Management Control Systems 6/3/14 1:55 PMSession 1:

Formal systems/Information based systems to implement organization’s strategies.

Hold/Alter organization’s activities

Levers of Control (How does an organization control its resources such as Capital and People given a chosen strategy----It is not a strategy formulation exercise). Quintessential Example: Narendra Modi

Belief System : (Core values of the organization conveyed through mission statement, vision statement) that provides the employees the freedom to be creative. For example: IE provides students with the ability to choose different ways of implementing learning such as ICP, Internship for a greater good. (Top down)

Boundary System : Giving limits to the freedom. Be creative but within the limits, don’t jump guns. Decide how you deploy your resources but also how you do not deploy your resources. (Top Down)

Diagnostic Control System : Tells you anytime you digress from the strategy. Gives you a warning signal

Interactive Control System : Futuristic system that helps organizations deal with unforeseen circumstances. Generally you are dealing with ambiguous and uncertain circumstances, so it helps to analyse the current strategy and readjust it or rethink about a new strategy

Delegation of Decision RightsDifferentiate between delegation of tasks and delegation of decision rights. DoT is simple but DoDR is a bit tricky.

Delegation of Task: It is a Behaviour Control. Whip and Carrot approach. Go and knock at the doors (This is a task).

Delegation of DR: When you ask for an outcome and there is no clear defined way to reach the outcome. I want an increase in sales of 10% (This is an outcome and there is no defined way to accomplish it).

Problems: A manager can delegate the DR to the assistant manager but the AM can fail because of two reasons: Incompetency or Self-Interest. Incompetency can be obviated by terminating the employees. Self-Interest can be obviated by aligning the goals of the employee with that of company’s.

NUCOR Case:Steel Company in the US

Worst performing High labour cost/Steel unions Overcapacity/low exports for the US Steel High Competition for imported Steel Not an Integrated Steel manufacturer but a Mini-mills (Steels from

Scrap)-- So basically a Low-Cost strategy

Explanations:1.) Industry Level: Not an attractive industry2.) Country Level: Not a good country to start a steel business (already a developed country)3.) Intra-Industry Structure

MM > ISM NUCOR >>>>> Others

4.) Internal Mechanisms

Differentiated Strategy: No Value Chain partner: Not Really Internal Organization: There you go ;) MCS rules the roost.

Everything was aligned with the low-cost strategy.

Session 2:

Budget as a control mechanism

Profit Centres have two categories Cost Centres: Input Costs (Minimize Cost): Performance measure

= Budgeted Cost – Actual Cost

Revenue Centres: Outputs Revenues (Maximize Revenues): Performance measure: Actual Revenue – Budgeted Revenue

Natural Cost Centre:Factory => Budgeted Costs (Budgeted # units * Budgeted Cost) => Sales Budget => Difference must only be in the number of units. Any budget vs Actual variance should only be in the #units. Uncontrollable part is #units whereas Manager related variance is controllable.Here we are dealing with efficiency and financial performance measures.

Artificial Cost Centre: Legal

Accounting Marketing Information System

Here we are not dealing with efficiency but effectiveness i.e. Qualitative and non-financial performance measures. But sometimes red-tapism is prevalent in these cost centres and their existence is dubious and questionable.

Incremental Budget: Based on last year’s budget and multiply it by “some” number. They are not a good management control mechanism since it does not reflect efficiency but people tend to

Zero-based: Everything is clearly defined and is aimed at reducing costs. It is applicable to project based companies or in the times of crisis because it is very effective in controlling costs. The downside is that it is very time consuming.

Vershire Company Case:

Session 3:1.) Sourcing: Freedom to buy from inside/outside2.) Transfer Pricing: What prices are inside

Retail Price Market Price Cost Price (Variable Costs or Total Costs)

3.) Intervention

North Country Auto:

Session 4:Profit Centre

Increase Compensation Profit margin

Decision Rule is maximizing divisional profits

Sourcing, Sales and Prices, Intervention

“If it is a regular order then you don’t deal with variable costs rather deal with Total Costs. You deal with the variable costs only when it is a special cost.”

How much and How to?

- Many times company wide profits KPIs cannot work because of lack of information about the profitability of other divisions.- Hence, the management can force divisions to share information but that also has downsides since you are destroying their bargaining power. Hence this option is also out.

As you decentralize more and more, the control also looses muscle.

Right now it represents only 5% of the overall revenue but if it was 90% of the revenue then it does not remain the division wide problem, and you have to integrate the two divisions because then cost matters and not the profits.

