Paper Pattern

Q.1 To Q.9 Any Six (Theory) Each of 6 Marks

Q.10 To Q.12 Any Two (Problems) Each of 7 Marks
Q.13 Compulsory (Case Study) Of 10 Marks
CHAPTER 1: Understanding Strategies, Perspective on MCS

Controlling: “Controlling is the measurement and correction of the performance of activities in order to ensure that 
the planned objectives are accomplished”

Elements of Control:

Press the accelerator, and your car goes faster. Rotate the steering wheel, and it changes direction. Press the brake
pedal, and the car slows or stops. With these devices, you control speed and direction, if any of them is inoperative,
the car does not do what you want it to. In other words it is out of control.

An organization must also be controlled, that is, device must be in place to ensure that its strategies intentions are
achieved, but controlling an organization is much more complicated process than controlling a car

Any control system has four important elements. They are:

(i) Detector or Sensor: The detector analyzes the situation that is being controlled
(ii) Assessor: Helps in comparing the actual results with the standard or expected results.
(iii) Effector: An effector is used to reduce the gap between the actual and the expected
(IV) Communications network: Transmits information between the detector, the assessor and the effector.

These elements of control can be better understood with the help of example:

Assume you are driving on a highway where the legal speed is 65 mph. Your control system acts as follows:

(i) Your eyes (Sensor) measures actual speed by observing the speedometer,
(ii) Your Brain (Assessor) compares actual speed with desire speed and, upon directing a deviation from
the standard,
(iii) Directs your foot (Effector) to ease up or press down on the accelerator,
(iv) Your nerves form the communication system that transmit the information from eyes to brain and
brain to foot.

Management Control:

“Management control is the process by which managers influence other members of

the organization to implement the organization’s strategy.”

Elements of Management Control:

(i) Detector or Sensor:- Reports what is happening throughout the organization,

(ii) An assessor:- Compares this information with desired state.
(iii) An effector:- Take corrective action once a difference is observed.
 
(iv) A communication network:- Tells managers what is happening and how that compares to the desired
state.

Simpler Controlling Process V/S. Management Control Process

(i) Much management control is self control, that is, control is maintained not by external devices, but by
the managers who are using their own judgment rather than following instructions from a superior.
(ii) In management control results may not be clear. We cannot know what action a given manager will
take when there is a significant difference between the actual and expected performance, nor what
action others will take in response to the managers signal. By contrast in case of automobile driver, the
assessor phase may involve judgment, but the action itself is mechanical once the decision to act has
been made.
(iii) Like controlling an automobile, management control is not automatic. Some detectors in an
organization may be mechanical, but the manager often detects information with his own eyes, ears
and other senses.
(iv) Unlike controlling an automobile, a function performed by a single individuals, management control
requires coordination among individuals.

Boundaries of Management Control

1. Strategy Formulation/ Strategic Planning

“Strategy formulation is the process of deciding on the goals of the organization and the strategies for
attaining these goals.” The process analyses the changes that take place in the environment and helps to
ascertain the related adjustments needed in the organizational goals. In order to attain goals through
optimum resources utilization it is important to have well define polices and control procedures.
The process of strategic planning relates to formulation of plans dealing with:
• Determination of the goals of the organization
• Evolving managerial policies and procedures
• Identifying markets and distribution channels required to serve the market
• Planning and initiating research and development activities
• Ascertaining the amount and sources of finance
• Acquiring or disposing facilities
• Ascertaining employee capabilities and skills needed to attain the goals

2. Management Control:
“Management control is the process by which managers influence other members of the organization to
implement the organization’s strategies”.
It involves variety of activities, including: Planning, coordinating, communicating, evaluating, deciding &
influencing.
Management control is all about ensuring that the necessary resources are mobilized and are deployed
efficiently so that the planned objectives are met without much difficulty. It is all about the organization,
methods and procedures adopted by management to provide reasonable assurance that available
resources and assets are properly deployed and safeguarded against waste and mismanagement and
frauds.

Strategy Formulation Management Control

Strategy formulation is the process of deciding new
Management control is relates with implementation
strategy of those strategies.
Require information about external environmental
Management control follows a system to achieve the
development organizational goals
Irregular and infrequent in nature It is systematic and continuous activity
Responsibility and task of top management In management control other managers also
participate besides the top and senior managers
Focus on specific problem at a time Management control involves total organization
More complex compare to Management control Less complex
Aimed for long term period Short term focus
Number of persons involve are small Large number of persons is involved
Aim and result is to making policies and Aim and result is to take corrective actions to get
programmes the planned or desired results
 
3. Task Control/ Operational Control:
Task control is the process of assuring that specific tasks are carried out effectively and efficcently. It is a
mechanism that deals with individuals tasks or transactions such as:
• Scheduling and controlling individual jobs
• Procuring specific item for inventory
• Specific personnel actions
Task control is helpful in establishing a relationship between the levels of activity and the cost incurred.

Management Control Task Control

Focuses on the control of the whole organization Directed towards the control of the one unit of the
organization
Management control functions and steps within it, are Task control functions are based on procedures and
framed in terms of strategies formulated by top rules which are derived from management control and
management its requirements
Under management control standards set for evaluation Under Task control the standard set for evaluation are
are not that much precise more precise
Under management control the control involves human Under task control, control is direct in nature
dynamics
Financial measures are used for control purpose Most often, non-financial measures are used for control
purpose
Requires summaries of transaction Requires transaction based information
Management control use approximations and estimates Task control uses exact and real situation data

Points Strategy Formulation Management Control Task Control

Level Concentrated at top level Practiced at all level Confined to supervisory level
Focus Focuses on one aspect at a Focuses on the whole Focuses on the efficiency of
time operation that obviously the individual
impacts the organizational
effectiveness
Complexity It is complex process Comparatively less complex Simple as the attention is on
as it involves administrative simple activities only
activities
Information Information is collected Data is financial in nature Data is tailor made for
from external sources & and is integrated. specific operation & is often
specific to problem non financial. It is in real
times
People involved Involves top management Involves both top Involves supervisors
management and line
managers
Time Horizon Long drawn Process Involves weeks, months and Involves day-to-day
years activities
Nature of activity Require creative and Requires administrative and Follows directions that are
analytical skills persuasive skills generally listed in rule book

Stages of Management Control Process

 
The system has following four components

1) Programming
Programming is defined as making programs by top/ senior management in terms of organizational goals and
strategies and deciding the funds and resources needed to accomplish the programs. Programs can be made about
development of new products, research and development of activities merger, takeover and other activities that
are not related much with the existing product lines. In service organizations such as hotel chain management may
draw programs for each hotel or each region where hotels are to be set up.
Programming is long range plan, covering period of approximately five future years. The reason is that it
programming is made for shorter period, the results and benefits of programming can not be realized within this
period. some organization like public utilities prepare long range plans for even a period of twenty years .because
of the relatively long time plan, only rough estimates are possible revenues ,expenses and capital expenditure.
Programming is time consuming and expensive. The most significant expense is the time devoted to it by
management, but it also involves a special programming staff and considerable paperwork. A formal
programming process is not worthwhile in some organization. it is desirable in organization that have the following
characteristics
Its top management is convinced that programming is important .otherwise programming is likely to be or to
become, a staff exercise that has little impact on actual decision making.
It is relatively large and complex in small, simple organizations, an informal understanding of the organizations
future directions for making decision about resource allocations, which is principal purpose of preparing programs.
If the future is so uncertain that reasonably estimates cannot be made preparation of a formal program is a waste
of time.

2) Budgeting
“Budget is formal financial plan for each year .a budget ,known as shorter angel plans ,is a technique of expressing
revenues ,expenses ,physical targets like production and sales ,profit ,assets and liabilities usually for a period of one
future year” .
1. Budget has the functions of motivating managers, coordinating activities, communicating to persons within
organization, providing standards for judging actual performance s and acting as control tool.
2. Budgeting involves operating managers as well as senior manager. Staff personnel have considerable input to
the programming process, but relatively less input to the budgeting process
3. The program structure consists of program and major project. It includes both capital expenditure and operating
items and it covers a period of several years. The budged is structured by responsibility centre (which may or may
not cut across program) the focus is on operating revenues and expenses and it typically is for a single year.
4. Budget preparation is done under greater time pressure and is more hectic than programming
5. A program is abroad brush sketch of the future. A budget has more details both because it is a fairly specific
guide to operating decisions and also because it will be used subsequently to evaluate the performance of
individual manager.
6. Programming decision can have consequences of great magnitude. Budgeting decision are typically much less
significant, because they are made within the context of the current level of operating activities, except as those
activities will be affected by program decision.
7. Behavioral consideration is much more important in the budget preparation process than in the programming
process. The approved project is a bilateral commitment; the program is not a commitment, because the budget
will be used to evaluate performance.

3. Executing:-
After the budget preparation, budgeting is used as a tool for coordinating the actions of individual and
department within the organization. In fact within the execution phase task control is done to ensure that actions
and performance match with the planned or desired result. While performing the mangers goal is to achieve
budgeted targets. However compliance to budget is not necessary if the plans given in the budget are found as
not the best way of achieving the objective.
After execution actual performance and result are compared with the budgeted plans and targets and variance
reports are prepared which highlight the variance between the 2 and the causes for such variances. Variance
reports should separate controllable item from non-controllable item, determine the effects of changes in volume
on revenues and cost and if possible, should mention changes in other circumstances affecting the variances

4. Evaluation:-
Management control Process ends with the evaluation phase in which the performances of managers are
evaluated. Since it is an after- event exercise, the evaluation does not affect what has happened. However,
evaluation phase acts like a powerful stimulus as employees know that their performances will be subsequently
evaluated. Also on the basis of performance evaluation, the future budget and plans are revised.
 

Features of Management Control System

1. A Total System:A management control system is a total system as it covers all aspects of the company’s
operations. It is an overall process of the enterprise which aims to fit together the separate plans for various
segments so as to assure that each harmonizes with the others, and that the aggregate effect of all of them
on the whole enterprise is satisfactory.

2. Monetary Standards:Barring some exceptions, the management control system is built around a
financial structure and all the resources and outputs are expressed in terms of money. The results of each
responsibility center in respect to production and resources are expressed in terms of the common
denominator of money.

3. Definite pattern:the management control system follows a definite pattern and time table. The whole
operational activity is regular and rhythmic. It is a continuous process even if the plans are changed in the
light of experience or change in technology.

4. Coordinated system: A management control system is a fully coordinated and integrated system. Even if
the information for one purpose varied from that collected for another purpose, the data reconciles with
one another. It is, therefore, more plausible to consider the interlocking sub – processes as a single set for
achieving the objectives of the enterprise.

5. Line manager: Information collected from various sources is organized by the line managers. The line
managers are the focal points in the management control system. Line managers motivate the employees
to improve their performance and thereby achieve the organizational goal. Business budgets are prepared
based on their advice and suggestions.

6. Effective Planning: Organization function on the basis of plans, policies and standards. These are
communicated to managers who have performance responsibility. Thus control depends on effective
planning without which organization never succeed in analyzing their accomplishments.

7. Involvement of top management: The attitudes and involvement of the top management determines
the effectiveness and efficiency of the management control system. The involvement of top management
imposes confidence in the system and ensure timely action for removing the cause of poor performance.

8. Motivation of employee: Motivation represents an urge to performeanf excel. In the absence of

motivation, goals often remain unachieved.

9. Establishing proper communication mechanism: Effective communication facilitates timely flow of

information across all level of management. Communication is useful in communicating organizational
goals, practicing control and facilitating reporting.

CHAPTER 2: Organizational Hierarchies and Behavior

Various Organizational Goals

The most common goals of the organization are:

(1) Profitability:
Profitability is the return made by the firm on its investment and may be expressed as Net Profit divided by
Investment. It refers to profit earned in the long run and short term profit do not find any place here. It is possible
that an organization may incur heavey capital expenditure, expenses on advertisement and sales promotion, and
research and development expenses which depress its present profits but are essential for its growth and generation
of long run profit.
(2) Maximization of Shareholder Value:
 
The goal of firm is to maximize the
present wealth of the ownersi.e
equity shareholders in a company.
A company’s equity shares are
actively traded in the stock
markets, the wealth of equity
shareholders is represented in the
market value of equity shares. The
firms cash flow and its impact on
value maximization is shown in
figure below:
The prime goal for company form
of organization is to maximize the
market value of equity shares of
the company. The market price of
a share serves as an index of the
performance of the company. It
takes into account present and
prospective future EPS, risk
associated with the business,
dividend and retention polices of
the firm, level of gearing etc. The
shareholder’s wealth is maximized only when the market value of shares is maximized. In the present context, the
term wealth maximization is redefine as value maximization. The objective of maximizing economic welfare. In
company form of business, the wealth created is reflected in the market value of its shares. Therefore, the financial
decision will cause to create wealth and it is indicated or reflected in market price of company’s shares. Hence the
prime objective of financial management is to maximize the value of the firm.

(3) Risk:
An organization’s pursuit of profitability is affected by management’s willingness to take risks. The degree of risk
taking varies with the personalities of individual manages. Nevertheless, there is always an upper limit, some
organizations explicitly state that management primary responsibility is to preserve the companies assets, with
profit consideration as secondary goal
(4) Miscellaneous Goals:
(i) Organizational Effectiveness
(ii) High Productivity
(iii) Good organizational leadership
(iv) High morale
(v) Good organizational reputation
(vi) Organizational efficiency
(vii) Organizational growth
(viii) Value to local community
(ix) Service to the public

Concept of Goal Congruence

Every individual has personal goals to be attained along with the organizational goals assigned to him. At times
individuals face a conflict between personal and organizational goals. This conflict can affect the performance
adversely. It is therefore necessary to evolve a mechanism that integrates the personal goals with organizational
goals so that goal congruence is achieved.
Goal congruence means the action people take in accordance with their perceived self-interest and also in the best
interest of the organization. The control system should discourage individuals from acting against the interest of the
organization.

Factors influencing goal congruence

(I) Informal Factors

(i) External Factors
(ii) Internal Factors
(a) Culture
(b) Management Style
(c) The informal Organization
 
(d) Perception and Communication
(II) Formal Factors
(a) Rules

Informal Factors that influence goal congruence

(i) External Factors:

External factors are norms of desirable behavior that exist in the society of which the organization is a part. These
norms include a set of attitudes, often collectively referred to as the work ethic, which is manifested in employees'
loyalty to the organization, their diligence, their spirit, and their pride in doing a good job (rather than just putting
in time). Some of these attitudes are local that is, specific to the city or region in which the organization does its
work. In encouraging companies to locate in their city or state, chambers of commerce and other promotional
organizations often claim that their locality has a loyal, diligent workforce. Other attitudes and norms are industry-
specific. Still others are national; some countries, such as Japan and Singapore, have a reputation for excellent work
ethics.

Example: Silicon Valley- a stretch of northern California about 30 miles long and 10 miles wide is one of the major
source of new business creation and wealth in the American economy. Silicon Valley attracts people with certain
common features: an entrepreneurial spirit, a zest for hard work, high ambition and a preference for informal work
setting. Over the last 50 years, Silicon Valley has created companies such as HP, Microsoft, Apple Computers,
Oracle, Cisco Systems etc

(ii) Internal Factors

(a) Culture

The most important internal factor is the organizations own culture-the common beliefs, shared values, norms of
behavior and assumptions that are implicitly 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. A company's culture usually exists unchanged for many years.
Certain practices become rituals, carried on almost automatically because "this is the way things are done here."
Others are taboo ("we just don't do that here"), although no one may remember why. Organizational culture is
also influenced strongly by the personality and policies of the CEO, and by those of lower-level managers with
respect to the areas they control. If the organization is unionized, the rules and norms accepted by the union also
have a major influence on the organization's culture. Attempts to change practices almost always meet with
resistance, and the larger and more mature the organization, the greater the resistance is.

Example: Johnson & Johnson has strong corporate culture; this was demonstrated during the Tylenol crises in 1982.
After taking poisoned Tylenol capsules, seven people died. J&J withdrew all Tylenol capsules from the US market,
even though all the poisoned capsules were sold in Chicago, the tampering occurred outside J&J premises, and the
individual responsible was not J&J employee. The company also undertook a massive publicity campaign to inform
health professionals and the public of the steps it was taken to prevent such tempering in the future. Altogether,
J&J spent over $100 million in response to the Tylenol crises. The employees maintain that their actions during the
crisis stemmed from their strong belief in the company’s credo, which underscore the responsibility of the company
to the public regardless of any potentially negative impact on short term profits.

(b) Management Style

The internal factor that probably has the strongest impact on management control is management style. Usually,
subordinates' attitudes reflect what they perceive their superiors' attitudes to be, and their superiors' attitudes ulti-
mately stem from the CEO.

Managers come in all shapes and sizes. Some are charismatic and outgoing; others are less ebullient. Some spend
much time looking and talking to people (management by walking around); others rely more heavily on written
reports.

