MCS 2009 Paper Solution

Q.1 Explain briefly various stages of management control process citing salient features of each.

Management control process involves communication of information to the managers at various levels of hierarchy and their interactions arising out of them. These communications aim towards attaining the organization's goals. But individual managers have their personal goals also. For example, a young manager with good education, experience, personality and social background joins a company like Britannia Industries or Reliance. The company finds him fit for the position as per job specifications, appoints him and makes him aware of what the company expects of him. The young manager sets his goals of gaining rich experience for his career progress besides adequate compensation packages. Naturally, his actions will be directed towards achieving his own objectives and goals while serving the company. Thus, his self-interest and the best interest of the organization are apparently in conflict. But the best results can be achieved by perfectly matching the two interests and this is called 'goal congruence'.

It is quite apparent that perfect congruence between the goals of the individual and the organization individual's goals and the organization's goals can never happen. Yet, the main purpose of a management control system is to assure goal congruence between the interest of the individual and the organization as far as practicable.

Management control systems

Formal and Informal Communication As mentioned earlier, all the communication of information may be either formal or informal. The formal communication system involves strategic plan, budgets, standards and reports whereas the informal communication is made through letters and memos, verbally or even by facial expression. Formal communications are all documented and addressed to the responsible managers for their information and actions, if necessary. However, the actions depend on the perception of the individual managers. Informal communication, on the other hand, relates to some external factors-work ethics, management style and culture. Added to these factors is the existence of an informal organization within the structured formal organization.

Informality refers to the relaxation of sharp differentiation and explicit description of behavior as indicated in the hierarchy and thereby, moving away from superior/subordinate relationship. However, such relations depend on the personal capabilities of the manager such as education, experience, expertise, trust and cooperation. For example, Accounts Manager of Nasik Plant (see the organization chart in the diagram 3.2) reports to the General Manager of the Plant. While visiting the Corporate Office for attending a Training Course, he meets other colleagues, parallel officers and even the Finance Director. The latter communicates some important matter to him verbally and wants action thereon. Accounts Manager carried out the instructions so given. As per the organization chart, he should inform his General Manager, but it depends on his own perception of the situation, and he mayor may not report to the General Manager.

Work Ethics, Management Style and Culture

External factors like work ethics vary from place to place. Therefore, organization work culture depends on the general behavior of the people in the society where the organization situates. Work culture generally differs because of the life style and the attitude towards the work. For example, people of Mumbai lead very fast life. Time has more value at Mumbai as compared to Kolkata, where people take things easily and leisurely. Japanese and Korean people have reputation for their excellent work culture. However, the most important internal factor is the organization's culture and climate. The culture refers to the set of common beliefs, attitudes, norms, relationships and assumptions that are explicitly or implicitly accepted and evidenced throughout the organization. The writer joined Union Carbide as an Assistant just three days before Christmas Eve. On the very second day, when he attended Christmas lunch, his table was shared by none other than the General Sales Manager Dr. W.R. Correa. He kept us amused with various stories of his recent tour abroad and recited Urdu 'shairies', even sharing jokes. Such a situation was unthinkable in Jessop & Co., where sharp differences were maintained at every level of hierarchy.

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Climate is used to designate the quality of the internal environment that conditions the quality of cooperation, the development of individuals, the extent of members' dedication or commitment to organizational purpose and the efficiency with which that purpose is translated into results. Climate is the atmosphere in which individuals work help, judge, and reward, constrain and find out about each other. It influences moral-the attitude of the individual towards his/her work and environment.

Culture differs between the organizations, but cultural norms are extremely important. They are not written like formal communication. But the existence of a good culture can be felt from the behavior of the members of the organization. Once the writer landed up with his family at Hyderabad in the early morning to discover that nobody had come to receive them at the station. His visit was arranged through non other than the Director of the company himself. His unit being new, telephone directory did not include any number of his unit, but the parent organization's telephone number was located. When an executive of the parent company was contacted, he immediately sent an officer of the company with a car to pick us up to their Guest House, entertain with coffee and then put up in a Hotel. What subsequently happened is a different matter, but the attitude and treatment of that member of organization speak volumes about their excellent culture.

In any organization, the culture remains unchanged as long as the Chief Executive remains in position. When a new executive replaces him, there is likelihood of some change in the culture, unless the new Chief follows the footsteps of his predecessor and maintains it. Generally, if higher positions are filled in through promotion of internal executives, the culture remains unchanged and the traditions are maintained.

The other important internal factor which influences management control system is management style-that is the attitude of the superior to his subordinates and the latter's reaction through their perception of the attitude of their superiors. Again, the attitude ultimately stems from the temperament of the Chief Executive, who controls the entire organization. That is why R. W. Emerson said "an institute is the lengthened shadow of a man".

Importance of Informal Communication

An organization indulges in informal control process when encountering non-routine decision-making or when seeking new information to increase understanding of some problem areas. During a very critical period in an organization, the writer found that the Chief Executive used to call managers informally at his residence or club to extract information in a relaxed manner rather than in a tense situation prevailing in the factory.

Formal Control Process

Formal communication system is structured as per the 'hierarchy outlined in the organization chart. The system has the following four components:

(a) Strategic plan and programme (b) Budgeting

(c) Operations and measurement in responsibility centers (d) Reporting

(a) Strategic Plan and Programme The foundation of management control process lies in the organization's goals and its strategies for attaining these goals. A strategic plan is prepared in order to implement the strategies, after carefully considering opportunities and threats in the external environment as well as the strengths and weaknesses in the internal environment. Thus, a strategic plan and programme is prepared as a guideline to budgeting.

(b) Budgeting

The strategic plan is converted to an annual budget incorporating planned expenditure and revenues for individual responsibility centers. Expenses and revenues are marked for each responsibility centre period wise, say monthly, quarterly, half yearly, and annually.