Don’t jump in the melee, take a step back and let divisional managers handle the issues especially when it is not a significant part of the company’s revenues.

Session 5:Profit EquationSales- VC=C.M.- FC= Direct Divisional Profit- Overheads= Divisional Profit after Overheads- Tax= PAT (Profit after Tax)

Assets: Working Capital (Managers manage this everyday in that they are always concerned about the Inventory, Accounts Receivables)

If you tie bonuses of the managers to ROA then you have to take the payments in your hands so that the “smart” managers do not monkey around with it. Because they might control the working capital by negotiating payment terms with the suppliers (basically lengthen the payment schedule so that accounts payable remains the same and Current Liabilities increase thereby decreasing the Working capital and increasing the Profits and hence ROA increase.Or He might not pay at all or try to decrease the assets in some way or the other to increase ROA

Gross Value Vs Book Value of the assets: If Gross Value then managers will replace old assets to enhance efficiency and hence discard the assets before its life. If Book Value, they will not replace the machine because the asset will depreciate and will increase ROA (not because they have improved on profits but because the assets have been decreasing consistently)

Bonuses contingent upon Residual Income will facilitate more goal congruence and not the ROA.

R.I. (Residual Income) = Actual Profit – Minimum ProfitTie the bonuses on Residual Income

ROA: Milwankee (25%), Columbus (38%), Atlanta (8%), Tucson (15%), Reno (42%)

Smartest manager: RenoDumbest Manager: Atlanta

Now if new opportunities arrive the dumbest one will send every opportunity that generates ROA more than 8% and if he gets 45% one and the Smartest one gets 35%, 36% and 39%, he will not send it to the Corporate head. So you are basically leaving the capital budgeting decision in the hands of the dumbest one.

Also when you compare ROA, you need to check whether it is a measurement issue or an industry issue because consulting projects are supposed to have higher ROA because they don’t use any asset because human capital is not counted as assets but a different project might be profitable but a capital intensive one, then ROA Is bound to be low. So comparison across industries is tricky, so be careful.

Session 6:Strategic Planning & Budgeting-Strategic Planning is less used for control and is Long term to medium term

Non Financial measures

-Budgeting is annual or shorter and is used as a control mechanism. Financial measures

Expectations

Allied OfficeAllied office is an office products company. We are only concerned about Total Forms Control (TFC)

Sell forms to the consumers so basically it is a printing press. Price = Cost + Margin (it is a commodity so it makes sense)

Cost Structure = Materials + Labour (Major contribution in the cost structure is the Master. So the general tendency is to keep making as many copies as you want because master cannot be reused. So you have high fixed costs and the only way to reduce it to manufacture large volumes)

Now they want to change. They came up with another strategyAny form, Any # of forms, Anytime, AnywhereResults: Sales increase but the profits went down

Product Hierarchy can be:From Commodity Commodity + Service Service Trans Services 1:1 Experience

ABC: In ABC we deal with variable overheads and not fixed overheads. But the upside is that we can find out the non-value added activity and can remove it.

Activities involved: Storage Picking & Packaging Purchase Order Entry Desktop Delivery Reporting

Low Cost High CostHigh Price Dream Customers Premium CustomersLow Price Price Sensitive Nightmare

I can’t price storage since it is not a customer driven problem but is a production driven problem.

Pick and Pack and Order taking also cannot be priced

The only thing that can be priced is the desktop delivery because this is the only added value.

If you change from one model to another, you have to think it through. In this case if you decide to do away with Customer B, sales people will vie for customer A but will get low revenues because the services portion of the cost is removed. This will decrease the commissions of sales people thereby decreasing in the number of good sales people.

Sometimes we should look to open up the value chain and should understand the repercussion of our decisions.

Budgets are contracts that can be used for Outcomes (short term performance, Control Mechanism, Financial

measures) Established Industries Behaviours (Long term performance, Not a Control mechanism,

Planning tool, non-financial measures) For new products

Budget – Actual = Variance (this is your performance measure)Expectations – Actual Performance = Performance Measure

Therefore Variance analysis is a very disciplined and effective approach in performance measures.

Session 7:Individual/Separable effect if each action (factor) on cost profit ceteris paribusVariance AnalysisSales Variance = Budgeted Sales - Actual Sales

Price Variance = (Budgeted Price – Actual Price)*Actual VolumeVolume = (Budgeted Volume – Actual Volume)*Budgeted Price

For Example:BP = $2/unitBV = 1000 unitsBudgeted Sales = 2000AP = $1.5/unitAV = 1500 unitsActual Sales = 2250

Production Volume may not be equal to Sales Volume since there is an inventory as well.

