently creating an unfavourable variance
might result in a manger being reprimanded or losing their job. However, the analysis is
typically used to help mangers prevent a negative situation from recurring by providing
information about what went wrong.
process all of the information necessary to discover why there may have been a problem
or benefit that caused the variance. Finally, the standard figures used to calculate the
variance may not be as accurate as the actual figures, thus the analysis may have little
usefulness.
Many people think that adverse result is not good for the company but it is not true. Many
a time it happens that the sales crosses the expected so in case of revenue there is a
favourable result, and obviously the costs incurred will be more than expected i.e. adverse.
So one cannot say that the results were bad, the results eventually were better than
expected. Therefore adverse effects are not always bad.
Sales revenue
Standard product 75 90 15 F
Premium product 30 25 -5 A
Costs
Wages 35 38 3 A
Rent 15 17 2 A
Marketing 20 14 -6 F
Other overheads 27 35 8 A
Profit 8 11 3 F
: 213
Introduction to In the given illustration
Management Control
Systems
1) The actual sales of the standard product are better than the expected sales.
NOTES Thus the result is favourable
2) The actual sales of the premium products are less than expected. Therefore the
variance is unfavourable.
4) Wages, rent and other overheads have exceeded the expected cost; thus adverse
variance.
5) Actual marketing cost is less than the expected cost; thus favourable variance.
7) The overall revenue is better than the overall cost structure in actual condition
thus the total profit is favourable.
In the given illustration though the cost is adverse the total profit is more than expected,
thus the total variance has a positive effect on the cost account.
Variance analysis helps in finding out where the actual results have been increased or
decreased and thus corrective action can be taken by the managers to improve the
profitability of the company by doing variance analysis. They can see where the costs
have increased and thus they can either increase the sales value or reduce other costs
to keep the profit per unit of the product same.
Amt in Rs
Per unit Fixed Budget Actual Result
Sales volume 1,000 1,200
Sales 900.00 9,00,000 9,60,000
Purchases 500.00 5,00,000 5,76,000
Packing cost 80.00 80,000 97,000
Other variable cost 5.00 5,000 6,000
Fixed Cost
Water Charges 1,000 1,000
Shop Overheads 1,20,000 1,23,000
Solution:
Particulars Amount(Rs)
Budgeted Profit
Actual Profit
The following illustrates the reconciliation between the budgeted and actual profits on
the basis of the illustration of Proud Parents Company discussed above:
: 216
Particulars Amount(Rs) Amount(Rs) Introduction to
Management Control
Systems
Budgeted Profit 194000
NOTES
Add: Favourable variances
Although the budget report shows variances, it does not explain the reasons for the
variance. The budget report is used by management to identify the sales or expenses
whose amounts are not what were expected so management can find out why the
variances occurred. By understanding the variances, management can decide whether
any action is needed. Favourable variances are usually positive amounts, and unfavourable
variances are usually negative amounts.
12.16 Summary
Budget is one of the important and powerful tools available to the organization to have
estimates about expenses and income for a definite period of time. Budget preparation
involves budget center, appointment of a budget officer, preparation of Budget manual,
appointment of a budget committee, identification of the budget period and identification
of key factors. The components of a master budget are Operating Budgets, Financial
Budgets and Capital budgets. Budgets can be classified on the basis of time, on the
basis of function and on the basis of level of activity. There are several advantages in
having budgets essentially because a budget compels management to think about the
future, which is probably the most important feature of a budgetary planning and control
: 217
Introduction to system. It forces management to look ahead, to set out detailed plans for achieving the
Management Control
Systems targets for each department, operation and (ideally) each manager, to anticipate and
give the organization purpose and direction. Whilst budgets may be an essential part of
NOTES
any proper control plan they do have a number of disadvantages, particularly in perception
terms. Budgets can be seen as pressure devices imposed by management, thus resulting
in bad labour relations, inaccurate record-keeping, departmental conflicts, empire
building etc.
Budgetary control is a tool of management used to plan, carry out and control the
operations of the business. The business finds it quite handy in planning the growth of
his business or enterprise. The process of comparing the budgets with the actual is
done by using several techniques. They are Variance analysis, budgetary variance using
flexible budget and Reconciliation of Budgeted profit with actual profit.
Capital Budgets involves planning for the long term and involves higher cash outlays NOTES
A variance is defined as the difference between the expected amount and the
actual amount of costs or revenues
A flexible budget is prepared by adjusting the budget as per the actual level of
output.
12.18 Questions
a given period which provides a standard for comparison with the results
actuality achieved.
iii) Capital Budgeting is an exercise to address the short term financial needs of a
business
vi) Budgets should be completely at the instance of the top management so that
there is no conflict in implementation of the budget
: 219
Introduction to
Management Control vii) Responsibility accounting usually involves the preparation of annual and monthly
Systems budgets for each responsibility centre
NOTES
12.18.2 Theory questions
A budget that would help evaluate performance when the actual output is
known
12.18.3 Practice Problems
1. The following information relates to the various departments of Pink Lotus &
Company, who produce offer financial consultancy services. They usually arrange
for loans, undertake credit rating of businesses and identify venture capitalists
and help small businesses to get capital investment. Each of these services are
kept independent of each other and whenever a client is offered multiple services-
for example, if a client approaches them for credit rating and eventually also
seeks venture capital, then the venture capital division pays referral fee to the
credit rating division.
The divisional budgets are sought to be prepared and the following information is made
available to you (All values in Rs.’000)
: 220
Introduction to
Particulars Loan Division Venture Capital Credit rating Management Control
Systems
Division Division
NOTES
Salaries 350 600 750
i. Common expenses of Rs.30,000/- per month which is divided between the Divisions
which are divided in the proportion of revenue earned
ii. Fixed expenses incurred at the Division level are Rs.75,000/-. Rs.82,000/- and
Rs.60,000/- respectively
iii. A special incentive of 10% on revenue is paid to the staff of venture capital
division in addition to the salaries and incentives mentioned above.
iv. Establishment expenses are divided between the Divisions equally. This amounts
to Rs.105,000/- per month.
v. Number of hours of billing for each division per month and the billable rate per
hour is anticipated to be as follows:
Required:
a. Suppose each of this Division is handled by different managers, how will you
prepare a performance budget?
: 221
Introduction to
c. How does the preparation of the budget help in fixing responsibility for each
Management Control
Systems manager?
NOTES 2. The Magic Mattress Company sells children’s garments. Their anticipated sales
for the month of October were 600 units. However, owing to demand fluctuations
the actual units sold were 550. The budget at 600 units and the actual performance
at 550 units is given below.
AmountinRs
Fixed Cost
: 222
Introduction to
12.19 Further Reading and References Management Control
Systems
I.M.Pandey, Management Accounting, 3rd Edition, Vikas Publishing House
NOTES
Abernethy, M. A., & Brownell, P. (1999). The role of budgets in organizations facing
strategic change: an exploratory study. Accounting, organizations and Society, 24(3),
189-204.
: 223
Introduction to
Management Control Unit 13: Multinational Organisations
Systems
Structure
NOTES
13.1 Introduction
13.2 Unit Objectives
13.3 Multinational organisations
13.4 Advantages of multinational organisations
13.5 Disadvantages of multinational Organisations
13.6 Distinguishing Features of Multinational Organisations
13.7 Why is it challenging to comply with different statutes?
13.8 Control Environment in Multinational Organisations
13.9 Multinational Transfer Pricing
13.10 Methods of Transfer Price
13.11 Exchange rate Differences
13.12 Measuring the exchange rate
13.13 Foreign Exchange Risk
13.14 Issues in design of Control Systems for Multinational
Organisations
13.15 Summary
13.16 Key Terms
13.17 Questions
13.17.1 State whether True or False:
13.17.2 Theory questions
which they engage. A multinational organisation operates out of several countries thus
exposing them to larger variation in environment, compliance with varied statutes at different
countries and more variation in cultures and affiliations. This Unit discusses the distinguishing
characteristics of multinational organisations and some of the special control systems that
may be required for the same.
Businesses expand into other nations and operate as multinational corporations for the : 225
Introduction to following reasons:
Management Control
Systems
1. To increase market share
NOTES
Businesses may reach a saturation point in the domestic market and need a
new outlet. They may start by exporting to other countries but eventually they
will want to have production facilities in several countries and so expand into
profitable markets.
Different nations have different kind of resources and talent. For example India
has plenty of technically proficient and English speaking work force which makes
it an attractive destination for software businesses. Australia has good quality
coal making it an ideal destination for electricity projects.
3. To mitigate risk
When businesses operate out of a single country the economic cycles of that
country affect the business greatly. Also the product may go out of demand or
input costs could suddenly increase. When the business operates out of several
countries, economic risk and political risk gets spread out thereby increasing
the sustainability of the business.
