MANAGEMENT

CONTROL SYSTEM
An Integrated Framework
to drive an organization on a Growth
track.

Recommended Text Book :

“Management Control Systems” … Robert
Anthony & Vijay Govindrajan (Tata-McGraw-
Hill/11th /12th Edition.)

1
Learning Objective :

What is the scope of Management

planning control system ?

How does a corporate enterprise

function ? What needs to be controlled ?

Who should be responsible for

management planning & control ?

2
What is the scope of Management planning & control
system in an organization ?

1.Build necessary internal control measures at

financial & non financial matters to create Value for
share holders.
Create a management culture to deliver the best
performance rater than mediocre output.
when a business environment is at its worst , every
strategy, action & expenditure is questioned & need
to be justified to the share holders.
A universal truth is that no business is steady, hence
management planning & control help to sustain its
commitments to shareholders during peak & trough
situation of business.

3
 How are they different in functioning ?

Family owned Government /PSU Privately held

business Having multiple
shareholders

4
Management of an organization is responsible for
creating wealth for it’s shareholders. All management
action & strategies to meet financial goal are guided
by SVC .
Corporate managers of contemporary business are
expected to focus on SVC.
Companies adopt different methods to measure
shareholder's value .
Shareholder Value Creation can be explained as
excess of market value over book value.

Market Value Added =

Market value of the firm – Market value of debt.

Market value of a firm is the value of its assets reflected in capital

market
5
When MV is in excess of invested capital , MVA is
said to be positive . Hence firm is said to have
created value for its shareholder.
The inherent drawback of MVA is that it ignores cash
flow received by share holders in the form of
dividend & shares buyback.
Alternative measure is market to book value ( M/B )
Market value per share = Market value of equity
Number of shares
outstanding

Book value per share = Invested equity capital

Number of shares outstanding

M/B > 1 Firm is creating value for share holders

M/B = 1 Value maintenance
M/B < 1 Value destroyed.
6
Management Control Focuses primarily on Strategy Implementation.
Three distinct systems/activities that require planning and
control can be defined:

Strategy Goals, Strategies, Policies

Formulation

Management
Implementation of Strategies
Control

Task
Control Performance of specific Tasks

• Management control does not necessarily require that all actions are per
the previously determined Plan; It, however, requires inducing people to
act in pursuit of own goals in ways that organization’s goal are also met:
Goal Congruence.
7
Starting Point: strategy formulation

Internal Analysis Environmental Analysis

Technology/Marketing/ Competitor/Customer/
Manuf./Supply Chain Supplier/Laws/Political

S.W O.T.

K.S.F.

And its financial impact:

“Strategy”
“Number crunching”

8
Strategic Financial Responsibility Performance
Plan budget centers Standard

Process of
Measurement
Plan Vs
Reward
Actual
Superior
performance Corrective
Action
Take corrective
action on
Inferior performance
9
An organization’s long term and short
term vision & goal are translated
quantitatively in terms of it’s financial
objective .
The management of closely held or
publicly held organization is directly
responsible & accountable for creating
shareholder’s value. Management
formulates strategy & action plan to
meet the financial goals given the
internal & external constraint to meet
the expectation of the shareholder.
10
 MANAGEMENT
CONTROL SYSTEM
It’s not enough for any business
to focus on building assets, but
must control it in short term &
long term perspective to achieve
sustained growth & visibility in
line with shareholder’s
expectation. .
What is being controlled?
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 CONTROL OF ASSETS

TANGIBLE INTANGIBLE
ASSETS ASSETS

FINANCIAL KNOWLEDGE EMPLOYEE

ASSETS ASSETS ASSETS

CUSTOMER & BRAND

SUPPLIER ASSETS
ASSETS

12
• Management control is the process by which
managers at all levels ensure their team align
themselves to the goal of the BU, division or
organization referred as “Goal congruence or
Goal alignment”

• Challenges of building good control system are:

•
• Unlike the simpler systems, the standard is not
pre-set , keep changing in dynamic market
• Control requires coordination amongst
individuals.
• The link between ‘need for action’ and
determining the action is not always clear;
• Much of control is self control.
13
 Asset control
Framework to support ( resource )
& higher
Management Control System shareholder
value.
(Management)

Performance
Controls
Strategy

Organization H. R.
Structure Management

Culture

• Org. Structure specifies creating roles, reporting relationships, responsibilities that

shape decision making;
• Culture refers to the set of common beliefs, attitudes that guide management actions;
• HR Management drives performance related career progression , compensation
14
 Conceptual model of Management
Control Systems.
Elements of Control
Assessor:
Control Device

Detector: Effector: Behaviour

Alteration, if needed.

Desired performance
Controlled Entity
by the management

15
McKinsey 7-S Framework to support control system
Of an organization.

STRUCTURE

STRATEGY SYSTEMS

SHARED
VALUES

SKILLS STYLE

STAFF

16
What Is Internal Control ?

“A process effected by an entity’s board of

directors, management and other personnel,
designed to provide reasonable assurance
regarding the achievements of objectives in the
following categories:
♦ Effectiveness & efficiency of operations.
♦ Reliability of financial reporting.
♦ Compliance with applicable laws and
regulations.”

17
What Internal Control Can Do
♦ It can help achieve performance &
profitability targets.( Financial Guideline )
♦ It can help prevent loss of resources.
♦ It can help ensure reliable financial
reporting.
♦ It can help ensure compliance with laws.
It can help an entity get to where it wants to
go,and avoid pitfalls and surprises along the
way.

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♦ Internal control is a process. It is a means to an
end, not an end in itself.
♦ Internal control is effected by people. It’s not
merely policy manuals and forms, but people at
every level of an organization.
♦ Internal control can be expected to provide only
reasonable assurance, not absolute assurance,
to an entity’s management and board.
♦ Internal control is geared to the achievement of
objectives in one or more separate but
overlapping categories.

19
Components Of Internal Control
♦ Control Environment.
♦ Risk Assessment.
♦ Control Activities.
♦ Information & Communication.
♦ Monitoring.

20
21
Control Environment
♦ Sets the tone of the organization.
♦ The foundation for all other components.
♦ It includes the integrity,ethical values and
competence of the people.
♦ Reflects management’s philosophy & operating
style,the way management assigns authority and
responsibility and organizes and develops its
people, and the attention and direction provided
by the board of directors.

22
Risk Assessment
♦ Every entity faces internal &external risks.
♦ Every entity sets objectives.
♦ Risk assessment is the identification and
analysis of relevant risks to achievements of
the objectives.

23
Control Activities
♦ The policies and procedures that help
ensure management directives are carried
out.
♦ They help ensure that necessary actions
are taken to address risks.
♦ Control activities occur throughout the
entity at all levels and in all functions.
♦ They include activities such as approvals ,
authorization,reconciliations and
segregation of duties.

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Information & Communication
♦ Relevant information must be identified ,
captured and communicated in a form &
timeframe that enables people to carry out
their responsibilities.
♦ Information systems produce reports
containing operational,financial and
compliance –related information that make
it possible to run and control the
business.
♦ Effective communication must occur in a
broader sense,flowing down,across and
up the organization.

25
Monitoring
♦ Internal control systems need to be monitored.
♦ Types of monitoring:
- ongoing during the course of operations.
- evaluation for which the scope and frequency
will depend primarily on an assessment of risks
and the effectiveness of ongoing monitoring
procedures.

26
What Internal Control Cannot Do
Internal controls ,no matter how well
designed and operated,can provide
only reasonable assurance to
management regarding
achievements of an entity’s
objectives.

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 Formal Management Process.