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(c) Operations and Measurement

Responsibility centers operate within the framework of the budget, established standards, standing instructions, practices and operating procedures embodied in 'rules', and 'manuals'. Thus, besides budget, the responsibility centers are also guided by a large number of rules. They record the resources actually used and revenue earned. They also classify the data by programmes as well as by responsibility centers for performance measurement.

(d) Reporting

Actual performance is analyzed, measured and reported against plan, indicating variances and highlighting areas of weaknesses. If the performance is satisfactory, feedback information is sent to the responsibility centre concerned for praise or reward. If the same is unsatisfactory feedback communication is sent to the responsibility centre concerned for corrective action. If such action requires to be included in the budget, then the latter is revised to give effect to the changed position. If required, then the plan itself can be revised and a new basis of control may be established.

The aforesaid formal control process has been presented in the following diagram:

Q.2 What is a responsibility centre? List and explain different types of Responsibility Centers with sketches.

Responsibility centers:

A responsibility center is an organization unit that is headed by a manager who is responsible for its activities. In a sense, a company is a collection of responsibility centers. Each of which is represented by box on the on the organization are responsibility centers for section work shifts or other small organization

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units. At a higher level are departments or business units that consist of several of these smaller units plus staff and management people these larger units are also responsibility center. And from the stand point of senior management and the board of directors, the whole company is responsibility center although the term is usually used to refer to unit within the company.

Nature of responsibility centers

A responsibility center exist one or more purpose are its objectives. The company as a whole has goals, and senior management has decided on a set of strategies to accomplish these goals. The objectives of responsibility centers are to help implement these strategies. Because the organization is the sum of its responsibility centers, if the strategies are sound and if each responsibility center, if the strategies are sound and if each responsibility center meets its objectives the whole organization should achieve its goals. A responsibility center uses inputs, and a variety of services. Its work with these resources and it usually require working capital, equipment, and other asset to do this work. As a result of this work the responsibility center produces output which is classified either as goods if they are tangible or as services if they are intangible. Every responsibility center has output that is it does something. In a production plant, the outputs are goods. In staff units, such as human resources, transportation, engineering, accounting, and administration, the output s are services. For many responsibility centers, especially staff units, outputs are difficult to measure; nevertheless, they exist. The products produced by a responsibility center or to the outside marketplace. In the first case, the product are inputs to the other responsibility center in the latter case, they are output s of the whole organization.

Types of Responsibility Centers

Cost Center

Cost centers are divisions that add to the cost of the organization, but only indirectly add to the profit of the company. Typical examples include Research and Development, Marketing and Customer service. Companies may choose to classify business units as cost centers, profit centers, or investment centers. There are some significant advantages to classifying simple, straightforward divisions as cost centers, since cost is easy to measure. However, cost centers create incentives for managers to underfund their units in order to benefit themselves, and this underfunding may result in adverse consequences for the company as a whole (reduced sales because of bad customer service experiences, for example). Because the cost centre has a negative impact on profit (at least on the surface) it is a likely target for rollbacks and layoffs when budgets are cut. Operational decisions in a contact centre, for example, are typically driven by cost considerations. Financial investments in new equipment, technology and staff are often difficult to justify to management because indirect profitability is hard to translate to bottom-line figures. Business metrics are sometimes employed to quantify the benefits of a cost centre and relate costs and benefits to those of the organization as a whole. In a contact centre, for example, metrics such as average handle time, service level and cost per call are used in conjunction with other calculations to justify current or improved funding.

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Profit Center

A responsibility centre is called a profit centre when the manager is held responsible for both costs (inputs) and revenues (outputs) and thus for profit. Despite the name, a profit centre can exist in nonprofits organizations (though it might not be referred to as such) when a responsibility centre receives revenues for its services. A profit centre is a big segment of activity for which both revenues and costs are accumulated: A centre, whose performance is measured in terms of both - the expense it incurs and revenue it earns, is termed as a profit centre. The output of a responsibility centre may either be meant for internal consumption or for outside customers. In the latter case, the revenue is realized when the sales are made. That is, when the output is meant for outsiders, then the revenue will be measured from the price charged from customers. If the output is meant for other responsibility centre, then management takes a decision whether to treat the centre as profit centre or not. In fact, any responsibility centre can be turned into a profit centre by determining a selling price for its outputs. For instance, in case of a process industry, the output of one process may be transferred to another process at a profit by taking into account the market price. Such transfers will give some profit to that responsibility centre. Although such transfers do not increase the Companys assets, they help in management control process.

Investment Centre

An investment centre goes a step further than a profit centre does. Its success is measured not only by its income but also by relating that income to its invested capital, as in a ratio of income to the value of the capital employed. In practice, the term investment centre is not widely used. Instead, the term profit centre is used indiscriminately to describe centers that are always assigned responsibility for revenues and expenses, but may or may not be assigned responsibility for the capital investment. It is defined as a responsibility centre in which inputs are measured in terms of cost / expenses and outputs are measured in terms of revenues and in which assets employed are also measured. A responsibility centre is called an investment centre, when its manager is responsible for costs and revenues as well as for the investment in assets used by his centre. He is responsible for maintaining a satisfactory return on investment i.e. asset employed in his responsibility centre. The investment centre manager has control over revenues, expenses and the amounts invested in the centres assets. The manager of an investment centre is required to earn a satisfactory return. Thus, return on investment (ROI) is used as the performance evaluation criterion in an investment centre. He also formulates the credit policy, which has a direct influence on debt collection, and the inventory policy, which determines the investment in inventory. The Vice President (Investments) of a mutual funds company may be in charge of an Investment Centre. In the Investment Centre, the manager in charge is held responsible for the proper utilization of assets. He is expected to earn a satisfactory return on the assets employed in his responsibility centre. Measurement of assets employed

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poses many problems. It becomes difficult to determine the amount of assets employed in a particular responsibility centre. Some of the assets are in the physical possession of the responsibility centre while for some assets it may depend upon other responsibility centers or the Head Office of the company. This is particularly true of cash or heavy plant and equipment. Whether such assets should be included in the figure of assets employed of the responsibility centre and if included, at how much value, is a difficult question. On account of these difficulties, investment centers are generally used only for relatively large units, which have independent divisions, both manufacturing and marketing, for their individual products.