1. Job Creation
Multinational Corporations bring expertise and skill sets which may not be
available in the host country. Many times they also bring in technology and
innovation.
2. Economies of Scale
Purchasing economies can be realized by adopting processes like bulk buying, NOTES
pooling suppliers and efficient inventory management. This will help in creating
options to purchase desired quality at minimal cost.
3. Technology transfer
Operating in many countries offers an advantage of being able to transfer
technologies to different nation. It also makes new and different varieties of
products available in the host country.
4. Cost Equalization
Multinational Enterprises help in equalizing of cost of factors of production around
the world. They provide an efficient means of integrating economies.
Multinationals’ profits are not usually kept in the host country. For example the money
made and saved by Hindustan Unilever in India may go back to the headquarters in the
United Kingdom.
Multinationals have been accused of cutting corners. Social responsibility may be ignored
by most of the organisations due to lack of cultural bond with the host country.. Numerous
firms have been accused of exploiting the workforce or providing detrimental working
environment. Workers can work below minimum wage and for longer hours.
Since they have a lot of access to capital, they could bull doze their way into several
countries by intense lobbying. Recently Walmart has been accused of lobbying in Mexico
using unethical means and getting clearance for putting up Walmart stores dangerously
close to Heritage sites.
: 227
Introduction to
Management Control
13.5 Distinguishing Features of Multinational
Systems Organisations
NOTES (1) Size of Operations
Several of the Multinational Organisations are extremely large in size. Some of the
multinationals have a turnover that equals the GDP of smaller nations! Hence the size
of operations leads to increased complexities difficult to control as compared to
smaller organisations that operate from a single geographic location.
One of the main contextual variable that influence management control within a
multinational enterprise is the cultural differences across countries. While culture itself
is believed to mean shared values, assumptions and norms of behaviour, cultural
differences result in conflicted values and assumptions. A study conducted by Hofstede
in 1983 identifies some very important cultural dimensions, namely:
· Power Distance
Power distance is the gap between the degree of acceptance and the expectation of
the less powerful members of organizations and institutions (like the family) that power
is distributed unequally. Cultures that endorse low power distance expect and undertake
power relations that are more consultative or democratic. People relate to one another
more as equals regardless of formal positions.
· Individualism/Collectivism
The degree to which individuals are integrated into groups determines individualism. In
individualistic societies, the stress is put on personal achievements and individual rights.
People are expected to take a stand for themselves and their immediate family, and to
choose their own affiliations. In contrast, individuals act predominantly as members of
a lifelong and cohesive group or organization in collectivist societies. Uncertainty
avoidance
This refers to a society’s tolerance for uncertainty and ambiguity. It reflects the extent
to which members of a particular society attempts to cope with anxiety by minimizing
: 228
uncertainty. People under cultures which avoids high uncertainty tend to be more emotional. Introduction to
Management Control
They try to minimize the occurrence of unusual circumstances and proceed with cautious Systems
step by step changes, planning by implementing rules, laws and regulations. In contrast,
NOTES
people in low uncertainty avoidance cultures acquire and feel comfortable in unstructured
situations or variable environment condition and try to have as few rules as possible.
People in these cultures tend to be more pragmatic, they are more tolerant of change.
The distribution of emotional roles between the genders defines the masculinity or
femininity of a culture. Masculine cultures’ values are competitiveness, assertiveness,
materialism, ambition and power, whereas feminine cultures grants more value on
relationships and quality of life. In masculine cultures, the disparity between gender
roles are more dramatic and less fluid than in feminine cultures where men and women
have the same values emphasizing modesty and caring.
Check Your Progress in different countries, it is referred as Multinational Transfer Pricing. Transfer pricing is
Why is it challenging to the general term for pricing cross border, intra firm transactions between related parties.
comply with different
statutes ?
Hence “Transfer pricing” refers to the setting of prices at which transactions occur
inclusive of transfer of property or services between associated enterprises. Transfer
Price is the price charged by individual entities for goods or services supplied between
multi-department, multi-office, or multinational firms. Transfer price policy is generally
aimed at evaluating financial performance of different business units (profit centres) of
a conglomerate.
a. Goal congruence,
b. Motivation,
c. Autonomy, and
d. Performance evaluation
: 230
Introduction to
However these are considered secondary in the case of multinational transfer pricing. In Management Control
multinational transfer pricing, the objectives are as follows: Systems
NOTES
(1) Evaluating financial performance of different business units (profit centres) of
a conglomerate, and/or
(2) To shift earnings from a high tax jurisdiction to a low-tax one.
For the Multinational firms operating in different tax jurisdictions, transfer prices serve
more than tracking internal transactions for managerial accounting purpose. They also
determine tax liability of affiliates in various countries- that is the overall tax liability of the
multinational enterprise. For example, a multinational with an affiliate in country B may
purchase goods from an affiliate in country A. If the tax rate in the country A is lower than
the tax rate in country B, the multinational will have incentives to set a high transfer price
to shift profits from country B to country A.
Tax authorities usually discourage transfer pricing aimed at tax avoidance and insist that
each internal part of the firm deals with the other on ‘arm’s length’ (market price) basis.
“Arm’s Length Price” is the price charged in comparable transactions between independent
parties, where price is not influenced by the relationship or business interest between the
parties in the transaction.
The Transfer Pricing policies of several countries are based on the OECD (Organization
of Economic Cooperation and Development) Guidelines on the subject.
Illustration 13.1
An item is produced by Division A in a Country with a 25% income tax rate. It is transferred
to Division B in a country with a 50% income tax rate. An import duty equal to 20% of the
price of item is assessed.
The full unit cost is Rs100/- and variable cost is Rs.60/-. Which of these should be chosen
as transfer price?
Solution
Whenever the tax rates differ, the country having a lower rate of tax should charge a high
price so that maximum income is booked in that country.
: 231
Introduction to Therefore in this case since Division A is situated in the low tax regime, it should charge
Management Control
Systems a higher transfer price of Rs100/-.
NOTES Therefore, income of Division A is Rs.40/- higher than if it had chosen Rs.60/- as the
transfer price.
20% of 40 = Rs.8/-
Therefore, Net Savings = Rs.2/- for the organisation if they choose the transfer price of
Rs.100/-
· Cost plus method (CPM): Under this method the standard cost plus mark-up
cost is added to arrive at the transfer price. It is generally used where semi-
finished products are transferred.
· Comparable Uncontrolled Prices Method (CUP): Most systems consider
a third party price for similar goods, services, or property under identical conditions,
called as comparable uncontrolled price (CUP), to be the most trusted indicator
of an arm’s length price. All systems permit testing using this method, but it is
not always applicable. Further, it may be possible to adjust CUPs reliably where
the goods, services, or property are identical but sales terms or other limited
items can be different. As an example, an interest adjustment could be applied
where the only difference in sales transactions is payment period (e.g., 30 days
vs. 60 days). CUPs are based on actual transactions. For commodities, actual
transactions of other parties can be reported in a reliable manner. For other
: 232
Introduction to
items, “in-house” comparables, i.e., transactions of one of the controlled parties Management Control
with third parties, may be the only available reliable data. When applying the Systems
· Resale Price Method (RPM): In this method the vendor adds comparatively
small or no value to goods taken from associate enterprises.
· Profit Split Method (PSM): In this method, the end profits are split between
the transacting entities using an agreed ratio and the transfer is carried out at
cost. It is used when associate enterprises are so combined that it turns into
difficult to make transfer pricing analysis on transactional methods basis.
· Spot Exchange Rate - the current market’s price of the currency is called as
spot exchange rate
· Real Exchange Rate - this is the ratio of domestic price indices between two
countries. A rise in the real exchange rate implies a worsening of competitiveness
for a country.
Foreign exchange risk (also known as exchange rate risk or currency risk) is a financial
risk posed by an exposure to unexpected fluctuations in the exchange rates between
two currencies. Investors and multinational businesses having business activities varying
from exporting, importing goods and services to making foreign investments throughout
the global economy are prone to exchange rate risks. This can have serious financial
consequences if not managed properly. The following are the types of exchange risks
that multinational organisations have to manage and control:
· Transaction Exposure
A firm has transaction exposure whenever it has contractual cash flows (receivables
and payables) whose values are subject to volatility in the exchange rates due to a
contract being denominated in a foreign currency.