Management
“Rules” Periodic decision
Goals & Other
Strategies Info.
•Task Control Review
•Safeguards “Reward”
Y
Strategic Resp Center Reports: Analysis/
BudgetingPerformance OK?
Planning “A vs P” Actions

Revision Measurement N
28
♦ Management planning & Control requires
to be done in 3 areas.
♦ The Environment – focusing on the
characteristics of organizations and
individual behaviour; organizing for
control and generic responsibility and
control devices in the behavioural context;
– The Process – how control is effected within
organizations; interactions, formal and
informal, to effect control and systems:
• Strategic planning for goal setting;
• Budget preparation;
• Execution & budgetary control;
• Evaluation and start of next cycle of control;
– The Developments – variations to the theme of
Control.

29
Responsibility centres for
Management Control

30
 Responsibility centres
“Decentralization”, the corner-stone of contemporary
Management Systems which leads to Responsibility
Centres.
“A Responsibility Centre is an organizational unit that is
headed by a centre head or business head responsible
for planning & controlling of its assets to meet
organizational goal in terms of revenue & profit
maximization , cost effectiveness , process efficiency &
people effectiveness.
Revenue ,profit, cost management
& control
People accountability Process
& responsibility Responsibility Alignment & control
Centre

BUSINESS GOAL ATAINMNET 31

Objective of responsibility center incude planning &
control of :
Cost /Profit /Revenue : Monetary measure of the
amount of resources used by a responsibility centre.

Efficiency: which is the ratio of outputs to inputs, or the

amount of output per unit of input; i.e. ‘least sacrifice of
resources for obtaining the required output’.

Effectiveness: is determined by the relationship

between the responsibility centre’s output and
attainment of its objectives; i.e. how well is the centre
achieving its objectives.

32
 Types Responsibility Centres:

1. Revenue Centres: Outputs in monetary terms,

inputs non-monetary ( MANAGER ACCOUTABLE FOR
REVENUE OBJECTIVE )
2. Expense Centres: Outputs non-monetary,
inputs monetary (as costs)

3. Profit Centres: Inputs & Outputs monetary (as

expenses & revenues)

4. Investment Centre: Profit centres + Investment

made in them.

33
Revenue Centre ( Sales Department ) view
Traditional
Inputs not related to
Outputs

Revenue
Centre
Input (money Output (money
only for direct revenue)
Costs incurred)

Contemporary view : Profit center : Since it’s performance is

measured on revenue generated, profit earned , cost control.
Management control on :
Cost of sale :- sales return ,
in effective recovery management
Low customer retention
34
 Expense Centres ( Manufacturing
function) Optimal Relationship
can be established

Engineered Expense
Centre
Input (money) Output (physical)

Planned expense on RM Inventory:

Capital expenditure planned on long term assets.
Management control through :
Monitoring planned production targets
Rejection cost
Down time cost
Low productivity ( Benchmark standard versus actual )
High production cost : Excess overtime. 35
Expense Centres

e.g. R & D Function & other service function

Optimal Relationship
cannot be
established
Discretionary Expense
Centre
Input (money) Output (physical)

Monitoring & Evaluation of asset is relatively difficult :

Long gestation period .
No direct correlation
Cost allocation under common overhead .

36
 Expense Centres: Control Characteristics
Budget Preparation:

 For Engineered expense Centre, a proposed operating budget focuses on

efficiently performing the task;

 For discretionary expense Centre, budget itself is the start of the financial control
process. There are two approaches:

o Incremental Budgeting &

o Zero-based Reviews.
• Input Costs tend to be structural (semi-variable) in nature, so short-term
control is difficult;.

37
 Profit Centre
A department /division in an organization responsible for
generating specified quantum of profit form the activities it
performs.
The performance of the department is judged in terms of the
profit it booked and cost it incurred.
The divisional manager’s performance are measured on the
profit objective they achieve. ( Profit target )
In an organization all products / category are treated as
independent profit centre.

38
 Profit & Investment Centre
( Independent BU)
Inputs are related to
Outputs

Profit
Centre
Input (money Output (money
as costs) in profits)

Inputs are related to

Capital Employed

Investment
Centre
Input (money Output (money
as costs) in profits)
Strategic Business Unit 39
 Profit Centres: General
Considerations
• General Characteristics of Companies are:
• At operating levels, all organizations are ‘functionally’
structured.
• Divisional managers are delegated the responsibilities
of cost –benefit decisions and trade-off.
• Delegating responsibility to “profit centre” requires
trade-offs between expenses & revenues, therefore pre-
requisites are:
• relevant information for effecting the trade-offs
• a device for measurement of effectiveness of
decisions. 40
• Benefits of a Profit centre are:
• increased speed & quality of decision making;
• greater delegation, better focus all around;
• increased profit orientation: consciousness &
measurement;
• increased HR pool: specializations and training;
• specific information on performance of diverse
parts;
• better service to target Customers & markets.

Currently, >70% of multi-product Companies have adopted the

“Profit Centre” format within the “BU” structure, with a focus on
financial control as the primary method for strategy
implementation;

41
• However, there are difficulties with Profit Centres:
• some loss of top-management control at operational end;
• Competencies of Staff – staffing dilemma;
• loss of cohesion within Organization: “Sibling Rivalry”;
• increased short-term profit focus – unbalanced, tactical;
• poor and uncertain linkages between sub & overall
optimization;
• additional costs due to redundancies.
• BU’s autonomy limitations stem from synergy & control trade-off:
• Product/Market independence/interdependence;
• Financing/company-structure issues
• Share-holding, ‘legal entity’, global fit etc.
• PR, Brand-building, restructuring etc.
• Economies of consolidation;
• Constraints on long-term issues: R&D, Investments, Systems
•Sibling rivalry , silo’s operation , redundancy at multiple level
42
 Measurement of Profitability of profit center

P/L statement: Control-level Possibilities

Revenue 1000
less Cost of Sales
( Variable Cost
Contribution Margin
Exp. 90
“Direct” Profit
less “Controllable” Corp Charge 10
“Controllable” Profit 120
less Corp. allocation 20
Profit before Taxes 100
less Taxes
Profit After Taxes
780 Most elementary form of “Profit”
– with no control responsibility
220 less Fixed
for “Fixed Costs”.
130
More integral form of “Profit” –
with control responsibility for
“Fixed Costs” in profit centre
35 More integral form of “Profit” –
65 add discretionary responsibility
for shared services.
More integral form of “Profit” –
add limited responsibility for
shaping Corporate structure
Integrated form of “Profit” –
highest level of responsibility. 43
 Profit Centres:

 The Marketing Function:

– Considered as a Profit Centre if charged with the cost
of products sold – as input;
– Authorized as such when cost/revenue trade-offs are
best assessed at the ‘front-end’ viz., International
Operations:
 conditions and circumstances diverse for different centres
 “act local” - strategies difficult to assess centrally;

– Convenient when sourcing from different centres for

diverse products e.g. Transnational operations;

44
 Profit Centres:
 The Manufacturing Function:
– Usually, an expense centre: but for a more ‘balanced’
approach (Quality, on-time delivery etc.) and for aggressive
standard setting, converted to Profit Centre by affixing a
price to transfer (internal sale) goods;
– Though imperfect, the ‘transfer price’ mechanism is
pragmatic tool;
– Convenient when it has more than one “customer”;
 Service & Support units:
– Current trends are to make ‘service providers’ profit
centres to support ‘make/buy’ decisions;
– Allows for competitive functional excellence build-up
through aggressive standard setting;
– Allows for revenues (Outside Customers) if “world-class”
levels of performance achieved.

