A PROJECT REPORT ON Responsibility Accounting

SUBMITTED IN PARTIAL FULFILMENT OF THE REQUIREMENTS FOR MASTER OF MANAGEMENT STUDIES TO UNIVERSITY OF MUMBAI BY ASHVANI RAVINDRA BHAGAT ROLL NO. 03 2011-2013 UNDER THE GUIDANCE OF Dr. Kinnarry Thakkar

SMT. K. G. MITTAL INSTITUTE OF MANAGEMENT MAHALAXMI, MUMBAI 400 034

A PROJECT REPORT ON TITLE OF THE PROJECT

SUBMITTED IN PARTIAL FULFILMENT OF THE REQUIREMENTS FOR MASTER OF MANAGEMENT STUDIES TO UNIVERSITY OF MUMBAI

BY FULL NAME OF THE STUDENT ROLL NO. 2010-2012 UNDER THE GUIDANCE OF DR. / PROF.

SMT. K. G. MITTAL INSTITUTE OF MANAGEMENT MAHALAXMI, MUMBAI 400 034

DECLARATION
I hereby declare that this dissertation submitted in partial fulfillment of the requirement for the award of MASTER OF MANAGEMENT STUDIES (MMS) of the University of Mumbai is my original work and has not been submitted for award of any other degree or diploma fellowship or other similar title or prizes. I further certify that I have no objection and grant the rights to SMT. K. G. MITTAL INSTITUTE OF MANAGEMENT to publish any chapter or project if they deem fit in journals or magazines and newspaper etc. without my permission.

NAME: ASHVANI RAVINDRA BHAGAT CLASS: MMS II SEM IV BATCH: 2011-2013 ROLL NO.: 03 DATE: 17th MARCH , 2012 PLACE: MUMBAI

SIGNATURE (ASHVANI BHAGAT)

PROJECT GUIDE CERTIFICATE FORM I Mr. Ashvani Ravindra Bhagat, the undersigned Roll No. 03 studying in the Third Year of MMS is doing my project work under the guidance of Dr./ Prof. DEEPA CHAVAN wish to state that I have met my internal guide on the following dates mentioned below for Project Guidance:-

SR. NO.

DATE

SIGNATURE OF THE INTERNAL GUIDE

______________________ Signature of the Candidate

______________________ Signature of Internal Guide

Smt. K. G. Mittal Institute of Management, IT and Research Marwari Vidyalaya Sanchalit (Approved By AICTE, New Delhi, Government of Maharashtra, DTE, Affiliated to University of Mumbai)

Certificate
This is to certify that the dissertation submitted in partial fulfillment of the requirement for the award of MMS of the University of Mumbai is a result of the bonafide work carried out by Mr. ASHVANI RAVINDRA BHAGAT under my supervision and guidance. No part of this report has been submitted for award o f any other degree, diploma fellowship or other similar titles or prizes. The work has also not been published in any scientific journals/ magazines.

DATE: 17th MARCH 2012 PLACE: MUMBAI

NAME: ASHVANI R. BHAGAT ROLL NO.: 03

-----------------------------Dr. Vidya Hattangadi (Director) Smt. K. G. Mittal Institute Of Management

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--------------------------Dr. /Prof (Project Guide)

ACKNOWLEDGEMENT
This project has been a great learning experience for me. I take this opportunity to thank Dr. / Prof. DEEPA CHAVAN, my internal project guide whose valuable guidance & suggestions made this project possible. I am extremely thankful to him/her for his/her support. He/She has encouraged me and channelized my enthusiasm effectively. I express my heart-felt gratitude towards my parents, siblings and all those friends who have willingly and with utmost commitment helped me during the course of my project work. I also express my profound gratitude to Dr. Vidya Hattangadi, Director of SMT. K. G. MITTAL INSTITUTE OF MANAGEMENT for giving me the opportunity to work on the project and broaden my knowledge and experience. My sincere thanks to Prof. Deepa Chavan for her valuable guidance and advice in completing this project. I would like to thank all the professors and the staff of SMT. K. G. MITTAL INSTITUTE OF MANAGEMENT especially the Library staff who were very helpful in providing books and articles I needed for my project. Last but not the least, I am thankful to all those who indirectly extended their cooperation and invaluable support to me.

EXECUTIVE SUMMARY
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Responsibility Accounting are a set of practices that have become recognized as one of the essential features of effective management in organizations of all sizes, in both the public and the private sectors, throughout the world. Management controls may be briefly defined as the organization, policies, and procedures used to help ensure that government programmers achieve their intended results; that the resources used to deliver these programmers are consistent with the stated aims and objectives of the organizations concerned; that programmers are protected from waste, fraud and mismanagement; and that reliable and timely information is obtained, maintained, reported, and used for decision making. Effective management controls are clearly essential to the success and well-being of government organizations, both as a safeguard against waste, abuse, and fraud and as a means of ensuring that the policies laid down by top management are properly implemented by the organization. However, even the most carefully designed control systems have their limitations, partly because, while they allow top managers to control the organization, they do not control the top managers themselves. Continuing vigilance is required to ensure that the systems are not undermined by instances of fraud or by failure to respond to changes in circumstances and operating procedures

Chapter No. 1
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Introduction
A responsibility centre is an organizational unit which is headed by a responsible person namely a manager. He is responsible for the activities of the unit. An organization is composed of a number of responsibility centre. These responsibility centre. These responsibility centres are created based on the need of the organization. The responsibility centres from a hierarchy with section, department, work shifts etc existing at the lowest level and department and a business unit at a higher level. The costs assigned to the responsibility centre are intended to measure the inputs that it consumer in a specified period of time. Management control on the behavior of managers in responsibility centres. The performance of responsibility centres is judged by the criteria of efficiency and effectiveness. Revenue in the revenue centres are measured and controlled separately from expenses centres. In discretionary expenses centres, budget describe the amounts that can be spent but it is not possible to determine the optimum level of these expenses. Therefore, Financial controls are not intended to measure its effectiveness. The principal types of discretionary expense centres are Administrative and Support centres, Research and Development centre and Marketing centres. A responsibility centre can be defined as an organizational unit which is headed by a responsible person namely a manager . He is responsibility for the activities of the unit. Responsibility centre is responsible for performing certain function which is its output. A company is a collection of responsibility centre, each of which is represented by a box on the organization chart. These responsibility centres from a hierarchy. The responsibility centre at the lower level are work shifts and small organizational units. Higher in the hierarchy are the department or business unit. The entire Company is a responsibility centre from the point of view of senior management and the board of directors. These responsibility centre use resources or inputs while performing their functions. The costs assigned to a responsibility centre are intended to measure the input that it ensures in a specified period of the time such as a week or a month. Management control focuses on the behavior of manager in responsibility centres. An organization is composed of a number of responsibility centres. These centres are created by the management based on the needs of the business organisations.