(c) The Informal Organization

 
The lines on an organization chart depict the formal relationships-that is, the official authority and responsibilities-
of each manager. The chart may show, for example, that the production manager of Division A reports to the
general manager of Division A. But in the course of fulfilling his or her responsibilities, the production manager of
Division A actually communicates with many other people in the organization, as well as with other managers,
support units, the headquarters staff, and people who are simply friends and acquaintances. In extreme situations,
the production manager, with all these other communication sources available, may not pay adequate attention
to messages received from the general manager; this is especially likely to occur when the production manager is
evaluated on production efficiency rather than on overall performance. The realities of the management control
process cannot be understood without recognizing the importance of the relationships that constitute the informal
organization.

(d) Perception and Communication

In working toward the goals of the organization, operating managers must know what these goals are and what
actions they are supposed to take in order to achieve them. They receive this information through various channels,
both formal (e.g., budgets and other official documents) and informal (e.g., conversations). Despite this range of
channels, it is not always clear what senior management wants done. An organization is a complicated entity, and
the actions that should be taken by anyone part to further the common goals cannot be stated with absolute
clarity even in the best of circumstances.

Moreover, the messages received from different sources may conflict with one another, or be subject to differing
interpretations. For example, the budget mechanism may convey the impression that managers are supposed to
aim for the highest profits possible in a given year, whereas senior management does not actually want them to
skimp on maintenance or employee training since such actions, although increasing current profits, might reduce
future profitability.

Formal Factors that influence goal congruence/ Formal Control System

Rules

We use the word rules as shorthand for all types of formal instructions and controls, including: standing instructions,
job descriptions, standard operating procedures, manuals, and ethical guidelines. Rules range from the most trivial
(e.g., paper clips will be issued only on the basis of a signed requisition) to the most important):e.g., capital
expenditures of over $5 million must be approved by the board' of directors).

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 judgment indicates that a departure would be in the
best interests of the organization.

Some rules are positive requirements that certain actions be taken (e.g., fire drills at prescribed intervals). Others
are prohibitions against unethical, illegal, or other undesirable actions. Finally, there are rules that should never be
broken under any circumstances: a rule prohibiting the payment of bribes, for example, or a rule that airline pilots
must never take off without permission from the air traffic controller.

Some specific types of rules are listed below:

Physical Controls

Security guards, locked storerooms, vaults, computer passwords, television surveillance, and other physical controls
may be part of the control structure.

Manuals
Much judgment is involved in deciding which rules should be written into a manual, which should be considered to
be guidelines rather than fiats, how much discretion should be allowed, and a host of other considerations. Manuals
in bureaucratic organizations are more detailed than are those in other organizations; large organizations have
more manuals and rules than small ones; centralized organizations have more than decentralized ones; and or-
ganizations with geographically dispersed units performing similar functions (such as fast-food restaurant chains)
have more than do single-site organizations

System Safeguards
 
Various safeguards are built into the information processing system to ensure that the information flowing through
the system is accurate, and to prevent (or at least minimize) fraud of every sort. These include: cross-checking totals
with details, requiring signatures and other evidence that a transaction has been authorized, separating duties,
counting cash and other portable assets frequently, and a number of other procedures described in texts on
auditing.

Task Control Systems

Task control is the process of assuring that specific tasks are carried out efficiently and effectively. Many of these
tasks are controlled by rules. If a task is automated, the automated system itself provides the control.

Types of organization Structures

(i) Functional Organizations:

A functional structure is one, in which each manager is

responsible for a specified function such as production
or marketing.

A functional organizational structure is one on which

the tasks, people, and technologies necessary to do the
work of the business are divided into separate
“functional” groups (such as marketing, operations, and
finance) with increasingly formal procedures for
coordinating and integrating their activities to provide
the business’s products and services

Advantages:

• Efficiency:The skilled specialist should be able to supervise workers in the same function better than the
generalist would, just as skilled higher – level managers should be able to provide better supervision of
lower – level managers in the same or similar function. This helps to increase the efficiency of the labor.
• Enhance Productivity: A worker who is an expert in his functional area can perform tasks with a high level
of speed and efficiency, which enhances productivity. Workers who know their jobs well can proceed with
confidence and with a minimum amount of mistakes. Because the career paths within the functional unit
are clear, the employees may be highly motivated to advance their careers by reaching the next rung on
the ladder, which may also make them more productive.
• Provide Quality Supervision: Subordinates are supervise by the experts in that function, so the get quality
supervision with quality knowledge.

Disadvantages:

• No way of determining the effectiveness of separate function: There is no unambiguous way of determining
the effectiveness of the separate functional managers e.g. the manager of marketing and of the production
contributes to the final output. There is no precise way of determining how much of the profit is earned by
each function.
• Co-ordination: it becomes difficult to maintain co-ordination between different functions. For example, the
marketing department may wants to satisfy a customer’s need for a certain quantity of product even if it
involves over time work by production, which the latter is not willing to bear.
• Diversified Products: Functional organizations are inadequate for a firm which has diversified products and
markets since the emphasis has to be different.
• Cross functional coordination: Functional organization prevent cross functional coordination. E.g.: At the
Boeing Company, there was time when design engineers works independently of the production and
operation people who actually built the plane. Here the designers would says. “Now, go build it”. Boeing’s
production people were given overly costly, hard-to-build designs. Boings broke down these functional
hierarchies by creating “design-build teams”, composed of members of all the different functions.

(ii) Divisional / Business Unit Organization:

 
In divisional structure, business unit managers are responsible for most of the activities of their particular unit, and
business unit functions as a semi-independent part of the company.

A business unit also called a division is responsible for all its functions involved in producing and marketing a specific
product line of group of product lines. Business unit managers act as if their units are separate companies. The
divisional managers performance is measured by the profitability of the business unit.

Although business unit managers exercise broad authority over their units, head office reserves certain key factors:

• Head office is responsible for obtaining funds for the company and for allocating these funds to the
various business units.
• Head office also approves budgets and appraises the performance of business unit managers.
• Head office establish charge for each business unit i.e. the product lines it is permitted to make and sell
and/or the geographical territory it can operate

Advantages of Divisional Organization

1. Emphasis on End Result: Divisional organization structure facilitates attention on the individual product line
for the purpose of ensuring highest efficiency in the form of production and sales in the particular product
line. So this form of structure emphasize on the end result i.e. product or customer for generating the
revenue in the organization.
2. Measurement of Performance: As the focus is made on the individual product line, it becomes easy to
measure the performance of the different lines and also control proves effective in these organizations.
3. Diversification: Attention on the individual product lines facilitates the expansion and diversification of the
enterprise. Organization size can be increased without any problem as new divisions can be opened
without disturbing the existing system.
4. Better Coordination: Overlapping of different functional activities is avoided as activities like sales,
production, marketing, etc., are coordinated in an effective manner as clear cut attention is given on
different product line.
5. Development of Managers: With the help of divisional structure, more managers with general outlook can
be developed, which make him possible to handle the higher positions in future. So the problem of
manager's succession comes to a halt.
6. Emphasis on Profits at Divisional Level: In divisional organizational structure, responsibility is fixed for the
individual product lines and they are respectively made accountable for that. So, every responsibility centre
has to achieve its own standards of profits.

Disadvantages of Divisional Organization

1. Costly: The divisional organizational structure is quite costly, because for every division separate facilities are
required to be arranged. So if the particular division does not justify its cost it should not be opened.
 
2. More Managerial Resources: This form of organization requires more persons with general manager ability.
Separate managers are required for each division because manager of one division will not comfortably
work in the other division.
3. Lack of Specialization: There is very less or no emphasis on the functional specialisation and sometimes due
to this reasons many professionals do not feel satisfied with this form of organizational structure.
4. Overlapping of Functions: Overlapping of the functions becomes difficult because managers have to
analyze each division separately. This is also one of the main disadvantages of this form of organizational
structure.
5. Difficult Control: To establish the control system is a major problem of the divisional organisation structure.
If the information monitoring system is not suitable, this system does not work properly.
6. Self-Centered: Every division becomes self-centered and concentrates on its own profits only and sometimes
at the cost of the profits of the other divisions. So overall organisational performance gets hampered

(iii) Matrix Organization:

In large organizations, there is often a
need to work on major products or
projects, each of which is strategically
significant, hence the requirement of a
matrix type of a organization structure.
Essentially, such a organization
structure is created by assigning
functional specialists to work on a
special project or a new product or
services. For the duration of the project,
the specialist from the different areas
forms a group or team and reports the
team leader.

Advantages:

• Allows individual specialists to be assigned where their talents are the most needed.
• Foster creativity because of the pooling of diverse talents.
• Provides good exposure to specialists in general management.
Disadvantages:

• Dual accountability creates confusion and difficulty for individual team members.
• Requires a high level of vertical and horizontal combinations
• Shared authority may creates communication problems.

MCS in Matrix Organizations

• The conflict, balance and stress are the three major aspects arising from matrix organization literature we
want to highlight here. They all are central for the nature of matrix and have to keep in mind when
designing control systems for matrix organization.
• Balance between the authorities – horizontal and vertical - is crucial in effective matrix organization. Often
the project/product managers tend to have less power than conventional functional managers. Controls
system of the organization must be constructed to support the balance between the authority of project
heads and functional managers.
• In matrix organization can be overlapping goals to achieve because of the cross-functional organizational
structure. There are three functions in budgeting process: common forecast, operational planning and
performance evaluation. When setting common goals and budgets all value creating dimensions must be
considered.
• In matrix organizations span of accountability is wide therefore there are wide range of variables and
tradeoffs that affect in specific measure. When span of accountability is wide few aggregate measures (f
are evaluated like Residual Income, Return on equity, P&L, Manufacturing cost, Operating expenses& sales.
• Matrix organizations can utilize non-financial measures when evaluating operating effectiveness for
example in decision-making process. Organizations can have various non-financial measures for inputs,
processes and outputs.
 
• Function managers and project managers experience confusion over their roles and responsibilities and
conflicts arise over authority, resource allocation and scheduling. This problem can be solved by conducting
written rules concerning the roles and responsibilities of both functional and project managers
• Because of the complex organizational structure inordinate information system is needed to support
accountability. Accounting and information technology systems play major role to get matrix organization
work. Information system must be capable to collect, aggregate and distribute information to support the
unit structure.

Functions of Controller

The term controller refers to the person who is responsible for designing and operating the management control
system. In much organization, the title of the person is chief financial officer. The controller perform the following
functions:
1. Designing and operating information and control system
2. Preparing financial statements and financial reports for shareholders and other external parties.
3. Preparing and analyzing the performance report, interpreting these reports for managers and analyzing
program and budget proposal from the various segments of the coampny and consolidating them into an
overall annual budget.
4. Supervising internal audit and accounting control procedures to ensure the validity of information,
establishing adequate safeguard again its theft and fraud and performing operational audits.
5. Development of personnel in his function and participating in the education of management personnel in
matter relating to controller function.

Business Unit Controller and Divided Loyalty

In a business unit form of organization, the finance and accounting function is headed by a business unit controller.
The business unit controller reports to the business unit manager. He also reports to the corporate controller. This
create what is known as divided loyalty.
While dealing with organization structures we have come across what is known as dotted line relationships.
 

 
In some organization, business unit controller reports directly to corporate controller and have a dotted line
relationship with business unit managers. This indicates that the corporate controller is the business unit controller
immediate boss.
In sharp contrast to above, we have companies where business unit controller reports directly to business unit
manager and have what is known as dotted line relationship with the corporate controller.
In India, the business unit manager generally report directly to the business unit manager and has a dotted
relationship with the corporate controller.
The reporting relation described above has its own merits & demerits. In case the business unit controller reports
directly to the corporate controller, the business unit manager may view him with suspicious and as a result may
not repose his trust and confidence in him. On the contrary, if the business unit controller reports directly to the
business unit manager, the former may not be in a position to discharge his responsibility in a faithful manner to the
company.

CHAPTER 3: Responsibility Centers

Concept of Responsibility Centers

 
Responsibility center is unit of organization that is headed by a manager having direct responsibility for its
performance. The responsibility area may be classified on the basis of department, product line, territories or any
other type of identifiable unit.

An organization is composed of a number of financial responsibility centres. These responsibility centres are created
by management based on the needs of the business enterprise.
Responsibility centers may be defined as an organizational unit which is headed by a responsible person namely a
manager. He is responsible for the activities of the unit. The responsibility centres is responsible for performing some
function which is its output. In performing these functions, it uses resources or ‘inputs’. The costs assigned to a
responsibility centre are intended to measure the input that it consumes in a specific period of time, such as a week
or a month.

Types of Responsibility Centers

1. Revenue Centers
2. Expenses Centers/ Cost Centers
¾ Engineered Expenses Center
¾ Discretionary Expenses Center
¾ Administration & Support Center
¾ Research & development Centers
¾ Marketing Centers
3. Profit Centers
4. Investment Centers

Revenue Centers

Revenue is a monetary measure of output. Where the output of responsibility centre is measured in terms of
money, we have what is known as revenue centres. According to Anthony, “in a revenue centre, outputs are
measured in monetary terms, but no formal attempt is made to relate inputs (i.e. expense or cost) to outputs”.
Examples of revenue centres are marketing organization where no responsibility for profit exists. Orders booked
and sales are compared with the budget to measures their performance.

The primary yard stick for judging the efficency of revenue centres is revenue earned vis a vis the budget. However,
the head of the revenue centre is held responsible for expenses incurred by his responsibility centre. Generally,
revenue centre managers do not have responsibility for estabilishing selling prices. Thus, in a revenue centre, there is
no relationship between inputs and outputs. Following figures shows the features of revenue centres.

Revenue Centers

Input Not Related to 
Output

Inputs    Outputs 

 
Rupees only for cost  Rupee for revenue 
directly incurred  PROCESS

Cost Centers
 
A cost center is unit of organization in which the manager held responsible for the cost incurred in that segment.
This unit is not responsible for revenues. The plans of this center are in the form of cost estimates, while the
performance is evaluated with the help of cost variance, that is, the difference between budgeted cost and actual
cost.

The managers of cost centers have control over some or all costs but not on the revenue. Since all costs are not
controllable, the cost center manager is responsible only for those costs that are controllable by him and his
subordinate.

Engineered Expenses Center

Engineered expense center is a unit where inputs are measured in monetary terms and outputs are measured in
physical terms. Engineered expenses centers are usually found in manufacturing, warehousing, distribution and
trucking.

Engineered expense centers do not just measures the cost but also responsible for the quality and volume of output.
Therefore the type and level of production and quality standards are set so that cost reduction is not achived by
compromising with the quality. Example Manufacturing Unit

Engineered Expense Centers

Optimal relationship 
can be established

Inputs    Outputs 

PROCESS 
Rupees  Physical 

Discretionary Expenses Center

Discretionary expenses center includes administration and support services, R&D and most marketing activities. The
operating profit of these centers cannot be measured in monetary terms.

Discretionary expenses reflect the management policies regarding certain expenses. Some examples of
management policies that deals with under discretionary expenses are:

¾ Marketing efforts initiated to face competition

¾ Services to be provided to customers
¾ Expenditure on R&D
¾ Financial planning and control mechanisms

Discretionary Expense Centers

Optimal relationship 
cannot be established

Inputs    Outputs 

PROCESS 
Rupees Physical
 

Budgeting Aspects of Engineering and Discretionary expenses center

In the case of engineered expenses centres, operating budgets are prepared based on management decision
regarding the cost of performing task efficiently for the future period. In other words, management decision
whether the proposed operating budget represents the cost of performing task efficiently for the coming period.
The size of the task is not much concern to management as the same is namely determined by the actions of the
other responsibility centres. For instant production is depend upon the marketing department capacity to sell.
However, while budgeting for a discretionary expenses centre one of the main problem confronting the
management the management to take a decision on the magnitude of the task. This become the principal task of
the management.

Management task is of two types (1) Continuing (2) Special. Where tasks have a tendency to reoccur from year to
year they are known as ‘Continuing task’ these task continue form year to year. Instance of such tasks are
prepration of annual tax returns, prepration of profit and loss account & balance sheet and other financial
statements during year end etc. On the contrary , ‘special tasks’ may be describe as ‘one time’ project which arises
once and remains till the same are completed. For instant, developing and installing a ERP in the firm.

While preparing a budget for a discretionary expenses centre, management by objectives technique is generally
used,. To quote Anthony,” MBO is a formal process in which a budgeted proposes to accomplish specific tasks and
states a means for measuring whether these tasks have been accomplish”.

In so far budget for Discretionary expenses centres are concerned, two methods are used. They are:

(i) Incremental Budgeting:-

In case if incremental budgeting the expenses incurred during a particular period in a discretionary expenses centre
is taken as given. In other words, the present level of expenses is assumed as the starting point. Proper adjustment
are made to the expenses in order to arrive at budgeted amounts. The adjustment are carried out for special tasks,
for expenses changes in the work load of continuing tasks, for inflation, for cost of compaaraable work in similar
units.