45
 Human Behaviour
&
Management Control

46
 Organizational Behaviour & Management
Control
Human Behavior must create a
favorable organizational climate for
Management control to influence
employees towards achieving a
firm’s Strategic Objectivee, i.e.
 Goal Congruence: Employees are led to
take in their perceived self-interest are
also in the interest of the firm:

Organization’sActions to motivate people to take in their own self

Vision/Objective interest?
Define KRA Define KRA
Actions in the best interest of the Organization?
SBU Employee
Objective Objective
Define & Define &
Measure through KPI Measure through KPI 47
 Formal and Informal processes influence
human behavior in organizations.

Informal processes need to be recognized

since they are ill-defined and are both
intrinsic and extrinsic to an Organization.

Extrinsic
“Work Ethic”: norms of desirable behavior
that exist in the society of which the
Organization is a part of.

48
 Intrinsic:
– Culture: the set of common
beliefs/attitudes/norms/links & relationships,
implicitly or explicitly accepted.
– (Management) Style: The most dominant influencer,
particularly the attitude of the (manager’s) superior
to the Control system.
– “Informal” Organization: power distance & centres
– realities!
– Communication & Perceptions:
– Cooperation & Conflict:

49
 Organization Culture

 Managers, especially top managers, create the

climate for the enterprise; their ‘values’ influence
the direction of the firm:

 Values are fairly permanent beliefs about

appropriateness and guides behaviours & actions
towards goal attainment;

 Changing a culture, thus, can be time consuming (5~10

years) since understanding the deep biases take time.

50
Increase Sociability by:
 Promoting sharing of ideas,
interests & emotions by
recruiting like-minded people;
 Increase social interactions by
organizing casual gatherings;
 Reducing formality between
employees;
 Limiting hierarchical
differences;
 Leader acting like a facilitator,
setting example of kindness
and caring for those in trouble.
Increase Solidarity
by:
 Developing awareness of
competitors through
briefings, mails, memos etc.
 Creating a sense of urgency
– a quasi-crisis;
 Stimulating a “will to win”
spirit;
 Encouraging commitment to
shared corporate goals. 51
Management style – the power of expectation

– What managers expect of their subordinates and the way they

treat them largely determine their performance and career
progress;
– A unique characteristic of superior managers is the ability to
create high performance expectations that subordinates fulfill;
– Subordinates, more often than not, appear to do what they
believe they are expected to do!

“You see, really and truly, apart from anything one can pick-up, the
difference between a lady and a flower girl is not how she behaves
but how she is treated. I shall always be a flower girl to Prof. Higgins
because he always treats me as a flower girl and always will. But I
know I can be a lady to you because you always treat me as a lady
and always will.” Eliza Doolittle from G.B.Shaw’s Pygmalion.
( reference: J.Sterling Livingston “Pygmalion in management”)

52
Formal System: Influence of
Organization Types
Strategy radically influences Organization Structure.
This, in turn, significantly affects design of the Control
System and its roll-out.
Commonly encountered Organization structures are:

Strategic Business Units: Developed

to negate the ills and
focuses on“lines of Business” with some limitations to
autonomy, leading to “closeness to Market”.
Generally, speed and effectiveness outweigh the cons
of some redundancies and lower functional excellence.

53
 Matrix: Currently popular for larger organizations to
capture the advantages of both systems i.e. Functional
excellence (traditional) and Effectiveness (BU’s). Thus,
organizations can:
 Avail of relevant (skill & experience) functional staff
 Drive for higher levels of functional excellence
(Value Chain)
 Meet rapid shifts in relative needs of specialization,
Without sacrificing the nimbleness of BU
operations. However, suffers from:
 loss of clarity (unity of command) and
 complexity (multiple controls).

54
If ‘ease of control’ (profitability, unity of command
etc.) were to be the only criterion, Companies
would be organized into BU’s whenever feasible.
This is often an over-weighted factor, without
considering:
benefits of ‘economies of scale’ from the
functional structure;
availability of ‘mature’ managers with general
management disposition;
Thus in designing systems, the appropriate
structure (driven by the environment) takes
precedence over nature of control systems.

55
 Transfer pricing , issues of
TP & management control system.

56
 Transfer Pricing

A business practice for satisfactorily (with

profit) accounting of the transfer of goods &
services between profit centers in a Company. It
focuses on :
– relevant trade-off between in-company costs and
revenues for economic performance of individual
profit centres;
– towards better goal congruence i.e. designed
system must support ‘better SBU profit &
accountability
– in a simple to understand and easy to administer
way.

57
 Benefit of T.P to the organization:

Identify the unit contribution to the total profit.

Encourage profit consciousness among managers
Measure management performance.
Maximize operating unit profitability
Identify the areas of inefficiency
Build value addition
Facilitate & maximize de centralized decision
making process
Exercise effective management control.

58
 Transfer Pricing Policy

Transfer pricing practices adopted by the companies

could be a possible tool for corporate abuse.
A transfer pricing cases, causing transfer of
economic resources to the related party at less than
the comparable price necessitates for host of
reasons like : evasion/avoidance of tax liability to
siphon-off the resources.
Transfer of resources to and from the related party
should comply to arm’s length and at arm’s length
price.

Any exception to this should be a subject matter of

close scrutiny, proper disclosure and effective
accountability.

59
Transfer pricing transactions, at present, are to be
addressed through Accounting Standards, (AS) – 18.

The AS-18 came in the effect for the accounting

periods commencing on or after 1st April, 2001.

The Standard provides for disclosure of related party

relationships, and certain particulars of transactions
with the related parties, in case of listed companies,
and companies whose turnover exceeds Rs. 50
crores.

60
 The application of Transfer Pricing .
Under the Relevant rules, cost statement of each service
(segment-wise and elements of cost) is Required to be
given.
The cost statement is also required to be submitted to the
Audit Committee under Section 292A of the Companies
Act, 1956.
Separate audit of record of transactions (related party) and
expression of opinion thereon. The record of transactions in the
prescribed format to form part of the audit report.

1. Verification of the report on implementation on transfer

pricing, by the separate auditor.
2. Disclosure in Directors’ Report/Annual Report:
3. Record of Transactions as per Schedule A.
4.Transfer Policy Statement (a comprehensive and detailed
one).
61
 5.The aforesaid disclosure are to be given in the
Director’s Report along with those required under
Accounting Standard –18 (disclosures as per AS –18
form part of accounts and, therefore, would require to
be re-disclosed in the Directors’ Report.)

6.Director’s certificate of compliance on Transfer

Pricing

62
 Prominent issues of T.P are

Divisional mangers tend to become more divisional

profit centric than corporate profit centric.
Lengthy disagreements on the T.P policy .

Whenever the market prices are not available to

bench mark , the decision process of convincing
the T.P is difficult .

De motivation arises when personal performance of

a division gets affected due to improper T.P

63
 Transfer pricing- International business

Multinational enterprises (MNEs) carry on

business in more than one country either
directly, through branches, or indirectly through
subsidiaries. Whatever the form, the activities of
an MNE’s SBUs perform financial transactions
between these units.

The price at which goods, services or capital are

exchanged between the related parties, the
transfer price is determined by the transfer-
pricing policies used within the related group.

64
The transfer price received or charged for
goods, services or financing will be included in
the income of supplier, and the corresponding
cost or payments will be deducted from the
profits of the legal entity benefiting from the
transaction and making the payments.

Often the amount of these charges represents

one of the largest inclusions or deductions in
computing the income of one or both of the
related parties.

65
Governments, through their tax systems, have
a vested interest in ensuring that appropriate
profits are reported in their jurisdiction.
Government concerns are high when one of
the parties to a related-party transaction is
subject to tax at a rate that is considerably less
than that applying in the other related party’s
country.
In addition to tax-rate pressures, other
government pressures can be brought to bear
on the transfer-pricing decision, including
heavy penalties or restrictive measures dealing
with related-party transactions.
66
 From a business perspective, following
dimensions influence the decision what to charge
for the inter company exchange of goods or
services.