· Economic Exposure
A firm has economic exposure (also known as operating exposure) to the degree that
its market value is influenced by unanticipated exchange rate fluctuations. Such exchange
rate adjustments can severely affect the firm’s market share respect, firm’s future
cash flows, and ultimately the firm’s value with respect to its competitors. Economic
exposure can affect the present value of future cash flows. Any transaction that exposes
the firm to foreign exchange risk also bind the firm with associated economic risks, but
: 234
Introduction to
economic exposure can also be caused by other business activities and investments which
Management Control
may not be mere international transactions, such as future cash flows from fixed assets. Systems
A shift in exchange rates that influence the demand for a good in some country will also NOTES
result in economic exposure for a firm that sells that good.
· Translation Exposure
A firm’s translation exposure is the degree to which its financial reporting is affected by
exchange rate volatility. As all firms generally must prepare consolidated financial statements
for reporting purposes, the consolidation process for multinationals entails translating foreign
assets and liabilities or the financial statements of foreign subsidiary/subsidiaries from
foreign to domestic currency. While translation exposure may not affect a firm’s cash
flows, it could have a significant impact on a firm’s reported earnings and therefore its
stock price. Translation exposure is distinguished from transaction risk as a result of
income and losses from various types of risk having different accounting treatments.
· Contingent exposure
A firm has contingent exposure when bidding for foreign projects, negotiating contracts
Check Your Progress
or making foreign direct investments. Such an exposure arises due to the probability that What are the various risks
in transacting in foreign
a firm could suddenly face a transactional or economic foreign exchange risk, contingent currency ?
on the outcome of some contract or negotiation. For example, a firm could be waiting for
a project bid to be accepted by a foreign business or government that, if accepted, would
result in an immediate receivable. While waiting, the firm faces a contingent exposure
from the uncertainty as to whether or not that receivable will happen. If the bid is accepted
and a receivable is paid to the firm then faces a transaction exposure, so a firm may
prefer to manage contingent exposures.
Some of the most important issues arising in evaluating the performance of a subsidiary
or branch of a multinational is that the profits or losses are not affected by the actions of
the business alone, but also on account of exchange rate fluctuations as discussed above.
Some of the issues that arise on account of this are:
: 235
Introduction to 1. How to treat exchange losses and who should be accountable- the subsidiary/
Management Control
Systems branch or the Head Office?
NOTES 2. Should the local currency be considered for performance evaluation or should a
common currency be considered across all subsidiaries/Divisions/Branches of
the organisations?
In addition to the above there are also issues of local economic, political and
seasonal cycles that affect the performance of subsidiaries.
A huge challenge for these organizations lies in how these issues are factored
in while attempting to evaluate performance of the subsidiaries. The control
systems must be designed so that the issues discussed as above are addressed
and a fair and proper performance evaluation system is in place.
13.13 Summary
13.15 Questions
: 237
Introduction to
Transfer price policy is generally aimed at evaluating financial performance of
Management Control
Systems different business units of a conglomerate
NOTES
13.16.2 Theory questions
5. What are the issues in design of Control Systems for Multinational Organisations?
2. Orange Juice Inc., is headquartered in the United States of America. They sell
fruit juices at various countries. They also manufacture the fruit juice extract
and sell it to other subsidiaries or sell it locally to other juice manufacturers.
A ton of fruit juice extract is available at Rs.35,000/- in India. After incurring a
processing cost of Rs.15,000/- a ton, it is sold at Rs.70,000/- per ton. The same
could be sourced from the USA at $500 a ton. The headquarter mark up on
selling price for this product is 20% on selling price. The import duties are 20%.
a. The price at which the product can be sold in the USA is $550 per ton
because it can be sold under the Orange Juice Brand.
b. The tax rate (hypothetical) in the USA and India is 50% and 30% respectively.
: 238
c. The exchange rate for rupee/dollar is Rs.50/- a dollar. Required: Introduction to
Management Control
a. Should the product be sourced locally or should it be imported, from the perspective Systems
of India?
NOTES
b. What decision would be in the best interest of the organization as a whole- to buy
from the USA or to source it locally?
Solution:
a. Profits for India is calculated in Rs. and for the USA it is calculated in $
Assuming that the product is sourced locally:
: 239
Introduction to
Profit 25.000/- 100
Management Control
Systems
Tax rate as applicable 17,500/- 50
NOTES
Profit after tax 17,500/- 50
It is better to source the material from USA in the best interest of the organization.
Profits earned in the US are taxed at a higher rate. Therefore it is better to sell the
fruit juice extract to India at $500 than locally in the USA at $550.
Note: The impact of exchange rate fluctuation has not been discussed as part of
this solution. Exchange rate fluctuations could have different implications to the
solution.
Grubert, H., & Mutti, J. (1991). Taxes, tariffs and transfer pricing in multinational
corporate decision making. The Review of Economics and Statistics, 285-293.
Sundaram, A. K., & Black, J. S. (1992). The environment and internal organization of
multinational enterprises. Academy of Management Review, 17(4), 729-757.
: 240
Introduction to
Unit 14: Management control process in service Management Control
organizations Systems
Structure NOTES
14.0 Introduction
14.1 Learning Objectives
14.2 Control Systems in Service Organisations
14.3 Basic differences in Characteristics of Service
Organizations
14.4 Professional Service organisations
14.5 Control Environment in Service Organisations
14.6 Profit Centres & Transfer pricing
14.7 Strategic Planning & Budgeting
14.8 Control of operations
14.9 Performance Evaluation
14.10 Controls in specialised organisations
14.10.1 Financial Service Organizations
14.10.2 Healthcare Organizations
14.10.3 Non-Profit Organization
14.11 Summary
14.12 Key Terms
14.13 Questions
14.13.1 State whether True or False
14.13.2 Substitute with a single word
The service organisations are different in terms of the dependence on human capital and NOTES
· Absence of Inventory
Manufacturing organisations tend to have inventory which can be stored. Goods can be
held as inventory, which is a buffer that helps to regulate the impact on production activity
due to fluctuations in sales volume. However, services cannot be stored. A manufacturing
company can earn revenue in the future from products that are on hand today, a service
organization is dependent on the real time services produced for the same. Service
organizations should try to minimize their unused capacity to maximize the number of
services produced at a current state of time. The costs of many manufacturing
organizations are essentially fixed in the short run. However, service industries operate
with long term costs and it is very difficult to tweak costs by temporary reduction in
capacity. A slow moving product can be withdrawn from the market or production can
be temporarily stopped, but if an airline suspends operations on a route even temporarily,
it may have a long run effect on its goodwill.
: 243
Introduction to
formal quality measurement systems and even when they seek to measure them, they
Management Control
Systems tend to be mostly subjective.
Therefore service organizations operate many units in various locations; each unit
Check Your Progress relatively small. Some of the units are owned; others operate under a franchise. The
Why are scale economies
absent in service firms ? 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.
Therefore controls should be designed bearing in mind the different nature of the service
industries and measurement of output should be done with lot of care.
: 244
Introduction to
a Chartered Accountant are professionals and their characteristics may slightly differ Management Control
from that of normal service organisations. Systems
NOTES
· Unlike service industries who replicate the same facility at multiple locations, say by
using a franchise agreement, professionals increase the scale of operations by increasing
the number of skilled personnel. For example, a Chartered Accountant can increase the
size of operations by roping in a few more professionals who bring in core competencies
in various areas within the same field. One of them may have expertise in corporate
taxation, while another partner may specialize in indirect taxation.
This kind of expansion makes it difficult to evaluate the service organization like a
manufacturing organization or another service organization operating with assets and
human resources rather than only human resources.
Check Your Progress
· Investment into expansion of business happens through training and learning rather Why are scale economies
absent in service firms ?
than acquisition of assets.
· Control is extremely difficult since performance measurement is not driven through input
output measures. A doctor’s performance cannot be measured by the number of patients
alone but also by the quality of service given to the patient. Similarly a lecturer’s
performance cannot be assessed just by the number of hours taught but also the quality
of lectures.
a. The real issue in performance measurement is that the service quality is intangible
unlike a product quality.
b. The measurement of service quality itself requires expertise. For example, a
patient cannot judge a doctor’s skill sets. He can only judge whether he felt
better after receiving the treatment. Similarly students cannot evaluate the
intellectual prowess of a lecturer; they can only evaluate their understanding.
c. The work performed by professionals is non repetitive thereby making it difficult
to come up with an evaluation scale.
the control systems that are designed in manufacturing organisations. However since this
: 245
Introduction to
Management Control kind of output definition is more subjective in case of service organisations, the control
Systems
system begins with pricing rather that the output.
NOTES
Pricing
Some of the issues that arise in the control for these kind of organisations is:
· Risk measurement and management are extremely important activities and hence
control is important on these
Hospitals usually require huge investment on health care equipment. The annual budget
preparation processes is conventional. Huge quantities of information are available
quickly for the control of operating activities. Financial performance is analyzed by
comparing revenues, and expenses with allocated budgets, identifying important
variances, and taking appropriate actions on them.