Generally, organizations in India have been found to use this method. The merits of this method are simplicity and
saving in time. The shortcoming are that during business downturns, change in management etc, such expenses are
substantially reduce without making a bad impact on the business. Secondly, this has a tendency to increase
overheads expenses from period to period. Managers of DEC are interested in providing additional services and as a
result they have a tendency to make request for extra resources during budgeting, which is generally sanctioned.
Available evidence suggest that the same is not necessary

(ii) Zero Base Budgeting:-

Using Zero base review involves through analysis. Each discretionary expenses centre is thoroughly analyzed. The
management prepares a schedule that would cover all discretionary expenses over a period of five years or so. As a
result off this exercise, a new base is derived.

The Zero base review does not take things for given. There is no starting point. The review which is extremely
extensive in nature is builds up from scratch the resources that an activity needs. It raises certain fundamental
questions and challenges established norms. The questions raised are:

(i) It is necessary to perform the function at all? Does the same add the value from the view point of end
uses (Customer).
(ii) What should be the level of quality? Are we doing to much?
(iii) Is it desirable to perform the function in this manner?
(iv) What should its cost be?

Intra firm comparisons, interfirm comparisons, and bench marking are also used as a part of approach. Cost and
output measures of the expenses centre are compared with averages of similar units within the firm. This is known
 
as ‘intra-firm comparison,. Similar comparisons may be made with data which is published by trade associations
and other outside organizations. Such an exercise is called interfirm comparisons. When a comparison is made with
information obtained by visits to a firm in which the performance is believed to be outstanding, it goes by the
name of ‘benchmarking’.

Zero base review is not a rose without thorns. It has its drawbacks also Firstly, such reviews are difficult.
Responsibility centre heads consider such review as unnecessary evil. They make concerted efforts to justify their
present expenditure and of then do their best to foil the entire exercise. The people also speared rumors and create
doubts in the minds of the people regarding the efficacy of the exercise. Secondly, it takes a lot time and energy
and can be nightmare for responsibility centre heads whose operations are being reviewed.

Performance Aspects of Discretionary Expenses Center

In case of an Engineered Expenses Centre the financial performance report is used for evaluating the manager’s
efficiency. Managers who spend in accordance with the budget amount or less are considered efficient.
In contrast, the main job of the discretionary centre head is to accomplish the planned output. Accordingly, actual
expenses incurred by him are viewed in relation to the desired output. Expenses incurred may be lower then the
budget and this is an indication that the planned work has not been done. In case, the spending is according to the
budget the situation is looked upon with satisfaction. Where the amount expended is higher than the budget, it
causes concern.
The manager of a Discretionary Expenses Centre plays a vital role in expenditure control. The system should ensure
that his approval is obtained before there is a budget overrun. However, in reality a nominal percentage of
overrun is allowed without prior approval.

Administration & Support Center

Administrative center includes senior corporate management and business unit management along with the
manager of the supporting staff unit. Support units are units that provides services to other responsibility centers.

It is very difficult to exercise control over these centers because of the following reasons:

¾ Difficulty in measuring Output: Principal output of Administrative & Support Center is advice or service
functions that are virtually impossible to quantify. Since output cannot be measured, it is not possible to set
cost standards against which to measure financial performance.
¾ Lack of Goal Congruence: Managers of administrative staff strives for functional excellence. Superficially,
this desire would seem to be congruent with company goals, in fact, much depends how one defines
excellence. A striving for ‘excellence’ can lead to “empire building’ or to ‘safeguarding one’s position’
without regards to the welfare of the company.

Budget Preparation

The proposed budget for an administrative or support center usually consist of a list of expenses items, with the
proposed budget being compared with the current year actual expenses. Some companies request a more
elaborated presentation, which may include some or all of the following components:

¾ A section covering basic costs of the center for which no general management decision are required.
¾ A section covering the discretionary activities of the center
¾ A Section fully explaining all proposed increase in the budget.

Research & development Centers

Research and Development constitutes a very important function in modern organizations. With the liberalization
of the Indian economy and globalization, a number of opportunities and challenges have been thrown up. This has
increased the importance of research and development.
 
Budgeting in Research and Development Center

Research and Development being a discretionary expense, it is difficult to budget for the same on a scientific basis.
A number of factors are generally considered while budgeting for such expenses:

• Firms normal spending level

• Competitors spending
• Firms strategic plan
• Significant break through during previous year

A specific percentage of average annual revenue is used for arriving at the budget amount. The reason underlying
this is simple. The size of the R&D centers should not vary with short term fluctuations in revenue.

Within the overall ceiling established for research and development expenses, the research programme consist of a
number of project plus an additional amount for unplanned work. There is a committee within the organization
for reviewing research work. The task of the committee is to take macro decision in so far as projects are concerned.
The decision concern the magnitude of the projects namely projects in which expenditure is to be reduced, new
projects, projects that are to be discontinued, and projects in which expansion of work should take place.

Having decided and implemented the long range research programme, the next task is to prepare the annual
research and development budget. The budget should confirm to the firms strategic plan. Management should
raise the searching question during this process. The questions should focuse on best use of resources expected to be
utilized during the budget period in the light of development which have take place so far. The expected expenses
during the budget period are sub divided into calendar periods.

The benefits which arise from annual budgeting are two in number. Firstly, costs are not allowed to exceed
budgeting limit, approvals of appropriate level of management is required where expenditure is expected to be
more then the amount budgeted. Secondly, it provides an opportunity to the management to review the research
and development program.
Problem of Control in Research & Development Centers

1. Lack of goal congruence: The head of research and development centers generally feels inclined to have
an excellent department which may beyond the companies means. It is also found that the personnel
engagement in research and development occasionally do not have interest in the business or adequate
knowledge of the business in order to provide proper direction to research.

2. Difficulty in Relating Results to Inputs:The results of research and development activates are difficult
to measure quantitatively. In contrast to administrative activates, R&D. usually has at least a semi
tangible output in the form of patents, new products, or new processes; but the relationship of output to
input is difficult to appraise on an annual basis because the completed “product” of an R&D group may
involve several years of effort. Thus, inputs as stated in an annual budget may be unrelated to ouputs.
Further more even when such a relationship can be established it may not be possible to reliably estimate
the value of the output. And even when such an evaluation can be made, the technical nature of the
value of the output. And even when such an evaluation can be made, the technical nature of the R&D
function may defeat management’s attempt to measure efficiency. A brilliant effort may against an
insuperable obstacle, whereas a mediocre effort may, by luck, result in a bonanza.

3. Several year for results: As research years take several years to bear fruits, it is difficult to control
research and development in effective manner on an annual basis. It takes sevral years to build up a
proper research and development center. The main element of expenditure is manpower cost and getting
highly skilled personnel is generally difficult.

Performance Measurement in R&D Centers

 
The measurement of performance is done by preparing and presenting financial reports to appropriate levels of
management. These reports are prepared on a monthly or quarterly basis in respect of all responsibility centers and
projects and show actual expenditure incurred against budgeted amount.

Performance report presented to the management may be of two types. In first type actual expenses incurred in
each responsibility center is compared with the budgeted amounts. This enables the executives in the R&D
department to plan their expenses and ensure that commitments made regarding expenses are being met.

The second type involve the comparison of amount approved for each project which is in progress with the current
forecasted figure of total cost. This enable the management to ascertain whether it is worthwhile making changes
in project which have been approved. In this context it should be noted that this report is presented in a periodic
manner to the head of R&D department.

Although these reports are of value to the management, judgment about the effectiveness of research is generally
made based partly on these financial reports and mainly on the basis of discussions.

Profit Centers

“When financial performance in a responsibility center is measured in terms of profit, which is the difference
between the revenue and expenses, the responsibility center is called a profit center”.
A profit center is the unit of organization to which both revenue and costs are assigned so that the profit of the unit
can be measures. A profit center can be established only when the unit costs and revenue can be separately
attributed.
A profit center works efficiently when the manager can make decision about the selling price and the level of
output to be sold at those prices.
The performance of profit center is measured in absolute term i.e. Profit

Profit Centers

Input are Related to 
Output 

Inputs  Outputs 
 

PROCESS 
Rupees Cost Rupee Profit

Investment Centre 

An investment centre is a responsibility centre in which the manager is held responsible for the use of assets as well
as for revenue & expenses. It is therefore the ultimate extension of the responsibility idea. The manager is expected
to earn a satisfactory return on capital employed in the responsibility centre.
Measurement of the investment base or capital employed gives rise to many difficult problems and the idea of the
investment centre being new, there is considerable disagreement as to best solution of these problems.
 

Investment Centers
 
Input are Related to 
  Capital Employed

  Inputs    Outputs 

capital 
Rupees Cost  Rupee Profit
 
 

CHAPTER 5: Profit Centres 

Definition of Profit Centers

(1) “An Organizational unit for which a measures of profit is determined periodically, but one of the features of
profit centre is to encourage decision making initiative”.

(2) “A profit centre is a unit for which managers have the authority to take sourcing decisions about the supply
and choice of markets”.
It should sell a majority of its output externally and should be free to choose the source of supply for its
goods and services. Even manufacturing or marketing division can be converted into profit centers even
they have limited authority on sourcing decisions.

(3) “When a Responsibility centers financial performance is measured in terms of profit then the centre is called
a profit centre”.

Advantages of Profit Centers

(a) Quality of decision improves because they are being made by managers closest to the point of decision.
(b) The Speed of making decision increased since they do not have to be referred to corporate headquarters.
(c) Headquarters management, relieved of day-to-day decision making, can concentrate on broader
management issues
(d) Managers, subjects to fewer have lesser corporate restrictions and are free to use their imaginations and
initiative.
(e) Because profit centers are similar to independent companies, they provide an excellent training ground for
general management. Their managers gain experience in managing all functional areas, and upper
management gains the opportunity to evaluate their potential for higher level jobs.
(f) Profit awareness is improvised since managers responsible for profit will find new ways of increasing it.
(g) Profit centre provide top management with information on the individual profits of business units.
(h) Profit centers are pressured to improve their performance since their profits is readily measured.

Condition Under which Advantages of Profit Center will arise:

(1) Proper system of transfer price: Transfer price should be fair to the buying and selling profit centers using
market price based/ cost price based/ negotiated price mechanism, which will affect profit of the division.
(2) Independence to divisional managers: The business unit managers must have greater authority to decide
on the quality or quantity or both of its output. He may not have complete authority but he should have
the liberty of buying goods internally or externally.
(3) Existence of a market: There must exist, a Reliable & stable market for the goods and services supplied by
one division to another. Identical products or at least a substitute must be available.
(4) Negotiation: Business unit, managers must freely negotiate & bargain. Buying profit centers try to minimize
& selling profit center try to maximize the Transfer price.
(5) Uniform system of Accounting: there should be a fool proof & uniform system of accounting to measure the
profit. Realistic profit standards should be compared to the company budgeted profit.
(6) Arbitration: A proper arrangement to settle disputes & resolve conflicts, with the help of an officials
arbitrator must exist.
(7) Organizational Requirements: (a) An organizational chart showing levels of authority & responsibility. (b) a
system of information & reporting like MIS (c) A low employee turnover.
 
Condition (Disadvantages) under which Management is Advice Not to Create Profit Center

(a) Loss of control:-

Decentralized decision making forces top management to rely more on management control reports,
rather than on personal know- how of an operation, which leads to loss of control.

(b) Reduction in quality of decision making:

If top management is more capable or better informed than the business unit managers, then business units
profits may increase.

(c) Conflicts:-
Arguments arise over the “TP”, allocating of common expenses and credit for revenue granted jointly by
business units.

(d) Unfair competition:

Functional units now compete as business units and an increase in profit for one unit may result in a loss for
another. Business unit may not forward sales leads, takeover personnel or equipments and take production
decision which increase the cost for other business units.
(e) Additional Cost:
Divisionalisation imposes additional cost because of staff and record keeping requirement.

(f) General management competence:

It may not exist in a functional organization due to lack of opportunities to develop management
competency.

(g) Short term profitability:

There may be too much focus on short term profitability instead of long term benefits & high turnover
profit centre manager may reduce cost on R & D, training and maintenance.

(h) Optimizing company’s profits:

Individual profit centre profits may not lead to optimum company profit.

Method to Measure Profit of Profit Center

(i) Direct Profit:- Direct profit is the excess of sales value Particulars Amount
over the marginal cost of sales and fixed cost attributable (Rs.000)
to the profit centre.
Sales 500
The merits of the method are that it is simple, easy to
Less: Marginal cost 200
understand, and conceptually sound. However, it has its
Contribution 300
weakness also. The technique fails to consider the
Less: Fixed Cost 100
motivation arising from the charging of costs of corporate
Direct profit 200
headquarters.

(ii) Contribution Margin:- Contribution margin is

Particulars Amount
arrived at after deducting the marginal cost of sales from
(Rs.000)
the sales value. It is the excess of sales value over the
marginal cost of sales and shows the amount of money Sales 500
contributed by the organizational unit towards the Less: Marginal cost 200
recovery of fixed cost & generation of profit. Contribution 300
The logic underlying this method is that since fixed expenses cannot be controlled by the manager, it is vital that he
should aim at ensuring spread between sales value and variable cost.

Particulars Amount (Rs.000)

Sales 500
Less: Marginal cost 200
Contribution 300
 
(iii) Income Before Income Less: Fixed Cost ( Incurred in Profit centre) 100
Tax:- income before tax represents Direct profit 200
the excess of sales revenue over the Less: Controllable corporate charges 50
cost of sales. It is computed by 150
deducting from the sales value the Less: Other allocated corporate overheads 30
following expenses: Income Before Income Tax 120
(a) Managerial cost of sales (b) Fixed cost of the profit centre
(c) Controllable corporate charges (d) Other controllable allocated
Overheads

Merits:-
(a) This act as a motivational tool for responsibility centre manager
(b) It reflect as true performance of the entity and facilitate interfirm comparisons.
(c) Allocation of corporate overheads helps to keep in check head office expenditure as they would be subject
to question by profit centre managers.
Demerits:-
(a) Suitable methods of allocating corporate overheads to profit centre are difficult to find.
(b) It is not possible to control the costs incurred by corporate service entities like legal, human resource
development, finance & accounts etc.

(iv) Controllable Profit:

Particulars Amount (Rs.000)
Controllable profit is arrived after
deducting following items of
Sales 500
expenses from the sales revenue:
Less: Marginal cost 200
(a) Marginal cost of sales
Contribution 300
(b) Fixed cost of the profit
Less: Fixed Cost ( Incurred in Profit centre) 100
centre
Direct profit 200
(c) Controllable corporate
Less: Controllable corporate charges 50
charges
Controllable Profit 150
The expenses that are incurred by
the corporate headquarter is of two types controllable and non-controllable. The profit centre manager is in the
position to control the first category of expenses if not fully to a great extant.
The logic underlying this method is that the measurement system should include only those costs that can be
influenced by the profit centre manager.
The drawback of this method are that the profit derived under this method cannot be compared with date
published by trade association or with published accounts

(v) Net Income:- This

technique uses the net income Particulars Amount (Rs.000)
figure to measures the Sales 500
profitability of a responsibility Less: Marginal cost 200
centre. Net income is the surplus Contribution 300
left after deducting all expenses, Less: Fixed Cost ( Incurred in Profit centre) 100
allocated corporate overheads, Direct profit 200
and income tax from sales Less: Controllable corporate charges 50
revenue. Controllable Profit 150
Less: Other allocated corporate overheads 30
Merits: Income Before Income Tax 120
(a) Decisions related to Less: Income tax @ 50% 60
installment sales/hire Net Income 60
purchase, acquisition of fixed assets and disposal of fixed assets are made by profit centre managers. These
decision influence income tax. Consequently this leads to motivation of the manager to minimize income
tax.
(b) The effective rate of income tax is the same among all profit centres.
Demerits:
(a) Corporate headquarters makes many decisions which have income tax implication and the performance of
managers of profit centres should not be affected by such decision.
(b) No advantage arises from the consideration of income tax as income tax as income after tax happens to be
constant percentage of income before tax.
 
Every SBU is Profit Center but Every Profit Center is Not SBU

Definition of SBU: Most business units are created as profit centers since managers in charge of such unit control
product development, manufacturing & marketing.
These managers can influence revenue and cost and they can be held responsible for the bottom line. A business
unit manager’s authority may be restricted which is reflected in the design and operation of the profit center.

Examples of profit centers which are not SBU:

(1) Functional Unit:
Multi-Business companies are divided into different business units, each of which is treated as an independent
profit generating unit but the sub unit of these business units may be functionally organized. The company desires
operation as profit centers but there is no fixed rule to classify business units as profit centers and others.

It is the management decision if a business unit should be a profit centers depending upon the amount of
authority the business unit manager has over the bottom line.

(a) Marketing: Marketing can be turned into profit center by charging it with the cost of goods sold. This transfer
price provides the marketing manager with information required to make optimum, revenue & cost tradeoff
and the standard practice of measuring a profit center manager suing profitability provides a check by the
top management.
The Transfer Price can be the standard cost rather than actual cost.
When marketing managers exist in different regional areas it is difficult to market, set the price, advertise, and
conduct traning it would be best converted into a profit center.
(b) Manufacturing: Manufacturing is an expenses center & managers are judged on standard v/s actual cot whose
disadvantages are:
• Managers may reduce cost of quality control, & transfer goods of infiror quality.
• The manufacturing managers will not change his schedule to accommodate an urgent order.
• There is no incentive or motivation for the manufacturing managers.
One of the openion is to change such a Manufacturing unit (SBU) into a profit center & give credit for sales, selling,
but this is imperfect because sales are beyond their control and hence profit will fluctuate.