1. Compensation and performance

may push in one direction .

2. Demand may push in another direction.

3. Tax considerations may push in a third.

67
Types of transactions between MNE’s that
come under the scope of TP are :

1 Charges for administrative or management

services .

2 Royalties and other charges for intangibles.

3 Transfer pricing for goods for resale.

4 Financing transactions.

5 Charges for technical services.

68
· Under an agreement of Organization for
Economic Co- operation & Development (OECD)
, 25 world’s leading industrialized countries,
have stated their acceptance of the arm’s-length
standard for setting inter-company transfer
prices and have set out guidelines for methods
that should be used in adhering to the standard.

The Policy States that a specific transfer pricing

methods to be used for different classes of
transactions with different parties with special
emphasis on those transactions where a
Comparable Uncontrolled Price/Transaction
(CUP/CUT) method could not be adopted.
69
There are three methods for determining T.P

Market based TP. Top management of the company

choose to follow the price for the product or service
in accordance with the publicly listed price
information.

Cost based TP. It is determined on the basis of the

cost of producing the product or service. Full cost
of the product is assessed upon calculating all
variable & fixed cost . It may use actual cost or
budgeted cost & include markup ( margin ) as return
on subunit’s investment.

Negotiated T.P : Subunits are given the freedom &

autonomy to negotiate the price in line with the
ability to earn profit. In a highly volatile market ,
such practice is common in large enterprises.
70
Division A manufactures certain item and transfers it to div B
which in turn add value and sell it in open market at Rs 200
per unit. The variable cost incurred by division B is Rs 30 per
unit. It buys semi finished goods from A at Rs 120 per unit. As
the competition dropped the price price for the finished goods
in the market to Rs 180 , Division B initiated a negotiation
with division A for Rs 100 per unit.
The competition of B meanwhile approached division A and
were ready to pay Rs 115 for per unit.
The cost details of Div A is as follows :
Fixed cost : Rs 5 lac
VC per unit Rs 15
Production capacity : 10000 units
If div A decides to sell to B’s competition , sales and
distribution overhead estimated is Rs 10 per unit . Competition
has assured to take all the output of division A.
As a profit center head of Division A what decision would you
take . At what TP will you sell items to division B ? 71
What action will you initiate from the point of view of
SBU head to ensure the corporate objective is being met ?
What TP methodology will you recommend. ?

72
Illustration: Hindustan Petroleum’s ( H.P) refinery &
transportation unit operates as independent profit
center. Transport unit supplies crude oil to refinery
unit, which is processed & transformed in to gasoline
by refinery unit. It takes two barrels of crude to
convert one barrel of gasoline. Variable cost is
computed for each division & fixed costs are based
on budgeted annual output of each division.
Transportation Unit :
Purchase cost of crude oil from oil field: Rs
120/barrel
VC /barrel Rs 10.00
FC/barrel Rs 30.00
Pipeline capacity to transport crude oil/day is 40,000
barrels .

73
 Refinery Unit :
Refinery unit’s selling price is Rs 580/barrel.
VC /barrel Rs 80.00
FC/barrel Rs 60.00
Operating capacity /day = 30000 barrels
( Consumes an average of 10000barrels /day supplied
by transport division & 20000 barrels /day bought
from outside @ R210/barrel locally.

Using all three methods calculate TP, & compare the

operating income of H.P
Suggest what should be an appropriate managerial
decision .

74
 Operating Income of HP with 100 barrels under
alternative T.P Methods.

@ Market Price @ full cost @ Negotiated

with 10% margin Price
Transport unit
17,600 19200
Revenue 210X100=21000 (120+10+30)x1.1
12000 12000
Purchase cost 120x100= 12000
1000
VC ( 10X100) 1,000 1000
3000 3000 3000
F.C 30 x100

Unit operating 5000 1,600 3,200

income
Refining Unit 29000
29000 29000
Revenue(580 x 50) 21000 17600 19200
Transferred in cost 4000 4000 4000
VC 3000
3000 3000
FC
Operating Income 1000 4400 2800 75
When market price of crude oil fluctuates( upward or
downward) , it will have an impact on the operating
income of transportation unit. In such a given market
situation, both division would like to negotiate an
acceptable & stable long term TP. price .
The price per barrel of crude oil drops to Rs 160.

76
 Operating Income of HP with 100 barrels under
alternative T.P Methods.

@ Market Price @ full cost @ Negotiated

with 10% margin Price
Transport unit
17,600 19200
Revenue 210X100=21000 (120+10+30)x1.1
12000 12000
Purchase cost 120x100= 12000
1000
VC ( 10X100) 1,000 1000
3000 3000 3000
F.C 30 x100

Unit operating 5000 1,600 3,200

income
Refining Unit 29000
29000 29000
Revenue(580 x 50) 21000 17600 19200
Transferred in cost 4000 4000 4000
VC 3000
3000 3000
FC
Operating Income 1000 4400 2800 77
Methods Of Computation

T.P shall be determined by any of the following

methods, being the most appropriate method,
having regard to the nature of transaction or class of
transaction, namely :-
(1) Comparable Uncontrolled Price Method
(2) Resale Price Method
(3) Cost Plus Method
(4) Profit Split Method
(5) Transactional Net Margin Method
(6) Any other basis approved by the Central
Government, which has the effect of valuing such
transaction at arm’s length price.
78
 Comparable Uncontrolled Price (CUP) Method :
( Negotiated Transfer price.)
The price charged or paid in a comparable
uncontrolled transaction or a number of such
transactions shall be identified , between the
related party transaction and the comparable
uncontrolled transactions or between the
enterprises entering into such transactions, which
could materially affect the price in the open
market.
The adjusted price shall be taken as arm’s length
price.

79
The resale price method would normally be
adopted where the seller adds relatively little or
no value to the product or where there is little or
no value addition by the reseller prior to the
resale of the finished products or other goods
acquired from related parties.

This method is often used when goods are

transferred between related parties before sale
to an independent party.

80
 Cost based Method :

The total cost of production incurred by the

enterprise in respect of goods transferred or
services provided to a related party shall be
determined. The amount of a normal gross
profit mark-up to such costs arising from the
transfer of same or similar goods or services by
the enterprise or by an unrelated enterprise in a
comparable uncontrolled transaction or a
number of such transactions, shall be
determined. The total cost of production
referred to above increased by the adjusted
profit mark-up shall be taken as arm’s length
price.
81
The cost plus method would normally be
adopted if CUP method or resale price
method cannot be applied to a specific
transaction or where goods are sold between
associates at such stage where uncontrolled
price is not available or where there are long
term buy and supply arrangements or in the
case of provision of services or contract
manufacturing.

82
 Profit Split Method :
The combined net profit of the related parties
arising from a transaction in which they are
engaged shall be determined.
This combined net profit shall be partially
allocated to each enterprise so as to provide it
with a basic return appropriate for the type of
transaction in which it is engaged with
reference to market returns achieved for similar
types transactions by independent enterprises.
The residual net profit, thereafter, shall be split
amongst the related parties in proportion to
their relative contribution to the combined net
profit.
83
This relative contribution of the related parties shall
be evaluated on the basis of the function performed,
assets employed or to be employed and risks
assumed by each enterprise and on the basis of
reliable market data which indicates how such
contribution would be evaluated by unrelated
enterprises performing comparable functions in
similar circumstances.
. The profit so apportioned shall be taken into account to
arrive at an arm’s length price .
This method would normally be adopted in those
transactions where integrated services are provided by more
than one enterprise or in the case multiple inter-related
transactions which cannot be separately evaluated.
84
 Transactional Net Margin Method :

The net profit margin realised by the enterprise from

a related party transaction shall be computed in
relation to costs incurred or sales effected or assets
employed or to be employed by the enterprise or
having regard to any other relevant base.