Q.3 Every SBU is a profit center but every profit center is not a SBU? What are the conditions that should be fulfill for an organization unit to be converted into a profit center? What are the different ways to measure the performance of profit center? Discuss their relevant merits and demerits.

Ans: Conditions for an organization to be converted into a profit centre: Many management decisions involve proposals to increase expenses with the expectation of an even greater increase in sales revenue.

Such decisions are said to involve expense/revenue trade-offs. Additional advertising expense is an example. Before it is safe to delegate such a trade-off decision to a lower-level manager, two conditions should exist.

The manager should have access to the relevant information needed for making such a decision.

There should be some way to measure the effectiveness of the trade-offs the manager has made.

A major step in creating profit centers is to determine the lowest point in an organization where these two conditions prevail. All responsibility centers fit into a continuum ranging from those that clearly should be profit centers to those that clearly should not. Management must decide whether the advantages of giving profit responsibility offset the disadvantages, which are discussed below. As with all management control system design choices, there is no clear line of demarcation.

Ways to Measure Performance: There are two types of profitability measurements used in evaluating a profit center, just as there are in evaluating an organization as a whole. First, there is the measure of management performance, which

focuses on how well the manager is doing. This measure is used for planning, coordinating, and controlling the profit center's day-to-day activities and as a device for providing the proper motivation for its manager. Second, there is the measure of economic performance, which focuses on how well the profit center is doing as an economic entity. The messages conveyed by these two measures may be quite

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different from each other. For example, the management performance report for a branch store may show that the store's manager is doing an excellent job under the circumstances, while the economic performance report may indicate that because of economic and competitive conditions in its area the store is a losing proposition and should be closed. .

The necessary information for both purposes usually cannot be obtained from a single set of data. Because the management report is used frequently, while the economic report is prepared only on those occasions when economic decisions must be made, considerations relating to management performance measurement have first priority in systems design-that is, the system should be designed to measure management performance routinely, with economic information being derived from these performance reports as well as from other sources.

Types of Profitability Measures A profit center's economic performance is always measured by net income (i.e., the income remaining after all costs, including a fair share of the corporate overhead, have been allocated to the profit center). The performance of the profit center manager, however, may be evaluated by five different measures of profitability: (1) contribution margin, (2) direct profit, (3) controllable profit, (4) income before income taxes, or (5) net income

(1) Contribution Margin: Contribution margin reflects the spread between revenue and variable expenses. The principal argument in favor of using it to measure the performance of profit center managers is that since fixed expenses are beyond their control, managers should focus their attention on maximizing contribution. The problem with this argument is that its premises are inaccurate; in fact, almost all fixed expenses are at least partially controllable by the manager, and some are entirely controllable. Many expense items are discretionary; that is, they can be changed at the discretion of the profit center manager. Presumably, senior management wants the profit center to keep these discretionary expenses in line with amounts agreed on in the budget formulation process. A focus on the contribution margin tends to direct attention away from this responsibility. Further, even if an expense, such as administrative salaries, cannot be changed in the short run, the profit center manager is still responsible for controlling employees' efficiency and productivity.

(2) Direct Profit: This measure reflects a profit center's contribution to the general overhead and profit of the corporation. It incorporates all expenses either incurred by or directly traceable to the profit center, regardless of whether or not these items are within the profit center manager's control. Expenses incurred at headquarters, however, are not included in this calculation. A weakness of the direct profit measure is that it does not recognize the motivational benefit of charging headquarters costs.

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(3) Controllable Profit: Headquarters expenses can be divided into two categories: controllable and non controllable. The former category includes expenses that are controllable, at least to a degree, by the business unit manager-information technology services, for example. If these costs are included in the measurement system, profit will be what remains after the deduction of all expenses that may be influenced by the profit center manager. A major disadvantage of this measure is that because it excludes non controllable headquarters expenses it cannot be directly compared with either published data or trade association data reporting the profits of other companies in the industry.

(4) Income before Taxes: In this measure, all corporate overhead is allocated to profit centers based on the relative amount of expense each profit center incurs. There are two arguments against such allocations. First, since the costs

incurred by corporate staff departments such as finance, accounting, and human resource management are not controllable by profit center managers, these managers should not be held accountable for them. Second, it may be difficult to allocate corporate staff services in a manner that would properly reflect the amount of costs incurred by each profit center.

There are, however, three arguments in favor of incorporating a portion of corporate overhead into the profit centers' performance reports. First, corporate service units have a tendency to increase their power base and to enhance their own excellence without regard to their effect on the company as a whole. Allocating corporate overhead costs to profit centers increases the likelihood that profit center manager will question these costs, thus serving to keep head office spending in check. (Some companies have actually been known to sell their corporate jets because of complaints from profit center managers about the cost of these expensive items.) Second, the performance of each profit center will become more realistic and more readily comparable to the performance of competitors who pay for similar services. Finally, when managers know that their respective centers will not show a profit unless all-costs, including the allocated share of corporate overhead, are recovered, they are motivated to make optimum long-term marketing decisions as to pricing, product mix, and so forth, that will ultimately benefit (and even ensure the viability of) the company as a whole. If profit centers are to be charged for a portion of corporate overhead, this item should be calculated on the basis of budgeted, rather than actual, costs, in which case the "budget" and "actual" columns in the profit center's performance report will show identical amounts for this particular item. This ensures that profit center managers will not complain about either the arbitrariness of the allocation or their lack of control over these costs, since their performance reports will show no variance in the overhead allocation. Instead, such variances would appear in the reports of the responsibility center that actually incurred these costs. .

