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Example; Following is the condensed income statement of a firm for the current year;
Particulars Amt (in lakhs)
Sales Revenue 500
Less: Operating costs 300
Less: Interest costs 12
Earnings before taxes 188
Less: Taxes (0.40) 75.2
Earnings after taxes 112.8
The firm’s existing capital consists of Rs 150 lakhs Equity funds, having 15% cost
and of Rs 100 lakh 12% debt. Determine the economic value added during the year.
Solution
(I) Determination of Net Operating Profit After Taxes
Particulars Amt (in lakhs)
Sales revenue 500
Less: Operating Costs 300
Operating profit (EBIT) 200
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During the current year, the firm has added an economic value of Rs.90.3 lakh to the
existing wealth of equity shareholders. Essentially, the EVA approach is a modified
accounting approach to determine profits earned after meeting all financial costs of all the
providers of capital. Its major advantage is that this approach reflects the true profit position
of the firm.
RI (EVA) has the following advantages:
(i) It avoids suboptimal decisions as investments are not rejected merely because they
lower the divisional manager’s ROI.
(ii) It maximizes the growth of the company and increases shareholders’ wealth by
accepting opportunities which earn a rate of return in excess of the cost of capital.
(iii) The cost of capital charge on divisional investments ensures that divisional
managers are aware of the opportunity cost of funds.
(iv)Charging each division with the company’s cost of capital ensures that decisions
taken by different divisions are compatible with the interests of the organization as
a whole.
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Culture:
This is the most important internal factor – is the organization’s own culture and how
is the individual of the organization are understanding and maintaining the culture. The
culture consists of – the common beliefs, shared values, norms of behavior, and assumptions
that are implicitly accepted and explicitly manifested throughout the organization. Cultural
norms are extremely important since they explain why two organizations, with identical
formal management control systems, may vary in terms of actual control.
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Rules:
Rules means all types of formal instruction and controls, including standing
instructions, job descriptions, standard operating procedures, manuals, and ethical guidelines.
Rules range from the most trivial to the most important.
Some rules are guides; that is organization members are permitted, and indeed
expected, to depart from them, either under specified circumstances or when their own best
judgement indicates that a departure would be in the best interest of the organization.
Q.3 (a) Explain how different types of expenses centers operates with the help of
sketches?
Answer:
Expense centers are responsibility centers whose inputs are measured in
monetary terms whose output are not. There are two general types of expenses centers: -
engineered and discretionary. These labels relates to two types of cost. Engineered costs are
those for which the ‘right’ or ‘proper’ amount can be estimated with reliability. For example,
factory’s costs for direct labour, direct material, components supplier and utilities.
Discretionary costs are those for which no such engineered estimate is feasible. In
discretionary expenses centers, the cost incurred depends on management’s judgment as to the
appropriate amount under the circumstances.
1. Engineered expenses centers:- it have following characteristics:-
2. The profit input can be measured in monetary terms.
3. Their output can be measured in physical terms.
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(Dollar) (Physical)
(Dollar) (Physical)
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Budget preparation:-
Managements make budgetary decision for discretionary expenses centers that
differ from those for engineered expenses centers. For the later, it decides whether the
proposed operating budget represents the unit of performance efficiently. Its volume is not a
major concern; this is largely determined by the action of other responsibility centers. The
marketing department’s ability to generate sales. This work done by discretionary expenses
centers falls into two category; continuing and special. Continuing work is done consistently
from year to year, such as preparation of financial statement by controller office. Special work
is a “one shot” project for example developing and installing a profit budgeting system in
newly acquired division as per the discretionary expenses center budget is a management by
objective, a formal process in which budgeter process to accomplish specific job.
Incremental budgeting in this model discretionary expenses centers current
level of expenses is taken as starting point. This amount is adjusted foe inflation, anticipated
change in the workload of continuing job. Incremental budgeting has two characteristics and
two drawbacks. The drawbacks are first, the discretionary expenses centers current level of
expenditure is accepted and not reexamined during the budget preparation process and second,
manager of these center typically want to increase the level of services and tend to request
additional resources, which they make a sufficiently strong case are usually provide.
Cost variability
Unlike cost engineered expenses center, which are strongly affected by short
run volume change costs in discretionary expenses center are comparatively insulated from
such short term fluctuation. This differences stems from the facts that in preparing the budget
for discretionary expenses center. Management tends to approve change that correspond
anticipated change in sales.