A non-profit organization are formed for the purpose other than generating profit and
in which no part of the organization’s income is distributed to members, directors, or
officers. Non-profit organizations are often termed “non-stock corporations” or “Not-
for-Profit Organization.” NPOs are usually grant tax exclusion and contributions to
them are often tax deductible. Non-profit organizations are designated as non-profit
when they are created which also pursue purposes permitted by statutes for non-
profit organizations. This include religious outfits, public schools, dispensaries and
hospitals, political parties, legal aid societies, volunteer services organizations, labour
unions, professional groups, research groups, museums, and some governmental
agencies. The initial funding is provided by the member, trustee, or others who do not
expect repayment, or who do not share in the profit and loss of the organization which
: 248
are retained.
Performance Measures in Non- Profit Organizations Introduction to
Management Control
Systems
As donors and fund providers in non-profit organizations want to know how well the
funds are spent, measurements of some kind need to be made. For this purpose, evaluation NOTES
can be a useful tool focusing on organizations’ programs with the objective of recommending
whether these programs should be expanded, contracted, redirected, or discontinued.
The ideal evaluation process is one that provides indisputable evidence that what was
intended to be done, is actually done. The question an evaluation process seeks to answer
can be which program can make the greatest contribution for a given cost, or which
program can achieve a given level of effectiveness at the least cost. These value-for-
money questions are keys in the minds of fund providers who want to see the greatest
return on the funds they provide. For example, a funder with only a limited amount of
money to devote to the cause of helping the blind wants to put that money to work in a
way that will have the greatest impact on that cause.
Evaluation is carried out through examining results of past actions, and in order to do that
the evaluator must work through several stages in the evaluation process:
: 249
Introduction to b. Relative standards – Instead of using pre-determined targets results
Management Control
Systems are compared with the results of similar activities or results from
previous periods.
NOTES
4. Interpreting and using the results of the evaluation by answering the questions:
a. What do the results tell us about what can be done better?
b. Should something be changed?
c. Should the program be dropped?
d. Should more money be invested?
And in case of poor results to find out:
Check Your Progress make a statement about outcomes, the end result of the activities that are being
Do non-profit organisations
evaluated. To achieve this, the evaluation effort is focused directly on getting
need control ? Why ?
information on specified outcomes.
· Process evaluation: Evaluation attempts to measure the occurrence of a
specific set of recommended activities undertaken by the evaluated. For example,
if the evaluator’s focus is on a leadership function, such as the way the board of
directors governs the organization, a process evaluation would seek to measure
various aspects of the way it runs its meetings, how it goes about setting goals
for the organization, or the roles and responsibilities of its committees.
· Input evaluation: Processes cannot be ensured without the initial investment
of financial, human and technological resources to make them happen. It is,
therefore, possible to perform an evaluation of these inputs. For example, how
much money can be allotted to a project, how many labor hours were devoted
to it, how much information technology and infrastructure was put in place,
how much managerial quotient was invested in developing the project, etc.
: 250
Introduction to
· Subjective Evaluation: The large majority of program measurements is
Management Control
subjective; as they are judgments arrived at by personal observations by an Systems
individual or a small committee. The validity of such evaluations depends heavily NOTES
on the expertise of those involved. Findings are also influenced by the situations
which the evaluators happen to observe; that is, they may be unduly impressed
by what appears to be either excellent or poor results in particular cases. For this
reason, it is desirable that the evaluators develop statistical or other data as a
means for adding credibility to their opinions.
· Statistical Evaluation: In this method relevant data about the programs is
collected routinely and the focus is placed on the development of performance in
order to determine whether and how much performance has improved or
worsened; current results of the programs are compared with the results of others,
presumably similar ones, or current results are compared with the results that
were anticipated when the program was started.
· Sample Survey Evaluation: This kind of measurement deals with an investigation
of samples of the target group, for example, the people that the program is intended
to benefit, or the ones that can provide useful information on the subject. The
survey may be either in the form of a written questionnaire or of oral interviews.
In order to provide valid results, survey questions must be worded so that the
respondents could give clear and understandable answers, and the sample of
selected people must be representatives of a much bigger population under
investigation.
There is large number of small enterprises in most of the countries. However, their
management accounting (MA) and management control systems (MCS) are rarely
Check Your Progress
explored. Traditionally, it has been stated that small firms don’t need MCS due to their What is statistical
evaluation ?
simple structures and scarcity of resources. On the other hand, a few studies on high
technology firms have shown that these firms have developed their customized MCS and
are also adopting sophisticated management accounting practices and information.
NOTES Of the total firms surveyed, 95% (high adoption) of them reported that the following
measures were adopted in their firms:
· Use of financial ratios analysis like profitability, leverage and liquidity ratios
· Analysis of business strengths and weaknesses etc.
· Estimates and plans for the number of employees
· Calculations of product or service-level costs
· Comparisons of financial ratios to industry averages and competitors’ ratios
· Employee analysis (performance, satisfaction etc.)
· Pricing based on full-costing approach
· Monthly or quarterly income statements including depreciation methods used
and highlighting change in stock
· Analysis of working capital and its parts (stocks, debtors, creditors) etc. including
use of ratios
· Fund flow statements of the financial year deciphering sources and uses of
earnings and capital
· Competitor analysis and forecasts
· Product and/or service profitability analysis
Close to 80% (moderate adoption) of the respondents adopted the following control
measures in their businesses.
14.11 Summary
The concept of Management control process in service organisations was introduced
by Anthony in 1966. An important feature of service firms relevant to the design of
management control system is the significant human participation in the “production
process” which presents challenges to researchers when presenting conceptual
framework in the design of management control system. For several reasons,
management control systems in service industries are somewhat different from
management control in the manufacturing companies. The service industries are
Check Your Progress
Why are small organisations characterised by absence of Inventory, absence of uniform quality control measures,
difficult to control ?
dependence on key personnel rather than equipment or technology and absence of
scale economies. Therefore controls should be designed bearing in mind the different
nature of the service industries and measurement of output should be done with lot of
care. The fundamental difference between service organisations and professional service
organisations is that service organisations provide services that are generalised- for
example a restaurant, car service station, insurance company etc. However professional
service organisations derive their identity from a core skill. A doctor, lawyer, architect or
a Chartered Accountant are professionals and their characteristics may slightly differ
from that of normal service organisations. Some other specialised service organisations
are financial service organisations, healthcare organisations, non-profit organisations
: 254
and small businesses. The Control systems for each of these have been discussed in Introduction to
Management Control
detail in the Unit. Systems
14.13 Questions
a. Service industries operate on short term fixed costs; hence it is easy to tweak
costs in the short run.
b. Service organisations heavily depend upon key personnel and they invest
heavily into training people rather than equipment.
c. Small firms do not need and use MCS due to their simple structures and poor
resources.
d. A service company cannot judge product quality until the moment the service
is rendered, and then the judgments are often subjective.
: 255
Introduction to
Management Control 14.13.2 Substitute with a single word
Systems a. A group organized for purposes other than generating profit and in which no
NOTES part of the organization’s income is distributed to members, directors, or
officers
b. Service Organisations that derive their identity from a core skill.
c. Relevant data about the programs is collected routinely and the focus is
placed on the development of performance in order to determine whether
and how much performance has improved or worsened.
d. In these organizations, the control system begins with pricing rather that the
output.
129: 1.
: 256
Introduction to
Jänkälä, S. (2007). Management control systems (MCS) in the small business Management Control
context. Linking effects of contextual factors with MCS and financial Systems
: 257
Introduction to
Management Control
Unit 15: MCS in Project Management
Systems
Structure
NOTES
15.0 Introduction
15.1 Learning Objectives
15.2 Meaning of Project Management
15.3 Unique features of Project Management
15.4 Difference between project Control and operational
control
15.5 Project Organisation Structure
15.6 Project Planning and Scheduling
15.7 Project Audit
15.8 Cost Management in Projects
15.9 Summary
15.10 Key Terms
15.11Questions
15.1.1 State whether true or false
15.1.2 Substitute with a single word:
15.1.3 Theory questions
15.1.4 Business case
15.12 Further Reading and References
: 258
Introduction to
15.0 Introduction Management Control
Systems
We have understood about controls for organisations so far. While these controls are
highly suited to operations, which are repetitive and perennial, we may have to view NOTES
other kind of activities that firms may undertake. In this Unit, we understand all about
controls for projects. A project is time bound and has a definite set of activities therefore
requiring different sets of controls.
The term project may be used to define any endeavour that is temporary in nature and
with a beginning or an end. The project must create something unique whether it is a
product, service or result and must be progressively elaborated. As the definition implies,
not every task can be considered a project. It would be worthwhile to keep this definition
in mind when categorizing projects and studying their role in the success of the organization.