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(5) Net Income: Here, companies measure the performance of domestic profit centers according to the bottom line, the amount of net income after income tax. There are two principal arguments against using this measure: (1) after tax income is often a constant percentage of the pretax income, in which case there would be no advantage in incorporating income taxes, and (2) since many of the decisions that affect income taxes are made at headquarters, it is not appropriate to judge profit center managers on the consequences of these decisions. There are situations, however, in which the effective income tax rate does vary among profit centers. For example, foreign subsidiaries or business units with foreign operations may have different effective income tax rates. In other cases, profit centers may influence income taxes through their

installment credit policies, their decisions on acquiring or disposing of equipment, and their use of other generally accepted accounting procedures to distinguish gross income from taxable income. In these situations, it may be desirable to allocate income tax expenses to profit centers not only to measure their economic profitability but also to motivate managers to minimize tax liability.

Merits:

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

The speed of operating decisions may be increased since they do not have to be referred to corporate headquarters. . Headquarters management, relieved of day-to-day decision making, can concentrate on broader issues.

Managers, subject to fewer corporate restraints, are freer to use their imagination and initiative.Because profit centers are similar to independent companies, they provide an excellent training ground for general management. Their managers gain experience in managing all functional areas, and upper management gains the opportunity to evaluate their potential for higher-level jobs.

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

Profit centers provide top management with ready-made information on the profitability of the company's individual components. . Because their output is so readily measured, profit centers are particularly responsive to pressures to improve their competitive performance.

Demerits:

Decentralized decision making will force top management to rely more on management control reports than on personal knowledge of an operation, entailing some loss of control.

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If headquarters management is more capable or better informed than the average profit center manager, the quality of decisions made at the unit level may be reduced.

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

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

Divisionalization may impose additional costs because of the additional management, staff personnel, and record keeping required, and may lead to task redundancies at each profit center.

Q.4 (a) solution

Transfer Pricing is not an accounting tool comment with an illustration

If a group has subsidiaries that operate in different countries with different tax rates, manipulating the transfer prices between the subsidiaries can scale down the overall tax bill of the group. For example the tax rate in Country A is 20% and is 50% in Country B. In the larger interest of the group, it would be advisable to show lower profits in Country B and higher profits in Country A. For this, the group can adjust the transfer price in such a way that the profits in Country A increase and that in Country B get reduced. For this the group should fix a very high transfer price if the Division in Country A provides goods to the Division in Country B. This will maximize the profits in Country A and minimize the profits in Country B. The reverse will be true if the Division in Country A acquires goods from the Division in Country B.

There is also a temptation to set up marketing subsidiaries in countries with low tax rates and transfer products to them at a relatively low transfer price.

Transfer price is viewed as a major international tax issue. While companies indulge in all types of activities to lower their tax liability, the tax authorities monitor transfer prices closely in an attempt to collect the full amount of tax due. For this they enter into agreements whereby tax is paid on specific transactions in one country only. But if companies set unrealistic transfer price to minimize their tax liabilities and the same is spotted by the tax authority, then the company is forced to pay tax in both countries leading to double taxation.

There have been instances where companies have fixed unrealistic transfer prices. The first case relates to Hoffman La Roche that imported two drugs Librium and Valium into UK at prices of 437 pounds and 979 pounds per kilo respectively. While the tax authorities in UK accepted the price, the Monopolies Commission did not accept the company's argument, since the same drugs were available from an Italian firm for 9 pounds and 28 pounds per kilo.

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The company's lawyers argued the case before the Commission on two grounds viz.

1. The price was not set on cost but on what the market would bear and

2. The company had incurred an R&D cost that was included in the price.

These arguments did not go well with the Commission and the company was fined 1.85 million pounds for the manipulative practices adopted while fixing the transfer price.

The second case is of Nissan. The company had falsely inflated freight charges by 40-60% to reduce the profits. The manipulation helped the company to hide tax to the tune of 237 million dollars. The next year Nissan was made to pay 106 million dollars in unpaid tax in the USA because the authorities felt that part of their US marketing profits were being transferred to Japan, as transfer prices on import of cars and trucks were too high. Interestingly the Japanese tax authorities took a different view and returned the double tax.

With a view to avoid such cases from recurring, Organisation for Economic Cooperation and Development issued some guidelines in 1995. These guidelines aim at encouraging world trade. They evolved what came to be known as the arm's length price. The principle states that the transfer price would be arrived at on the basis as if the two . companies are independent and unrelated. The price is determined through:

Comparable Price Method where the price is fixed on the basis of prices of similar products or an approximation to one.Gross Margin Method where a gross margin is established and applied to the seller's manufacturing cost.

In spite of all these efforts, it has to be admitted that setting a fair transfer price is not easy. So the onus of proving the price has been put on the taxpayer who is required to produce supporting documents. If the taxpayer fails to do this he is required to pay heavy penalty. For example, in USA, failure to provide documentary evidence results in a 40% penalty on the arm's length price. In UK the penalty is to the tune of 100% of any tax adjustment. Other countries are also in the process of evolving tight norms for the same. Countries across the globe also allow the taxpayer to enter into an Advance Pricing Agreement whereby dispute can be avoided and so also the costly penalty of double taxation and penalty.

Q.4.( b) Solution

Market Price is ideal transfer price even in limited markets. Comments

By limited market it means that the markets for buying and selling profit centers may be limited.