(2) Service & Support Unit:

Units for maintenance =, IT, Transportation, customer services etc. are all support activities but they can also be
converted into profit centers.

They can charge customers internally & externally for services provided such that revenue is at least equal to
expenses. When service units are organized as profit centers their managers are motivated to control cost to
prevent customers from going elsewhere, while managers of the receiving units are motivated to make decision
about suing the services and paying the price.

CHAPTER 6: Transfer Pricing

Concept of Transfer Pricing

The transfer price is the price charged by one profit center of an organization for a product supplied to another
business unit of the same organization. 

“A price related to goods or services transferred from one process or department to another or from one member of
a group to another”.

Objectives of Transfer Pricing

Objectives of transfer pricing should be specified clearly before deciding to adopt a particular transfer pricing
method for an organization. The main objectives of inter-company transfer pricing policy are as follows:

(1) To foster a commercial attitude in those who are responsible for the performance of profit centers. The
main emphasis should be on profitability. It will force the units to improve their profit position.
(2) To optimize the profit of the company over a gain period of time. For this purpose the resources should be
utilized to the maximum extent.
  
(3) To make optimum use of company’s financial resources. It should be based on relative performance of
various profit centers, which are influenced by transfer pricing polices.
(4) To enable the performance of a division to be evaluated by compensating it for benefits provided for other
division and changing it for benefits received by the division.
(5) To motivate divisional manager for maximizing the profitability of their divisions acting in the best interest
of the company as a whole.
(6) To manage transfer price between countries in order to minimize overall tax burden by the international
companies/groups.

How transfer pricing influences Goal Congruence

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
The ideal transfer price is based on a well established, normal market price for the identical product being
transferred that is, a market price reflecting the same conditions (quantity, delivery time, and quality) as the
product to which the transfer price applies. The market price may be adjusted downward to reflect saving accruing
to the selling unit from dealing inside the company.

4. Freedom to source
Alternative for sourcing should exist and manager should be permitted to choose the alternative that is in their own
best interests. The buying manger should be free to buy from the outside and the selling manager should be free to
sell outside. In these circumstances, the transfer price policy simply gives the manager of each center the right to deal
with either insider or outsider at his or her discretion. The market thus establishes the transfer price. The decision as to
whether to deal inside or outside also is made by the marketplace.
This method is optimum if the selling profit center can sell all of its product to either insider or outsider. The market
price represents the opportunity cost to the seller of selling the product inside. This is because if the product were not
sold inside, it would be sold outside. From the company point, the relevant cost of the product is the market price
because that is the amount of cash that has been forgone by selling inside. The transfer price represents the
opportunity cost to the company.

5. Full Information
Manager must know about the available alternative and the relevant costs and revenue of each.

6. Negotiation
There must be a smoothly working mechanism for negotiating “contracts” between business units.If all these
condition are present, a transfer price system based on market prices would induce goal congruent decision, with no
need for central administration.
Methods of Transfer Pricing

(I) Market Price Method

(II) Cost Based Method
(III) Two step pricing Method
(IV) Profit Sharing Method
(V) Two Sets of price Method (Dual Pricing)
(VI) Negotiated Method

(I) Market Price Method:

  
Under this method the transfer price is determined on the basis of well established, normal market price for similar
product being transferred. The market price reflects the same condition (delivery time, quality and the like) as the
product to which the transfer price is applicable. Downward adjustment may be made to the market price to
consider saving arising to the selling unit from dealing inside the company. For example, there would be lower
advertisement, publicity, and selling expenses and no bad debts when there is transfer of products from one business
unit to another.

Merits:

(i) Easily Available: Market prices are available with relative ease from published sources , suppliers etc.,
(ii) Measurement of Business Unit Performance: The market price is an impartial measure of overall efficiency of
both the purchasing anf selling divisions.
(iii) No need for central administration: there is no need for corporate headquarters to intervene in price fixation.
This results in saving of precious time and money.
(iv) Opportunity cost: The market price represent the opportunity cost of producing the product.
Demerits:

(i) Problem of interpretation: The term ‘market price’ is subject to a number of interpretations. It could be
wholesale price index, ex-factory price, price to consumer etc.
(ii) No market price of intermediate and semi-finished products: it is possible that intermediate and semi-
finished products may not be available in the market and as result it is impossible to get their market price.
(iii) Inflation: During a period of inflation, market price tends to fluctuate frequently. Consequently, it would not
serve as a good guide in fixing transfer prices.
(iv) Audit problem: market price includes a profit element and valuation of stocks using market price would
lead to the inclusion of profit in closing stock. This would invite objections from statutory auditors.
(v) Additional cost: In the absence of ready availability of market information, additional costs have to be
incurred to procure the same.

(II) Cost Based Method:

Transfer prices may be establishmay be established on the basis of cost or cost plus a profit in case competitive prices
are not available. Cost based transfer prices are widely used in USA, UK, Japan, Canada and India. The business unit
must make two decisions in a cost based transfer price system:

1. How cost is to be defined?

2. How is the profit markup to be computed?

1. Actual Cost Basis: -

Under this method of transfer pricing, transfer price is arrived at on the basis of actual cost of production. While
determining transfer price, firms excluded financing, advertising, bad debts and other expenses that the vendor not
incurred in internal transections.

Merits:

As transfer price is based on actual cost, the selling business unit is in position to recoup the cost incurred.

Demerits:

The use of actual cost as transfer price will lead to the transfer of production inefficiencies to the purchasing profit
center.

2. Standard cost basis : -

The standard cost of product is used for the purpose of fixing the transfer price. Standard cost is a scientifically
predetermined cost based on management assessment and view of efficient operations and relevant expenditure.
While determining transfer price, firms excluded financing, advertising, bad debts and other expenses that the
vendor not incurred in internal transections.

Merits:
  
The standard cost basis is a sound method of establishing transfer price when market price is not available as
production inefficiencies are not passed on to the purchasing unit.

Demerits:

• The Vendor profit center may not possess the competence to fix transfer price.
• Inventories lying with the vendor and purchasing profit center at year end have to be adjusted to0 actual cost in
order to prepare statutory annual accounts.

3. Cost plus mark up : -

This method of transfer pricing envisages the recovery of all costs plus a markup or allowances for profit. The profit
performance of each unit can therefore be measured and it is possible to determine their efficiency with reasonable
degree of accuracy.

In so far as the base for calculating profit markup is concerned, the percentage of costs is one of them. It is simple to
understand and easy to use and as a result it is widely used. However, it ignores the capital employed. Another
method is percentage of investment. This method calculates s the profit markup based on the capital employed in
manufacturing and selling the product. This is conceptually sound and superior to the “percentage of cost” method.

The second design that needs to be made with the profit markup is the level of amount of profit. The profit
allowances should be calculated on the investment necessary to produce the volume of products required by the
purchasing profit centers. The calculation of investment required would be done at a ‘standard’ level with inventories
and fixed assets being valued at current replacement costs.

Merits:

• Profit is the main yardstick on the basis of which the efficiency of the management is judged.
• This facilitates interim comparisons as profit and return on investment are good indicators.

Demerits: The inclusion of profit elements in closing stock are not allowed by statutory auditors.

4. Profit Sharing Method : -

This is another method of Transfer Pricing where upstream fixed costs and profits are involved. Under this method,
the product is transferred to the profit centre at standard variable cost. Once the product is sold, the contribution
earned is shared by the business units.
Advantages:
(i) The profit of the company which is shared is real.
(ii) It is easy to understand and calculate.
(iii) It is fair to all business units.
(iv) It follows marginal costing analysis which is scientific accounting system.
(v) There is no competition between business unit.
Disadvantages:
(i) Argument over profit sharing of the business units will require top management to resolve disputes.
(ii) It is costly and time consuming
(iii) It is against De-Centralization.
(iv) It may affect autonomy of Business Unit Manager.
(v) Allocation of profit does not give valid information on business unit profits.
(vi) Manufacturing units profit depends upon the marketing units ability to sell and to sell at a proper price.
5. Two step pricing method:
  
The two step pricing method is another way to solve the problems arising from upstream fixed costs and profits.
Under this, a charge is firstly made for each unit sold. This is equal to the standard variable cost of production.
Secondly, a charge is made periodically that is equal to fixed costs of the facility reserved for the buying unit. A profit
margin should be included in either of these components. Generally, a month is chosen as the period for the periodic
charges.

Example:

Business Unit X (Manufacturer) Product A

Expected monthly sales 5000 units
Variable cost per unit Rs.5 p.u
Monthly fixed cost Rs. 20000
Profit per unit Rs. 2

As per normal method of Full cost + profit transfer price would be

Variable cost per unit Rs. 5
+ Fixed cost per unit Rs. 4
+ Profit per unit Rs. 2
Transfer price Rs. 11 x 5000 units = Rs. 55000

As per two step pricing method transfer price would be:

Variable cost Rs. 25000 (5000x5)
+ Fixed cost Rs. 20000 (5000x4)
+ Profit Rs. 10000 (5000x2)
Transfer price Rs. 55000

Now assume that units transferred in one month is 6000

Transfer price as per normal method = 6000 x 11 = 66000
As per step pricing
Variable cost Rs. 30000 (6000x5)
+ Fixed cost Rs. 20000 (We need to keep fixed cost same)
+ Profit Rs. 10000 (6000x2)
Transfer price Rs. 60000

6. Negotiated price method:

Under this method, periodical meetings between the representatives of the purchasing and vendors units are held to
make decisions on external selling prices and on the sharing of profits in respect of products which have major
amount of upstream fixed cost and profit. A firm could establish a formal mechanism for this purpose.

The review should be conducted only in respect of decisions that involve a significant amount of business to atleast
one of the profit centers.

Merits: It is an effective method of dealing with a situation where upstream fixed costs and profit are involved.

Demerits: It is possible that the review process may go beyond decisions relating to business of profit center and as a
result it will cease to be workable.

7. Two sets of prices method:

This method envisages credit of manufacturing profit center revenue at the external sale price and purchasing profit
center is charged the total standard cost in respect of the product transferred .the corporate headquarters account is
charged with the difference during the consolidation of business unit statements the same is eliminated. The two sets
of prices method is occasionally used when the frequency of conflict between the vendor and purchasing units cannot
be settled by any other method.
  
This method has a number of demerits it involves additional book keeping expenses as the account of corporate
headquarters is debited everytime a transfer is made and again eliminated when the consolidation of business units
statements takes place secondly this system gives the impression thet business units are earning money while it may
be possible that the firm may be losing money after the considering debits made to corporate heatquatares account.
Lastly by vitue of this system of transfer pricing business units may be motivated to lay more stress on internal
transfer where the profit markup the profit markup is lucrative and ignore outside market sales.

Situation of Limited Market & Excess or Shortage of Capacity

Transfer price can be very simple or complex depending on the business. Ideally we need a proper negotiation
system, a proper arbitration system, a proper conflict resolution system, a proper product classification system,
competitive managers, good atmosphere, available market price, freedom to source and full information. All of
these have to be present for a market price based transfer price system to induce goal congruence. Ideally, the
buying and selling profit centre manager should be free to source but it may be unfeasible by company policy.

1. Limited market:

Market for buying & selling profit centres may be limited due to:
(i) The existence of internal capacity might limit the development of external sales. Most of the large
companies in an industry are highly integrated hence production capacity for an intermediate product
is limited. These profit centres can handle only a limited amount of demand. When internal capacity
become tight, the market is flooded with demand for the intermediate product. Even though outside
capacity exists it may be unavailable to the integrated company unless used on a regular basis or it
may have trouble getting it externally when capacity is limited.
(ii) If the company is a sole producer of a differential product then no external source exists.
(iii) If a comaapy has invested in facilities, it is likely to use external sources, unless the external selling price
is equal to variable cost which is unusual. Hence the produced products are captive.
Integrated Oil companies send crude oil from the production unit to the refining unit even if there is an external
market for the crude oil.
Even in the case of limited markets, the best transfer price satisfying all requirement of a profit centre is the
“Competitive Price”. If internal capacity is unavailable the company will buy from outside at the “Competitive
Price”. The difference between the “Competitive Price” and the internal cost is money saved by producing rather
than buying.
Methods of finding ‘Competitive Price’ if there are no External Transaction
(a) If published market prices are available they can be used to establish the “TP”, but these must be actual
figures & consideration & consistent with “TP” for similar quantities i.e. if the company is producing in bulk,
it should find the external wholesale market price instead of the retail price.
(b) Market prices may be set by using ‘Bids’, only if the lowest bidder gets the business. Companies put out a
bid for all products, but purchase only half of the product externally and produce the balance internally.
(c) If the Buying Profit Centre purchases similar products from suppliers, it can duplicate the ‘Competitive
Price’ internally.

2. Excess or Shortage of Capacity:

If the selling profit centre sells externally all of its production, i.e. it has excess capacity, which means there is a
shortage of Demand in the industry, then the company may not optimize profits if the buying profit centre
purchases from outside, in spite of the capacity being available internally.
Conversely the selling profit centre will benefit by selling internally when the Buying Profit Centre cannot buy from
outside because there is a shortage of supply in the industry. Here the output of the buying profit centre is restricted
& company profit may not be optimum.
Top management does not interfere, based on the theory that keeping the profit centre independent will set-off the
loss from sub-optimizing company’s profits.
Selling profit centre appeals if buying profit centrecontinue to buy from outside even when capacity is available
internally & buying profit centre appeals if selling profit centre continue to sell externally even when internal
demand exists.
Buying profit centre deal externally arguing that outsiders provide better service, which leads to rivalry in a
decentralized company. Top management should be aware of the politics involved in “TP” Negotiations. Even is a
constrains on sourcing exists, the market price is always best “TP”
  
In every case, the transfer price would be the competitive price (market price). In other words, the profit center is
appealing only the sourcing decision. It must accept the product at the market price.

Problems in pricing of corporate services by corporate staff to business units Capacity

There are some of the problems associated with charging business units for services furnished by corporate staff
units. Central accounting, public relations, administration these are the costs of central service staff units over which
business units have no control if these costs are charged at all, they are allocated, and the allocations do not include
a profit component. The allocations are not transfer prices.
There remain two types of transfers:
1. For central services that the receiving unit must accept but can at least partially
control the amount used.
2. For central services that the business unit can decide whether or not to use.

Control over amount of service

Business units may be required to use company staffs for services such as information technology and
research and development. In these situations, the business unit manager cannot control the efficiency with which
these activities are performed but can control the amount of the service received. There are three schools of
thought:
• One school holds that a business unit should pay the standard variable cost of the discretionary services. If it
pays less than this, it will be motivated to use more of the service than is economically justified. On the other
hand, if business unit managers are required to pay more than the variable cost, they might not elect to use
certain cervices that senior management believes worthwhile from the company’s viewpoint. This possibility
is most likely when senior management introduces a new service, such as a new project analysis program.
The low price is analogous to the introductory price that companies sometimes use for a new product.
• A second school of thought advocates a price equal to the standard variable cost plus a fare share of the
standard fixed costs-that is, the full cost. Proponents argue that if the business units do not believe the
services are worth at least this amount, something is wrong with either the quality or the efficiency of the
service unit. Full costs represent the company’s long run costs, and this is the amount that should be paid.
• A third school advocates a price that is equivalent to the market price or to standard full cost plus a profit
margin. The market price would be used if available (e.g. costs charged by a computer service bureau); if
not, the price would be full cost plus a return on investment. The rationale for this position is that the
capital employed by service units should earn a return just as the capital employed by manufacturing units
does. Also, the business units would incur the investment if they provided their own service.

Optional use of Services

In some cases management may decide that business units can choose whether to use central service units. Business
units may procure the service from outside, develop their own capability, or choose not to use the service at all. This
type of arrangement is most often found for such activities as information technology, internal consulting groups,
and maintenance work. These service centers are independent; they must stand on their own feet. If the internal
services are not competitive with outside providers, the scope of their activity will be contracted of their services
may be outsourced completely.

Profit Centre Decentralization:

Management style and culture influence concept of decentralized operation which top management chooses to run
the organization. It is concerned with how control over divisional operations is exercised by top management
through personal interactions, policies and procedures, including planning system. The chief executive of a
company has to distribute the responsibility for profit earning among the top executives, keeping the control with
him. In a big company with diversified products manufactured and distributed through number of units scattered
over wide geographical locations-there is danger of responsibility for profit being diffused.
Under functional structure, the management of profit becomes a very hard task and may even cut into the
efficiency of the firm. Decentralization is surely an effective means to overcome this diffusion of profit responsibility.  
CHAPTER 7: Measuring and Controlling Profits & Assets 

EVA (RI) Analysis

The EVA method is based on the past performance of the corporate enterprise. The underlying economic principle
in this method is to determine whether the firm is earning a higher rate of return on the entire invested funds than
the cost of such funds (measured in terms of weighted average cost of capital, WACC). If the answer is positive, the
 
firm’s management is adding to the shareholders value by earning extra for them. On the contrary, if the WACC is
higher than the corporate earning rate, the firm’s operations have eroded the existing wealth of its equity
shareholders. In operational terms, the method attempts to measure economic value added (or destroyed) for
equity shareholders, by the firm’s operations, in a given year.