The net profit margin realised by the enterprise or by

an unrelated enterprise from a comparable
uncontrolled transaction or a number of such
transactions, shall be computed having

85
regard to the same base. This net profit margin
shall be adjusted to take into account the
differences, if any, between the related party
transaction and the comparable uncontrolled
transactions or between the enterprises entering
into such transactions, which could materially
affect such net profit margin in the open market .

This method would normally be adopted in the case of

transfer of semi finished goods.; distribution of finished
products where resale price method cannot be
adequately applied; and transaction involving provision
of services.

86
Birch paper company Case 6.2

Divisions :Thomson Northern Southern Timber

Div Div Div Div

Custom made RM
boxes & label.

Liner board
& corrugated box

87
 Northern Division
Price : $480/ Th $430/Th $432/Th
Thomson West paper Eire paper

Cost material 280 90

cost ( 70%)
Label 25 30
Other cost 95 164.5 ( 254.4 - 90
(comparable internal cost )
Total cost $ 400 284.5

Loading 20% margin on cost , Thomson division can be

much more competitive than the prevailing market price , if it
is able shed the excess unproductive cost.
Using market price as a bench mark , 430- 284.5 = 145.5 is the
potential market opportunity for Thomson division.
88
 ACTIVITY BASED
COSTING & PROFIT
CENTER

89
Traditional financial reporting does not reveal a separate
profits and losses of products or customers for three
reasons:
(1) It examines and reports department-level expenses but
not the work-efforts within a department that matter .

(2) The in-direct product and non-base-service costs are

usually allocated using broad averaging approach ( Peanut –
Butter costing ) but not traced to respective products or
base services .

(3) Customer-related activity costs are rarely isolated and

directly charged to the specific customer segments causing
these costs.
As business units have been restructured in profit center &
product , service & customer diversity increased, above
approach proved to be inaccurate method of assigning .
90
Today, selling, merchandising, and distribution costs are no
longer trivial costs—they are sizable. For example, it now
costs General Motors more to sell its trucks and cars than to
make them!

A high-tech semiconductor manufacturer discovered that it

was making roughly 90 percent of its profits from 10 percent
of its customers. That alone is not unusual, but it was losing
money on half of its customers. Upon discovering this, this
manufacturer could alter their own approach to lessen the
loss so that a fair profit could be attained.

91
Traditional financial reporting does not reveal
the separate profits and losses of products or
customers for three reasons:

1) It examines and reports department-level

expenses but not the work-efforts within a
department that matter.

2) The in-direct product and non-base-service

costs are usually allocated but not traced to
products or base services.

3) Customer-related activity costs are rarely

isolated and directly charged to the specific
customer segments causing these costs.
92
Therefore , in financial accounting terms, the
costs for selling, advertising, marketing,
logistics, warehousing, and distribution are
immediately charged to the “time period” in
which they occur. Consequently, the
accountants are not tasked to trace them to
channels or customer segments.

As selling, merchandising, and distribution

costs are sizable, a firm must allocate the
expenses to the respective head to analyze
the true profit generated by the product line.
As an example, For General Motors it costs
more to sell its trucks and cars than to
make them! 93
As an example, a high-tech semiconductor
manufacturer performed ABC/M and discovered it was
making roughly 90 percent of its profits from 10
percent of its customers. That alone is not unusual,
but it was losing money on half of its customers.
Upon discovering this, this manufacturer explained to
some of its unprofitable customers how those specific
customers could alter their own behavior to lessen
the workload on the manufacturer so that a fair profit
could be attained.
The remaining unprofitable customers were “fired,”
asked to take their business elsewhere because it was
evident their was little hope their sales would cover
their costs. Thus manufacturer’s sales levels dipped,
but profits tripled.

94
The lesson from this example is that there is a
“quality of profit” associated with sales volume and
product mix. There should be a focus on the
customer contribution margin devoid of simplistic
cost allocations.

There is a red-flag warning from this: Two

traditionally popular measures— market share and
growth—can potentially be dangerous in the new
order of competition. This is because organizations
now realize that there can be a sizable unprofitable
segment of products, service lines, and customers in
the mix.

95
 Over costing
Under costing
Cost ( Rs)
Products
Category Selling sales Reverse packaging Total
overhead promotion logistics
Lifebuy 110 0 40 120 270

Liril 200 80 140 120 540

Lux 150 40 80 145 415

Dove 140 40 60 165 405

Total 600 160 320 550 1630

Average 150 + 40 + 80 + 137.5 = 407.5
Cost allocation
Cost analysis revels that average apportion of cost leads to
cross subsidization. Liril’s cost getting heavily subsidized by
lifebouy. 96
 Profit center cost Management

Peanut butter costing to Activity based costing

Revenue of a Bill of Cost activities Profit /Loss

Profit center - of profit center = incurred
in profit
center
1. Identify the direct & indirect cost associated to
product , service , staff & cost involved in serving
specific customer of the division. ( Cost Pool)

2. Identify cost allocation bases for allocating indirect

cost to cost base.
3. Identify total indirect costs associated to each base.

4. Compute cost per unit of product or service. 97

Revenue of a Bill of Cost activities Profit /Loss
Profit center - of profit center = incurred at
( Price X Volume ) profit center

98
 Total
Direct Costs Direct Costs
+
In Direct Cost Pool Cost Allocation Bases Bill of activities
cost
Total Hrs X Hrly
production Rate
no. of trips X Cold chain
transport Cost
Specialized material
handling equipments hired

99
See Vision has been a pioneer in cosmetic contact lenses.
The produce simple lens called S3 & cosmetic contact lens
called CCL 5. Company has historically simple costing
system . Annual production of lenses are as follows : 60000
S3 & 15000 CCL5 .
As a practice , total material & manufacturing costs are
divided by total budgeted production volume.
Cost elements for : S3 ( Rs) Cost elements for CCL5
( Rs)

Material : 1,12,50,000 67,50,000

Manufacturing 60,00,000 19,50,000
Labour
To allocate the following costs to S3 & CCL5 , company
uses manufacturing labour- hour as an allocation base.
Estimated manufacturing labour hour is 39750 Hrs. ( 30000
M-L –Hr for S3 & 9750 M-L-Hr for CCL5 ) 100
Total budgeted cost for salary , Administration,
Sales , distribution Customer service , promotion,
adds to Rs 2,38,50,000.
SeeVision’s selling price for S3 is far more than that
offered by its immediate rival’s price of Rs 530.
Management countered it by saying that the
technology & process are inefficient in manufacturing
& distribution. However management is not convinced
as they have years of experience in S3 . They often
make process improvement . Kaizan initiative is used
to drive manufacturing process. However
management has less experience in CCL5 as it started
it recently . Management is surprised to know that the
market finds its CCL5 prices fairly competitive. At its
price point , organization earns large profit margin on
CCL5. Ever since See Vision restructured it’s
business as profit center units, business managers of
S3 are de motivated & has low morale. 101
 Revenue breakup from S3 & CCLS5 is s follows :
S3 Rs 3,78,00,000 & CCL5 Rs 2,05,50,000
Business unit head is less certain about the
accuracy of the costing system & measuring the
overhead resources used by each type of lens.
The finance manager of the division has been
empowered with any system of cost control to
improve the profitability of the division.

1. As a finance manger of the division , how would

you approach the issue.
2. What additional inputs are required by you to
convince CFO & Business unit head.
3. At what operating margin is S3 currently doing
their business.