Measurement of performance
The primary job of discretionary expenses centers manager is to obtain the
desired output spending and an amount that is “on budget “to do this satisfactory. Spending
more than that is cause for concern and spending less may indicate that planned work is won’t
be done. In discretionary centers as apposed to engineered expense centers, the financial
performance report is not a means of evaluating the efficiency of manager. Control over
spending can be exercised by required the supervisors approval before the budget is overrun is
permitted without additional approval.
Q4. What is profit center? Explain condition under which profit center decentralization
will most beneficial to an organization.
Answer:
Profit center:
When responsibility centers financial performance is measured in terms of
profit the center is called a profit center. Profit is particularly useful performance measure
since it allows senior management to use one comprehensive indicator rather than several.
Advantages of profit center:-
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Thus, from the objective, it is understandable that the Transfer price is mainly
transferring of goods and services from one unit to another where much important is not given
to accounting basis but also to all other effect.
Q. 5 (b) State that condition under which transfer price mechanism is likely to induce
goal congruence.
Ans: A market price- based transfer price will induce goal congruence if all the following
condition exists. But it just suggests a way of looking and to improve the operation of transfer
price mechanism.
1. Competent people
Ideally manager should be interested in the long run as well as short run
performance of their responsibility centers. Staff people involved in negotiation and arbitration
of transfer prices also must be competent.
2. Good Atmosphere
Managers must regard profitability, as measured in their income
statements, an as important goal and a significant consideration in the judgment of their
performance. They should perceive that the transfer price are just.
3. A Market Price
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• First, there is the measure of management performance, which focuses on how well the
manager is doing. This measure is used for planning, coordinating, and controlling the profit
center’s day-to-day activities and as a device for providing the proper motivation for its
manager.
• Second, there is the measure of economic performance, which focuses on how well the
profit center is doing as an economic entity. The messages conveyed by these two measures
may be quite different from each other.
For eg: The management performance report for a branch store may show that the store’s
manager is doing an excellent job under the circumstances, while the economic performance
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1) Contribution Margin
Contribution margin reflects the spread between revenue and
variable expenses. The principal argument in favour of using it to measure the performance of
profit center managers is that since fixed expenses are beyond their control, managers should
focus their attention on maximizing contribution. The problem with this argument is that its
premises are inaccurate, in fact, almost all fixed expenses are at least partially controllable by
the manager, and some are entirely controllable. Many expense items are discretionary; that is,
they can be changed at the discretion of the profit center manager. Presumably, senior
management wants the profit center to keep these discretionary expenses in line with amounts
agreed on in the budget formulation process. A focus on the contribution margin tends to direct
attention away from this responsibility. Further, even if an expense, such as administrative
salaries, cannot be changed in the short run, the profit center manager is still responsible for
controlling employees’ efficiency and productivity.
2) Direct Profit
This measure reflects a profit center’s contribution to the
general overhead and profit of the corporation. It incorporated all expenses either incurred by
or directly traceable to the profit center, regardless of whether or not these items are within the
profit center manager’s control. Expenses incurred at headquarters, however, are not included
in this calculation.
A weakness of the direct profit measure is that it does not recognize the motivational
benefit of charging headquarters costs.
Example: Knight-Ridder, the second-largest newspaper publisher in the United States,
measured each of its newspapers based on direct profit. The publisher set specific targets for
direct profit at each of its newspapers. For 1996 the Miami Herald had a target of 18 percent
and the Philadelphia Inquirer and the Philadelphia Daily (which were operated as one unit) had
a target of 12 percent.
3) Controllable Profit
Headquarters expenses can be divided into two categories: controllable
and non-controllable. The former category includes expenses that are controllable, at least to a
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There are situations, however, in which the effective income tax rated
does vary among profit centers. For example, foreign subsidiaries or business units with
foreign operations may have different effective income tax rates. In other cases, profit centers
may influence income taxes through their installment credit policies, their decisions on
acquiring or disposing of equipment, and their use of other generally accepted accounting
procedures to distinguish gross income from taxable income. In these situations, it may be
desirable to allocate income tax expenses to profit centers not only to measure their economic
profitability but also to motivate managers to minimize tax liability.