Since WACC takes care of the financial costs of all sources of providers of invested funds in a corporate enterprise, it
is imperative that operating profits after taxes (and not net profits after taxes) should be considered to measure
EVA. The accounting profits after taxes, as reported by the income statement, need adjustments for interest costs.
The profit should be the net operating profit after taxes and the cost of funds will be the product of the total
capital supplied (including retained earnings) and WACC

EVA= [Net operating profits after taxes – [Total Capital * WACC]

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
Less: Taxes (0.40) 80
Net operating profit after taxes (NOPAT) 120
(II) Determination of WACC

Particulars Amt (in lakhs)

Equity (150 lakh * 15%) 22.5
12% Debt (100 lakh * 7.2%) 7.2
Total Cost 29.7
WACC (29.7 lakh/ 250 lakh) 11.88%
Cost of debt= 12% (1 – 0.4 tax rate) = 7.2%

(III) Determination of EVA

EVA = NOPAT – (Total capital * WACC)
Rs 120 lakh – (Rs 250 lakh * 11.88%)
Rs 120 lakh – Rs 29.7 lakh = Rs 90.3 lakh

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

EVA Analysis its Advantages & Disadvantages

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 capiital charge on
o divisional investmentss ensures tha at divisional managers are
a aware ofo the
oppportunity costt of funds.
(iv) Chaarging each division with the comp pany’s cost of o capital ennsures that ddecisions tak
ken by diffeerent
divissions are com
mpatible witth the interessts of the org
ganization as
a a whole.

RI (EVA)
( has the
t following weakne esses:
(
(i) Like ROI it is diffiicult to havee satisfactoryy definitions of ‘divisional profits’ and
d ‘divisional investment’.
i
(
(ii) It ma
ay be difficult to calcula ate an accura ate cost of caapital. Also, decision hass to be taken n whether to
o use
the company’s
c coost of capitaal or a speciffic divisional cost of capiital. The formmer enhancees divisional goal
congruency and the latter reeflects each division’s
d leveel of risk.
(
(iii) Identtifying controollable and uncontrollab
u ble factors att the division
nal level mayy be difficultt.
(
(iv) EVA is moree concerneed about the shareholders benefit an nd less concerned
c abt
employees,debto ors,creditors etc.
e

Perform
mance Meas
sures for In
nvestment Centers

(I) Rate of Return

R on Investment
I t (ROI)
A performance
e measure useed to evalua ate the efficieency of an in
nvestment or
o to comparre the efficiency of a num
mber
of different
d inveestments. Too calculate ROI, the beenefit (returrn) of an investment is divided byy the cost off the
inveestment; the result is exprressed as a percentage
p o a ratio.
or

The return on in
nvestment fo
ormula:

Retu
urn on investtment is a veery popular metric beca ause of its veersatility and
d simplicity. T
That is, if an investment does
not have a posittive ROI, or if
i there are other
o opporttunities with
h a higher RO OI, then the investment should
s be no
ot be
undertaken.
Advvantages:
(a) ROI rela
ates return too the level off investmentt and not salles as the ratte of return iis more realistic.
(b) ROI cann be decomp posed into other variablee show. Thesee variable ha ave tremend dous analyticcal value.
(c) ROI is an
n effective to
ool for inter firm comparrison.

Disa
advantage e:
(a) Financiaal experts offten differ ono the comp ponents of Profit
P and neet assets as used in RO OI. This generrates
differentt results makking it difficu
ult to decidee which one is
i correct andd reliable.
(b) Inter-firm
m compariso on is possiblee only when firms being compared adopta similarr accountingg policies rela
ating
to depen ndent, stockk treatment of o R& D expenses etc. Th his makes intter-firm com mparison unreeliable.
(c) ROI ofteen induces margin
m to select project that
t gives hig
gh rate of reeturn. Investments that increase
i valuue of
the business are rejeected. This offten results in
n a situation
n where the managers
m sh
hrinks the inv
vestment ba ase to
single prroject that earns highest ROI but on an extremelly low capita al base.

(II) Residual Income

I
The amount of income
i that an individual has after all personal debts, includ ding the moortgage, havee been paid. This
calculation is usually made on a month hly basis, afteer the monthly bills and
d debts are p
paid. Also, when
w a mortg
gage
has been paid off in its en ntirety, the income
i thatt individual had been putting tow ward the mo ortgage beco
omes
residdual income..
Adv vantages:
1) It considers a company's
c m
minimum ratte of return.
2) Any
A project th hat increases residual inccome will bee pursued byy division maanagement.

Disa
advantage e:
The relative sizee of the divisiions is not co
onsidered.

(III)) Transfer Pricing

 
The Price at which Divisions of a company transact with each other. Transactions may include the trade of supplies
or labor between departments. Transfer prices are used when individual entities of a larger multi-entity firm are
treated and measured as separately run entities.
Also known as " transfer cost "
In managerial accounting, when different divisions of a multi-entity company are in charge of their own profits,
they are also responsible for their own "Return on Invested Capital". Therefore, when divisions are required to
transact with each other, a transfer price is used to determine costs. Transfer prices tend not to differ much from the
price in the market because one of the entities in such a transaction will lose out: they will either be buying for more
than the prevailing market price or selling below the market price, and this will affect their performance.

Benefits of transfer pricing

1. Divisions can be evaluated as profit or investment centers.
2. Divisions are forced to control costs and operate competitively.
3. If divisions are permitted to buy component parts wherever they can find the best price (either internally or
externally), transfer pricing will allow a company to maximize its profits.

Few other Non - financial Performance Measurement Tool

1. Measures of product quality
2. Customer complaints and warranty experience
3. Customer satisfaction and retention rates
4. Product availability and on-time performance
5. New product time to market and market share

Single Measure or Separate Measures to Evaluate Profit Performance and Capital Investment
Performance

We totally agree with belief what MCS designers have ,the fact that they disagree with individually evaluating
Profit Performance and Capital Investment Performance is apt. As we know Profit Performance Evaluation is
nothing but calculating the Profit in figures that we earned for the amount of Sales that took place. And
Evaluation of Capital Investment Performance is reaching to a figure that tells us “How much we earned for the
Capital we Invested.”
DEFINITION: Comparison of the sums to be invested in a project with the earnings expected over the period of the
investment, expressed usually as return-on-investment (ROI) percentage per accounting period is briefly noted as
Capital Investment Performance.

Most proposals require significant new capital. Techniques for analyzing Capital Investment Proposals attempt to
find either,

1.) The net Present Value of the project, that is, the excess of the present value of the estimated cash inflows
over the amount of investment required.
OR
2.) The internal rate of return implicit in the relationship between inflows and outflows.

Capital investment decisions that involve the purchase of items such as land, machinery, buildings, or equipment
are among the most important decisions undertaken by the business manager. These decisions typically involve the
commitment of large sums of money, and they will affect the business over a number of years. Furthermore, the
funds to purchase a capital item must be paid out immediately, whereas the income or benefits accrue over time.
Because the benefits are based on future events and the ability to foresee the future is imperfect, you should make
a considerable effort to evaluate investment alternatives as thoroughly as possible. The most important task of
investment analysis is gathering the appropriate data. Selecting investments that will improve the financial
performance of the business involves two fundamental tasks:

1) Economic profitability analysis and

2) Financial feasibility analysis.

Economic profitability will show if an alternative is economically profitable. However, an investment may not be
financially feasible: that is, the cash flows may be insufficient to make the required principal and interest payments.
 
Three cash flow/discount rate evaluation methods can be used in the financial analysis: the net operating cash flow
method, the net cash flow to investors method, and the net cash flow to equity holders method. Any of the three
methods can be used because the three elements that must be incorporated in the analysis (risk, financing mix, and
debt financing benefits) can be included in either the cash flows or the discount rate.

Performance Measures for Investment Centers for Various Assets

(i) Idle:- The business units may have idle assets. These assets may or may not be capable of being used by other
business units. Where a business unit has idle assets that can be used by other units, the business unit may be
allowed to exclude them form the investment base. By virtue of this permission, business unit managers are
encouraged to release unutilized assets to other business units that may have better use for them.
Unfortunately, in case the fixed assets cannot be used by other business units, the managers of business units who
owns such assets should include them in the investment base. If the business unit manager were permitted to
exclude them from the investment base, it could result in dysfunctional actions. For instant the manager of business
unit may be encouraged to idle assets that are partly utilized and not earning a return equal to the profit
objectives of the business unit. Incidentally, if the assets do not have any alternative use, any contribution arising
from this equipment would lead to improvement of firms profits.

(ii) Intangible:- There are two distinct approaches to the treatment of intangible assets. Some companieshave a
practice of capitalizing such assets and amortizing them over their economic life. Other expense the expenditure
incurred on an immediate basis.
The method of treatment of intangible assets has the potential of changing the manner the business unit head
views these expenses. By capitalizing intangibles assets and thereby treating it as long term investment, the unit
head will reap less short term benefits from reducing R&D expense. In case such expenditures are expensed
immediately, each rupee reduction would represent a rupee increase in pretax profits. On the contrary, if the
capitalization of R&D costs takes place, each rupee reduction will lead to the decrease in the assets employed by a
rupee. Consequently, there is a fall in the capital charge by one rupee times the cost of capital, which has a much
smaller impact upon EVA.

(iii) Leased:- In a lease, the lease rentals would be higher than the depreciation charge that is no longer
necessary. However, this would increase the EVA because the higher cost would be more than offset by the
decrease in the capital charges. Consequently business unit managers have an inducement to lease assets inested of
owing them, provided the interest charge that is built into the rental cost is less then the capital charge that is
applied to the business unit investment base.Many leases provide an alternative mode of obtaining the use of assets
that otherwise would acquire by funds obtained from debt equity financing. These are financing arrangements.
Financial lease havesimilarity with debt hence are required to be capitalized.

(iv) Cash:- Generally cash is controllable by corporate headquarters. The central control of cash is in the best
interest if the firm as it enable it to use a lower cash balance then would be the case if each business unit held cash
balances adequate enough to provide the necessary cushion for the unevenness of its cash inflow and outflows. The
‘float’ between daily receipts and daily payments may well be the cash balance of business units. As a result, actual
cash balances maintained by business unit have tendency to be lower than would be required if the business unit
were an independent company. Therefore, the cash to be included in the investment base is done by using a
formula by many companies. Thus, DuPont uses two months cost of sales less depreciation.
There is a logic behind including a higher balance of cash then is usually held by a business unit. The higher amount
is necessary in order to enable one to carry out interfirm comparisons. The return which are shown by internal units
would be extremely high and might mislead top management if actual cash balance was shown.

(v) Receivables:- The amount of debtors is influenced by the actions of business unit managers. This could be
indirect like the ability to make sales and direct through fixation of credit terms, approval of individual credit
accounts and credit limits, and efforts made in collecting overdue amounts. The average of intra period balances is
conceptually a better measure of the amount that should be related to profits. However, receivables are often
included at the actual end of period balances for the sake of simplicity.
The next question that arises is this: at what value should receivable be included- cost of goods sold or selling price?
This is debatable issue. It could be argued that the real investment of business unit in receivable is only cost of goods
sold and it is adequate to earn satisfactory return on investment. On the contrary, it could be argued that the
business unit has the opportunity available to reinvest the amount of money collected from receivables.
Accordingly, receivables should be included at selling prices. Generally, firms follow a simpler method. They include
receivable at book value namely selling price less bad debts.
 
(vi) Inventories:- Inventories ordinarily are treated in a manner similar to receivables –that is they are often
recorded at end-of-period amounts even though intraperiod averages would be preferable conceptually. If the
company uses LIFO (last in first out) for financial accounting purposes, a different valuation method usually is
used for business unit profit reporting because LIFO inventory balances tend to be unrealistically low in periods of
inflation. In these circumstances, inventories should be valued at standard or average costs, and these same costs
should be used to measure cost of sales on the business unit income statement
If work-in-process inventory is financed by advance payments or by progress payments from the customer, as is
typically the case with goods that require a long manufacturing period, these payments either are subtracted from
the gross inventory amounts or reported as liabilities.
For e.g. with manufacturing periods a year or greater, Boeing received progress payments for its
airplanes and recorded them as liabilities.

Some companies subtract accounts payable from inventory on the grounds that accounts payable represent
financing of part of the inventory by vendors, at zero cost to the business unit. The corporate capital required for in-
ventories is only the difference between the gross inventory amount and accounts payable. If the business unit can
influence the payment period allowed by vendors, then including accounts payable in the calculation encourages
the manager to seek the most favorable terms. In times of high interest rates or credit stringency, managers might
be encouraged to consider forgoing the cash discount to have, in effect, additional financing provided by vendors.
On the other hand, delaying payments unduly to reduce net current assets may not be in the company's best
interest since this may hurt its credit rating.

Superiority of EVA over ROI Analysis

1. With EVA, all business units have the same profit objective for comparable investment. The ROI approach
on the other hand, provides different incentives for investment across business units.
2. Decisions that increase a centers ROI may decrease its overall profits. If an investment centers performance
measured by EVA, investment that produce a profit in excess of the of capital will increase EVA and
therefore be economically attractive to the manager.
3. Different interest rates may be used for different types of assets, management control system can be made
consistent with the framework used for decision about capital investment and resources allocation.
4. EVA has strong positive correlation with changes in a company’s market value. The best proxy for
shareholder value at the business unit level is to ask business unit manager to create and grow EVA. When
used as a performance metric, EVA motivates managers to increase EVA by taking actions consistent with
increasing stakeholder value. The following actions can increase EVA:
(a) Increase in ROI through business process re-engineering and productivity gains, without increasing the assets
base.
(b) Disinvestment os assets, products and business whose ROI is less than then cost of capital.
(c) Encourage new investment in assets, products and business whose ROI exceeds the cost of capital.
(d) Increase in sales, profit margin or capital efficiency or decrease in cost of capital percentage without
affecting the other variables.

CHAPTER 8: Performance Measurement & Control

Balance Score Card

David Chaudron defines BSC as:

• A way of measuring organizational, business unit or
departmental viewpoints.
• A way of Balancing long term and short term actions.
• A way of Balancing different measures of success such as:
Financial, Customer, Internal operations and Human Resources
systems & Development.
• A way of tying strategy to measures to action.
In short, BSC is a business management concept that transforms both
financial and non-financial data into a detailed roadmap that help an
enterprise measure performance and meet both short and long term
objectives.
 
Implementation of Balance Score Card

(1) Definition of Strategy: -

This is the initial step in the implementation of a BSC. Since the BSC establishes a linkage between strategy and
operational action, the definition of an organization’s strategy should necessary be the starting point in defining the
BSC. The goals of the organization should be in writing at this stage and target should have been prepared.

While steps should be taken to develop the scorecard at the corporate level for single industry firms, in respect of
multibusiness firms, the development should start at the business unit stage. However, in respect of the single
industry firm, and each business unit scorecards should thereafter be prepared for functional levels and below.

(2) Definition of measures of strategy:

This is the second stage involved in the implementation of a balance score card. While developing measures for
supporting the define strategy, it is important to focuse attention on a few measures which are considered critical
for the organization. The reason underlying this is to ensure that management is not burdened with a large
number of measures which could prove dysfunctional. There must be an efforts to establish cause and effect linkage
between the individual measures

Perspective Measures
Innovation and learning perspective  Manufacturing skills 

Internal business perspective 
First – pass yield order cycle 

Customer perspective 

Customer satisfaction survey. 
Financial perspective 

Sales revenue growth 
(3) Integration of measures into the management system:
This is the 3rd step in the implementation of the BSC. At this stage, efforts must be made to integrate the BSC with
the culture, HR Practices in formal and formal structures of the organization. However, other system in the
organization can create imbalance among the measures.

(4) Frequent Review of measures and results:

This is the last stage in the implementation of BSC. The senior management of the firm must review the BSC
constant basis. These review show the seriousness of management regarding the utility of these measures, indicates
whether the strategy is being implemented in a correct manner and the degree of success with which it is
functioning, serve to align measures to changing strategies, and help in improving measurement.