102
S3 Lens CCL5 Lens
Volume : 60000 Units 15000 Units
Per unit Per unit
Material 1,12,50,000 187.5 67,50,000 450
Manufacturing 60,00,000 100 19,50,000 130
labour
Total 287.5 580
Indirect cost 1,80,00,000 300. 58,50,000 390
Total cost 3,52,50,000 587.5 1,45,50,000 970

Indirect cost rate = 2,38,50,000/ 39750= Rs 600

For S3 : 600 X 30000= 1,80,00,000/60000=300
For CCL5 :600 X 9750 = 58,50,000/15000=390

103
S3 Lens ( 6000units) CCL5 Lens ( 15000 units)
per unit per unit
Revenue: 3,78,00,000 630 2,05,50,000 1370
Cost 3,52,50,000 587.5 1,45,50,000 970
Operating 25,50,000 42.5 60,00,000 400
Income
Profit margin% 6.74 29.19

104
Activity based costing approach for See Vision.
Manufacturing labour hour has little effect on
overhead resources .
Identifying indirect cost pool :
Set up activity at production for manufacturing each
type of lens .
Resources required for CCL5, like molding machines
, cleaning time , small batch production adds to more
resources per setup.
Set up data for :
S3 CCL5
Volume 60000 15000
Output/batch 240 50
No of batch 250 300
Setup time 2 hr 5hr
Per batch
Total Hr 500 1500
105
 Set up data for :
S3 CCL5
Volume 60000 15000
Output/batch 240 50
No of batch 250 300
Setup time 2 hr 5hr
Per batch
Total Hr 500 1500
Total cost of set up comprises of cost of process engineers ,
quality engineers , supervisors , & equipment used adds to
Rs30,00,000 .
(30,00000/2000) x 500= 750,000
(30,00,000/2000) x 1500= 22,50,000
Other cost drivers identified having impact are packing & shipment
cost , distribution cost , administration cost .
106
S3 Lens CCL5 Lens
Volume : 60000 Units 15000 Units
Per unit Per unit
Material 1,12,50,000 187.5 67,50,000 450
Manufacturing 60,00,000 100 19,50,000 130
labour
Mold cleaning 12,00,000 20.00 15,00,000 100
& Maint
Total dir cost 1,84,50,000 307.5 1,02,00,000 680
Indirect cost
Design 13,50,000 22.5 31,50,000 390
Setup 7,50,000 12.5 22,50,000 150
Mold 45,00,000 75 18,75,000 125
Operation
Shipping 4,05,000 6.7 4,05,000 27
Distribution 26,10,000 43.5 13,05,000 87
Admin 19,24,530 32.1 6,25,470 41.7
Total cost 2,99,89,530 499.8 198,10,470 1320.7
107
 Budgeting & Budgetary Control.
Budgets are integral part of management control
system . When administered systematically , budgets
Promote Coordination & communication among sub
units with the company.

•Budget estimates the profit potential of a BU .

•Provides framework for judging the performance

•Creates motivation & involvement within managers .

108
It provides monetary & non monetary indicators to the
managers for effective decision making in line with
the goal of the BU.

It is reviewed periodically by the concern managers

for necessary action & strategy.

It forms the basis for Financial budgets like :

•Capital expenditure budget

• Budgeted balance sheet
•Cash Budget
•Budgeted cash flow statement .

109
An operating budgets is prepared for a fiscal year . It
is split in to half yearly, quarterly, or monthly for
easy administration & control.

If the business is highly driven by seasonality , it is

desired that the budgets are made for peak & lean
season.

Once approved , it is only changed under specific

conditions.

Budgets are compared with the actual financial

performance achieved during the period for taking
necessary financial control.

110
 Revenue
Budget

Inventory Production
Budget Budget

Direct
Manufacturing labor, Material cost , Manufacturing overhead
COG Sold
Budget

R&D , Marketing , Distribution , Customer Service Administrative

cost
Budgeted Income Statement
Financial Capital Cash Budget Budgeted cash flow
Budget 111
Preparation of master budgets :

operation Budget, created after taking & having debated

sufficiently with the line managers & functional managers
are used for preparing master budget .
Outcome of operation budgets is budgeted income
statement for the fiscal year.
Cash budget is prepared from this statement , which is
used for planning capital expenditure budget , Cash flow
statement & budgeted balance sheet .
The decision of the organization as how much to source
fund ( Source of fund : External equity , Debt, Reserve
fund ) for capital expenditure can only be known form
budgeted income statement .

112
Operational budgets include :
I. Revenue budgets :

Projected Sales
Projected volume ( Non Financial )
FY08-09
Vol Av selling price Revenue
Product 1 X Y XxY
Product 2 A B AxB
___________________________
Total
Since input for revenue budgets is drawn form sales forecast, an in
accurate sales forecast leads to upset the budget plan of the BU.

Control : Measured periodically by revenue center head ( Sales &

Marketing Head ) .
BU finance head reports the variation in plan Versus actual to the
profit center head for necessary action.

Action : Revise overhead budgets , non financial budgets etc.

113
Flexible budgets must help the mangers to evaluate
& control variances in price & efficiency with
respect to cost measures.

Management by Exception is the practice of

concentrating on areas not operating as expected.
Information gained out of variances are used for re-
allocating resources & seek manager explanation for
early correction.
Budgeted revenue & budgeted costs are compared
against the actual in the same budget period. On the
basis of this, a deviation statement ( flexible budget
statement ) is prepared & reported to the concern
managers.
This also forms a basis for variable compensation
component of the managers & his team popular in
industry as MPLC.
114
If budgeted selling price is Rs 1200 /unit & budgeted variable
costs are Rs 880 & budgeted Fixed costs are 2,60,000. for
planned volume of 12,000 units. At the end of the month sale
is 10000, the variance analysis can be as follows:

Direct Material cost = Rs 600/unit

Direct labour = Rs 160/ unit
Overhead = Rs 120 /unit

115
 Sales- Volume Variance analysis report for Q1 – April 2008 .
Actual Variance flexible Sales –Vol Static
budget Variance budget
___________________________________________________________
Units 10000 0 10000 2000U 12000
sold
Revenue 1,25,00,000 5,00,000F 1,20,00,000 24,00,000U 1.44 Cr

Dir Mat 62,16,000 2,16,000U 60,00,000 12,00,000F 72 L

D-M-L 19,80,000 3,80,000U 16,00,000 3,20,000F 19.2 L

Mfg O/H 13,05,000 1,05,000 U 12,00,000 2,40,000 F 14.4 L

Total 95,01,000 7,01,000U 88,00,000 17,60,000F
1,05,60,000
Cont 29,99,000 2,01,000 U 32,00,000 6,40,000U 38.4 L
Margin
116
Ratios are most powerful tool financial analysis & control.

•It helps to know the division’s ability to meet current

obligation.
•Firms ability to use long term solvency b borrowing funds.
•Efficiency with which the firm is utilizing it’s asset in
generating sales revenue
•Overall operating efficiency & performance of the firm.

Control role of ratios: Ratio analysis raise pertinent

questions on a number of managerial issues.
It provides basis for to investigate such issues in micro
detail.
To prevent from being misled by ratio , managers must
do trend analysis & competitive analysis before arriving at
any conclusion.

117
 What mangers should focus while using Ratios :

Profitability analysis : Is return on equity due to ROI ,

Financing mix or capitalization for reserves.
What is the trend of profitability & compare it with like
market factors .
Is it improving because of better utilization of resources or
curtailment of expenses.

Asset utilization : How effectively the company utilize the assets

in generating sales.
Are the levels of debtors & inventories relative to sales
acceptable ,given the competitive environment & operating
efficiency.

118
Liquidity analysis : What is the level of CA relative to CL
. Is it acceptable , given the nature of the business.
How fast it converts it current asset in to cash.
What is the desired mix of debt & equity .