: 259
Introduction to
Management Control 15.3 Unique features of Project Management
Systems
Project management is somewhat different from the regular operations of a business. It
NOTES
is a fact that all activities of an organization can be divided into projects and operations.
Operations are ongoing, continuous and repetitive activities in any organization such as
accounting, finance, or production. On the other hand, projects are specific tasks that
have a beginning and an end such as working on developing a new product. All efforts
and energies of an organization are distributed between these two categories of work.
Let us see how project management differs from operation management.
To illustrate, let’s use the example of a company that produces plastic tubes for product
packing in the FMCG industry. Their analysis revealed that the profit margin for tooth
paste tubes was declining rapidly. As such, the senior management formed a project
team to look into developing another product to shore up profits. The project team did a
market research and discovered that margins were better in the beauty segment which
looked promising and it was for the face creams and gels. Based on the research
findings, the senior management decided to reduce the production output for toothpaste
tubes and decided to allocate more resources for the tubes for the beauty and personal
care segment and also sent more quality specialists to control the new product operation
to ensure that the new product meets the high quality standards required by the industry.
When the restructuring was completed, the two product line helped the organisation to
improve their corporate strategy of diversifying into other products and securing an
increase in profit margin.
: 261
Introduction to
Management Control and therefore projects are more sensitive to the environment in which they function
Systems rather than a function of the organisation controls.
· Programmatic based, in which project managers have authority only within the
program focus or area
· Matrix based, in which the project manager shares responsibility with other
program unit managers
· Project based, in which project managers have total authority.
· Mixed Organisations which could be a combination of two or more of the above
stated structures
1. Programmatic Based
The programmatic focus refers to a traditional structure in which project
managers have formal authority over most resources. It is only suitable for
projects that require a homogenous specialization. For example if an activity is
to be automated, the Information Technology (IT) team carries it out as a
standalone project and everybody is from the IT team. However, it is not suitable
for projects that require a diverse mix of people with different expertise from
various program sectors. In a programmatic based organization, a project team
Check Your Progress is staffed with people from the same area. All the resources needed for the
Who are matrix project team come from the same unit.
organisations complex ?
Some of the advantages of programmatic based projects are:
· There are clear lines of authority, in large projects the project managers tend to
also be the program unit manager. There is no need to negotiate with other
: 262
Introduction to
program units for resources, since all of the staff needed for the project will
Management Control
come from the same department or division. Systems
· Another advantage of this type of organization is that the team members are NOTES
usually familiar with each other, since they all work in the same area.
· The team members also tend to bring applicable knowledge of the project.
However, a major disadvantage of the programmatic based organization is that the all of
the specialists needed to work on a project may not be available from that Division or
Department.
2. Matrix Based
Matrix based project organizations allow various divisions in the organisation to
focus on their specific technical competencies and allow projects to be staffed
with specialists from throughout the organization. For example, a project or task
team established to develop a new product might include engineers and design
specialists as well as those with marketing, financial, personnel and production
skills.
These teams can be temporary or permanent depending on the tasks they are asked to
complete. Each team member can find himself/herself with two managers - their normal
functional manager as well as the team leader of the project.
It is common for people to report to one person in the programmatic unit, while working
for one or two project managers from other projects in different programmatic units.
The main advantage of the matrix based organization is the efficient allocation of all
resources, especially scarce specialty skills that cannot be fully utilized by only one project.
For instance, monitoring and evaluation specialists may not be utilized full-time on a
project, but can be fully leveraged by working on multiple projects. The matrix based
organization is also the most flexible when dealing with changing programmatic needs
and priorities. The matrix allows companies to leverage vast resources while staying
small and task-oriented. The matrix encourages innovation and fast action, and speeds
information to those who know how to use it (Sy, Thomas; D’Annunzio, Laura Sue,
2005). Some of the significant advantages to matrix management are:
: 263
Introduction to · It allows team members to share information more readily across the unit
Management Control
Systems boundaries, allows for specialization that can increase depth of knowledge and
allow professional development and career progression to be managed.
NOTES
· It is easier for a program unit manager to loan an employee to another manager
without making the change permanent. It is therefore easier to accomplish work
objectives in an environment when task loads are shifting rapidly between
programmatic units.
Some of the control issues that arise in a matrix organization form
Check Your Progress might report to programmatic unit managers for whom little work is done, while actually
Who are matrix working for one or more project managers. It becomes more important for staff members
organisations complex ?
to develop strong time management skills to ensure that they fulfill the work expectations
of multiple managers.
The programmatic managers may have different goals, objectives, and priorities than
the project managers, and these would have to be addressed in order to get the job
done.
An approach to help solve this situation is a variation of the Matrix organization which
includes a coordinating role that either supervises or provides support to the project
managers. In some organizations this is known as the Project Management Office
(PMO), dedicated to provide expertise, best practices, training, methodologies and
3. Project Based
In this type of organization project managers have a high level of authority to manage
and control the project resources. The project manager in this structure has total authority
over the project and can acquire resources needed to accomplish project objectives
from within or outside the parent organization, subject only to the scope, quality, and
budget constraints identified in the project.
In the project based structure, personnel are specifically assigned to the project and
report directly to the project manager. The project manager is responsible for the
Check Your Progress
performance appraisal and career progression of all project team members while on Who are matrix
organisations complex ?
the project. This leads to increased project loyalty. Complete line authority over project
efforts affords the project manager strong project controls and centralized lines of
communication. This leads to rapid reaction time and improved responsiveness.
Moreover, project personnel are retained on an exclusive rather than shared or part-
time basis. Project teams develop a strong sense of project identification and ownership,
with deep loyalty efforts to the project and a good understanding of the nature of
project’s activities, mission, or goals.
Pure project based organizations are more common among large and complicated
projects. These large projects can absorb the cost of maintaining an organization whose
structure has some duplication of effort and the less than cost-efficient use of resources.
In fact, one major disadvantage of the project based organization is the costly and
inefficient use of personnel. Project team members are generally dedicated to one
project at a time, even though they may rarely be needed on a full-time basis over the
life cycle of the project. Project managers may tend to retain their key personnel long
after the work is completed, preventing their contribution to other projects and their
professional development.
: 265
Introduction to
Management Control In this type of organization, limited opportunities exist for knowledge sharing between
Systems projects, and that is a frequent complaint among team members concerning the lack of
NOTES career continuity and opportunities for professional growth. In some cases, project
personnel may experience a great deal of uncertainty, as organization’s or donor’s
priorities shift or the close of the project seems imminent.
4. Mixed Organisations
Another design is based on a mixed structure that includes a matrix, programmatic
Check Your Progress focus and project based; this mix reflects the need for more flexibility in a development
Who are matrix
organisations complex ? organization to accommodate different requirements. These type of organizations are
more situation based and when an organization has multiple projects having varying
time frames, deliverables and specialization a mix of structures could be useful.
Project planning starts by setting a goal for the project that’s consistent with the SMART
(specific, measurable, achievable, realistic and timed) goal-setting principle. The goal
should be narrowed down to a very specific purpose and there should be a way to
gauge the team’s progress toward that goal. The steps required to reach the goal needs
to be listed. Once the project is planned, each planned activity is broken down and fit
: 266
into time slots. Each specific point on the project plan is entered into the project Introduction to
Management Control
management or calendar software that is used in the business. This scheduling technique Systems
is used by many companies because it allows the team to keep track of progress on the
NOTES
project. The access to the project management software or calendar should be shared
with the project team so that each member can stay abreast of the project as well.
A network depicts the sequence of activities necessary to complete a project. Check Your Progress
Segments of a project are represented by lines connected together to show the What are mixed
organisation ?
interrelationship of operations and resources. When duration is associated with
each segment, the model shows the time distribution of the total project and its
operations. This information can be used to coordinate the application of resources.
There are two very well known techniques for network scheduling:
CPM (Critical Path Method) is used to assist the project manager in scheduling the
activities (i.e., when should each activity start). It assumes that activity durations are
known with certainty.
NOTES
15.7 Project Audit
Projects usually run independently and therefore it is difficult to identify any problems
until it becomes obvious that there are problems with schedule, cost or quality. At that
point (when it is obvious) it is usually too late to meet the original expectations. In order
to avoid situations such as what has been described, organisations undertake project
audits.
Project audits can help determine the true state of a project, and whether the project
looks to be on track to finish successfully. Audits can also specifically point out whether
good project management rigour and structure is in place
· Compliance with policies, procedures and controls built into the chosen project
· The achievement of user requirements and other project benefits and outcomes
A number of project management reviews within the annual internal audit plan may be
combined to provide a process review of the project methodology provided this is agreed
with management at the outset.