Responsibility centres constitute the structure of a control system. The assignment of the responsibility to organizational subunits should reflect the organizational strategy. A responsibility centre is an organizational unit which is headed by a management and he is responsible for its objectives. These are two types of responsible centre which are important i.e. revenue centre and expense centre. Objectives of Responsibility Accounting: The objectives of responsibility accounting are the following: a. Overall organizational goals are broken down into small goals, each of the small goals is meant for better achievement of a responsibility center. b. With the attached responsibility each responsibility center is tied up & there is adequate authority so that responsibility can be discharged. c. At the end of a period, evaluation is done of the performance of each responsibility center & comparison of the performance is done with the predetermined targets. d. Thorough study is made of the achievements which are above or below the targets & remedial measures are adopted. e. Assessment is made of the contribution made by each responsibility center & examination is done of how far its possible for the contribution to fulfilling its share in the ultimate organizational growth. f. Emphasize is given on the control of cost through planning. g. Use is made of the principle of management by exception for the purpose of recording only those data where the actual performance of responsibility center falls short of the set target & where the variance is beyond the reasonable limit.

Nature of Responsibility centre: Responsibility centres are created by conscious acts of management. It is a unit of an organization. The aims of such units is to achieve certain objectives. The objectives are to 10

implement the strategy for accomplishing the goals of the organization centres. The entire organization is responsible for achieving its objectives. A responsibility centre uses certain inputs and then generates the output. The input includes labor, material and others services. The responsibility centres process these resources by using plant and machinery, furniture, vehicles and working capital. The output is created out of these inputs. The output may be in the form of intangible goods or tangible goods. The output generated from finance, logistics, insurance, marketing are in the form of services. The output of the responsibility centre may be sold in the market in exchange of money. It can be also be used by another responsibility centre of the organization. The amount of money generated by a responsibility centre is called as 'Revenue'.

Pre-requisites of effective responsibility accounting: The pre-requisites of the effective responsibility accounting are the following: a. Under the supervision of a manager should be each responsibility center & for the purpose of operating, it must be separable & identifiable. b. The independent measurement of performance of each center must be capable of being done. c. Each responsibility center should have clearly set targets. d. Each responsibility centers budget should set targets which should be neither too high nor too low i.e., the budget should be one which can be realised. e. The top management should fully support the system. f. All managers of responsibility centers should participate in the formulation of plans & policies relating to responsibility centers for the purpose of providing motivation. g. For sincere performance of each responsibility center the organizational environments must be conducive.

Advantages of Responsibility Accounting: For the purpose of exercising control, responsibility accounting is an important tool in the hands of management. For the purpose of effecting efficient control on operations & achieving the organizational goal, responsibility accounting system should be introduced by the organizations which have large dimensions & complex & operations which are decentralized. 11

Since for the purpose of achieving the overall goal in a piecemeal way; to various responsibility centers, overall responsibility & authority are decentralized, continuous communication should be there between the overall responsibility center & various subresponsibility centers. Thus a communication system is automatically established by responsibility accounting. The following advantages can be expected from responsibility accounting system: a. Allocation is made of all the activities of the organization, all the items of income & expenditure including capital expenditure to the well defined responsibility centers. Profit of each responsibility center is also identified. It should be understood by the manager of the centre what has to be performed by him with what resources & in what time period. He gets the things done by making his own way without any interference. Thus much importance is given to human resources. b. The managers of responsibility centers worked independently which helps in achieving the ultimate goal. c. There is a relationship between efforts & achievement, thereby, loopholes, if any, in the operations gets easily detected. d. The overall goals of the organization & individual goals of responsibility centers are communicated to all so that by keeping a view on that, guidance can be given the managers in their respective centers to the operations. e. Among the managers & their subordinates, cost-consciousness gets generated which results in automatically reducing cost. f. It becomes easy to detect the weak areas in the organization. So for the purpose making the weak areas strong, corrective measures are taken. g. By recording the negative variances between the actual performance & target, introduction of management by exception can be done. h. For the purpose of exercising best managerial control over the affairs of the organization & achieving the desired goal, responsibility accounting system & budgetary control system can work together.

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i. As realistic goals are fixed for a responsibility centre, its achievement by the employees becomes easy. Their contribution can be assessed by themselves for the purpose of achieving the goal of the organization as a whole. A sense of belonging to the organization is created among the employees by the systematic responsibility accounting as the reward of the employees for accomplishment is not unsatisfactory. j. As managers of responsibility centers are allowed to sit with the top management for exchanging of views & opinions, appropriate decision making is almost assumed. As against expected advantages there are also some apprehended disadvantages. Disadvantages of Responsibility Accounting: The following are the apprehended disadvantages of responsibility accounting: a. Solely upon the sincere efforts put in by the managers of the responsibility centers, the success of the responsibility accounting depends. Whether the system will succeed or not shall be decided by the personal factors of the managers. b. The place of good management cannot be ever taken by the responsibility accounting because the latter is only a tool in the hands of the former. c. Although theoretically, the manager of each organization is given free hand, in actual practice, neglect of employees reaction, interference etc. is often noticed. Thus, in the way of proper discharging of responsibility, this stands. d. In modern organizations, among the departments, inter-relations & inter-departments are mostly observed. So it becomes almost impossible to demarcate responsibility centers by clear-cut outlines. e. Manager of the responsibility center prepares & communicates performance reports. The desired result will not be achieved by the responsibility accounting system, if there is any shortcoming in the report. f. Remuneration, future prospects, rewards, good working condition, welfare work & many others account for the individual interest of employees. Co-operation from the employees may be required where there is a clash between individual interest & the organizational interest. 13

Chapter No. 2 Responsibility Centres

Responsibility Structure The responsibility structure of an organization consists of responsibility centers and related performance measurement systems. These responsibility centers work towards the achievement of the organizational goals. This hierarchical placement of the responsibility center helps the top management to ensure that decisions made in one part of the organization are congruent with decisions made in other parts. The responsibility structure includes an accounting system. A responsibility accounting system helps managers to record the plans and performances of the center for which the manager is accountable. The measurement of the performance of a responsibility center is done through cost, profit, revenue, investment and quality goals set by the organization. There are three different methods of 14

measuring the performance of a responsibility center. They are: The efficiency measure The process measure Effectiveness measure The efficiency measure measures performance in terms of inputs received over a specified period of time for a given level of output. The process measure pertains to the production process, and the effectiveness measure gauges the output of the organization in terms of its goals and objectives. The above mentioned methods of performance evaluation help in assessing the progress of each subunit, and this is done with those variables for which the manager has reasonable amount of control in mind. Overall Effectiveness Measures: Return on Investment (ROI) The most important objective of a firm is to achieve a good return on investment. The logic behind the hierarchy of responsibility centers and the responsibility accounting system is to make all the decentralized subunits of an organization responsible for various elements of ROI. The performance of responsibility centers in an organization is based on cost, quality, revenue and investment. Donaldson Brown of General Motors divided ROI into a number of elements for easy understanding. These elements are helpful in establishing performance measures for various subunits of a division that are goal congruent and would have an influence over the performance measures. ROI= Net profit/invested capital ROI can be divided into two components- net profit, which is a percentage of the sales revenue, and the turnover of investments in relation to the sales revenue. Profit margin = net profit/sales revenue Investment turnover = sales revenue/invested capital