Accordingly , the managers may use :

Liquidity ratio
Leverage ratio
Activity Ratio
Profitability ratio

119
The total sales of cement division of India Cement is Rs 6,40,000
& its gross profit margin is 15% . The division is operating at
sustained current ratio of 2.5 .
It’s Current liabilities: Rs 96000
Current asset
1 Inventories Rs 48000
II Cash Rs 16000
Average inventory
carried by the division : Rs 1,20,000
Inventory turnover : 5
Opening balance of debtors is 80,000 & competitive analysis by
ETIG shows that average collection period for cement business
is 60 days .
BUH has a guideline for maximizing he profit . While there is
much scope to increase the price , he feels division should operate
more efficiently & eliminate operating inefficiency. You have
been asked to analyze & prepare a financial report .
120
Inventory turn over = COG Sold / Av Inventory

Average collection (Av Debtors / Credit sales )x 365

Period =

Av debtors = (OP Debtor + Cl Debtors) / 2

For closing balance of debtor , find Current asset .
Less Inventory & Cash

121
Investment center Decisions

122
ROI Problems
♦ Feed the Dogs ( Over Investment )
♦ Starve the Stars ( Under Investment )

High

STAR PROBLEM
CHILD
Relative
Market
Growth CASH COW DOG

Low
High Market Share Low
123
 EVA Basic Premise
Managers are obliged to create value for their investors
Investors invest money in a company because they expect returns
There is a minimum level of profitability expected from investors,
called capital charge
Capital charge is the average equity return on equity markets;
investors can achieve this return easily with diversified, long-term
equity market investment
Thus creating less return (in the long run) than the capital charge is
economically not acceptable (especially from shareholders
perspective)
Investors can also take their money away from the firm since they
have other investment alternatives

124
EVA is the gain or loss that remains after assessing a charge for
the cost of all types of capital employed.
What an accountant calls profits in an income statement includes
a charge for the debt capital employed which is commonly
referred to as interest expense. However, an income statement
does not include a charge for the equity capital that was employed
during the accounting period.

Therefore, EVA goes beyond conventional accounting standards

by including a provision for the cost of equity capital. The cost of
equity needs to be factored into business investment decisions in
order to enhance shareholder value.

125
Although EVA is couched in financial analysis, its primary
purpose is to shape management behavior.

EVA can be used as a performance measure to evaluate an

overall company, a division within a company, a location
within a division, or an individual manager.

By setting goals, EVA can become a motivational tool at

various levels of management.

EVA can also be used in downsizing decisions.

126
EVA and Corporate Culture
Paying managers for performance is a backward-looking practice,
but the capital markets assign value on a forward-looking basis.
Therefore, companies that pay for past performance may be
unwittingly paying their managers to undermine value creation.

When EVA-related performance measurement process is

implemented throughout your company, all affected employees need
to understand the goal, as well as how their actions contribute to
meeting it.
In this respect, the EVA’s popularity parallels the 1980s “total
quality management” trend. Like quality, value is every employee’s
responsibility. To this end, management and employee training
programs are a crucial component of any EVA plan.

127
What is Needed to Calculate Company’s Economic
Value Added (EVA)?
Only following the information is needed for a
calculation of a company’s EVA:

•Company’s Income Statement

•Company’s Balance Sheet

128
Illustration: Income Statement
Net Sales 2,600.00

Cost of Goods Sold 1,400.00

SG&A Expenses 400.00
Depreciation 150.00
Other Operating
Expenses - 100.00

Operating income 550.00

Interest : 200.00
Income Before Tax 350.00
Income Tax (40%) 140.00

Net Profit After Taxes 210.00

Add Interest 200.00
NOPAT 410.00
129
Illustration: Balance Sheet

Current Assets Current Liabilities

Cash 50.00 Accounts Payable 100.00
Non
Receivable 370.00 Accrued Expenses 250.00 Interest
Inventory 235.00 Short-Term Debt 300.00 Bearing
Liabilities
Other Current
Assets 145.00
Total current Assets 800.00 Total Current Liabilities 650.00
Fixed Assets Long-Term Liabilities
Long-Term Debt 760.00
Land 650.00 Total Long-Term Liabilities 760.00
Equipment 410.00 Capital (Common Equity)
Other Long
Term Assets 490.00 Capital Stock 300.00
Total Fixed Assets 1,550.00 Retained Earnings 430.00
YTD Profit/Loss 210.00
Total Equity Capital 940.00
TOTAL ASSETS 2,350.00 TOTAL LIABILITIES 2,350.00
130
CCRDebt = [Debt/(Debt+Equity)](1-t) Where t represents the
company’s tax rate.

+
CCREquity = Equity/(Debt+Equity)

Capital Cost Rate (CCR) will be :

Assume owners expect 13 % return* for using their money
because less are not attractive to them, therefore, company
has 940/2350 =40% (or 0.4) of equity with a cost of 13%.

Company has also 60% debt and assume that it has to pay
8% interest for it. So the average capital costs would be:
CCR ** = Average Equity proportion * Equity cost +
Average Debt proportion * Debt cost = 40% * 13% + 60% *
8% = 0.4 * 13% + 0.6 * 8% = 10%
131
** Note: if tax savings from interests are included (as they
should if), then CCR would be:
CCR = 40% * 13% + 60% * 8% *(1- tax rate) =
0.4 * 13% + 0.6 * 8% * (1 - 0.4) = 8.08 % (Using 40 % tax
rate)

Companies paying high taxes and having high

debts may have to consider tax savings effects, by
adding the tax savings component later in the
capital cost rate (CCR)

132
Identify Company’s Capital (C)
Company’s Capital (C) are

Total Liabilities less Non-Interest Bearing Liabilities:

Total Liabilities 2,350.00

less
Accounts Payable 100.00 [ No interest cost incurred on these
Accrued Expenses 250.00 Liabilities. ]
----------------------------------
Capital : 2,000.00

133
EVA = NOPAT - C * CCR
= 410.00 - 2,000.00 * 0.10
= 210.00 This company created an EVA of 210.

Note: this is the EVA calculation for one year.

If a company calculates & reports EVA in its quarterly report

,then it’s capital costs will be :
Q1 Capital costs for 3 months: 3/12 * 10% * 2,000 = 50
Capital costs for 4 months: 4/12 * 10% * 2,000 = 67
Q2 Capital costs for 6 months: 6/12 * 10% * 2,000 = 100
Q3 Capital costs for 9 months: 9/12 * 10% * 2,000 = 150

134
To estimate the cost of capital for a small company, a
method derived from the WACC estimation and the
CAPM( capital Asset Pricing ) model is called cost of
capital cost rate CCR . . The CCR for a small company can
be estimated as follows:
CCRDebt = Prime Rate + Bank Charges

Where the average Bank Charges for small companies vary

between one to two percent per year.
CCREquity can be estimated as follows:
CCREquity = RF + RP

Where RF is the risk free investment rate and RP is the risk

premium investment rate. RF can be estimated using a yield-
to-maturity rate for government bonds. In contrast, RP
reflects the risk resulting from investing in a company’s
equity. The riskier the investment, the higher the RP.
135
General Guide line for RP
6 % and less Extremely low risk, established
profitable company with extremely
stable cash flows.

6 % - 12 % Low risk, established profitable company

with relative low fluctuation in cash flow.

12 % - 18 % Moderate risk, established profitable

company with moderate fluctuation in
cash flow 18 % and more High business
risk

136
Income statement Balance Sheet

137
Cost of Capital Rate (CCR)
Assume that the current Prime Rate is eight percent and that
Pitt Products is paying one percent by borrowing new money,
independent if they ask for short-term or long term debt.