A typical approach to project management reviews is for the internal auditor to join a
Project Board or team with the inclusion of time in the audit plan for meetings. The
advantages of having an auditor in the project can be described as follows:
: 268
· It enables quick responses in case of overruns in a project. Introduction to
Management Control
Systems
· Decisions can be evaluated decisions as they are made. In a fast moving
project this may be extremely useful NOTES
All the advantages notwithstanding, sometimes the presence of internal audit can slow
down, even delay progress. Internal audit may not always need to be part of Project
Board meetings to provide advice through their consultancy role. They could provide audit
advice even from outside the team. This will enable the project to have audit advice, yet
the project itself will not slow down on account of the need for audit clearances.
2. Parametric Modeling
Parametric modeling uses a mathematical model based on known parameters to
predict the cost of a project. The parameters in the model can vary based on the
type of work being completed. A parameter can be cost per cubic yard, cost per
unit, and so on. A complex parameter can be cost per unit with adjustment factors
based on the conditions of the project. In addition, the adjustment factors may
have additional modifying factors depending on additional conditions. To use
parametric modeling, the factors the model is based on must be accurate. The
: 269
factors within the model are quantifiable and don’t vary much based on the
Introduction to
Management Control effort applied to the activity. And finally, the model must be scalable between
Systems project sizes.
NOTES
There are two types of parametric estimating:
% Learning curve This approach is simple: the cost per unit decreases the more units
workers complete; this is because workers learn as they complete the required work.
The more an individual completes an activity, the easier it is to complete. The estimate
is considered parametric, as the formula is based on repetitive activities, such as wiring
telephone jacks, painting hotel rooms, or other activities that are completed over and
over within a project. The cost per unit decreases as the experience increases because
the time to complete the work is shortened.
3. Bottom-Up Estimating
Bottom-up estimating starts from zero, accounts for each component of the
work breakdown structure (WBS), and arrives at a sum for the project. Estimates
are created for all tasks at the lowest level of the WBS and then these are
Check Your Progress accumulated to determine the estimates for the whole project. It is completed
How do you estimate cost with the project team and can be one of the most time consuming methods to
in projects ?
predict project costs. While this method is more expensive, because of the time
invested to create the estimate, it is also one of the most accurate. A fringe
benefit of completing a bottom up estimate is the project team may buy-into the
project work as they see they cost and value of each cost within the project.
Project Evaluation
Project Evaluation is the process of evaluating the performance and progress of a project
and comparing it to what was planned. Project evaluation assists the organization in the
following ways:
: 270
· Evaluating performance of project manager and create a suitable incentive and Introduction to
Management Control
reward plan Systems
· To identify budget overruns
NOTES
However since each project is unique the project evaluation has no historical data to
compare against. Only current data can be used to evaluate and review a project. This
makes project evaluation complex. Yet unless proper evaluation mechanisms are in place
it may be difficult to run the project as envisaged. Different projects require different
evaluation techniques. However a proper evaluation at the completion of each project is
as important as the project itself making it a very important part of the successful
completion of the project.
15.9 Summary
Project Management is the art of managing all the aspects of a project from inception to
closure using a scientific and structured methodology. Project management is some-
what different from the regular operations of a business. It is a fact that all activities of an
organization can be divided into projects and operations. Operations are ongoing,
continuous and repetitive activities in any organization such as accounting, finance, or
production. On the other hand, projects are specific tasks that have a beginning and an
end such as working on developing a new product. Some of the aspects that make
project control different from normal operational control are the dynamic decision mak-
ing environment in which a project functions, temporary nature of projects, budget con-
straints in which projects operate, limited time frame available to complete a project,
absence of reliable Standards and the greater environmental influence on the project. A
project has four organization structures available for design and all are defined by the
level of organizational authority given to the project manager. Programmatic based, in
which project managers have authority only within the program focus or area; Matrix
Check Your Progress
based, in which the project manager shares responsibility with other program unit manag- How do you estimate cost
ers; Project based, in which project managers have total authority; Mixed Organisations in projects ?
which could be a combination of two or more of the above stated structures. Project
Scheduling is an important activity in project management. The project scheduling is usu-
ally done using varying techniques such as Gantt or bar charts and network scheduling.
The two very well known techniques for network scheduling are CPM (Critical Path
Method) which is used to assist the project manager in scheduling the activities and
PERT (Program Evaluation and Review Technique) which is used to assist in project
: 271
Introduction to scheduling similar to CPM. Project audits can help determine the true state of a project,
Management Control
and whether the project looks to be on track to finish successfully. Audits can also
Systems
specifically point out whether good project management rigour and structure is in place.
NOTES
Cost management is a very important aspect in projects. Any overruns in project cost
could reduce profits or sometimes push the projects into loss. Some of the techniques for
cost estimation for a project are Analogous Estimation, Parametric Modeling and Bot-
tom-Up Estimating. Project Evaluation is the process of evaluating the performance and
progress of a project and comparing it to what was planned. Project evaluation assists
the organization in evaluating performance of project manager and create a suitable
incentive and reward plan and to identify budget overruns.
Project planning starts by setting a goal for the project that’s consistent with
the SMART (specific, measurable, achievable, realistic and timed) goal-setting
principle.
Project audits can help determine the true state of a project, and whether the
project looks to be on track to finish successfully.
: 272
Introduction to
15.11 Questions Management Control
Systems
15.11.1 State whether true or false
NOTES
a) Performance standards tend to be less reliable for projects than for normal
operations.
b) In project management, decisions take shape according to the size and nature of
the project and can be changed in between also.
c) Operational activities have permanence while projects are rather temporary in
nature and therefore performance measures are difficult to identify.
d) Any overruns in project cost could reduce profits or sometimes push the projects
into loss.
e) Operations are ongoing, continuous and repetitive activities in any organization
such as accounting, finance, or production
a. This organization form allows team members to share information more readily
across the unit boundaries, allows for specialization that can increase depth of
knowledge and allows professional development and career progression.
b. Specific tasks that have a beginning and an end such as working on developing
a new product.
d. This type of cost estimation starts from zero, accounts for each component of
the WBS, and arrives at a sum for the project.
e. The factors within this cost estimation model are quantifiable and don’t vary
much based on the effort applied to the activity.
: 273
Introduction to 15.11.3 Theory questions
Management Control
Systems
1. What is project management and what are the unique features of Project
NOTES Management?
2. What are the essential differences between project Control and operational
control?
3. What are the different types of Project Organisation Structure?
4. What is the importance of Project Planning and Scheduling and what are
the common techniques for the same?
5. What is the importance of Project Audit?
6. What are the Cost Management techniques used in Projects?
: 274
Introduction to
15.12 Further Reading and References Management Control
Systems
Phillips, Project Management Professional Study Guide 2E W/Cd, Tata McGraw Hill
Education NOTES
: 275
Introduction to
Management Control
Unit 16: Role of Audit in Control Systems
Systems
Structure
NOTES
16.1 Introduction
16.2 Learning Objectives
16.3 Types of Audit
16.4 Internal Control
16.5 Responsibility for internal controls in Organisation
16.6 Role of Audit in Controls
16.7 Internal Audit
16.8 Cost Audit
16.9 Efficiency audit
16.10 Measuring efficiency
16.11 Management Audit
16.12 Energy Audit
16.13 Ethics in Business and Role of Control
16.14 Summary
16.15 Key Terms
16.16 Questions
16.16.1 State whether true or false
16.16.2 Substitute with a single word
16.16.3 Theory questions
16.17 Further Reading and References
: 276
Introduction to
16.0 Introduction Management Control
Systems
We know that control is any action taken by management, the board, and other parties to
manage risk and increase the likelihood that established objectives and goals will be NOTES
achieved. We also know that management plans, organizes, and directs the performance
of sufficient actions to provide reasonable assurance that objectives and goals will be
achieved. Controls play an important role in keeping businesses on track and audit plays
an important role in ensuring controls. In this Unit, we will understand the role of audit in
controls and the application of various audits to ensure proper control mechanisms in
organisations.
· Energy Audit
: 277
Introduction to
Management Control 16.2 Types of Audit
Systems
Audit can be carried out for the purpose of ensuring compliance with the statute-for
NOTES
example, in India compliance with the provisions of the Companies’ Bill (2012). Such an
audit is called financial audit. As per Standards on Auditing (SA) 200 issued by Institute
of Chartered Accountants of India- “Auditing is the independent examination of financial
information of any entity, whether profit oriented or not, and irrespective of its size or
legal form, when such an examination is conducted with a view to expressing an opinion
thereon.”
Audit is also carried out to identify processes, ensure compliance with set standards
and report in a periodic manner when such standards are not met with. These are called
non-financial audits. The types of non-financial audits are discussed later in the Unit.