Superiority of Balance Score Card Over Other Methods

There are several benefits from implementing a Balanced Scorecard. Originally the Balanced Scorecard was seen as
a useful tool for performance measurement. In this role, the Balanced Scorecard was seen as integrating
financial/non-financial, internal/external and leading /lagging information on firm performance in a coherent
fashion.
Later it was realised that the Balanced Scorecard could play a pivotal role in the strategic management process.
Because the Balanced Scorecard requires management to clarify and obtain consensus on the strategic objectives
of the firm, it can assist in the communication of the chosen strategy, consequently aligning the efforts both of
individuals and of departments. In this role, there is a clear link between the Balanced Scorecard and management
by objectives (MBO). Effective implementation of a Balanced Scorecard project will generally involve the
 
development of a series of hierarchical (cascaded) scorecards. Given the overall corporate scorecard, supporting
scorecards can be developed for each department within the firm. Within each department, a scorecard can be
developed for each manager (or perhaps even for each individual member of staff) which links the objectives on
each perspective for that manager back to the objectives for each perspective outlined in the scorecard for the
department and finally, back to the objectives listed in the firm’s overall scorecard.
The Balanced Scorecard could be used to assist in corporate restructuring. In recent years, many firms have
migrated away from a traditional hierarchical structure to a flatter, team-based organisational structure. The
Balanced Scorecard can support such changes, as it can help clarify the objectives and the critical success factors for
the newly formed teams.
Apart from the communication and co-ordination roles of the Balanced Scorecard in strategic implementation, the
Balanced Scorecard can be used to link strategy to specific critical success factors in the customer, internal business
process and growth/learning perspectives. By setting both short and long-term targets for driver and outcome
measures and by comparing actual attainment against target, feedback is obtained on how well the strategy is
being implemented and on whether the strategy is working.
Building on the Balanced Scorecard’s use as a strategic management tool, it has been suggested that the Balanced
Scorecard can play a role in the investment appraisal process(5). Traditional methods of investment appraisal such
as discounted cash flow do not cope well with investments which generate indirect rather than direct financial
returns. Examples of these include investments which enhance the future ‘flexibility’ of a firm or investments in the
firm’s infrastructure, such as an enhanced management information system. The Balanced Scorecard can assist
management’s investment appraisal decisions as it provides managers with a mechanism to incorporate the
strategic aspects of the investment into the appraisal process. This could be achieved by using a weighting system
developed from a firm’s Balanced Scorecard measures to evaluate new projects. An index score would be
calculated for each investment opportunity and projects would then be ranked and selected based on this score
Balance Score Card of Rockwater

BSC shown below is of Rockwater, a wholly owned subsidiary of Brown & Root, a global engineering and
construction company, which is a worldwide leader in underwater engineering and construction. The measures
have been divided into four broad category. This enable the company to be viewed from four different
perspective. You will find that all the measures given in the company’s BSC are specifically related to strategy.
Rockwater strategy is to be the preferred provider in the underwater engineering and construction industry. They
select the measures like External (eg. Market share, customer ranking survey) and internal measures (Eg. Project
Performance Index, Safety Incident Index). There are also derived measures namely staff attitude survey, time
spent with customer on new work and outcome measures such as ROCE.

Pitfalls of Balance Score Card

(1) Trade off is difficult:

While some firms prepare a single report by suitably combining financial and non-financial measures and giving
weights to each of the measures, no weights are assigned explicitly to the measures in most of the BSC.
Consequently, making trade offs between non-financial and financial measures is difficult owing to the lack of
weights.
 
(2) Correlation between non-financial measures and result is poor: -
The underlying assumption in the BSC is that the achievement of measures is the score card leads to future
profitability. This is far from true. There is no certainly that accomplishing targets in any non-financial area would
give rise to profitability in the future. Although it is theoretically possible to establish cause and effect relationship
among the different measures, there is a poor understanding of the linkage between the non-financial measures
and financial performance. Consequently, firms which adopt a BSC should understand this problem.

(3) Failure to update measures:-

While changes and adoption of different strategies necessitates updation of measures to bring about alignment, it is
surprising that many firms lack formal mechanism to update the measures. Consequently, measures based on past
strategy are being still developed by firms. Also, as employees become familiar with the use of measures they tend
to build up inertia.

(4) Bias towards financial results:-

Senior management are highly trained conversant with measures used for judging financial performance of a firm.
Apart from this, because of the pressure applied by the BOD on behalf of the shareholders, the financial
performance of a given priority.

The BSC is of-ten linked up in a poor manner to an incentive scheme. As a result, the compensation of senior
management is based on financial performance. Moreover, there is a good deal of bias towards financial
performance by senior manager who have made an effort to link rewards to measures in BSC. This could lead to
managers being more concerned about financial measures resulting in loss of goal congruence.

(5) Managerial overload:-

How many critical measures can one manager track at one time without losing? Unfortunately there is no right
answer to this question except it is more than 1 and less than 50. It too few then the manager is ignoring measures
that are critical to creating success. If it too many then the manager may risk losing focus and trying to do too many
things at once.

Interactive Control

We know that there are certain industries which are influenced by extremely changes, in the environment. In case
of such industries, the idea about new strategies in this field and the same has been refereed to be him as
‘Interactive Control’. The figure shows the interactive control.

Survival of firms is a rapidly changing and dynamic environment demands the creation of a learning organization.
When we use the term ‘learning organization’ we means the employee’s capacity to learn to deal with
environmental changes on a continuing basis. The purpose of interactive control is to forewarn management of
strategic uncertainties based on which managers adopt to rapid environmental changes, this is done by thinking
and formulating new strategies.
Interactive controls should not be viewed as a separate system. In fact, they form a part of the management
control system.

The following are the features of the interactive control:

1. It is subset of management control information

 
2. This informa
ation pertaiins to the sttrategic unccertainties coonfronting thet business and becom mes the focuus of
attention.
3. Such information is conssidered seriou
usly by senioor managers..
4. The informaation generated by the syystem becom me the focal point of attention of ma anagers at all
a levels.
5. Meetings arre held am mong peers, subordinatees and supeerior for thee interpreta ation and discussion
d off the
information. The purposse of this meeeting is to fo
ormulate stra
ategic initiattive for the future.
6. The meetinggs are held fa
ace to face.
7. During such meetings, thhe underlyinng assumptio ons, data and
d actions aree debated and challengeed. 

The following fig

gure shows the role of Intteractive Co
ontrol as a to
ool of Strateg
gy Formulattion

Fre
ee Cash Flow

A measure
m of fin
nancial perfformance ca alculated as operating caash flow minnus capital eexpenditures. Free cash flow
(FCF
F) represents the cash thhat a compa any is able to
t generate after laying out the mooney requiredd to maintaain or
expa
and its asseet base. Freee cash flow is importan nt because it allows a company to pportunities that
o pursue op
enha
ance sharehholder value. Without ca ash, it's toug
gh to develo
op new prod ducts, makee acquisition
ns, pay divid
dends
and reduce debbt. FCF is calcculated as:

(B) Process of its Computation

Step
p 1: Calculation of contrib
bution by deeducting Varriable cost fro
om sales.
Step
p 2: Calculatee EBDIT by deducting
d th
he Fixed Cosst from contrribution.
Step
p 3: Calculatee EBIT by deeducting Dep preciation frrom EBDIT.
Step
p 4: Calculate the EBT byy deducting interest from m EBIT.
Step
p 5: Calculatee the EAT byy deducting taxes from EBT.
E
p 6: We add back depreeciation (Non cash expenses) and in
Step nterest (sincee it is paid to
o providers of
o capital) to
o the
EATT to arrive att the NOPLA AT.
Step
p 7: The NO OPLAT is adjjusted to deeduct capita al expendituure & investm ment in Nett Working Capital
C to finally
arriv
ve at FCF
Exammple: 

Parrticulars  Amount  EBT  40 

Lacs 
Sales  500  Less: Taax  ‐12 
Lesss: Variable ccost  ‐300  EAT  28 
Conntribution  200  Add: De epreciation  50 
Lesss: Fixed Costt  ‐100  Add: Intterest  10 
EBDDIT  100  NOPLATT  88 
Lesss: Depreciattion  ‐50  Less: Caapital Expendditure  ‐40 
EBIIT  50  Less: Inccrease in NW
WC  ‐10 
Lesss: Interest  ‐10  Free Cash Flow  38 

ER 9: MCS IN
CHAPTE I SERVIC
CE AND NO
ON PROFIT
T ORGANIZ
ZATION

F
Features off Service Organizatio
O on

(1) Absence
e of invento
ory buffer

Gooods can be heeld in inventtory, which iss a buffer th

hat dampenss the impactt on production activity of
o fluctuatio
ons in
saless volume. Services
S can be stored. The airplan ne seat, hoteel room, ho
ospital opera
ating room, or the hou urs of
 
lawyers, physicians, scientist, and other professionals that are used today are gone forever. Thus, although, a
manufacturing company can earn revenue in the future from products that are hand today, a service company
cannot do so. It must try to minimize its unused capacity.
Moreover, the cost of many services organizations is essentially fixed in the shorts run. In short, a hotel cannot reduce
its costs substantially by closing off its rooms. Accounting firms, law firms, and other professional organizations are
reluctant to lay off professional personal in times of low sales volume because of the effect on morale and the costs
of rehiring and training.
A key variable in most service organization, therefore, is the extent to which current capacity is matched with
demand. Service organization attempts this matching in two ways. First they try to stimulate demand in off –peak
periods by marketing efforts and price concessions. Cruise lines and resort hotels offer low rates off seasons. Second,
if feasible, service organization adjusts the size of workforce to anticipated demand, if feasible, by such measures as
scheduling training activities in slack periods and compensating for long hours in busy periods with time off later.
The loss from unsold services is so important that occupancy rates and similar indications of success in selling
available services are normally key variable in service organizations.

(2) Difficulty in Controlling Quality

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

(3) Labor Intensive

Manufacturing companies add equipment and automate production lines, thereby replacing labor and reducing
costs. Most service companies are labor intensive and cannot do this. Hospitals do add expensive equipment, but
mostly to provide better treatment, and this increase costs. A law firm expands by adding partners and new
support personnel.

(4) Multi-Unit Organizations

Some services organization operate many units in various locations, each unit relatively small. These organizations
are fast-food restaurant chains, auto rental companies, gasoline services stations, and many others. Some of the
units are owned; others operate under a franchise. The similarity of the separate units provides a common basis for
analyzing budgets and evaluating performance not available to the manufacturing company. The information for
each unit can be compared with system wide or regional averages, and high performance 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 companies.

(5) Historical Development

Cost accounting started in manufacturing companies because of the need to value work in process and finished
goods inventories for financial statement purposes. These systems provided raw data that were easily adapted for
use in setting selling prices and for other management purposes. Standard cost systems, separation of fixed and
variable costs and analysis of variances were built on the foundation of cost accounting system, separation of fixed
and variable costs and analysis of variances were built on the foundation of cost accounting systems. Until a few
decades ago, most texts on cost accounting dealt only with practices in manufacturing companies.
Many service organizations (with the notable exception of railroads and both cost data. Their use of product costs
and other regulated industries) is not having a similar impetus to develop cost data. Their use of product cost and
other management accounting data is fairly recent –mostly since World War II. Nowadays, their management
control systems are rapidly becoming as well as those developed as those in manufacturing companies.

Features of Professional Service Organization

(1) Small in size:

Generally, professional; organizations are small in size and are small in size and are located at one place.
Accordingly, personal observation is possible on the part of senior management and this forms the basis for
motivation of employees. Consequently, the need to have profit centres and formal reports of performance is less
felt. This means that the need to have an intricate management control system is lower. While such organizations
are small, there is still the need to tie remuneration to actual performance, prepare a budget, regularly compare
actual performance against the budget etc.
 
(2) Goals:
While earnings a satisfactory return on assets is the main goal of a manufacturing organization, it is not possible to
calculate the same for non-profit organization as it possesses only a few tangible assets. The skill of its human
resources that is professional staff is its main asset. This being the case, the main financial goal of such organization is
to pay adequate remuneration to its professional staff. Another goal of professional organization is to expand.
While this leads to scale economics through better utilization of staff at corporate headquater it also reflects the
success of the organization as size is an indicator of success.

(3) Professionals:
While professional organization are not capital intensive like manufacturing organization but labour intensive in
nature, professionals working in such organizations possess a number of characteristic. There are:
(i) They like to work independently.
(ii) The labour is of special kind
(iii) Those amongst them who also work in the capacity of managers devote only part time attention to
management activities.
(iv) Most of them do not possess a formal management education.
Senior partner of law firms have client, senior partners of consulting frims play an active role in consultancy
assignment, and senior partner of accounting firms take an active part is audit assignments.
As a result of the above characteristic, professionals have low regards for managers.
By virtue of their background, they are interested in doing the job in the best possible manner without having any
regards for the cost. This results in virtually ignoring the financial implications of their decisions. Similarly this affects
the attitude of non-professional and other approved staff.

(4) Measurement of Output & Input:-

One of the problems confronting a professional organization is how to measure the outputof its professionals. This is
because traditional measures of performance which are used in manufacturing industry such as tons, units etc
cannot be used in these organizations. While output is the effectiveness of the professional work, this cannot be
measured by:
(a) The number of hours a consultant spends with his client or the number of pages in report.
(b) The number of hours a lawyer spends in the court room or the number of pages a brief has.
(c) The number of patients that is treated by the physician daily.
Although some professional organization employs revenue as a measure of output, it must be appreciated that this
measures volume of services provided by the organization and not their quality.
Whereas, some tasks performed by professional are repetitive in nature, the major portion of the work done by
them can be considered as non-repetitive. Instances of repetitive work are physical stocktaking by auditors,
drafting simple contracts, wills, deeds by lawyers etc. It is possible to develop standards for such tasks and use them
profitably. However, in respect of non-repetitive tasks, planning the time required, establishing standards
considered reasonable for performing tasks, and evaluation of performance become a difficult task.
Another problem that arises in performance measurement is the unwillingness of professionals to maintain records
relating to time spent. Although this problem can be resolved if senior management takes the initiatives in ensuring
accurate reporting of time, the problem arises in connection with the amount to be charged per hour for time
spend on a job.

(4) Marketing in Professional Service Organization:

Whereas there exists a strict demarcation between manufacturing and marketing activities in manufacturing
organizations, it is hard to find such dividing line in professional organizations. Professional working in professional
firms is like accounting, law and medical are debarred from openly marketing the firm’s services by virtue of their
professional code of ethics. However, most of the organizations need to engage in marketing as its an essential
activity. Consequently, professional who work for clients, that is devote most of their time and energy to production
make speeches, play golf, establish contacts and similar activities to market the organizational services.

MCS inProfessional Service Organization

The most important aspects of management control systems in professional organizations are:
• Pricing
• Strategic planning and budgeting
• Control of operations
• Performance measurement and appraisal

(1) Pricing
 
Most professional firms determine the price of their services in a traditional manner. If the professional service
offered is dependent on time, then the fee is fixed on the basis of time spent on the service. Investment banking is
an exception to this. In case of investment banking, the service charge is determined on the basis of monetary size
of the securities issue. Prices of services offered differ from profession to profession. The prices are high for
accountants and physicians compared to research scientists, for instance.

(2) Strategic planning and budgeting

Manufacturing organizations have better strategic planning systems when compared to professional organizations
of similar size. One of the main reasons for this could be that professional organizations do not need such a system.
Strategic planning is important for manufacturing organizations because any commitment relating to the
procurement of plant and equipment does effect its capacity and expenditures for years, and such effects are
irreversible. In professional organizations, the main assets are people and changes in the size and composition of the
staff are irreversible and easier to make. The strategic plan of a professional organization is not as comprehensive
as that of a manufacturing organization. It is mainly a longrange staffing plan and does not cover other functions.

(3) Control of operations

Scheduling the working hours of employees is one of the most important aspects of controlling the operations in
professional organizations. The billed time ratio, that is the ratio of hours billed to total professional hours available,
should be analyzed thoroughly. Idle time should be minimized and appropriate rates should be used for billing
engagements.

(4) Performance measurement and appraisal

In professional organizations, it is easy to analyze the performance of employees at the top most and the lowest
hierarchical level, but it is difficult to analyze the performance of employees who are placed somewhere between
the two extremes. The main reason for this is the absence of objective criteria for performance appraisal. But there
are exceptions to this too. For example, the performance of an investment analyst can be appraised by comparing
his recommendations and the market behavior of securities. In many cases, performance appraisal depends on
human judgment. An employee’s performance may be judged by his superiors, peers, subordinates and clients.
Professional organizations use formal performance appraisal system– numerical ratings of specified performance
attributes. These ratings are used as deciding factors for wage hikes and promotions.

Features of Non- Profit Organization

(1) Contributed Capital:

While a business organization receives money from its shareholders by issuing shares, a non profit organization
receives contributions. While the contributed capital are of two main type- endowments and plant, endowments
are nothing but gifts from donors whose intention is that the principal should remain intact for a specific period or
indefinitely and only income arising therefrom should be employed for financing purpose.
Work of art, museum objects, contribution of money for acquiring building, equipments and miscellaneous fixed
assets are within the category of ‘plant’.
(2) Profit motive is non existent:
While most business organization have profit as their main goal which is measured by the net profit shown in the
profit and loss account, non profit organization have multifarious goals and owing to the absence of profit motive
no such performance measure exists.
The income and expenditure account shows the surplus or deficit of the non profit organization. Unlike a business
organization, a non profit organization cannot earn a large surplus. The reason underlying this is that a large
surplus means that the entity is not providing the services desired by the contributors of capital. Similarly, continous
deficit would make the organization bankrupt. Consequently, it is desireable that such organization should earn a
modest profit.
(3) Governance:
Trustees who are nominated to govern non profit organization work in honorary capacity and several trustees are
not familiar with the management of business. Apart from this, it is difficult to measure the performance of such an
organization. Consequently, the control of trustees is less and they are likely to isolate actual and incipient problems
compared the directors of a business organization.