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Types of Responsibility Centres Revenue centers Revenue centers are those organizational units in which outputs are measured in monetary terms. These centers are marketing organizations and they are not directly responsible for profits. Revenue centers are also called expense centers, as the revenue center managers are held responsible for expenses incurred by the unit. The main objective of revenue centers is to maximize revenues. For example, a marketing organization is a sales revenue center. Such a center is devoted to increasing the revenue, and assumes no responsibility for production. In this center, the manager is responsible for the level of revenue or outputs of a center, measured in monetary terms, but is not responsible for the costs of the goods or services that the center offers. Expense centers In expense centers, inputs or expenses are measured in monetary terms whereas the outputs are not measured in monetary terms. There are two types of expense centers-engineered expense centers and discretionary expense centers. There are two types of cost involved in engineered expense centers and discretionary expense centers respectively-engineered costs and discretionary costs. Engineered costs are costs that can be estimated to a reasonable extent by the management. Examples are direct labor and direct material. Discretionary costs, on the other hand, are costs that cannot be estimated by the management. Engineered expense centers In these centers, inputs or expenses are measured in monetary terms and outputs are measured in physical terms. These centers are usually found in the manufacturing units that use a standard cost system. There are certain responsibility centers within administrative and support departments that actually are engineered expense centers. In these centers, the cost of the product is determined by multiplying the output of each unit with its standard cost. Its efficiency is measured by comparing the actual cost with the standard cost. Discretionary expense centers 16

In discretionary expense centers, the output cannot be measured in monetary terms. Discretionary expense centers include administrative and support units like legal, accounting, industrial and public relations units. Here, the efficiency is not the difference between budgeted and actual expense, but the difference between the budgeted input and actual input. In discretionary expense centers the management decides on certain policies that should govern the company's operation. These relate to the amount of money that should be spent on R&D, financial planning, public relations, etc. The decisions related to such activities depend on the way a company operates. Control characteristics for expense centers The management control systems for expense centers are discussed, taking into consideration factors like budget preparation, cost variability, financial control and measurement of performance. Budget preparation: The decisions regarding the budget of expenses for a discretionary expense center is different from that for an engineered expense center. In engineered expense centers, the costs are determined by the management, taking into view the operating budget required to perform the task effectively in the future. However, in a discretionary expense center, the principal task is to decide on the magnitude of the job that has to be performed. These tasks are of two types-continuing and special. Continuing tasks take place year after year (like financial statements) while special tasks are one-time tasks, for example, developing a profit budgeting system for a newly acquired division. Management by objectives is a useful technique in preparing budgets for a discretionary expense center. Management by objectives is a technique where the objectives of performance are jointly determined by subordinates and their superiors. The progress towards these objectives is periodically reviewed and the rewards are allocated on the basis of performance. Another method used to understand the appropriate level of spending in a discretionary expense center is sensitivity analysis. According to this technique, the budget has a section which explains the activities that can be undertaken if the budget is increased. Sensitivity analysis is mostly not taken by companies as they think that it is important for a manager to prepare the 17

possible budget for accomplishing activities that should be undertaken. Cost variability: The costs, in a discretionary expense center, tend to vary from one year to another according to the volume. However, these are not influenced by short-term fluctuations in volume within a year. In engineered expense centers, costs vary with short-term fluctuations in volumes. Financial control: The financial control in a discretionary expense center is different from that in an engineered expense center. Here, the operating costs are minimized by setting a standard for the costs and comparing the actual costs with this standard. In discretionary expense centers, costs are controlled by determining the tasks that have to be undertaken and the amount of effort that is required for each task. Financial control is, hence, determined at the planning stage. Measurement of performance: The financial performance report of a discretionary expense center does not help in evaluating the efficiency of the manager, whereas in engineered expense centers the financial report helps in evaluating the efficiency of the manager. If the two centers are not properly distinguished, the management may consider the performance report of a discretionary center as an indication of its efficiency.

Administrative and support centers Administrative centers include the senior corporate management, the business unit management and the managers responsible for their staff units. Support centers provide services to other responsibility centers. Problems related to control in administrative and support centers include difficulty in measuring output, as they basically provide service and advice to the responsibility centers. Therefore, it becomes difficult to set cost standards. Hence, their performance cannot be branded as efficient or inefficient. Secondly there is lack of congruence between goals of staff units and responsibility centers. The suggestions that staff departments may provide regarding the development of systems, programs or functions may be too costly when one thinks of the additional profits that these would generate. The severity of the problems is also related to the 18

organizational level. At the operational level, the staff activity is controlled by the plant manager, and at the business unit level, by the business unit manager. When compared to the plant level, there is more discretion of tasks at the business unit level. Support centers charge a particular price for the services they provide to other responsibility centers. Budget preparation: The budget for a support center consists of expenses, and is prepared by comparing with the current years actuals. This budget consists of the following componentsthe basic costs of running a center (for which there is no need of management decisions), costs incurred by the discretionary activities of the center, and a section containing proposed increases in budget (other than those related to inflation). Research and development centers Control problems in research and development: The problems in research and development are: Difficulty in measuring quality: The inputs for an R&D activity can be measured whereas the outputs are difficult to measure. For R&D activities, the time taken for a particular research cannot be estimated as it may take months or sometimes years for a particular activity. Also the output is difficult to measure because of its technical nature. Lack of goal congruence: As in administrative centers, goal congruency is lacking in R&D centers, too. Conflict may arise between the research manager and the business unit manager. The research manager may want to build the best research and development center, no matter what the expense be, while it may not be possible for the company to afford it. Also, the researchers may not have sufficient knowledge about the business, in some cases. The research and development costs cannot be controlled on a year-to-year basis because a research project may take years to show results and the organization would have to bear the cost of the project for that period of time, mainly the cost on labor. Marketing centers There are two types of marketing activities in every organization: order filling (logistics) and order getting. Order getting is an actual marketing activity. Order filling activities include 19

transferring goods from the company to the customer, and receiving the appropriate pay from the customer. These are mostly engineered expense centers. Order getting activities include test marketing, training sales force, advertising, sales promotion, etc. Though the output of a marketing organization can be measured, it is difficult to evaluate the marketing effort, as the marketing department has no control over economic conditions or competitors actions. These actions may be different from what was expected when the sales budgets were established. In such situations, it is difficult to achieve management control. Also, it becomes difficult to measure the efficiency and effectiveness of these costs. Profit centers When financial performance of a responsibility center is measured in terms of the organizations profit, then it is called a profit center. In a profit center, performance is measured in terms of the numerical difference between revenues (outputs) and expenditure (inputs). A profit center is given the responsibility of earning profits. It is involved in the manufacture and sale of outputs, and it measures how well the center is doing economically. The profit center also determines the efficiency of the manager in charge of the center. A profit center helps in motivating managers to perform well in areas they control and also encourages managers to take initiatives. The profit center helps the organization to make the best use of specialized market knowledge of the divisional managers, and entrusts the local managers the responsibility of tradeoffs. Profit centers have been used as a major management control tool. The major advantages of profit centers are: These help in increasing the speed of making operating decisions as they do not have to be referred to corporate headquarters. As the decision-making authority lies with the managers they can make better decisions