Fixed Costs are uncontrollable (Risk Before), whereas Variable costs are controllable (Control Damage)

Margin = Selling Price – Variable CostBEP = FC/(C.M. in percentage)

High FC and Low Variable Costs will increase the BEP and the margin but the multiplier effect will also be high

Low FC and High VC, the BEP and the margin will be less but the multiplier will also be less

You can make a profit at BEP in production because the implicit assumption is the production volume equals sales volume but they may not be the same.

Product Market StrategyMargin/Turnover = (Profit/Sales) * (Sales/Assets)

Profit, Cash Cycle, ROE: Three most important ways to create shareholder value ROE is a Financing Strategy

Think about the need before implementing any system

Marketing Strategy 6/3/14 1:55 PMUnilever Case

Problem: The company wants to make inroads into low-income households market

that poses few germane questions Should the company fight in the lower-end of the market where even

small players with a lower cost structure struggled to make profits? Should the company launch a new brand or position its already existing

cheaper brands? Ideal marketing mix for lower end consumers? Marketing Strategy?

4C’s

Company Consumers Collaborators Competitors

Context (PEST)

Consumer goods

Well known company with 45 brands of detergents

81% market share of detergent powder with 75% market share in NE detergent market

Low-income Consumers

48 million (53% of whom are below 1-2 times average national income)

Dependent on agriculture

28% Own washing m/c in NE (67% in SE)

73% think bleach is necessary in NE (18% in SE)

Use bars of laundry soap and use the detergent only for good fragrance

5 times a

Generalist Wholesalers but are sometimes dependent on small wholesalers

Specialized Distributors with exclusive rights to sell Unilever’s detergent in certain regions

Since it is a big component of the product cost and the decision cannot be reversed, the choice of distributors is vital

P&G (15% market share) and 17.5 in NE detergent market

Ace (11% market share)

Cheaper Local Brands

Tax Incentives for companies investing in NE

Water is soft which facilitates more foam formation which basically removes one key advantage of the detergent powder

week in NE vs 3.9 time a week in SE

Women consider it pleasurable

4P’s

Product Price Place Promotion

Detergent powder

OMO (Favourite brand)

Minerva (only brand sold as both detergent powder and laundry soap) and

Campeiro (company’s cheapest brands)

Low Margin

Solutions: Large packet

or sachets Right

attributes to control price

Low price (52%) OMO at

$3 /kg (17%) Minerva

at $2.4 /kg (6%) Campeiro

at 1.7 /kg

Northeast of Brazil

Rural

Can’t use “products for low-income” people which will alienate them from the brand and will leave them with a perception that the product is of inferior quality

Cannot make it aspirational which will jeopardise the existing consumers

Explaining to the small stores where the most of the target customers go and rely on their advice

70% ATL (lower cost per contact and increased visibility) and 30% BTL

or 70% BTL (overall reduced cost but higher cost per contact and lower visibility) and 30% ATL

6 Product attributes looked before effecting purchase:1. (24%) Perceived power more cleanliness per quantity of product,

whitening and productivity2. (20%) Smell, and softness3. (16%) Ability to remove stains w/o need of for laundry soap and

bleach4. (16%) Consistency and granularity of the powder (Ease of

dissolving)5. (13%) Packaging: simple, easily recognizable6. (11%) Impact on colours (Fading) ---Least preferred metric

Market (Northeast)1. Detergent Powder:

$ 106 million 42000 tons Growing at a rate of 17% Barriers to entry are high because its capital intensive Average revenue $2520 per ton

2. Laundry Soap 102 million 81250 tons Growing at 6% Barriers to entry are lower since it is easy to produce Average revenue $1250 per ton Used to remove tough stains No fragrance Top 4 have 38% market share with Minerva at 19% selling @

$1.7/kg P&G is absent in this segment leaving only local brands as big

competitors out of which the biggest one being ASA with its brand Bem-te-vi enjoying 11% market share and sold @ $1.2 /kg and Flora Fabril with 6%

Concerns of entering low-income segmento Cannibalisation of high-margin brands with low-margin oneso Starting of price waro Brand dilution since it’s been operating in premium segmento Will result in repelling top students and brand managerso Whether they have right skills and organization to compete in this

marketo Cost-benefit trade off??o Brand repositioning or brand extension?