(4) Accounting of funds:

 
An accounting system called ‘fund accounting’ is used by several non profit organizations under which separate
accounts are maintained in respect of many funds. The accounts are self balancing. Generally, the following funds
are maintained by organizations: Endowments fund, capital fund, general fund and special purpose funds.
The endowments fund accounts for contribution from donor, whereas the capital fund is used for maintaining
account for capital contribution in the form of capital assets. In so far the general fund is concerned, it is nothing but
the income and expenditure account. The general fund forms the focus for management control.

(5) Financial Accounting:

The non profit organization follows the guidelines laid down by the government for preparing financial accounts for
external purpose. However while reporting to the government body as well as management, they follows the
above practice. The income anf expenditure accounts and balance sheet also form a part of external reporting.
MCS in Non- Profit Organization

A nonprofit organization was define by law, is an organization that cannot distribute assets or income to, or for the
benefit of, its member, its officers, directors. The organization can, of course, compensate its employees, including
officers and members, for services rendered and for goods supplied,. This definition does not prohibit an
organization from earning a profit, on average, to provide funds for working capital and for possible “rainy days”.

(1) Product Pricing

Many nonprofit organizations give inadequate attention to their pricing policies. Pricing of services at their full
const is desirable.A “full-cost” price is the sum of direct costs, indirect cost, and perhaps a small allowance for
increasing the organization’s equity. This principle applies to services that are directly related to the organization’s
objectives. Pricing for peripheral activities should be market-based. Thus a nonprofit hospital should price its health
care services at full const, but prices in its gift shop should be market based.In general, the smaller and more specific
the unit of service that is priced, the better the basis for decisions about the allocation of resources. For example, a
comprehensive daily rate for hospital care, which was common practice a few decades ago, masks the revenues for
the mix of services actually provided. Beyond a certain point, of course, the cost of the paper work associated with
pricing units of service outweighs the benefits.As a general rule, management control is facilitated when prices are
established prior to the performance of the services. If an organization is able to recover it’s incurred costs,
management is not motivated to worry about cost control.

(2) Strategic planning and budget Preparation

In nonprofit organizations that must decide how best to allocate limited resources to worth-while activities,
strategies planning is a more important and more time-consuming process than in the typical business.Colleges and
universities, welfare organizations, and organization in certain other nonprofit industries know before the budget
year begins, the approximate amount of their revenues. They do not have the option of increasing revenues during
the year by increasing their marketing efforts. They budget expense so that organization will at least break even at
the estimated amount of revenue. They require that managers of responsibility centre limit spending close to the
budget amounts. The budget is, thereof, the most important management control tool, at least with respect to
financial institution.

(3) Operation and Evaluation

In most nonprofit organizations, there is no way of knowing what the optimum operating costs are. Responsibility
centre managers, therefore, tend to spend whatever is allowed in the budget, even though the budgeted amount
may be higher than is necessary. Conversely, they may refrain from making expenditures that have an excellent
payoff simply because the expenditure was not included in the budget.Although nonprofit organizations have has
a reputation for operating inefficiently, this perception has been changing for good reasons. Many organization
have had increasing difficulty in raising funds, especially from government resources. This has led to belt-tightening
and to increased attention to management control. As mention above, the most dramatic change has been in
hospital costs, with the introduction of reimbursement on the basis of standard prices for diagnostic-related groups

Performance Evaluation in Non- Profit Organization

 

The evaluation of performance is not possible using financial measures, for these entities do not exist to earn profit.
The performance is therefore evaluated on the basis of comparisons between budgeted expenditure and actual
expenditure.
 
For any organization, the most important reasons to measure performance are to improve effectiveness and to
acquire information that will allow the organization to drive its agenda forward. If the motivation for doing
evaluation remains outside an organization, the evaluation will have limited impact. To do performance
assessment effectively, an organization must commit to adopting a culture of measurement, because acceptance
must come from senior management, staff, funders, and board members alike.

(a) Board self-evaluation

Members of the Board of Directors should regularly evaluate the quality of their activities on a regular basis.
Activities might include staffing the Board with new members, developing the members into well-trained and
resourced members, discussing and debating topics to make wise decisions, and supervising the CEO. Probably the
biggest problem with Board self-evaluation is that it does not occur frequently enough. As a result, Board members
have no clear impression of how they are performing as members of a governing Board. Poor Board operations,
when undetected, can adversely affect the entire organization.

(b) Staff and volunteer (individual) performance evaluation

Most of us are familiar with employee performance appraisals, which evaluate the quality of an individual’s
performance in their position in the organization. Ideally, those appraisals reference the individual’s written job
description and performance goals to assess the quality of the individual’s progress toward achieving the desired
results described in those documents. Continued problems in individual performance often are the results of poor
strategic planning, program planning and staff development. If overall planning is not done effectively, individuals
can experience continued frustration, stress and low morale, resulting in their poor overall performance.
Experienced leaders have learned that continued problems in performance are not always the result of a poor
work ethic – the recurring problems may be the result of larger, more systemic problems in the organizations.

(c) Program evaluation

Program evaluations have become much more common, particularly because donors demand them to ensure that
their investments are making a difference in their communities. Program evaluations are typically focused on the
quality of the program’s process, goals or outcomes. An ineffective program evaluation process often is the result of
poor program planning – programs should be designed so they can be evaluated. It can also be the result of
improper training about evaluation. Sometimes, leaders do not realize that they have the responsibility to verify to
the public that the nonprofit is indeed making a positive impact in the community. When program evaluations are
not performed well, or at all, there is little feedback to the strategic and program planning activities. When
strategic and program planning are done poorly, the entire organization is adversely effected.

(d) Evaluation of cross-functional processes

Cross-functional processes are those that span several systems, such as programs, functions and projects. Common
examples of major processes include information technology systems and quality management of services. Because
these cross-functional processes span so many areas of the organization, problems in these processes can be the
result of any type of ineffective planning, development and operating activities.

(e) Organizational evaluation

Ongoing evaluation of the entire organization is a major responsibility of all leaders in the organization. Leaders
sometimes do not recognize the ongoing activities of management to actually include organizational evaluations –
but they do. The activities of organizational evaluation occur every day. However, those evaluations usually are
not done systematically. As a result, useful evaluation information is not provided to the strategic and program
planning processes. Consequently, both processes can be ineffective because they do not focus on improving the
quality of operations in the workplace.

CHAPTER 10: Summing Up

Corporate Level Strategy

Strategy may be define as “ Where the organization wants to go to fulfill its purpose and achieve its mission, it
provides the framework for guiding choices which determine the organization nature and direction and direction
 
and these choicces related to t the organ nization’s prroducts or seervices, mark ket, key cap pabilities, grrowth, returrn on
capiital, and allo
ocation of resources.”
Corpporate strateegy is defineed as the dettermination of the busin ness in whichh firm will co
ompete and the allocatio on of
resources among g business.
Corpporate strateegy involvess the formulation of stra ategy for thee firm as a whole. It is cconcerned withw being in n the
rightt businesses. Thus, it can be said thatt corporate strategy
s has more to do with where to compete..
Firm
m can be gro ouped into th hree broad category
c bassed on their corporate
c level strategy::
1. Single Inndustry Firm ms: A firm which operatees in one lin ne of businesss is known a as a single inndustry firm
m e.g.
Gujarat Ambuja Ceement (Cemeent Business)), Exxon Mob bil (Petroleum Industry)..
2. Related Diversified Firms: A firm m that opera ates in a nummber of industries and tthere exists a common set s of
core com
mpetence wh hich benefitss business units e.g Hinduustan Unileveer Limited, P & G Limiteed etc.
3. Unrelated e Diversifieed Firms: A fiirm that opeerates in bussiness that are not relateed to one an nother. Thesee are
also kno
own as congllomerates eg g. Grasim Ltd d., L & T Ltd
d., etc.

Thesse 3 Strategies at corpora

ate level aree shown belo
ow

• Extent of
o Diversifica
ation: Relatees to the num
mber of indu
ustries in whicch the comp
pany operatees.

• Degree of relatedneess: refers to the

t nature of
o linkage accross the mulltiple businesss units.

Corporate Level Stra

ategy and itts Implication on Org
ganizationa
al Structure
e

Parrameters Single Inddustry Relaated Diverssified Unrelated d Diversifie ed

Orga anizational Structure Functional Businness Unit Holding Co ompany
Induustry Familia
arity High Meddium Low
Functional Back kground Relevant Experince
E Meddium Mainly Finance
Deciision Making g Authority More Centtralized Meddium Decentralizzed
Size of corporatee Staff High Meddium Low
Internal Promottion High Meddium Low
Use of lateral Trransfer High Meddium Low
Corpporate Cultuure Strong Meddium Low
In case of singlee industry, the
t compan ny tends to be function nally organizzed. Top m managers aree responsiblee for
deveeloping the company’s overall strategy
t to com
mpete in its chosen
c indusstry as well a
as its functio
onal strategiies in
such
h areas as reesearch and developmen
d nt, manufactturing and marketing.
m H
However, all single indusstry firms aree not
funcctionally org
ganized. For example, holes,
h super market
m etc. are single industry firmms but organ nized as bussiness
unitts. They havee both produ
uction and marketing
m fu
unctions at different locattions.

On the other haand, every unrelated diversified

d co
ompany is organized intto relativelyy autonomou us business units.
u
Duee to large an
nd diverse seet of businesss top mana
agers in such firm tend to focus on p
portfolio ma
anagement. They
T
deleegate the wo
ork of develoopment of neew product, marketing strategy to the
t business unit manageers. Thereforre, at
 
At the single industry end of corporate strategy, top managers are likely to be extremely familiar with the industry
in which the firm competes. Many of them tend to have expertise in research and development, manufacturing
and marketing. On the other, at the unrelated diversified end, top managers tend to be expert in finance.

If a firm moves form single industry to the unrelated diversified and, the autonomy of the business unit manager
tends to increase. The top managers of unrelated diversified firms may not have the knowledge and expertise to
make strategic and operating decision for a group of desperate business unit. Moreover, there is very little
interdependence across business units in conglomerates. However, there may be great deal of interdependence
among business units in single industry firm, related diversified firms. Greater interdependence calls for more
intervention by top managers.

The size of a conglomerate corporate staff tends to be small as compared to single industry firm of small size.
Corporate level managers are less involved in business unit operations. Promoting from within or by laterally
transferring executives from one business unit to another is less likely to benefit conglomerate. A conglomerate may
not have the single, strong corporate culture like single industry firms.

Corporate Level Strategy and its Implication on Management Control

(A) Strategic Planning: Conglomerates tend to use strategic planning systems due to low level of interdependence.
The business units prepare strategic plans and submit them to top management for review and approval.
Strategic planning system for related diversified and single industry firms tends to be both vertical and horizontals
due to high level interdependence.
(B) Budgeting: In a single Industry firm, the CEO may know the firm’ s operations and the corporate and business
unit managers will have more frequent contacts. The CEO of single industry firms are able to control the operation
of their subordinates through informal systems, and personal interactions. This help to depend less on budgeting
system for control. On the other hand, in case of a conglomerate, it is not possible for CEO to depend on informal
system and interpersonal contacts. However mush of the communication and control has to be achieved through
the formal budgeting system.
(C) Transfer Pricing: Transfer of goods within business units are common in case of single industry and related
diversified firms. The transfer pricing policy in a conglomerate has to give certain flexibility to business unit at arm’s
length market prices. In case of single industry and related diversified firms synergies may be important and
business units can be given freedom to make sourcing decision.
(D) Incentive Compensation:

(i) Use of formula: Multi industry firm’s compensation to business units managers may be based on certain
formulas while in single industry firm it may be more flexible depending on the overall performance of
the company.
(ii) Profitability Measures: In multi industry firms, incentive bonus of business units managers is dependent
more on the profitability of that company, but in single industry firms it is the reverse.
Parameters Single Industry Related Diversified Unrelated Diversified
(1) Strategic Planning Vertical & Horizontal Combined Vertical Only
(2) Budgeting
(a) Relative control of business Low Medium High
unit managers over Budget
formulation
(b) Budget Importance Low Medium High
(3) Transfer Pricing
(a) Importance of TP High Medium Low
(b) Sourcing Flexibility Constrained Mixed Arms Length Pricing
(4) Incentive Compensation
(a) Bonus Criteria Fin. & Non Fin. Criteria Combined Primarily Fin. Criteria
(b) Bonus Determination Subjective Combined Formula Based
Approach
(c) Bonus Basic Based on Business Unit Combined Business Unit Performance
& Companies
performance
 
Business Unit Strategy

Business unit strategies deal with how to create and maintain competitive advantage in each of the industries in
which a company has chosen to participate. The strategy of business unit depends on two interrelated aspect: 1) its
mission (what are its objective) and 2) its competitive advantage (“how should the business unit compete in its
industry to accomplish its mission”).

Business unit mission

In a diversified firm one of the important task of senior
management is resource deployment. Make decision
regarding the use of the cash generated from some business
unit. Several planning model have been developed to help
corporate level manager of diversified firms to effectively
allocate resource. These models suggest that a firm has
business unit in several categories, identifies by their mission
the appropriate strategies for each category differ. Together
the several unit make up a portfolio, the component of
which differ as to their risk/ reward characteristic just as the
component of investment portfolio differ. Both corporate
office and business unit general manager are involved in
identified the mission of individual business unit.
Of the many planning model two of the most widely used
are Boston consulting group two by two growth share
matrix and general electric company / mc Kinsey &
company three-by three industry attractiveness –business
strength matrix while these model differ in the methodology
they use to develop the most appropriate mission for the various business unit, they have same set of mission from
which to choose: Build, hold, harvest, & divest.

Build
This mission implies an objective of increased market share, even at the expense of short term earning and cash
flow.

Hold
This strategic mission is geared to protection of the business unit market share and competitive position. (IBM
Computer)

Harvest
This mission has the objective of maximizing short term earning and cash flow , even at the expense of market
share.

Divest
This mission indicates a decision to withdraw from the business either through a process of slow liquidation or
outright sale.

The mission for existing business units could be either build , hold, or harvest .These mission constitute a constitute a
continuum with “pure build” at one end and “pure harvest” at the other end. To implement the strategy effectively
there should be congruence between the mission chosen and the type of control used. we develop the control
mission “fit” using the following line of reasoning”

• The mission of the business unit influences the uncertainty that general managers face and the short term
versus long term trade off they make.
• Management control system can be systematically varied to help motivate the manager to cope
effectively with uncertainty and make appropriate short term versus long –term tradeoffs.
• Thus different mission often require systematically different management control system.

Business Unit Strategy and its Implication for Management Control

 

(A) Strategic planning

A strategy describes the general direction in which an organization plans to move to attain its goals while designing
a strategic planning process, an organization has to consider several issues. The response of the business unit to these
issues tends to depend upon the mission it is pursuing. The implication for strategic planning process for different
strategic mission is shown in the chart:

Parameters Build Hold Harvest

Importance of Strategic Relatedly High Medium Relatively Low
Planning
Formalization of capital Less Formal Medium More Formal
expenditure decision
Capital Expenditure Emphasis on non-financial Both Financial and Non- Financial Data
Evaluation criteria Data financial Data
Discount Rates Relatively Low Moderate Relatively High
Capital investment Subjective and qualitative Qualitative and Objective and
analysis Quantitative Quantitative

(B) Budgeting
Budgeting involves analyzing the firms financial flows, costs, revenue etc forecasting the outcome of different
investment, financing, dividend and other decision. Budgeting is the process of preparation, implementation and
operation of budgets. It is the formulation of plan for given future period in numerical terms. The implication for
designing budgeting system to support different missions is shown in the chart:

Parameters Build Hold Harvest

Role of budget Mere a short term planning Mere a control tool
Æ

Business unit managers influence in Relatively High Æ Relatively Low

preparing budget
Revision of the budget during the Relatively easy Æ Relatively Difficult
year
Frequency of informal reporting More frequent on policy issues- Æ Lessfrequent on policy issues-
and contracts with supervisors less frequent on operating issues More frequent on operating issues
Frequency of feedback from Less Often Æ relatively Low
supervisor on actual performance
against budget
Control limit used on periodic Relatively high Æ Relatively Low
evaluation against the budget
Importance attached to meeting Relatively low Æ Relatively High
the budget
Output versus behavioral control Behavioral Control Æ Output Control

Top Management Style and Implication on Management Control

The management control function is an organisation is influenced by the style of senior management. The style of
the chief executive officer affects the management control process in the entire organization. For example Narayan
Murthy of Infosys, MukeshAmbaniOf Reliance, Ratan Tata of Tatas etc.