related to the task they are performing, because they can understand the nature of the work better. Since profit centers make their day-to-day decisions themselves headquarters can

concentrate on broader issues of the organization. 20

Managers are motivated to perform more effectively, as they are responsible for

increasing the profit of their unit. Managers use their imagination, take initiatives to perform more effectively, to increase the profit of their unit. However, there are certain difficulties associated with the creation of profit centers. The management cannot have considerable control over the different profit centers when decisions are centralized. The top management has to depend on management control reports which may not be as effective as the personal knowledge of an operation. There may be no place for competent general managers in a functional organization because of lack of opportunities for them to develop creative management skills. Organizational units compete with one another, and this may, sometimes, result in conflict between different centers and reduction in cooperation between different units and sharing of resources.

Types of profit centers Functional units can be classified as different types of profit centers. A multibusiness company can be divided into independent profit generating units such as marketing, finance, manufacturing etc. The decisions regarding whether a particular functional unit can be a profit center depends on the responsibility center manager's ability to influence, if not control, other activities that affect the company's bottom line. The different types of profit centers are discussed below: Marketing: A marketing activity becomes a profit center if it is charged with the cost of the products sold. A marketing activity can be given the responsibility of making profit when the marketing manager has the authority to make principal cost/revenue trade off in terms of marketing a product, spending on sales promotion, the appropriate time for this expenditure and 21

on which media to spend. Manufacturing: This is an expense center and the management of activities here is based on performance against standard costs and overhead budgets. Problems in measurement may occur because of inadequate quality control, shipping of inferior quality products, and so on, to obtain standard cost credit. At times, there may arise the need to accommodate an order in-between production schedules, and the manufacturing managers may be reluctant to interrupt these schedules. In manufacturing units, when performance is measured against standards, there may be no incentives for manufacturing products that are difficult to produce. These factors may demotivate the managers, and eventually, they may not try to improve standards. Hence, while measuring the performance of manufacturing activities against standard costs, it is important to take into consideration quality control, production scheduling and the make or buy decisions. Measuring profitability: Profitability measurements in a profit center can be of two typesmanagement performance and economic performance. Management performance focuses on the managers performance while economic performance relates to how well a profit center is performing as an economic entity. Management performance is a measure used for planning, controlling and coordinating the day-to-day activities of the profit center. The performance measures of profit centers can be different and hence, the necessary purpose for the information should not be obtained from a single set of data. For example, the management performance report can show excellent performance of a profit center manager. But the economic and competitive forces for that particular report can show poor economic performance. As a result, the center may run into losses and may even have to close shop. Types of profitability measures: The parameters that can be used for measuring the profitability of a profit center are contribution margin, direct profit, controllable profit, income before taxes and net income. Contribution margin: This performance measure is used on the premise that, since fixed expenses are not controllable by the manager, the focus should rest on maximizing the difference between revenues and variable expenses. The problems of using contribution margin is that since many of the centers expenses may vary according to the discretion of the profit 22

center manager, focus on the contribution margin tends to direct the attention of the profit center manager away from the goals of the center. Direct profit: This measure helps in understanding the contribution of the profit center to the general overhead profit of the corporation. It encompasses all the expenses directly incurred by profit centers or related to profit centers, irrespective of whether the expenses are controllable by the profit center manager. However, it does not include corporate expenses. Controllable profit: The headquarters expenses in an organization can be divided into two categories-controllable and uncontrollable. Controllable expenses include expenses that are controlled by the business unit manager. The advantage of including such costs in the measurement system is that the profit will be calculated after the deduction of expenses that can be influenced by the profit center manager. Hence, these are controllable profits. As uncontrollable headquarters expenses are taken into consideration while calculating controllable profits, controllable profits cannot be compared directly with published data or with trade association data, which report the profits of other companies in the industry.

Income before taxes: In this method, all corporate overhead profit is allocated to the profit center. The amount of expense incurred by each profit center forms the basis of allocation of profit. Such allotment has its own drawbacks. Firstly, the costs in departments like finance, and HR are not controllable by the profit center and hence, profit centers should not be held accountable for such costs. Also, it is difficult to quantify the amount that has been spent on human resources in each profit center. However there are certain advantages in allocating costs. Corporate service units often have a tendency to spend lavishly to make their units as excellent as possible without paying due attention to the value they create for the company. Once such costs are allocated to profit centers, the profit center managers will try to keep a check on the expenditure. The performance of profit centers is easily comparable to that of competitors performance who pay for similar services. 23

Since the profit center can earn profit only when it has recovered all its costs, including allocated corporate overhead costs, the profit center manager will be motivated to make longterm marketing decisions such as pricing, product mix, and so on, because the center will have to recover its share of corporate overhead costs. For profit centers to function with the allocated costs in mind, it is important that they are allocated budgeted costs, and not actual costs. This ensures that the profit center managers will perform without complaining about the arbitrariness of the allocated costs, since there would be no variances in the allocated overheads in the performance reports. Net income: The performance is measured by taking into consideration the net income after the payment of taxes. The disadvantage of using this method is that many decisions that have an impact on the income taxes are made at headquarters, and profit center managers should not be judged by these decisions. If the income after tax payment is constant percentage of the income before tax payment, then there would be no need to measure performance based on this method. This method would be useful if profit centers influence decisions like installing credit policies or disposing of equipment. This method is also useful to motivate the manager to minimize taxes in case the taxable income differs from income, as measured by using generally accepted accounting principles. The performance of profit centers can be measured by comparing actual results with one or more of the measures discussed above with budgeted amounts. In addition, data on competitors and industry provide a good crosscheck on the appropriateness of the budget. Investment centers An investment center has control over sales revenues and operating costs, and the assets used to generate profit. An investment unit manager must be in a position to influence the size of the investment and profit variables. An investment center is a measure of economic performance, and it analyzes all elements of profit and investment. The objective of this center is to maximize profit, given the amount of investment required to generate the profit.

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Cost centers The objective of cost center is to minimize the variance between standard costs and actual costs. A cost center is a production or service function, activity or item of equipment the costs of which may be attributed to cost units. Cost centers are basically related to costs, and not to the revenues or assets and liabilities of the organization. A cost center is a separate organizational unit for which separate cost allocation is done. A cost center forms the basis for building up cost records for cost measurements, budgeting and control. From a functional point of view, a cost center is a production cost center (where only production is undertaken like a assembly department), a service cost center (offering service to production departments like personnel, accounting etc.,) or an ancillary manufacturing center (producing packing materials).