138
In this case, the pre-tax CCRDebt will be :
CCRDebt = Prime Rate + Bank Charges
= 8% + 1% = 9%

Assume that the yield-to-maturity of 10-year government

bonds is five percent. Pitt . Products management, believe that
RP of seven percent is adequate because its business .
CCREquity = RF + RP
= 5% + 7% = 12%

CCR = 9 % ´ (600/(600+600))(1- 0.4)

+ 12 % ´ (600/(600+600))
= 2.7% + 6% = 8.7%

139
Assume that in Pitt Product’s case that all financing will
be made using owner’s equity. Thus, no interest expenses will be
incurred. However, with this financing approach, tax savings are
lost. Therefore ,its profit will increase by the interest savings
component, less the tax shield on interest expenses. Tax shield,
or tax savings, on interest expenses can be estimated by
multiplying the interest expenses by the tax rate. In addition,
owner-managers stated that they regard approximately 50,000 of
their salaries as a kind of compensation for their investment in
the company. Because Pitt Product’s income statement does
not show categories, such as Research & Development, market-
building outlays, employee training, unusual write-offs or gains,
there were no further adjustments needed. Hence e NOPAT is

NOPAT = (Net Profit after Tax + Total Adjustments)

– Tax Savings on Adjustments
= 192 + (42 +50) – (42 +50) x 0.4
= 248.4 140
Calculation of EVA is must for internal reporting for all
investment centers.

Permanent EVA improvement has to be the main management objective

•EVA has to be calculated periodically (at least every three months)
•Changes in EVA have to be analyzed
•EVA development is the basis for a company’s financial and business
policy

•Try to improve returns with no or with only minimal capital investments .

•Invest new capital only in projects, equipment, machines able to cover

•capital cost while avoiding investments with low returns

•Identify where capital employment can be reduced

•Identify where the returns are below the capital cost; divest those
investments when improvements in returns are not feasible .

141
Creating an EVA-based Compensation Plan

The four primary factors in creating a compensation plan are:

1. Align management performance and shareholder value.
2. Create strong wealth leverage, so employees work hard and make
difficult decisions.
3. Employee retention risk, particularly in bear markets or industrial
slumps, when performance-based compensation may decrease through
no fault of the employee.
4. Cost of the compensation plan to shareholders.

142
Like other financial performance measures, such
as return on investment (ROI), EVA, on its own, is
inadequate for assessing a company’s progress in
achieving its strategic goals and in measuring
divisional performance. Other more forward-
looking measures, often non-financial in nature,
should be included in regular performance reports
to provide early warning signs of problem areas .

Another problem of EVA is that it is distorted by

inflation, with the result that it cannot be used
during inflationary times to estimate actual
profitability. A superior measure, the adjusted
EVA, corrects for inflationary distortions .

143
INVESTMENT CENTER MANAGEMENT MILESTONES.

Enjoy leadership
in business

Control &
Compliance
Integrate Track , Measure &
Long term audit Financial and
Financial Initiate operational
goal necessary Performance
With key changes at
process business
Initiative operation
process Drive internal
& people Process using IT
level.

Clearly define
expectation

Set role models ,

examples
Within the
business 144
1. Creates a bridge between Strategy, KPI’s, operational
measures and outcome measures.

2. Includes non-project Investments.

3. Focuses on organizational affordability and aggregate

risk.

4 . Brings together the process disciplines of integrating

Finance, operational efficiency and outcome measures
linked to business objectives and Change Management .

5. Assists Executives to make choice and trade-offs

between competing and non competing options to align
with business goals.

145
146
 Monetary Value Added
1. Accounting Value
2. Economic Value Added
3. Market Value Added
Non-Monetary Value Added
1. Human Resource Value Added
2. Intellectual Value Added
Customer Satisfaction
1. Price
2. Satisfaction Index
3. Quality
4. Service
Learning & Growth
1. Technology Leadership
2. Research and Development
3. Market Leadership
4. Cost Leadership 147
Concept of Balance Score Card.

148
Competence and Learning perspective.

149
 Audit : Compliance & Control
Why Audit ?

For Compliance & Control .

What is to be audited ?

1.Financial performance Audit

2. Process Audit

3 People Audit

4 Knowledge Audit

150
The Audit Committee is created by the Board of Directors
of the Company to assist the Board in maintaining the
integrity of the financial statements and internal controls
of the Company, the qualifications, independence and
performance of the Company’s independent auditor, the
performance of the Company’s internal audit function,
compliance by the Company with legal and regulatory
requirements; prepare the audit committee report that
Securities and Exchange Commission rules require to be
included in the Company’s annual statement.

151
Financial Statements; Disclosure and Other Risk Management
and Compliance Matters

1. The Audit Committee shall review and discuss with

management:

(a) the annual audited financial statements, including the

Company’s disclosures under “Management’s Discussion
and Analysis and Analysis of Financial Condition and
Results of Operations”, prior to the filing of the Company’s
quarterly financial statements.
(b) any analyses or reports prepared by management, the
internal auditors and/or the independent auditor setting forth
significant accounting or financial reporting issues and
judgments made in connection with the financial statements,
including critical accounting estimates analyses of the effects
of alternative GAAP methods on the financial statements
152
(c) the effect of regulatory and accounting initiatives
or actions, off-balance sheet structures and related
party transactions on the financial statements of the
Company; and any major issues regarding
accounting principles and financial statement
presentations, including any significant changes in
the Company’s selection or application of accounting
principles .

153
With regard to “material” non-listed subsidiary companies
Clause 49 stipulates the at least one independent director of the
holding company to serve on the board of the subsidiary. The
audit committee of the holding company should review the
subsidiary’s financial statements particularly investment plans.

The minutes of the subsidiary’s board meetings should be

presented at the board meeting of the holding company and the
board members of the latter should be made aware of all
“significant” (likely to exceed in value 10% of total
revenues/expenses/assets/liabilities of the subsidiary)
transactions entered into by the subsidiary.

154
Internal Audits :
» Compliance with management controls
» System and process improvements
» Financial impropriety and fraud audits
» Due diligence for acquisitions and investments

155
The areas where Clause 49 stipulates specific corporate
disclosures are: (i) related party transactions;
(ii) accounting treatment;
(iii) risk management procedures;
(iv) proceeds from various kinds of share issues;
(v) remuneration of directors;
(vi) a Management Discussion and Analysis section in the
Annual report discussing different heads of general business
conditions and outlook;
(vii) background and committee memberships of new directors
as well as presentations to analysts. In addition a board
committee with a non-executive chair should address
shareholder/investor grievances.
.
156
The CEO and CFO or their equivalents need to sign off on
the company’s financial statements and disclosures and
accept responsibility for establishing and maintaining
effective internal control systems.
The company is required to provide a separate section of
corporate governance in its annual report with a detailed
compliance report on corporate governance.

It should also submit a quarterly compliance report to the

stock exchange where it is listed. Finally, it needs to get its
compliance with the mandatory specifications of Clause 49
certified by either the auditors or practicing company
secretaries.

157
The system of internal control
An internal control system encompasses the policies, processes,
tasks, behaviors and other aspects of a company that, taken
together: facilitate its effective and efficient operation by
enabling it to respond appropriately to significant business,
operational, financial, compliance and other risks to achieving
the company’s objectives . This includes the safeguarding of
assets from inappropriate use or from loss and fraud, and
ensuring that liabilities are identified and managed; help ensure
the quality of internal and external reporting. This requires the
maintenance of proper records and processes that generate a
flow of timely, relevant and reliable information from within
and outside the organization; help ensure compliance with
applicable laws and regulations, and also internal policies with
respect to the conduct of business.

158
159