Businesses usually put in place certain controls effected by an entity’s board of directors,
management and other key personnel of the organization. These controls are designed
to provide reasonable assurance regarding effectiveness and efficiency of operations,
reliability of financial reporting, and compliance with applicable laws and regulations in
terms of attaining desired objectives. Such controls are known as internal controls.
records. It provides reasonable assurance that all the transactions authorized by the
management are promptly and properly recorded. E.g. Stores Department can issue
materials only against requisition slip duly produced. Administrative controls are basically
regarding improving operational efficiency and adherence to management policies.
· It is a process.
· It is achieved by people.
Detective Controls – It is an approach that helps to find out flaws or shortcomings that
reduced the efficiency or system after the objective is achieved. The main aim of detective
controls is to contribute to the success of future projects by substituting inefficient processes
by efficient and tested processes. Examples: Reviews, analyses, variance analyses,
reconciliations, physical inventories, and audits.
Internal Controls are usually designed by the auditors of an organization. However, ev-
eryone plays a part in the organization’s internal control system. The responsibility to
each area of operation is delegated to ensure that internal controls are established, prop-
erly documented, and maintained. Responsibilities are disbursed to each and every em-
ployee for making this control system functional and effective. Therefore, all employees
need to be aware of the concept and purpose of internal controls.
Internal controls are effective and desirable for organizations. However, they alone are
not sufficient. Most businesses take the help of auditors to perform several types of audit
that help in the process of control. By definition, an audit is an official, professional,
independent examination and verification of a company’s financial statements and Check Your Progress
accounting documents in accordance to generally accepted auditing standards. Systematic Give examples for
and regular audit has the potential to give rise to valuable ideas for increasing operations preventive controls ?
efficiency, raising profitability and strengthening internal controls. This is accomplished
by the audit team working in tandem with the management to understand their risks and
goals along with maintaining a continuous and close relationship throughout.
· They help formulate a systematic set process for various business functions
· They give timely warning whenever required and hence help course correction
Some popular types of auditing include internal audit, cost audit, efficiency audit,
management audit and lately even energy audit. A brief overview of each of these
follows.
The internal audit activity evaluates the adequacy and effectiveness of controls
encompassing the organization’s governance, operations, and information systems.
Internal audit reviews include the reliability and integrity of financial and operational
information, effectiveness and efficiency of operations, safeguarding of assets, and
compliance with laws, regulations, and contracts. These reviews also ascertain the
extent to which operating and program goals and objectives have been established and
conform to those of the organization, as well as the extent to which results are consistent
with established goals and objectives and whether operations and programs are being
implemented or performed as intended.
Consequent to internal audit function becoming a routine and non-value added activity
in business, many business organizations started ignoring the internal audit function. The
: 280
Introduction to
internal audit staff came to be deployed for other activities as well. This resulted in
Management Control
weakened controls leading to several systematic frauds in business. Notable among these Systems
were the accusations of fraud in Enron Corporation, an energy company based in Houston, NOTES
Texas. Enron’s auditor firm, Arthur Andersen, was accused of applying reckless standards
in its audits because of a conflict of interest over the significant consulting fees generated
by Enron. During 2000, Arthur Andersen earned $25 million in audit fees and $27 million
in consulting fees (this amount accounted for roughly 27% of the audit fees of public
clients for Arthur Andersen’s Houston office). The auditor’s methods were questioned
as either being completed solely to receive its annual fees or for its lack of expertise in
properly reviewing Enron’s revenue recognition, special entities, derivatives, and other
accounting practices.
In July 2002, the United States Congress passed the Sarbanes- Oxley Act (“the Act”/
SOX) into law. The Act was primarily designed to restore investor confidence following
well-publicized bankruptcies that brought chief executives, audit committees, and the
independent auditors under heavy scrutiny. The Act is applicable to all publicly registered
companies under the jurisdiction of the Securities and Exchange Commission (SEC).
SOX is a far reaching legislation, effecting significant changes to laws affecting officers,
directors and reporting obligations of public companies, and mandating a myriad of new
regulations to prevent securities fraud and other abuses.
The Sarbanes Oxley Act called for the formation of a Public Company Accounting
Oversight Board (PCAOB) and specified several requirements (“sections”) that include
management’s quarterly certification of the financial results (Section 302) and
management’s annual assertion that internal controls over financial reporting are effective
(Section 404) among others. The Act has largely ignored the differences in practices and
corporate governance regimes between the United States and other countries, and has
extended the reach of the United States’ laws to many aspects of the internal affairs and
governance regimes of foreign companies and their auditors. There are of course certain
reliefs for Foreign Private Issuers (“FPI”) in the act.
Internal audit plays a more proactive role in non-financial reporting matters, risk
management and key emerging risks. Most businesses engage external auditors to review
the work done by their employees and check for errors or irregularities. An internal
: 281
Introduction to
Management Control auditor is a person employed by a business to do the same thing. The difference is that
Systems while the external auditor has many clients and does this work for a fee, the internal
NOTES auditor is an employee and works within the business alongside other employees. The
standard method for conducting an audit is to examine a transaction or process, compare
how it was done with the way it is documented in an operating procedure and report to
management on any differences.
Concept in Action
The CAG(Comptroller and Auditor General) reported in 2011 that there was a revenue
leakage of Rs.4543.83 crores owing to lack of coordination between the various wings
of Income Tax Department in India. Consequently the Income Tax department had
started internal audits for its various tax collection arms for non-recovery of tax arrears .
The tax department’s idea through these audits was to plug any leakages owing to various
reasons and better its revenue collection.
way. This is essentially an Internal Audit and is done as a tool for optimising management NOTES
efficiency.
The most important benefit is the location of unseen leaks in revenues or unproductive or
under- productive employment of resources. It is mandatory if the Business is under
scrutiny by a financial institution or regulator on the basis of complaints of mismanagement.
It is desirable to have a Cost audit done periodically, to prevent the situation getting out of
control, and to help the management to take prompt action where necessary.
Application of Cost Audit in Business
1. Cost Audit is a Management Tool for better Control. Cost Audit is admitted
internationally by business enterprises as a management tool, rather than as a
cost verifying mechanism.
2. Cost accounting techniques, which are prescriptive (e.g. budgeting, standard
costing, variable costing, pricing methods like target pricing etc.), help the Check Your Progress
management in controlling costs. What is cost audit ?
An economy and efficiency audit, or simply efficiency audit, focuses on the resources
and practices of a program or department, according to the “Encyclopaedia of Public
Administration and Public Policy,” which provides descriptions of typical audit activities.
An economy and efficiency audit might analyze the procurement, maintenance and
implementation of resources, such as equipment, to identify areas that require improvement.
The objectives of auditing efficiency can include assessing one or more of the following:
: 283
Introduction to
Management Control • The level of efficiency achieved by an organization or operation in relation to
Systems reasonable standards’
NOTES
• The adequacy and reliability of systems o, procedures, tools and techniques
used to measure and report efficiency
· Help managers and staff to be more sensitive to their obligation of due regard
to efficiency;
· Demonstrate the scope for lowering the cost of delivering programs without
reducing the quantity or quality of outputs or the level of service;
· Increase the quantity or improve the quality of outputs and level of service
without increasing spending; and
: 284
· Identify improvements required in existing controls, operational systems, and Introduction to
Management Control
work processes for better use of resources. Systems
In 2011, the city in United Kingdom called Southampton started a complete review
of its employees working in government offices, which it called “Performance
Efficiency Audit of Southampton employees working in government offices.”
While the word “audit” is used to explain this initiative, the review was not
intended as an audit in the strictest meaning of theterm. Rather, an “efficiency
audit” uses a range of techniques to identify issues, possible research solutions,
exploring best practices, and develop recommendations – all activities designed
to identify opportunities for its employees, eliminate repetition of work, and to
work smarter. This review was intended to help the state achieve two goals:
1. Producing the best possible outcomes for its managers to improve the
performance
Check Your Progress
2. Receiving the highest return on time management and every effort they put in by How is efficiency audit
the employees important ?
The objective of a management audit is not to appraise and evaluate the management
team as a whole in relation to their competition Rather than focusing on individual
performance of executives.
The purpose of management audit is establishing seven objectives that are : understand
current practices, relate these to company financials, suggest new procedures which will
improve the efficiency of managers, present a financial gain related to these new
procedures, and create benchmarks and projections for the future.
The audit follows a systematic process, step-by-step format, including initial interviews
with key managers. A study team analyse the interview process to define the scope of
the audit. Next, the team requests various forms of documentation, including budgets,
planning documents, corporate reports, financial statements, policy and procedure manuals,
biographical material, and various other documents.