Chapter No. 3 Segment Reporting and Profitability

Decentralization and segment reporting A segment is a part or activity of an organization about which managers need to know cost, revenue or income data. Examples of segments include divisions of a company (responsibility centers), sales territories, projects, product families, individual stores, programs, operational departments, individual customers, services categories and product lines. Effective decentralization requires segment reporting, so the companywide income statement, reports are needed for individual segments of the organizations. These segmented 25

income statements are useful in analyzing the profitability of segments and measuring the performance of segment managers. A different kind of income statement is required for evaluating the performance of a cost center, a profit center or an investment center. This income statement should emphasize on the segment rather than the performance of the company as a whole. A contribution margin or a residual contribution margin, format income statement is used to evaluate the performance of different types of segments. In a contribution margin format income statement cost of the segment consists only of the direct costs (variable and fixed costs). To prepare an income statement for a particular segment variable costs are traced for the resources which use depends of the degree of the activity of the segment and the fixed costs dont depends of the degree of the activity, but are related with the segment. This fixed cost are designated by traceable fixed and are assigned to the segments but non-traceable or common fixed costs are not assigned to segments.

Segment Contribution Margin The segment contribution margin is obtained by deducting the variable and the traceable fixed costs from the segment revenues. It represents the margin that is available after a segment has covered all of its own costs. The segment contribution margin can be the best gauge of the long-run profitability of a segment, since it includes only those costs that are caused by the segment. If a segment cannot cover is own costs, then that segment probably should not be retained (unless it has an important side effects on other segments or is strategic relevant). From a decision making point of view, the segment contribution margin is most useful in major decisions that affect capacity such as dropping a segment, including decisions relating to short-run changes in volume, such as pricing special orders that involve utilization of existing 26

capacity. Example As an example, a segmented report is shown, where the segments have been defined as divisions. Report also has a column of total company performance for the period. We can see that divisional segment margin is Rs60,000 for business product division and Rs40,000 for the consumer product division. This report is very useful for company's divisional managers they may want to know how much each of their divisions is contributing to the company's profit. Segments defined as divisions (values in mRs):

Total __Segments_____ _ Revenues (ex: sales) Variable expenses: Cost of goods sold 36,000 Other variable expenses 10,000 Total variable expenses 46,000 Margin 54,000 Traceable fixed expenses 34,000 Divisional Contribution margin 20,000 Common fixed expenses (not traceable to the individual divisions)17,000 Net operating income 3,000 27 Company Division A Division B 100,000 60,000 40,000 24,000 6,000 30,000 30,000 18,000 12,000 12,000 4,000 16,000 24,000 16,000 8,000

Traceable and Common Fixed Costs One of the most puzzling aspects of segmented income statements is probably the treatment of fixed costs. While preparing segmented income statements the fixed cost is divided into two parts, one is traceable fixed cost and other is common fixed cost. Only traceable fixed costs are assigned to the segment. If a cost is not traceable then it is not assigned to segments. Following paragraphs define explain these two types of fixed costs. Traceable fixed cost: A traceable fixed cost is a fixed cost that is incurred because of the existence of a segment. If the segment had never existed, the fixed cost would have not been incurred; and if the segment were eliminated, the fixed cost would disappear. Examples: Examples of traceable fixed costs:

The salary of the Division A manager is a traceable fixed cost of the Division A.

The

renting of the equipment to produce exclusively the Product Line P, is a traceable fixed cost of the Product Line P.

The depreciation of a car for rent is a traceable fixed cost of the renting business in a rent

a car company. Common fixed cost: A common fixed cost is a fixed cost that supports the operations of more than one segment, but is not traceable in whole or in part to any one segment. Even if a segment were entirely eliminated, there would be no change in true common fixed cost. Examples: 28

Example of common fixed cost includes the following:

The salary of general manager who controls all the segments. The salary of CEO at

TELECOM is also an example of common fixed cost. No single segment can be regarded as the sole reason of this cost.

The salary of receptionist at an office shared by a number of doctors is a common fixed cost

of the doctors. The cost is traceable to the office, but not to any one of the doctors individually. Identifying traceable and common fixed costs is crucial in segment reporting, since the traceable fixed costs are charged to the segments and common fixed costs are not charged to segments. In actual situations, it is sometimes hard to determine whether a cost should be classified as traceable or common. The general guideline is to treat as traceable costs only those costs that would disappear over time if the segment itself disappeared. Fixed cost that is traceable to one segment is, usually, a common cost for another segment. For example, one Trading Company might want a segmented income statement that shows the segment margin for each territory where is operating and for each client. The fixed territory manager salary is a traceable fixed cost of one territory, but it is a common fixed cost of the client segment of that territory. So, traceable and common cost is relative concepts. Problems to Proper Cost Assignment in Segmented Reporting: For segment reporting to accomplish its intended purposes, costs must be properly assigned to segments. If the purpose is to determine the profits being generated by particular segment or division, then all of the costs attributable to that division or segment--and only those costs--should be assigned to it. Unfortunately, three practices greatly hinder proper cost assignment: Omission of costs:

29

The costs assigned to a segment should include all costs attributable to that segment from the company's entire value chain. The value chain consists of major business functions that add value to a company's products and services. All of these functions, from research and development, through product design, manufacturing, marketing, distribution, and customer service, are required to bring a product or service to the customer and generate revenues. Inappropriate methods for allocating costs among segments: Cost distortion, occurs when costs are improperly assigned among a company's segment. Cross-subsidization can occur in two ways; first, when companies fail to trace costs directly to segments in those situations where it is a feasible to do so; and second, when companies use inappropriate bases to allocate costs. Costs that can be traced directly to a specific segment of a company should not be allocated to other segments. Rather, such costs should be charged directly to the responsible segment. For example, the rent for a branch office should be charged directly against the branch office rather than included in a companywide overhead pool and then spread throughout the company. Some companies allocate costs to segments using arbitrary bases such as sales value or cost of goods sold. For example, under the sales value approach, costs are allocated to the various segments according to the percentage of company sales generated by each segment. If a segment generates 20% of total company sales, it would be allocated 20% of the company's overheads expenses as its fair share. This same basic procedure is followed if cost of goods sold or some other measure is used as the allocation base. For this approach to be valid, the allocation base must actually drive the overhead cost. Or at least the allocation base should be highly correlated with the cost driver of the overhead cost. For example, when sales value is used as the allocation based for SG&A expense, it is implicitly assumed that overheads expenses change in proportion to change in value sales. If that is not true, the allocated expenses to segments will be misleading.

30

Arbitrarily dividing common costs among segments The third business practice that leads to distorted segment costs is the practice of assigning no traceable costs to segments. For example, some companies allocate the costs of the corporate headquarters building to products on segment reports. However, in a multiproduct company, no single product is likely to be responsible for any significant amount of this cost. Even if a product were eliminated entirely, there would usually be no significant effect on any of the costs of the corporate headquarters building. There is no cause and effect relation between the cost of the corporate headquarters building and the existence of any one product. As a consequence, any allocation of the cost of the corporate headquarters building to the products must be arbitrary.