Even in case of limited market the transfer price that is ideal or satisfies the requirement of a profit center system is the competitive price. In case if a company is not buying or selling its product in an outside market there are some ways to find the competitive price. They are as follows:

1. If published market prices are available, they can be used to establish transfer prices. However, these should be prices actually paid in the market-place and the conditions that exist in the outside market should be consistent with those existing within the company. For example, market prices that are applicable to relatively small purchases are not valid in this case.

2.Market prices are set by bids. This generally can be done only if the low bidder has a reasonable chance of obtaining the business. One company accomplishes this by buying about one-half of a particular group of products outside the company and one-half inside the company.

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The company then puts all of the products out to bid, but selects one-half to stay inside. The company obtains valid bids, because low bidders can expect to get some of the business. By contrast, if a company requests bids solely to obtain a competitive price and does not award the contracts to the low bidder, it will soon find that either no one bids or that the bids are of questionable value.

3.If the production profit center sells similar products in outside markets, it is often possible to replicate a competitive price on the basis of the outside price.

4.If the buying profit center purchases similar products from the outside market, it may be possible to replicate competitive prices for its proprietary products. This can be done by calculating the cost of the difference in design and other conditions of sale between the competitive products and the proprietary products.So we see from the above arguments that market price is ideal transfer price even in limited markets

Q.5 Soniya Company has two Divisions: A & B. Return on Investment for both divisions is 20%. Details are given below:-

Particulars Div A Div B

Divisional sales 4000000 9600000

Divisional Investment 2000000 3200000

Profit 400000 640000

Analyse and comment on divisional performance of each.

ANSWER

As Profit Margin = Profit *100

Sales

Profit Margin for Division A= 4,00,000 /40,00,000 *100 = 10%

Profit Margin for Division B = 6,40,000/ 96,00,000 *100 = 6.6%

Turnover of Investment = Sales * 100

Investment

Turnover of Investment for Division A = 40,00,000/20,00,000 = 2 times

Turnover of Investment for Division B = 96,00,000/32,00,000 = 3 times

As Return on investment for both Divisions A and B is 20%.

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COMMENTS

Division A Although A has more profit margin than Division B that is 10% as compared to 6.6% of B, so it has more profitability but inspite of it, division A has lower turnover of investment that its assets management is bad than Division B, it can be improved by increased sales or reducing investment.

Division B Needs to improve profit margin by increasing sales and reduce variable cost and sales at same price or by reducing salesprice and increase the volume of sales so that its profit would improve. As it has good assets management shown by its turnoverof Division B that is 3 times which is better than Division A. So it can become profitable organisation by improving Profit Margin.

Q.6 (Can find answer for only two types)

Financial Audit Management Audit It is concerned with financial aspects of business transactions of the year under audit

It is concerned with the review of the past Performance to ascertain whether it is in tune with the objectives, policies and procedures of the enterprise.

The auditor examines the past financial records to report his opinion on the truth and fairness of the representations made in the financial statements. Examination of the performance of the management is beyond his scope

The management auditor reports on performance of the management during a particular period and suggest ways to remedy the deficiencies, including modification of objectives, policies etc.

Past year '(Financial) transactions are Covered Enterprises such as companies, trust and societies etc.

No limit as to the period to be covered

Financial audit is compulsory in the case of certain enterprises such as companies, trust and societies etc.

There is legal compulsion as regards management audit.

The auditor reports to the owner, i.e. shareholders in the Case of a company

The auditor reports to the management

Q.7 Organizations with Business Divisions (Profit Centre) format have observed that Divisional Controllers experience divided loyalty in carrying out their functions, causing a possible dysfunction. How could such a situation be resolved? Define role of controller which suits your suggestion.

To the extent the decision are decentralized top management may lose some control. Relying on control reports is not as effective as personal knowledge of an operation. With profit center, top management must change its approach to control. Instead of personal direction senior management must rely to a considerable extent on management control reports.

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Competent units that were once cooperating as functional units may now compete with one another dis advantageously. An increase in one managers profit may decrease those of another. This decrease in cooperation may manifest itself in a manager unwillingness to refer sales lead to another business unit, even though that unit is better qualified to follow up on the lead in production decision that have undesirable cost consequence on other units or in the hoarding of personnel or equipment that from the overall company standpoint would be better off used in another units. There may be too much emphasis on short run profitability at the expense of long run profitability. In the desire to report high current profits, the profit center manager may skip on R&D, training, maintenance. This tendency is especially prevalent when the turnover of profit center managers is relatively high. In these circumstances, manager may have good reason to believe that their action may not affect profitability until after they have moved to other job. There is no complete satisfactory system for ensuring that each profit center by optimizing its own profit , will optimize company profits.

If headquarter management is more capable or has better information then the average profit center manager the quality of some of the decision may be reduced. Divisionalization may cause additional cost because it may require additional management staff personnel and recordkeeping and may lead to redundant at each profit center. Business units as profit centers:

Business units are usually set up at profit centers. Business unit managers tend to control product development, manufacturing, and marketing resources. They are in a position to influence revenue and cost and as such can be held accountable for the bottom line. However as pointed out in the next section a business unit manager authority may be constrained such constrained should be incorporated in designing and operating profit center. Constraint on business unit authority To realize fully the advantage of the profit center concept the business unit manger would have to be as autonomous as the president of the independent company. As a practical matter however such autonomy is not feasible. If a company were divided into completely independent units the organization would be giving up the advantage of size and synergism. Also senior management authority that a board of director gives to the chief executive. Consequently business unit structure represents trade off between business unit autonomy and corporate constraint. The effectiveness of a business units organization is largely dependent on how well these trade off are made. The performance of a profit center is appraised by comparing actual results for one or more orf these measures with budgeting amounts. In addition, data on competitors and the industry provide a good cross check on the appropriate of the budget. Data for individual companies are available from the securities and exchange commission for about key business ratios; standard & poor computer services, Inc; Robert Morris associates annual statement studies; and annual survey published in fortune, business week, and Forbes. Trade associations publish data for the companies in their industries.