Following this stage, the study team then prepares a schedule and detailed plan of study,
all aimed at proceeding to the internal fact finding step. Fact-finding relies once again on
interviews, documentation, and personal observation of facilities and organizational work
patterns. The team generally turns next to an external review, using interviews to
determine the opinions and attitudes key people outside the organization have about its
operations. These interviews provide the audit team with more objective evaluations,
and lead to an analysis of all the information and data collected. The study team then
develops conclusions and recommendations which are communicated to the organization’s
management for the benefit of the organization.
An energy audit identifies where energy is consumed and how much energy is consumed
in an existing facility, building or structure. Information gathered from the energy audit
: 286
can be used to introduce energy conservation measures (ECM) or appropriate energy- Introduction to
Management Control
saving technologies, such as electronic control systems, in the form of retrofits. Energy Systems
audits identify economically justified, cost-saving opportunities that result in significantly
NOTES
lowered electrical, natural gas, steam, water and sewer costs. An energy audit, therefore,
is a detailed examination of a facility’s energy uses and costs that generates
recommendations to reduce those uses and costs by implementing equipment and
operational changes.
There are three types of audits that are described below in order of increasing degree of
detail.
Social audit
Social audit as a term was used as far back as the 1950s. There has been a flurry of
activity and interest in the last seven to eight years in India and neighboring countries.
Voluntary development organizations are also actively concerned.
Social audit is based on the principle that democratic local governance should be carried
Check Your Progress out, as far as possible, with the consent and understanding of all concerned. It is thus
Is social audit relevant and a process and not an event.
necessary ?
Social auditing creates an impact upon governance. It values the voice of stakeholders,
including marginalized/poor groups whose voices are rarely heard. Social auditing is
taken up for the purpose of enhancing local governance, particularly for strengthening
accountability and transparency in local bodies.
The key difference between development and social audit is that a social audit focuses
on the neglected issue of social impacts, while a development audit has a broader
focus including environment and economic issues, such as the efficiency of a project
or programme.
: 288
Background Introduction to
Management Control
Systems
In the United States and Europe during the 60s, public repudiation of the war in Vietnam
triggered a movement to boycott the goods and shares of some companies that were NOTES
associated with the conflict. Society demanded a new ethical attitude and some companies
began to provide accounts for their social actions and objectives. Drawing up and publishing
annual reports containing information of a social nature led to what we now know as “the Check Your Progress
social audit”. In Brazil the idea began to be discussed in the 70s, but only in the 80s the Is social audit relevant and
necessary ?
first social audits were published. From the 90s onward, corporations of various sectors
began to publish their results annually.
The issue only gained national attention in June 1997 when sociologist Herbert de Souza
- Betinho - launched a campaign for companies to publish their social audit on a volunteer
basis. With the support and participation of prominent business personalities, the campaign
took off and led to a series of debates in the media and in seminars and forums. The
initiative has now succeeded and what is now underway is a process of shaping another
mentality and innovative practices amid the business sector.
1. Assessing the physical and financial gaps between needs and resources available
for local development.
5. Estimation of the opportunity cost for stakeholders of not getting timely access
to public services.
: 289
Introduction to
Beneficiaries of social audit
Management Control
Systems The social audit benefits all groups involved with the company’s activities. It provides
NOTES useful information for directors to make decisions regarding the social programs the
company sponsors. Preparing the social audit stimulates the employees to take part in
choosing social actions and projects, thus improving internal communication and
integration between managers and staff.
Suppliers and investors learn how the company faces its responsibilities with regard to
human resources and the environment, which is a good indicator of how the company is
Check Your Progress
run. The social audit shows consumers its philosophy and the quality of the product or
Is social audit relevant and
necessary ? service that is provided, pointing to the way the company chooses to make itself known.
The State also benefits through the identification and formulation of social policies.
2. Consider and scrutinize existing schemes and local activities of the agency; and
Some examples of social audit have been highlighted by Srivastava and Chandan
Datta(2003) in their discussion about the Panchyati Raj model in India.
: 290
Examples of social audit Introduction to
Management Control
Systems
1. Social audit in Jharnipalli Panchayat, Agaipur block, Bolangir district, Orissa
NOTES
In October 2001, the gram sabha members of Jharnipalli Panchayat conducted a one-
day social audit of development works carried out in the Panchayat over the preceding
three years. This audit took place with the active participation of many individuals and
agencies, including block and district administration officials, MKSS [Mazdoor Kisan
Shakti Sanghatan], NCPRI [National Campaign for People’s Right to Information] and
Action Aid India.
· Although the works were not carried out, the sanctioned funds were shown in
the records as having been utilized.
· The BPL families could not buy subsidized food from the public distribution system
(PDS) shops as partial wages because they did not possess the needed ration
cards.
This led to the identification of several goals. One of them was to construct a drain.
Inspired by the participatory local planning process, the community contributed half the
: 291
Introduction to cost of the drain (Rs 50 000). Those who could not give money offered their labour. The
Management Control
Systems rest of the money came from the district office and was mobilized by the Gram
Panchayat and its pro-active woman president, the Sarpanch.
NOTES
Every member of the Gram Sabha developed a sense of ownership of the project. The
Gram Sabha monitors the work. Gram Panchayat representatives also hold regular
ward-level meetings. The relationship between people and their local representatives
developed quickly into one of mutual support.
Business ethics is usually understood as the study of business situations, activities, and
decisions where issues of right and wrong are addressed.
: 292
social values. Today most major corporations promote their commitment to non-economic Introduction to
Management Control
values under headings such as ethics codes and social responsibility charters. Systems
Governments use laws and regulations to point business behaviour in what they perceive NOTES
to be beneficial directions. Ethics implicitly regulates areas and details of behaviour that
lie beyond governmental control. The emergence of large corporations with limited
relationships and sensitivity to the communities in which they operate accelerated the
development of formal ethics regimes.
Ethics in actionThe Tata Steel Group is proud of its longstanding reputation as a fair
and caring employer, and respects all human rights both within and outside the workplace.
The Tata Code of Conduct stipulates that all employees have a personal responsibility to
help preserve the human rights of everyone at work and in the wider community.
16.13 Summary
Businesses usually put in place certain controls effected by an entity’s board of directors,
management and other key personnel, developed to provide reasonable assurance
regarding the accomplishment of objective in terms of effectiveness and efficiency of
operations, reliability of financial reporting, and compliance with legal issues and
regulations. Such controls are known as internal controls. Every employee has some
responsibility for making this internal control system function. Therefore, all employees
need to be aware of the concept and purpose of internal controls. There are several
types of audit that help in strengthening controls in a business. Some popular types of
auditing include internal audit, cost audit, efficiency audit, management audit and lately
even energy audit.
: 293
Introduction to The objective of a management audit is to appraise the effort of management team as
Management Control
Systems a whole rather than rewarding individual performances.It allows to find out the inefficiency
in terms of collaborative effort of the management team needs to be delivered. A social
NOTES
audit is a way of measuring, understanding, reporting and ultimately improving an
organization’s social and ethical performance. A social audit helps to narrow gaps in
terms of perceived value an organization should have in the eyes of stakeholders and
society.Businesses should eventually benefit the community and society and certainly
not harm them. To ensure this, it becomes important that they operate within an ethical
framework.Business ethics is usually understood as the undefined perceived code of
conduct that needs to be followed in business situations, events, and decisions where
issues of right and wrong are addressed.
Cost Audit is defined as the verification of Cost Accounts and a check on the
adherence to the Cost Accounting plan.
Social audit is based on the principle that democratic local governance should
be carried out, as far as possible, with the consent and understanding of all
concerned.
16.15 Questions
: 294
2. Controls play an important role in keeping businesses on track and audit plays an Introduction to
Management Control
important role in ensuring controls. Systems
3. Internal control system comprises of purely accounting control and does not NOTES
4. The social audit benefits all groups involved with the company’s activities by
providing useful information for directors to make decisions regarding profitability
of business.
5. Social auditing is taken up for the purpose of enhancing local governance and
helping government to function profitably.
7. Information gathered from the energy audit can be used to introduce energy
conservation measures or appropriate energy-saving technologies, such as
electronic control systems, in the form of retrofits.
2. These controls are designed to find errors or irregularities after they have
occurred.
3. The verification of Cost Accounts and a check on the adherence to the Cost
Accounting plan
4. The extent to which time, effort or cost is well used for the intended task or
purpose is usually called as
: 295
Introduction to 6. This audit identifies where energy is consumed and how much energy is
Management Control
Systems consumed in an existing facility, building or structure
NOTES 7. This audit is a way of measuring, understanding, reporting and ultimately improving
an organization’s social and ethical performance.
3. Do all businesses carry out cost audit? What is the role of cost audit?
: 296