• If profit centers are to be charged for a portion of corporate overhead, this item
should be calculated on the basis of budgeted, rather than actual, costs, in which case the
“budget” and “actual” columns in the profit center’s performance report will not complain
about either the arbitrariness of the allocation or their lack of control over these costs, since
their performance reports will show no variance in the overhead allocation. Instead, such
variances would appear in the reports of the responsibility center that actually incurred these
costs.
Ans - The balance score card is a management system (not only a measurement system) that
capable organization to clarity their vision and strategy and translate them into action. It
provides feedback around both the internal business processes and external outcomes in order
to continuously improve strategic performance and results. When fully deployed, the balance
scorecard transforms strategic planning from an academic exercise into the never center of an
enterprise.
Kaplan and Norton describe the innovation of the balanced scorecard: “The
balance scorecard retains traditional financial measures. But financial measures tell the story
of the past events; an adequate story for industrial age companies for which investments in
long-term capabilities and customer relationships were not critical for success. These
financial measures are inadequate, however, for guiding and evaluating the journey that
information age companies must make to create future value through investment in
customers, suppliers, employees, processes, technology, and innovation.”
The balanced scorecard fosters a balance among different strategic measures in an effort to
achieve goal congruence, thus encouraging employees to act in the organization’s best
interest. It is a tool that helps the company’s focus, improves communication, sets
organization objectives, and provides feedback on strategy.
Ans - The balance score card implement in an organization from four perspectives, and to
develop metrics, collected data and analyze it relative to each of these perspectives:
o The learning and growth perspective
o The Business process perspective
o The Customer perspective
o The Financial perspective
This perspective includes employee training and corporate culture attitudes related to
both individual and corporate self-improvement. In a knowledge-worker organization, people
—the only repository of knowledge—are the main resource. In the current climate of rapid
technological change, it is becoming necessary for knowledge worker to in a continuous
learning mode. Government agencies often
Find themselves unable to hire new technical workers and at the same time is showing a
decline in training of brain drain that must be reversed. Metrics can be put into place to guide
managers in focusing training where they can help the most.
In any case, learning and growth constitute essential foundation for success of any
Knowledge-worker organization.
This perspective refers to internal business process. Metrics based on this perspective
allow the managers know how well their business is running, whether its products and
services conform to customer requirements. These metrics have to be carefully designed by
those who know these processes most intimately; with our unique missions these are not
something that can be developed by outside consultants. In addition to the strategic
management process, two kinds of business processes may be identified: a) mission-oriented
processes, and b) support processes. Mission oriented processes are special functions
government offices, and many unique problems are encountered in these processes. The
support processes are more repetitive in nature.
Kaplan and Norton do not disregard the traditional need for financial data. Timely and
accurate funding data will always be priority, and manager will do whatever necessary to
provide it. In fact, often there is more than enough handing and processing of financial data.
With the implementation of a corporate database, it is hoped that more of the processing can
be centralized and automated. But the point is that the current emphasis on financial needs to
the”unbalanced” situation with regard to other perspectives.
Ans – Auditing is necessary for every business, corporate and organization. Because if you
survive a life to take food, similarly auditing is need for organization. Audit means inspection
of past performance of organization. Auditing approved where your business going on profit
or loss. If you not make audit his organization, you cannot find it, what your business earn
profit or loss monthly or yearly, you will not know. Why organization’s or corporate sector’s
owner make audit his organization. Because he want to know his organization staff working
right or wrong. If he does wrong his working, they want to know, where is wrong? Why is
wrong? What is reason for wrong? Every problem is solved by auditing.
There are three types of auditing: a) internal audit, b) external audit and c) concrete
audit. Here I am explaining “Internal audit means nothing but policing”. It is rule of
government auditing is necessary to every organization. Because government get tax both:
organization and one who take contract of auditing.
Ans - Internal control is not one event, but a series of actions and activities that
occur throughout on entity’s operations and on an ongoing basis. Internal control should be
organized as an integral part of each system that management uses to regulate and guide its
operations rather than as a separate system within an agency. In this sense, internal control is
management control that is built into the entity as a part of its infrastructure to help managers
run the entity and achieve their aims on an ongoing basis.
Five standards for internal control:
- Control environment
- Risk management
- Control activities
- Information and communication
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Control environment:
Management and employees should establish and maintain an environment
throughout the organization that sets a positive and supportive attitude toward internal control
and conscientious management.
Risk management:
Internal control should provide for an assessment of the risk the agency faces from
both internal and external sources.