Residual Income

Residual income is the net operating income that an investment center earns above the minimum required return on its operating assets. Residual income is a consistent approach to measuring an investment center's performance. Economic Value Added (EVA) is an adoption of residual income that has recently been adopted by many companies. When residual income or EVA is used to measure managerial performance, the objective is to maximize the total amount of residual income or EVA. Example For the purpose of illustrating, consider the following data for an investment center of a company. Basic Data for Performance Evaluation 31

Average operating assets Net operating income

Rs 80,000 Rs18,000

Minimum required rate of return15%

The company has long had a policy of evaluating investment center managers based on ROI, but it is considering a switch to residual income. The following table shows how the performance of the division would be evaluated under each of the two methods:

Alternative Performance Measures Residual Income 1. Average operating assets Rs 80,000 Rs 80,000 2. Net operating income Rs 18,000 Rs 18,000 ROI, (2) (1) 22,5% Minimum required return (15% Rs 12,000 Rs80,000) Rs 6,000 Residual income Comparison of return on investment (ROI) and residual income: One of the primary reasons why controllers of companies would like to switch from ROI to residual income has to do with how managers view new investment under the two 32 ROI

performance measurement schemes. The residual income approach encourages managers to make investments that are profitable for the entire company but that would be rejected by managers who are evaluated by ROI formula. To illustrate consider the data mentioned above and further suppose that the manager of the division is considering purchasing a machine. The machine would cost Rs 25,000 and is expected to generate additional operating income of Rs 4,500 a year. From the stand point of the company, this would be a good investment since it promises a rate of return of 18% [(Rs4,500 / Rs25,000) 100], which is in excess of the company's minimum required rate of return of 15%. If the manager of the division is evaluated based on residual income, he would be in favor of the investment in the machine as shown below. Performance evaluated using residual income Present Rs 80,000 Rs 18,000 Rs 12,000 Rs 6,000 New Project Rs 25,000 Rs 4,500 Rs 3,750 Rs 750 Overall Rs 105,000 Rs 22,500 Rs 15,750 Rs 6,750

Average operating assets Net operating income Minimum required return

Residual income Since the project would increase the residual income of the division, the manager would want to invest in the new machine. Now suppose that the manager of the division is evaluated based on the return on investment (ROI) method. The effect of the machine on the division's ROI is computed as below: Performance evaluated using residual income Present 33 New project Overall

Average operating assets (1) Rs 80,000 Net operating income (2) Rs 18,000 ROI, (2) (1) 22,5%

Rs 25,000 Rs 4,500 18%

Rs105,000 Rs 22,500 21,4%

The new project reduces the ROI from 22, 5% to 21,4%. This happens because the 18% rate of return on the new machine, while above the company's15% minimum rate of return, is below the division's present ROI of 22,5%. Therefore the new machine would drag the division's ROI down even though it would be a good investment from the standpoint of the company as a whole. Basically, a manager who is evaluated based on ROI will reject any project whose rate of return is below the division's current ROI even if the rate of return on the project is above the minimum rate of return for the entire company. In contrast, any project whose rate of return is above the minimum required rate of return of the company will result in an increase in residual income. Since it is in the best interest of the company as a whole to accept any project whose rate of return is above the minimum rate of return, managers who are evaluated on residual income will tend to make better decisions concerning investment projects than manager who are evaluated based on ROI. So, in financial point of view, residual income leads managers to take decisions more aligned with overall company interest. Residual income is more convergent than ROI.

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Chapter No. 4 ROLE IN PRACTICING A PERFORMING MANAGEMENT

A responsibility centre corresponds to an inferior level of responsibility for the enterprise and, in the same time, it is the base for calculating the performances of the one responsible with the accomplishment of the undertaken tasks. From the economic viewpoint, the responsibility centres can be classified into profit centres and costs centres. The profit centres can be considered those divisions of an enterprise, which are realizing in fact the outlet, such as the basis wards. The costs centres are those divisions of an enterprise, which are determining only the expenses (costs). From budgeting the profit and cost centres, meaning the responsibility centres, we can forecast the complete posts regarding the determination of the supplying prices. The budget laying down methodology supposes the following steps: A. Elaborating the outlet costs budget; B. Elaborating the general administrating expenses budget; C. Elaborating the marketing expenses budget. Enterprises goals achievement is materialized for each structural level, which imposes the forecasts study on enterprises divisions, called responsibility centres. The responsibility centre is regarded as an interconnected elements ensemble, which is forming an entirety, having a certain autonomy level in using and optimizing the resources available. 35

A responsibility centre corresponds to an inferior level of responsibility for the enterprise and, in the same time, it is the base for calculating the performances of the one responsible with the accomplishment of the undertaken tasks. Usually, a responsibility centre can be assimilated to a managerial entity having precise structural characteristics. It is defined as an ensemble in one physic persons responsibility, as an official service provided with self-means, which are allowing it to accomplish its attributions and goals. Considering that available grouping of the responsibility centres are not valid if the units specific and their structure relieve a diversity of possibilities. Some authors delimitate partial and global responsibility centres depending on the main purchases. From the economic viewpoint, the responsibility centres can be classified into: - Profit centres; - Costs centres. The profit centres can be considered those divisions of an enterprise, which are realizing in fact the outlet, such as the basis wards. It is the strategic link where we can calculate the profit as a difference between the revenues and expenses. The costs centres are those divisions of an enterprise, which are determining only the expenses (costs) - in this case we can control only the costs level. The responsibility centres structure can be illustrated as it follows in the next diagram:

36

Figure no. 1. Responsibility centres structuring into profit and costs centres . Regarding the costs calculation depending on costs centres, we have to specify that, the structure is particular depending on the outlets specific and enterprises organizational framework. The costs centres represent the enterprises technique, productive, organizational and managing frames divisions, depending on which is organized the planning and analytic supervising of the outlet expenses. The concrete result of the outlet process is individualized in costs calculation, designated as costs bearers, represented through products, works and services obtained in the outlet process, which have generated the exploitation expenses for which the cost is determined and the activitys supervising is realized also. The costs calculation structure regards the costs centres (productive wards) in which the costs are allocated on different bearers. The costs bearer accomplishes the individual costs identifying function, as well as the control function regarding the enterprises activity volume. Excepting the costs and profit centres there are revenues centres, as divisions generating 37

revenues (for example, the sells department) or investment centres, which reflects the revenues from the outlet selling, and as well, the investments done for the outlet finality. The profit centres are the ones that generate revenues able to cover entirely the activitys expenses, and finally obtaining an over income, meaning a profit. The cost centres have only maximum limits for the expenses that are ensuing from a normal activity. From budgeting the profit and cost centres, meaning the responsibility centres, we can forecast the complete posts regarding the determination of the supplying prices. The budget laying down methodology supposes the following steps: A. Elaborating the outlet costs budget (ward cost), which includes - Raw materials direct expenses budget; - Salaries and accessories direct expenses budget; - Outlet indirect expenses budget (outlet administrating expenses); B. Elaborating the general administrating expenses budget C. Elaborating the marketing expenses budget. Synthetically the complete commercial costs budget can be presented as it follows:

38

Figure no. 2. Complete Commercial Costs Budget A. The complete commercial costs budget can be determined by using the following mathematical models: 1) BCCC = BOC + BGAE + BME Where: BCCC - Complete Commercial Costs Budget; BOC - Outlet Costs Budget; BGAE - General Administrating Expenses Budget; BME - Marketing Expenses Budget. Outlet Costs Budget (BOC) - it includes the direct outlet expenses budget and indirect outlet expenses budget, and is calculated as it follows: 2) BOC = BDE + BOIE Where: 39

BDE - Direct Expenses Budget; BOIE -Outlet Indirect Expenses Budget. Direct Expenses Budget (BDE) includes the raw materials direct expenses budget and the direct salaries expenses budget. So: 3) BDE = BRMDE + BSDE Where: BRMDE - Raw Material Direct Expenses Budget; BSDE - Salaries Direct Expenses Budget. Raw Material Direct Expenses Budget (BRMDE) - is determined based upon the technological consumptions norms and the acquisition/outlets costs of the raw materials and direct materials. 4) BRMDE = Q * ? nci * ci Where: Q - Fabricated product quantity; nci - Technological consumption norm for i material; c i - Acquisition/outlet cost for the i material; n - Used materials number. The budgets measure determined before considers the finished good obtained quantity. For the average (per unit) determination of the budget we report the obtained amount at the outlets volume. Salaries Direct Expenses Budget (BSDE) - it is established considering the time norms for realizing the operations necessary for costs bearers outlet and the hourly tariffs corresponding to each operation. 5) BSDE = Q * ?nti * ti Where: nti - time norm corresponding for the i operation; ti - hourly tariff for the i operation;

40

n - The necessary number of operations for the products fabrication Outlet Indirect Expenses Budget (BOIE) - is determined for each ward separately. It supposes the added of the installations maintenance and functioning expenses with the general expenses of the ward, as it follows: 6) BOIE = BMFE + BWGE Where: BMFE - Installations Maintenance and Functioning Expenses Budget; B WGE - Wards General Expenses Budget. At the enterprises level the total outlet indirect expenses budget is obtaining through the addition of the outlet indirect budget with the outlet wards budgets. Mathematically: 7) BTOIE = BOIE1 + BOIE2 + + BOIEn = ? BOIEi Where: BTOIE - Total Outlet Indirect Expenses Budget; BOIEi - Outlet Indirect Expenses Budget for the i ward; n - The enterprises wards number. If we consider the two elements of the outlet indirect expenses budget, then the formula above is becoming:

8)

BTOIE = ? BOIEi = ? (BMFEi +

BWGEi) Where: BTOIEi - Installations Maintenance and Functioning Expenses Budget for the i ward; B WGEi Wards General Expenses Budget for the i ward. Installations Maintenance and Functioning Expenses Budget (BMFEi) - includes: Technological installations and transportation means maintenance and functioning, technique reviews and current reparations expenses for the ward; 41

- Expenses regarding the depreciation of the technologic installations and transportation means of the ward; - Expenses regarding the depreciation of the special destination installations and the inventory objects of the ward; Expenses regarding the energy, fuel and other expenses with the materials used for

technological goals of the ward; - Other expenses regarding the installations maintenance and functioning and the transportation means of the ward. Wards General Expenses Budget (BWGE) - includes two budgets: the general interest expenses budget of the ward and husbandry expenses budget. The first one includes: - Expenses regarding the salaries and the salaries accessories of the managing, technique, economic and other specialty personnel; - Expenses regarding the current reparations of the buildings and other means of general interest of the ward, as well as the capital reparations of the buildings and wards fixed means; - Expenses regarding the buildings and other wards fixed means depreciation; - Expenses regarding labor protection inside the ward; - Other general interest expenses of the ward. The second budget includes: - Expenses regarding maintenance and cleaning of the husbandry buildings of the ward; Expenses regarding the energy for husbandry use; 42

- Expenses regarding water, sanitation and for the husbandry needs of the ward; - Expenses regarding the office materials for the wards needs; - Expenses regarding the magazines, books, publications and subscriptions for the wards needs and the Posts expenses; - Other husbandry expenses of the ward. B. General Administrating Expenses Budget (B GAE) includes the entirety of the general interest expenses and the enterprises husbandry expenses. 1) BGAE = BEGIE + BEHE Where: BEGIE - Enterprises General Interest Expenses Budget; BEHE - Enterprises Husbandry Expenses Budget. the Enterprises General Interest Expenses Budget (BEGIE) - are included: Expenses

regarding the salaries and salaries accessories of the managing, technique, economic, other specialty, administrative, service and security personnel of the enterprise; - Expenses regarding the buildings current reparations; Expenses regarding the depreciation of the enterprises fixed means; - Expenses regarding the researches, experiences, studies, investments and general interest innovations; - Expenses regarding the general labor protection; - Expenses regarding enterprises interest rates; Other enterprises expenses (personnel transportations cost, buildings taxes, insurance policies). The Enterprises Husbandry Expenses Budget (BEHE) includes: - Expenses regarding the offices materials; 43

Expenses regarding the acquisition of books, magazines and subscriptions; for the companys interest;

Expenses

regarding the business travels, detaches or transfers in the country with or without trips abroad

- Expenses regarding the energy consumption for husbandry goals; - Posts expenses of the enterprise; - Expenses regarding the water, sanitation for management and husbandry purposes; - Others expenses for enterprises husbandry. Depending on the services number and complexity (finances, marketing, personnel) offered by the management can be laid down two or more budgets. Regarding the small companies it can be only one budget. C. Marketing Expenses Budget (BME) includes the entirety of expenses generated by the outlet selling process, such as: - Expenses regarding the products transportation and manipulation, products that are delivered to the internal customers; - Internal transportation, manipulation, storage, reconditioning and clearance expenses of the products delivered for export; - Wrapper expenses for the delivered products; - Advertising expenses.