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Revenues: choosing the appropriate revenue recognition method is important. Should revenue be recognized at the time as order is received, at the time an order is shipped, or at the time cash is received? In addition to that decision, issues related to common revenues may need to be considered. There are some situations in which two or more profit centers participate in the sales effort that results in a sale; ideally, each should be given appropriate credit for its part in this transaction. Many companies have not given much attention to the solution of these common revenue problems. They take the position that the identification of price responsibility for revenue generation is too complicated to be practical and that sale personnel must recognize they are working not only for their own profit center but also for the overall good of the company. They for example, may credit the business unit that takes an order for a product handled by the another unit with the equivalent of a brokerage commission or a finder fee. In the case of a bank the branch performing a service may be given explicit credit for that service even though the customer account is maintained in another branch. Role of controller

It should publish procedure and forms for the preparation of the budget.

It should provide assistance to budgetees in the preparation of their budget.

It should administer the process of making budget revision during the year.

It should coordinate the work of budget departments in lower echelons

It should analyze reported performance against budget, interprets the result, and prepares summary report for senior management.

Q.8 Goal Congruence and informal factors affecting it.

Management control systems influence human behavior. Good management control systems influence behavior in a goal congruent manner; that is, they ensure that individual actions taken to achieve personal goals also help to achieve the organization's goals. The concept of goal congruence, describing how it is affected both by informal actions and by formal systems. Senior management wants the organization to attain the organization's goals. But the individual members of the organization have their own personal goals, and they are not necessarily consistent with those of the organization. The central purpose of a management control system, then, is to ensure a high level of what

is called "goal congruence." In a goal congruent process, the actions people are led to take in accordance with their perceived self interest are also in the best interest of the organization. The significance of human behavior patterns in management control system can be explained with the help

of Informal Factors that influence Goal Congruence. In the informal forces both internal and external

factors play a key role.

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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.

Internal Factors

Culture The most important internal factor is the organization's 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.

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 ultimately 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.

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

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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.

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., conver-sations). 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.

The informal factors discussed above have a major influence on the effectiveness of an organizations management control. The other major influence is the formal systems. These systems can be classified into two types: (1) the management control system itself and (2) rules, which are described in this section.

Q.9 Short Notes

i) Zero Based Budgeting:

Zero-based budgeting is a technique of planning and decision-making which reverses the working process of traditional budgeting. In traditional incremental budgeting, departmental managers justify only increases over the previous year budget and what has been already spent is automatically sanctioned. No reference is made to the previous level of expenditure. By contrast, in zero-based budgeting, every department function is reviewed comprehensively and all expenditures must be approved, rather than only increases.[1] Zero-based budgeting requires the budget request be justified in complete detail by each division manager starting from the zero-base. The zero-base is indifferent to whether the total budget is increasing or decreasing.

The term "zero-based budgeting" is sometimes used in personal finance to describe the practice of budgeting every dollar of income received, and then adjusting some part of the budget downward for every other part that needs to be adjusted upward. It would be more technically correct to refer to this practice as "active-balanced budgeting".

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Advantages of Zero-Based Budgeting:

1. Efficient allocation of resources, as it is based on needs and benefits. 2. Drives managers to find cost effective ways to improve operations. 3. Detects inflated budgets. 4. Municipal planning departments are exempt from this budgeting practice. 5. Useful for service departments where the output is difficult to identify. 6. Increases staff motivation by providing greater initiative and responsibility in decision-making. 7. Increases communication and coordination within the organization. 8. Identifies and eliminates wasteful and obsolete operations. 9. Identifies opportunities for outsourcing. 10. Forces cost centers to identify their mission and their relationship to overall goals.

Disadvantages of Zero-Based Budgeting:

1. Difficult to define decision units and decision packages, as it is time-consuming and exhaustive. 2. Forced to justify every detail related to expenditure. The R&D department is threatened whereas

the production department benefits. 3. Necessary to train managers. Zero-based budgeting must be clearly understood by managers at

various levels to be successfully implemented. Difficult to administer and communicate the budgeting because more managers are involved in the process.

4. In a large organization, the volume of forms may be so large that no one person could read it all. Compressing the information down to a usable size might remove critically important details.

5. Honesty of the managers must be reliable and uniform. Any manager that exaggerates skews the results

We define net cash flow as net income plus non cash adjustment which typically means net income plus depreciation though that cash flows cannot be maintained over time unless depreciated fixed assets are replaced. So management is not completely free to use its cash flows however it chooses. Therefore we define the term free cash flows.

ii) Free cash flow is the cash flow actually available for distribution to investor after the company has made all the investment in fixed assets and working capital necessary to sustain ongoing operation. When we studied income statement in accounting the emphasis was probably on the firms net income, which is accounting profit. However the value of companys operation is determined by the stream of cash flows that the operations will generate now and in the future. To be more specific, the value of operation depends on all the future expected free cash flows, defined as after- tax operating profit minus the amount of new investment in working capital and fixed assets necessary to sustain the business. Therefore the way for managers to make their companies more valuable is to increase their free cash flow.

Uses of FCF: 1. Pay interest to debt holders, keeping in mind that the net cost to the company is the after tax interest

expense. 2. Repay debt holders, that is, pay off some of debt. 3. Pay dividends to shareholders. 4. Repurchase stock from shareholders. 5. Buy marketable securities or other non operating assets.