Control activities:
Internal control activities help ensure that management directives are carried out.
The control activities should be effective and efficient in accomplishing the agency’s control
objectives.
Monitoring:
Internal control monitoring should assess the quality of performance over
Time and ensure that the finding of audits and reviews are promptly resolved.
Q 10: The budget vs. actual comparison for the division ABC of the company X at the
end of the year 01 is as follows:
(All the figures in Rs. lacs)
Budget Actual
Sales 100 185
Material and other variable costs 120 109
Employee and other fixed expenses 30 30
Sales promotion 10 07
Operating profit 40 39
Net working capital 100 103
Fixed assets 40 37
For this division, which areas of performance would you like to investigate and what
would be the corrective action, if any, you would like to out in place?
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Solution:
Particulars Budget Actual
• Profit Margin:
40 / 200 *100 39/185 * 100
Profit / Sales * 100 = 20 % = 21.08 %
• Turnover of Assets:
• Return on Investment:
• Profit margin
• Turnover of Investments
In case of profit margin actual is higher than budgeted though the profit and the actual
sales are in absolute terms as compared to budget but the percentage profit to sales is higher
against budget. The following reasons can be associated to:
1. The variable cost as percentage to sales as compared to budget is 60% and actual is 58%.
11. In company XYZ, division B contracted to buy from division A, 10,000 units of a part that
goes into the final product made by division B. The transfer price for this internal transaction
was set at Rs.12 by mutual consent. This comprised of material cost of Rs.6 per unit, direct and
available labour cost of Rs.2 per unit , fixed over heads of Rs.2 per unit (lumsum of Rs.20,000)
and Rs.2 per unit as return on investment of Rs.1,00,000 that division A would have had to
make for this incremental activity. During the year, division B’s actual off take from division a
was 9800 units. Division a was able to effect 5% out back in material consumption but had
10% overrun on investment budgeted for this activity.
Make a budget versus actual comparison statement for this activity.
Solution:
Material
cost 60000 58800 55860
T.P. 12
Comments:
Comparing budget with actuals would not serve the purpose due to different
no. of units. Hence, budget as per actual figures has been prepared. The figures show that the
actual units consumed were 9800 instead of 10000. Still, Div A was in a position to reduce the
material consumption cost. The labour cost was same as budget as per actual units and hence,
company was in a position to control the costs. It shows that the company’s control system is
efficient.
OR
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Sales 1120
Other income 4
Materials consumed 426
Labour 291
Factory overheads 168
(including Rs.40 lacs depreciation)
Selling and administration 123
Profit before interest and taxes 116
Interest on borrowing 25
Income tax 15
1) What is the cash and book return on net worth?
2) What is the operating return on operating investment?
3) How is return on assets related to sales margin and assets turn over?
Solution:
1) Cash and Book return on net worth:
Profit before interest and tax (+) Depreciation (-) Tax
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Cash = 40.51%
• Dupont Analysis:
Return on Assets = Net profit Margin * Assets Turnover ratio
Net Profit = Net profit * Sales
Total Assets Sales Total assets
76 = 76 * 1120
508 1120 508
14.96 = 14.96
Q.12 (a) Best and company comprises five divisions A, B, C, D and E and at present
measures divisional performance and managerial performance on the basis of return on
asset. However the controller has recently suggested to the management that the
company should switch over to EVA as the criterion rather than return on asset. From
the information given below, compute both return on asset and EVA for each division
and tabulate the same.
Division Profit Fixed asset Current asset
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Conclusion
From the above analysis of these division which it notice that division A
performed the best in respect of ROA and EVA all division have positive ROA whereas while
calculating the EVA division C has negative EVA as against positive ROA 6.25%. Controller
has advice evaluation of division can be made on the basis of EVA instead of ROA, EVA has
following advantages:-
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A Q.12 (b) sterling associate has three divisions with varying operation characteristics.
Division M is exclusively involved in marketing; division P in production while division C
is involved in both marketing and production activities.
Information about these divisions is tabulated below where in all the figures are in
thousand of rupees.
Depreciation on all fixed assets is on the basis of straight line (10years). Division M must
spend Rs. 300000 for market development and division C must also spend Rs. 150000 for
same purpose, where as 10% of production facilities are to be replaced in division P,
treating these as annual operating expenses, what are the rates of returns achieved by
each division? Comment in detail.
Solution
Formula
ROI = operating profit/ investment *100