GO: Big Market 50 million If we don’t go, P&G will occupy Leverage experience in India Focus on customers who may be growing

Supply Chain Management 6/3/14 1:55 PMCost (under-stocking) = Opportunity Cost = 1 – 0.2Cost (over-stocking) = 0.20 – 0.0 (salvage value)

C.R. = (1 – 0.2)/{1 – 0.2 + 0.2-0} = 0.8

P(Demand < Supply) = Cost (under-stocking)/(cost(under stocking) + cost (over-taking))

If we introduce retailerPrice retailer = 1.00Cost retailer = 0.80

Price (you) = 0.80Cost (you) = 0.20

Critical Ratio (you) = Cost under stocking/{Cost under-stocking + Cost overstocking} = (0.80 – 0.20)/(0.80 – 0.20 + 0.20 – 0) = 0.75

Critical Ratio (retailer) = (1 – 0.8)/{1 - 0.8 + 0.8} = 0.2

Managing People at Work 6/3/14 1:55 PMSession 10

Hewlett Packard abandons pay-for-performance plansBecause costs of these programs are higher than the benefits. Instead effective leadership, clear objectives, coaching or training were better investments. Why? Let us explore now

Higher performance means search for managerial practices that will enhance competitiveness === MONEY!!! :P

Problems with traditional compensation systems: Pay becomes entitlement Benefits are given for tenure Base pay is function of levels and not performance Merit increases do not differentiate performance sufficiently Even bonuses becomes entitlement

Pay for Performance: Efficiency improves in 2 out of 3 programs ROI is 134% Those using showed twice the return than those not using it

Problems: Destructive effect on

o Intrinsic motivationo Self-esteemo Teamworko Creativity

Motivate employees to focus on doing to gain rewards. Sometimes at the expense of doing other things that would help the organization

Two barriers to implementing this system Linking performance to effort

o Difficulty in measuring performanceo Uncontrollable factors being paid for that performanceo Managers and peers are uncomfortable with ratings

employees differently

Linking pay to performanceo Employees can come to rely on the additional compensationo Employees are biased toward overestimating their own

contributiono Corporate budgets for bonuses limits payouto Managers can lose commitment to the pay system if it pays

out more than anticipated due to problems in payout standards and if there are changes in performance standards due to changes in technology and organizational arrangements and unanticipated learning curves.

CULTURE shapes the policies implemented to pay-to-performance Discourages opportunism Top managers lead by example by reinforcing this culture Long-term careers in which reputation is a valuable commodity

Corporate Finance 6/3/14 1:55 PMSession 5:Asset beta/Unlevered contains only business/operational riskEquity/Levered beta contains business + financial risk

Ba = Be/[1 + (D/E)*(1-t)]

So unlevered first and then use different debt equity ratios to calculate Equity beta and cost of equity capital

Value = FCF*(1+g)/[WACC – g]

Actual Tax Shield = 5559*0.36 = 5977*t*

If we do not change the tax rate then we are overestimating the tax shield.

Session 6:Dividend Cash Assets goes down That means Equity also goes down Leverage goes up

If you have been doling out dividends but stop paying in the next fiscal year, then it gives a negative sign in the market that the firm must have stopped to grow.Every cash flow is discounted depending upon its type such as interest payments are discounted at rd and the dividend will be discounted as re , the cash flows will be discounted at WACC.

After paying the dividend, the stock price will go down by the same amount since that dollar amount has been taken out of the expected cash flow and will change the calculations of the potential investor. Present Value concept

If declaration provides new information then it will attract market reaction such as if the company announces dividend unexpectedly then the reaction will result in increase in the share price, but if it is a regular process then the stock price will not change but will fall on the ex-dividend date.

Return on stock = (Share Price1 – Share Price0)/P0 + D1/P0 = (P1 – P0 + D1)/P0

(Share Price1 – Share Price0) is known as Capital Gains

Re = Risk free rate + Beta*(market risk premium)

For Diageo:Re = 5.83 + 0.55*5% (CAPM) = 8.58%

Dividend yield for Diageo = 5%

=> Dividend as a percentage of total return for Diageo’s shareholder = 5/8.58% = 58%

So Diageo’s shareholders are receiving their 58% of the return in form of dividends.

Dividend Policy is very important for Diageo, when dividend is such a big chunk of the returns. Which is why Diageo did not want to cut the dividends and would rather cut the CapEx and Marketing Expenditures.

Stock Price is the present value of the expected dividends from now to infinity and if you take out a portion of the dividend the P.V. goes DOWN!!!!

Signalling implications of the dividend policy matters and not the mathematics of it. Check the slide of Dividend Irrelevance

Free Cash flow is the cash available to pay to shareholders and bondholdersSo FCFE is calculated after deducting interest payments (considering debt cushion) and any change in debt.