In practice, most companies combine these five uses in such a way that the net total is equal to FCF. For example, a company might pay interest and dividends, issue new debts, also sell some of its marketable securities. Some of these activities are cash outflows (paying interest and dividends) and some are cash inflows (issuing debt and selling marketable securities), but the net cash flow from these five activities is equal to free cash flows.

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Computation of free cash flows: Eg: Suppose the company had a 2001 NOPAT of $170.3million and depreciation is only the non cash charge which is $100million then its operating cash flow in 2001 would be NOPAT plus any non cash adjustment on the statement of cash flows.

Operating cash flow =NOPAT +depreciation (non cash adjustment) = $17.03 + $100 = $270.3

Company has $1,455million operating assets, at the end of 2000, but $1,800 at the end of 2001.it made a net investment in operating assets of

Net investment in operating assets = $18, 00 - $1,455 = $345million

iii) Management control in matrix structures Matrix organizational structure assigns multiple responsibilities to the functional heads. Evaluation of performance of such organizational entities is very difficult. Though they offer economies of using scares functional staff, it poses problems of casting the individual responsibility. This form of organization is very complex, from the point of view of management control system.

At the end we must not forget that the management control system is for the organization and not the organization exists for management control system. One has to mold and remold the management control system to suit the given organization structure

A citation by Anthony is worth noting in this regard.

Usually in an advertisement agency, account supervisors are shifted from one account to another on periodic basis, this practice allows the agency to look at the account from the perspectives of different executives. However taking in to consideration the time lag of result realization in such services is quite large. And this may pose problem of performance assessment of a particular executive. This does not mean a control system designer should insist on abandoning the rotation system of the executives.

Matrix structure offers advantages such as faster decision making process, efficiency and effectiveness but simultaneously it may pose problems such as added complexity in control function, assignment of responsibility and authority etc. If net fixed assets rose from $870million to $1000million however company reported $100million of depreciation. So its gross investment in fixed assets would be

Gross investment = net investment + depreciation = $130 + $100 = $230million

Company free cash flows in 2001 was

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FCF = operating cash flow gross investment in operating assets = $270.3 - $445 = - $174.7million

An algebraically equivalent equation is

FCF = NOPAT - Net investment in operating assets = $170.3- $345 = - $174.7million

Even though company had a positive NOPAT, its very high investment in operating assets resulted in a negative free cash flow. Because free cash flow is what is available for distribution to investor, not only was there nothing for investors, but investor actually had to provide additional money to keep the business ongoing. A negative current FCF not necessarily bad provided it is due to the high growth or to support the growth. There is nothing wrong with profitable growth; even it causes negative free cash flow in the short term

Q.10 Pritam Engineering manufacturers (MCS-2005) Numerical Pritam Engineering manufacturing variety of metal product at many factories. Currently. It is experiencing crisis, Management has, therefore, decided to detailed expense control system including responsibility budgets for overhead expense items at each factory. From historical data, Controller developed a standard for each overhead expense item (relating expense to volume of activity). Summarized expenses for November,2005 given to concerned Production Supervisor for comments is tabulated. All figures are in Rs. 000.

Item Standard at nominal volume Budgeted at actual volume actual

Management Supervision

720 720 582

Indirect labour 12706 11322 12552 Idle time 420 361 711 Materials, Tools 3600 3096 3114 Maintenance, scrap 14840 13909 17329 Allocated expenses 21040 21040 21218 Total per ton (Rs.) 2133.04 2103.39 2413.3

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

Ans. (A) There is two general types of expense centers: engineered and discretionary. This label relate to two types of cost. Engineered costs are those for which the right or proper amount can be estimated with reasonable reliability for example, a factorys costs for direct labor, direct material, components, supplies, and utilities. Discretionary costs (also called managed costs) are those for which not such engineered estimate is feasible. In discretionary expense centers, the costs incurred depend on managements judgment as to the appropriate amount under the circumstances.

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Engineered expense centers Engineered expense centers are usually found a manufacturing operations. Warehousing, distribution, trucking, and similar units within the marketing organization may also be engineered expense centers, as may certain responsibility centers within administrative and support department for instance, accounts receivable, accounts payable, and payroll sections in the controller department; personnel records and the cafeteria in the human resources department; shareholder records in the corporate secretary department; and the company motor pool. Such units perform repetitive tasks for which standard costs can be developed. These engineered expense centers are usually located within departments that are discretionary expense centers.

In an engineered expense center, output multiplied by the standard cost of each unit produced measures what the finished product should have cost. The difference between the theoretical and the actual cost represents the efficiency of the expense center being measure. We emphasize that engineered expense centers have other important tasks not measured by cost alone; their supervisors are responsible for the quality of the products and volume of production as well as for efficiency. Therefore, the type and level of production are prescribed, and specific quality standards are set. So that manufacturing costs are not minimized at the expense of quality. Moreover, managers of engineered expense centers may be responsible for activities such as training and employee development that are not related to current production; their performance reviews should include an appraisal of how well they carry out these responsibilities. There are few, if any, responsibility centers in which all cost items are engineered. Even in highly automated production departments, the use of indirect labor and various services can vary with managements discretion. Thus the term engineered expense center refers to responsibility centers in which engineered costs predominate. But it does not imply that valid engineered estimates can be made for each and every cost item.

Discretionary expense centers Discretionary expense centers include administrative and support units (e.g. accounting, legal, industrial relations, public relations, human resources), research and development operations, and most marketing activities. The output of these centers cannot be measured in monetary terms. The term discretionary does into imply that managements judgment as to optimum cost is capricious or haphazard. Rather it reflects managements decisions regarding certain policies: whether to match or exceed the marketing efforts of competitors; the level of services the company should provide to its customers; and the appropriate amounts to spend for R&D, financial planning, public relations, and a host of other activities.