Similarly, the style of the business unit manager affects the unit’s management control process in their functional
areas. If feasible, designers should consider management style in designing and operating control system.(If chief
executive offers actively participate in system design, as should be the case, the system will reflect their preferences.)

(A)Differences in Management Styles

“Managers manage differently”.
 
Some rely heavily on reports and certain formal documents; others prefer conversations and informal contacts.
Some think in concrete terms; others think abstractly.
Some are analytical; others use trial and error.
Some are risk takers; others are risk averse.
Some are process oriented; others are result oriented.
Some are people oriented; others are task oriented.
Some are friendly; others are aloof.
Some are long-term oriented; others are short-term oriented.
Some dominate decision making (“Theory x”), others encourage organisation participation in decision making
(“Theory Y”).
Some emphasize monetary rewards; others emphasize a broader set of rewards.

(B) Different Management Styles are as follows:

1. Autocratic: An autocratic manager makes all the decisions & keeps the information as a decision maker
within the senior management. Objectives & tasks are well set & workers are expected to do exactly as
required. The communication of objectives is mainly downwards from the leader to the worker.
2. Democratic: Here the manager allows the employees to take part in the decision making & everything is
approved by majority. The advantage is that it is useful when complex decisions are to be made requiring
the help of specialists but the disadvantage is that it take a long time & the collective decision may not be
the best.
3. Laissez-faire: in this leadership style the staff managers are transformed into owner of their own areas of
business & it brings in highly professional & creative group of employees. The advantage is that the focuse is
on the staff & they have the freedom to work within fixed parameters but the disadvantage is that the top
management is cut off from all decision making.

(C) Factors which influence top management style:

(1) Percentage of ownership in the company: If the company has more of equity participation rather
than debt then it will tend to have a more paternalistic approach since there is no pressure from outsiders.
Also since the company is managed in a family business way they tend to be very supportive and
concerned about the Junior Management & the workers e.g. Birla Group
(2) Debt owned companies: Since most of the funds in such companies are from the outside there is a lot of
pressure for top management to show profit hence they will adopt an autocratic style where top
management issues orders to the lower levels. E.g. Reliance Group
(3) Self-esteem of the CEO: If the CEO has high degree of self-esteem and self-respect then he will be
confident of his business and will adopt the democratic style of leadership E.g. Infosys, Microsoft.
(4) Cooperatives: In companies which require lot of experts & where there is considerable involvement of the
Bottom line staff to the profits of the company, their CEO may adopt a Laissez Faire Approach. E.g. Amul,
Toyota.

(D) Implications for Management Control

The various dimensions of management style significantly influence the operation of the control systems. Even if the
same reports with the same set of data go with the same frequency to the CEO, two CEOs with different styles
would use these reports very differently to manage the business units. The dramatic shifts in the control process
within General Electric when Jack Welch succeeded Reginald Jones as the CEO.

Style affects the management control process-how the CEO prefers to use the information, conducts performance
review meetings, and so on-which in turn affects how the control system actually operates, even if the formal
structure does not change under a new CEO. In fact, when CEOs change, subordinates typically infer what the new
CEO really wants based on how he/she interacts during the management control process. (e.g., whether
performance reports or speeches and directives take precedence).

Personal versus Impersonal Controls: Presence of personal versus impersonal control in organisations is an
aspect of managerial style. Managers differ on how much importance they attach to formal budgets and reports as
well as informal conversations and other personal contacts. Some managers are “numbers oriented”; they want a
large flow of quantitative information, and they spend much time analyzing this information and deriving
tentative conclusions from it. Other managers are “people oriented”; they look at a few numbers, but they usually
arrive at their conclusions by talking with people, judging the relevance and importance of what they learn partly
 
on their appraisal of the other person. They visit various locations and spend time talking with both supervisors and
staff to get a sense of how well things are going.

Managers’ attitudes towards formal reports affect the amount of detail they want, the frequency of these reports,
and even their preference for graphs rather than tables of numbers, and whether they want numerical reports
supplemented with written comments. Designers of management control system need to identify these preferences
and accommodate them.

Tight versus Loose Controls: A manager’s style affects the degree of tight versus loose control in any situation.
The manager of a routine production responsibility center can be controlled relatively tightly or loosely, and the
actual control reflects the style of the manager’s superior. Thus, the degree of tightness or looseness often is not
revealed by the content of the forms or aspects of the formal control documents, rules, or procedures. It is a factor
of how these formal devices are used.

The degree of looseness tends to increase at successively higher levels in the organisation hierarchy: higher level
managers typically tend to pay less attention to details and more to overall results (the bottom line, rather than
the details of how the results are obtained). However, this generalization might not apply if a given CEO has a
different style.

Example. The classical illustration of this point is IIT under Harold Geneen. One could argue that IIT, being a
conglomerate, should be managed based on monitoring the business unit bottom line and not through a details
evaluation of every aspect of the business unit operations. This is so since, in a conglomerate, the CEO typically has
“capacity limitations” in understanding the nuts and bolts of various business units operations. In such context, it
was Harold Geneen’s personal style that explains the detailed evaluations hr made of the business units’ managers.

When Rand Araskog succeeded Harold Geneen at IIT, he altered the detailed and tight control system since,
among other things; Araskog’s personal style was not oriented toward exercising tight controls.
The style of the CEO has a profound impact on management control. If a new senior management with a different
style takes over, the system tends to change correspondingly. It might happen that the manager’s style is not a
good fit with the organization’s management control requirements. If the manager recognizes the incongruity and
adapts his/her style accordingly, the problem disappears. If, however, the manager is unwilling or unable to change,
the organisation will experience performance problems. The solution in this case might be to change the manager.

CHAPTER 11: AUDIT

Internal Control

“Internal control is the plan, methods and procedures adopted by the management for the efficient conduct of the
business, adherence to management policies, safeguarding of the assets, prevention and detection of fraud and
error, the accuracy and completeness of records and timely preparation of reliable financial information”. ---- ICAI

Objectives of Internal Control

i) Adherence to managerial policies and directives.
ii) Protection of assets against possible losses.
iii) Adherence to management policies and authorization.
iv) Generation of reliable, complete and accurate accounting records.
v) Timely preparation of financial information.
vi) Compliance with statutory requirements.
vii) Prevention and early detection of error and frauds.

Types of Internal Controls

(i) Administrative controls: This control deals with the functioning procedures that influence the decision
making process and managerial authorization of transaction. Example: Delegation of authority, job
descriptions etc.
(ii) Accounting controls: This control covers the accounting systems and procedures. This involves
recognizing, calculating, posting, analyzing, summarizing and reporting transactions.
(iii) Physical controls: This includes providing for protective devices for safeguarding the assets.

Five standards for internal control:

 

(i) 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.

(ii) Risk management: Internal control should provide for an assessment of the risk the agency faces
from both internal and external sources.

(iii) 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.

(iv) Information and communication: Information should be recorded and communicated to

management and other within the entity who need it and in a form and within a time from that
enables them to carry out their internal control and other responsibilities.

(v) Monitoring: Internal control monitoring should assess the quality of performance over Time and
ensure that the finding of audits and reviews are promptly resolved.

Internal Audit

Internal auditing is an independent, objective assurance and consulting activity designed to add value and
improve an organization's operations. It helps an organization accomplish its objectives by bringing a systematic,
disciplined approach to evaluate and improve the effectiveness of risk management, control, and governance
processes.
It is an ongoing appraisal of the financial health of a company's operations by its own employees. Employees who
carry out this function are called internal auditors. During an internal audit internal auditors will evaluate and
monitor a company's risk management, reporting, and control practices and make suggestions for improvement.
Internal auditing covers not only an organization's finance function, but all the operations and systems in a firm.
While internal auditors are typically accountants, this activity can also be carried out by other professionals who are
well-versed with a company's functions and the relevant regulatory requirements.

Internal Audit Facilitates

y Review of internal accounting controls.

y Scrutiny of all the reports.
y Safeguarding of assets from losses to damages.
y Verifying the authenticity of the transactions.
y Studying the operational efficiencies.
y Determining whether the operating objectives, targets and related control procedures are promptly
instituted and the degree to which the desired results are achieved.
y Examining and ascertaining the extent to which established policies, plans and procedures are compiled
with.
y Assessing the budgetary standard setting.

Major advantages Havingan Internal Audit Department

• It dispenses the need to employ external consultants to act as internal auditors hence saving large sum of
money. This is even especially true when an internal audit department is properly run with well trained and
experienced internal auditors;
• The internal auditors are intimately acquainted with the business as they are continuously employed in the
same concern and have access to much confidential information and to all levels of management. Hence,
they really are “special” personnel who have very in depth inner knowledge which can then contribute to
the company;
• The Internal Audit maintains a group of highly skilled people available to cope with non-recurring and
exceptional jobs which no many employee could deal with efficiently and effectively;
• It ensures that the organization detailed standard policy and procedures are running smoothly. This
compared to the external auditors’ primary role of the ability to express the true and fair view of the
clients’ financial statements audit;
• Internal auditors are invaluable in areas like operational audits, constant examination of internal check
  
controls, the detailed application of normal auditing method and detailed review of the various type of
management reporting;
• Last but not least, it provides an excellent training ground for future executives. Trainee personnel obtain
intimate knowledge of the business which they can study problems of all kinds at different levels.

Internal Auditing means nothing but Policing

“An Internal Auditor is a Watchdog not a Bloodhound”. An auditor must keep a watch over the activities of the
company but he must not be very suspicious of all transactions. The internal audit team must comprises of managers
or accountant who are of a balanced mind and not doubtful of others.
Internal audit involves policing i.e safeguarding the assets of the company but apart from this features it also
perform other functions. An internal auditor is a helpful police officer who rewards good decision & punishes errors
and frauds. The internal auditor must make sure that any misappropriation must be brought to notice of the top
management but he should also be willing to check management control and help managers to enforce the right
control.
Functions of Internal Auditor
(A) Checking the records to find the degree of reliability of the information.
(B) Examining documentary evidence
(C) Detection and prevention of errors and frauds.
(D) A general examination of the financial statement which give a true and fair view for better efficiencies of the
financial record.
Therefore internal audit is distinct from authorization and recording. It is not only concerned with examining
transactions as recorded in the books of accounts but it is an appraisal of procedures for better efficiencies.

Financial Audit

“Financial audit is a historically oriented, independent evaluation performed by the internal auditors or external
auditors for the purpose of confirming the Fairness, accuracy and reliability of the financial data, providing
protection of the company’s assets and evaluating the internal control systems designed to provide fairness and
protection. Financial data apart from other data is the primary evidence of the company and the evaluation is
performed on a planned basis rather than a request.”
Examples of Financial Audit:
Balance Sheet Audit, Cash Audit, Bank Reconciliation Statement, RevenueAudit, Payments Audit
Features of Financial Audit:
(a) It is concerned with the financial aspects of the business transactions of the year under audit.
(b) The auditors examines the past financial records to record his openion on the truth and fairness of the
financial statement.
(c) The performance of the management is outside the scope of financial audit.
(d) Financial Audit is compulsory in case of certain companies, trusts and societies.
(e) The auditor reports to the shareholder of the company

Management Audit

The management audit is ‘An Informed and Constructive analysis, Evaluation and a series of Recommendations
regarding Plans, Processes, People and Problems of a Company’ Management audit is define as investigation of a
business form the top levels to the bottom levels to check for proper management and to have an effective
relationship with the outside world and smooth running of the company internally.

Features of Management Audit:

(a) It check performance of all management levels by comparing them to objectives, policies and
procedures of the company.
(b) The management auditor report on management performance during a particular period and has
suggestions to rectify deficiencies and modification of objectives and policies.
(c) The management auditor reports to the top level management.
(d) Management audit is not legally compulsory and it can cover any number of year longer than the
financial year.
(e) A management audit is more qualitative rather then quantitative.

Examples of Management Audit

 
Strategic Operations Audit, R & D Audit, Time Management Audit, Budget Audit, M&A Audit, IPO Audits.

Difference between Financial Audit & Management Audit

Financial Audit Management Audit

It is concerned with financial aspects of It is concerned with the review of the past
Performance to ascertain whether it is in tune with the
business transactions of the year under objectives, policies and procedures of the enterprise.
Audit
The auditor examines the past financial The management auditor reports on performance of
records to report his opinion on the truth the management during a particular period and
and fairness of the representations made in the financial suggest ways to remedy the deficiencies, including
statements. Examination of the performance of the modification of objectives, policies etc.
management is
beyond his scope
Past year '(Financial) transactions are No limit as to the period to be covered
Covered Enterprises such as companies, trust and societies
etc.
Financial audit is compulsory in the case of certain There is legal compulsion as regards management
enterprises such as companies, trust and societies etc. audit.
The auditor reports to the owner, i.e. The auditor reports to the management
shareholders in the Case of a company
Operational Audit

Operational audit can be define as checking each and every operation of the company. It is a type of internal
audit, where different operating functions, cost revenues are checked. Operational audits are conducted for various
projects to ensure that the criteria for planned expenses are being followed. Operational audit will cover services,
wages and salaries, overheads, depreciation, production, WIP, stock record etc.

Features of Operational Audit:

(a) It covers the cost accounts of the financial year of the company.
(b) It checks the internal efficiency by verifying cost records.
(c) For enterprises in production, processing/manufacturing the cost/operational audit is compulsory.
(d) It can be conducted by cost accountants or chartered accountants or operational experts.

Example of Operational Audit

Energy audit, efficiency audit, pollution audit, project audit, PERT and CPM 
 
Difference between Financial Audit, Management Audit& Operational Audit

Financial Audit Operational Audit Management Audit

Financial Audit is compulsory Operational Audit is compulsory Management Audit is optional
Financial audit reports are send to Operational audit reports send to Management audit reports are send
the shareholders in the annual the government to the top management
report
Financial audit deals with financial
Operational audit deals with Management audit evaluates
aspects operational cost and deadlines. people (HR)
Financial audit helps shareholdersOperational audit helps the Management audit helps the top
government. management.
Financial audit are objective Operational audit are objectives Management audit is subjective
(Quantitative) (Quantitative) (Qualitative)
Financial audit basicallyAnalysis Operational audit has Suggestions Management audit Appraises
(Evaluâtes)
 
The best example to explain the difference between Financial, Operational and Management Audit are the
Financial Statement i.e The Profit/Loss A/c and the Balance Sheet.
The financial auditor will check the Reliability and Accuracy of the Financial Data.
The Operational Auditor will compute various Ratios like Stock Turnover, Debtors T/O etc.
The Management Auditors will look into VRS, ESOP’s, Employee Retention etc.

Efficiency Audit

Efficiency is the ratio of output to input. It is measured as: Efficiency = Output / Input

An efficiency audit is carried out in order to ascertain the efficiency levels in an organization. It is a process of
ensuring that every rupee invested yields optimum results.

At any production system where the output is maximized, this ratio is said to be maximum

Efficiency can be of two types namely, economic efficiency and technical efficiency. Economic Efficiency is a
measure that considers quantity of input i.e cost of inputs. If the input cost is minimum for a given level, the firm is
said to have achieved efficiency.

Technical Efficiency is a measure that considers output with respect to input. If the input is minimum for a given
level but the output is maximum, the firm is said to have achieved technical efficiency.

Objectives of Efficiency audit:

(a) Achive optimum utilization of resources invested
(b) Channelize the investment into the most profitable ventures
Efficiency audit is based on following parameters:

(a) Return on capital employed

(b) Utilization of available capacity
(c) Optimum utilization of resources
(d) Performance in the global market
(e) Liquidity position of the firm
(f) Payback period of investment made.
Quality Audit

Quality Audit is Periodic, independent, and documented examination and verification of activities, records,
processes, and other elements of a quality system to determine their conformity with the requirements of a quality
standard such as ISO 9000. Any failure in their proper implementation may be published publicly and may lead to
a revocation of quality certification.
The purpose of a quality audit is to determine whether the company is complying with its quality program or
whether it needs to make changes to its business practices.
Usually, a quality audit is an external audit, meaning it is conducted by an independent auditor or team of
auditors who have expertise in the area.
A company may also elect to perform an internal audit of its quality control systems on a periodic basis.
Members of the audit team are typically professionals who have extensive knowledge about auditing standards,
procedures, and principles.
In addition, auditors should have hands-on experience with examining, evaluating, and reporting on whether each
aspect of a quality system is deficient or satisfactory.
Technical Audit

Systematic analysis of a company’s Research & Development activities conducted by an outside expert can be
called a technical audit.
The audit examines all current R & D activities, to make an honest appraisal of their potential and worthiness.
After an audit, priorities on all projects should be clear to all involved.Almost any organizations that conduct R & D
and are frustrated with the results go with technical audit.
Company wants answer of question “Are R&D Department working on the right projects?” The technical audit
addresses this question fully, suggesting which projects to emphasize, which ones to drop and which ones to start. It
focuses your attention on the projects that will help your organization. And just as importantly, it eliminates work
that wastes precious resources