One company may have a small headquarters staff, while another company of similar size and in the same industry may have a staff 10 times as large. The senior managers of each company may each be convinced that their respective decisions on staff size are correct, but there is no objective way to judge which (if

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either) is right; both decisions may be equally good under the circumstances, with the differences in size reflecting other underlying deferences in the two companies. As far as above stated over heads are concern, we can easily estimate proper or right amount with responsible reliability. There for standard (1) is more meaningful for expenses control.

Ans. (B) A responsibility center is an organization unit that is headed by a manager who is responsible for its activities. In a sense, a company is a collection of responsibility centers, each of which is represented by a box on the organization chart. These responsibility centers form a hierarchy. At the lowest level are the centers of the sections, work shift, and other small organization units. Departments or business units comprising several of these smaller units are higher in the hierarchy. From the standpoint of senior management and and the board of directors, the entire company is a responsibility center, though the term is usually used to refer to units within the company and there for Supervisor is responsible for the uses of the Above stated Resources (over heads) like Indirect labor, idle time, Materials, tools, maintenance, scrape and Management supervision by proper supervising supervisor can control the listed overhead expenses.

Q.11 Anand & Company comprises of five divisions A, B, C, D and E and the present performance. metric is return on assets. However, the controller has suggested management to switch over to economic value added (EVA) as the criterion rather than return on assets. Compute and tabulate both return on assets and EVA on the basis of following information (Rs. lakhs) and comment on divisional performance.

Division Profit Fixed Assets Current Assets

--

A 300 800 160

- - ----

B 220 400 1600

C 100 600 1000

________

D 110 400 800

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-

E 180 200 800

Controller feels corporate finance rates on current assets and .fixed assets should be 5% and 10% respectively.

Solution:

Working Note:

Return on Assets = Profit * 100

Total Assets

A = 300/960*100 = 31.25%

B = 220/2000*100 = 11%

C = 100/1600*100 = 6.25%

D = 110/1200*100 = 9.17%

E = 180/1000*100 = 18%

Economic Value Added (EVA) = Profit (W.A.C.C.* Capital Employed)

In this case,

EVA = Profit (W.A.C.C. on Fixed Assets * Total Fixed Assets) + (W.A.C.C. on Current Assets * Total Current Assets)

A = 300 (0.10*800) + (0.05*160) = 212 lakhs

B = 220 (0.10*400) + (0.05*1600) = 100 lakhs

C = 100 (0.10*600) + (0.05*1000) = -10 lakhs

D = 110 (0.10*400) + (0.05*800) = 30 lakhs

E = 180 (0.10*200) + (0.05*800) = 120 lakhs

Summary

Division Return on Assets (R.O.A.) Economic Value Added (E.V.A.) (Rs. lakhs)

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A 31.25% 212

B 11.00% 100

C 6.25% -10

D 9.17% 30

E 18.00% 120

Comments:

1. It appears from the above analysis that division A has performed the best among the five divisions.

2. Also, it can be clearly noticed that divisions C and D seem to be in trouble.

3. Division A has performed the best when seen in terms of return on assets and economic value added.

4. The reason why division A has performed the best is that it has the best working capital management that can be reflected in the total amount invested in current assets and which is the least among the five divisions.

5. The above reason holds true for the poor performance of divisions C and D as can be seen that they have a huge amount invested in current assets which does not indicate good signs about their operational efficiency.

6. A company which is into an expansion and overall growth mode primarily invests into fixed assets and this is also one of the major reasons why the performance of division A is the best amongst all.

7. Though division C has also invested a huge amount in fixed assets the advantage is offset due to the fact that it perhaps has a larger investment in current assets.

8. Division E is the second best both in terms of R.O.A. as well as E.V.A.

9. Though division E has the same amount invested in current assets as that of division D and perhaps a lesser amount invested in fixed assets its profitability is much better and hence it has delivered a better performance.

10. Division B is a better performer than divisions C and D in terms of R.O.A. as well as E.V.A. but the major problem with this division is that it has a terrible working capital management. Its current assets are the highest and this reflects that it has huge sums of money held up either in debtors or inventory or rather it is holding a large amount of cash which is not a good sign.

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Q.12 Division B of Shayana company contracted to buy from Div. A, 20,000 units of a components which goes into the final product made by Div. B. The transfer price for this internal transaction was set at Rs. 120 per unit by mutual agreement. This comprises of (per unit) Direct and Variable labour cost of Rs. 20; Material Cost of Rs.60; Fixed overheads of Rs.20 (lumpsum Rs.4 lacs) and Rs.20 lacs that Div. A would require for this additional activity. During the year, actual off take of Div. B from Div. A was 19,600 units. Div. A was able to reduce material consumption by 5% but its budgeted investment overshot by 10%. a) As Financial controller of Div. A, compare Actual Vs Budgetred Performance b) Its implications for Management Control?

Solution: a)

Particulars Budgeted (Rs. Per Unit)

Budgeted (Total in Rs.)

Actual (Rs. Per Unit)

Actual (Total in Rs.)

Direct and Variable Labour Cost

20 4,00,000 20 3,92,000

Material Cost 60 12,00,000 57 11,17,200 Fixed Overheads 20 4,00,000 4,00,000 Total Cost 100 20,00,000 19,09,200 Transfer Price 120 24,00,000 119.86 23,49,200 Profit 20 4,00,000 4,40,000 Investment 20 20,00,000 22,00,000 ROI = Profit/Investment

20% 20%

Despite of increase in investment by 10%, there is negligible difference in transfer price. Also the sales have decreased by 400 units. Therefore we can say that additional investment has not achieved any positive results. (Cant find answer for subquestion (b))

For 20,000 Units For 19,600 Units