Chapter No. 5 Transfer Pricing

When an organization has a decentralized structure, it has several separate profit centers1. Goods and services are transferred internally from one profit center to another, before the final product/service is brought to the market. Companies find it useful to account for the value of goods and services exchanged, even if the exchange is only internal and does not involve the market at all. This helps the company to assess the contribution of each of the profit 44

centers separately. To help in such assessment, a mechanism called transfer pricing has been developed. Transfer pricing helps to determine the value of goods and services transferred before calculating the profits of the company. A transfer price is defined as the price that is assumed to have been charged by one part of a company for products and services it provides to another part of the same company, in order to calculate each division's profit and loss separately. In this chapter we will discuss the objectives of transfer pricing, various methods of transfer pricing and ways of administering these prices. PRINCIPLE OF TRANSFER PRICING The fundamental principle of transfer pricing is that the transfer price should be similar to the price that would be charged if the product were sold to outside customers or purchased from outside vendors. Goal Congruence While designing the mechanism for transfer pricing, the interests of profit centers should neither supersede the interests of the overall organization, nor should there be a clash of interests between the organization and its profit centers. In other words, there should be goal congruency between profit centers and parent organization. Some of the prerequisites for achieving goal congruency are: Competent people Good organizational atmosphere Details of market prices Freedom to source Availability of information

Organizations need managers who can balance long-term and short-term goals. Managers are often accused of sacrificing long-term gains for shortterm profits. This approach can prove disastrous for the organization. Transfer pricing can be misused for manipulating profits, and this gives a wrong picture of the position of the company. Hence, organizations should have competent people skilled at negotiation and arbitration, who are capable of determining the appropriate transfer prices. This makes goal congruency possible. 45

Good atmosphere In order to achieve goal congruency, managers of profit centers, especially the buying profit centers, should ensure that the transfer prices charged by the selling profit centers are just. This will create an atmosphere of trust between selling profit center and buying profit centers. Details of market prices When a product is transferred from one profit center to another, the normal market price for the identical product can be taken as the basis for establishing the transfer price. The market price should reflect the same conditions in terms of quantity, quality, time for delivery, etc. as characterize the product to which the transfer price applies. The market price can be adjusted to reflect savings due to lower expenses on advertising and marketing as the product is sold within the company. Freedom to source Managers of selling profit centers should be given freedom to sell their goods in the external market, while managers of buying profit centers should be allowed to buy their goods from the external market. Thus the market becomes the main determinant of the transfer price. Availability of information Managers should be fully aware of market conditions and should have all the necessary information available to them, before they take any decision. For example, managers should be aware of the alternatives available and the relevant costs of and revenues derivable from each alternative. Scope for negotiation There must be a mechanism for negotiating contracts, and managers who take transfer pricing decisions should be trained in negotiation. If all the above conditions are met, then companies can devise a mechanism for transfer pricing based on the market price. But quite often these conditions are not fulfilled, and it becomes difficult to achieve goal congruency. Some situations that are not favorable for achieving goal 46

congruency are: Limited markets Excess or shortage of capacity in the industry Limited markets Markets for buying and selling the goods of the profit centers may be either very small or nonexistent. Some of the reasons for this are: Firstly, the profit center may have spare internal capacity, but may not wish to make any external sales. Secondly, if the company is the sole producer of a differentiated product then outside capacity does not exist. Thirdly, a company that has invested heavily in facilities will not want to source goods from outside unless the selling price in the market is as low as its own variable cost. Excess or shortage of industry capacity There may be situation of excess capacity or shortage of capacity in the industry. The selling profit center does not sell in the outside market when there is excess capacity in the industry. The buying profit center may purchase from outside vendors even though there is capacity available inside the company. Thus the company, as a whole, may not be optimizing its profits. In a situation of insufficient capacity in the industry, the buying profit center may be unable to obtain products it needs from the external market, whereas the selling profit center is able to make profits by selling the product in the external market. This situation occurs when demand is high and industry capacity is low. Here also, the company, as a whole, may not be able to optimize profits. Sourcing constraints When there is an excess or shortage of industrial capacity, the sourcing decisions taken by the company are vital. A company may allow its buying profit center to buy goods from outside, if the profit center is getting a better deal in terms of quality, price and service. In the same way, a selling profit center may be allowed to sell its products in the open market if it gets a better profit by selling in the market. Whatever be the case, the management should not get bogged 47

down by pressures within the company and should try to take decisions that optimize the profit of the company. METHODS OF CALCULATING TRANSFER PRICE Methods used for calculating the transfer price differ from company to company. Companies should evaluate all the methods before adopting one that is most suitable for them. The following criteria should be used to evaluate the methods for calculating transfer price. Goal congruence: As already discussed, transfer prices should balance between goals of enterprise as a whole and its profit centers. Rationality: Transfer prices should not interfere with the process by which the buying center manager rationally strives to minimize costs and the selling center manager rationally strives to maximize revenues. Transfer Pricing Autonomy: Each profit center manager should be free to satisfy his centers needs either internally or externally at the best possible price. Performance evaluation: Transfer pricing should aid in objective evaluation of the activities of the profit center. It should be used as a tool for making proper decisions. It should also aid in appraisal of managerial performance and of the enterprise as a whole.

The three methods of calculating transfer price that are used commonly are: Market-based pricing method Cost-based pricing method Negotiated pricing method Market-Based Pricing Method 48

Companies that use this method price the goods and services they transfer between their profit centers at a price equal to that prevailing for those goods and services in the open market. This is similar to arms length pricing as intracompany transfers are priced the same as those for external customers. Market-based pricing method has two main advantages for a company. Firstly, business units can operate as independent profit centers with the managers of these units being responsible for their own performance as well as that of the business unit. When managers are made responsible for performance of the business unit, it increases their motivation and it also becomes easier for the headquarters to assess the actual operating performance of its business units. Secondly, tax and customs authorities favor the market price method because it is more transparent and they can crosscheck the price details provided by the company by comparing them with market prices on that date. In practice, however, the use of a market price as a benchmark is difficult because often there is no competitive market which can provide a comparable price. For some types of complex capital equipment, an external market may not exist at all. In some cases, prices may be distorted by monopoly elements. Moreover, a definitive market price may be difficult to determine because of variance in prices from one market to another due to changes in exchange rates, transportation costs, local taxes and tariffs etc. In addition, a company may set its selling price depending on the supply and demand conditions prevalent in a specific market. In sum, these factors mean that a unique market price for companies to follow does not always exist. Cost-Based Pricing Method The cost-based pricing method calculates transfer price on the basis of the cost of a good or service. The cost of a good or service is available in the cost accounting records of the company. This method is generally accepted by the tax and customs authorities since it provides some indication that the transfer price approximates the real cost of item. Cost-based approaches are, however, not as transparent as they may appear. A company can easily manipulate its cost accounts to alter the magnitude of the transfer price. Companies that adopt the cost-based transfer pricing method have to choose between alternative approaches, which are listed below: Actual costs approach Standard costs approach Variable costs approach 49

 Marginal costs approach Apart from this, companies also have to decide on the treatment of fixed costs, and research and development costs. These issues can prove problematic for the company that adopts a cost-based transfer pricing method. Cost-based methods usually create difficulties for the selling profit center, as their incentive to be cost-effective may fall, if they know that they can recover increased costs simply by raising the transfer price. Without an incentive to produce efficiently, the transfer price may erode the competitiveness of the final product in the market place. Negotiated Pricing Method In this approach, buying and selling business units freely negotiate a mutually acceptable transfer price. Since each unit is responsible for its own performance, this will encourage cost minimization and encourage the parties to seek a transfer price which yields them an appropriate profit return. However the tax authorities have their reservations about this method because companies that use this method have greater scope of manipulating transfer prices, to minimize their tax liability.

Chapter No.6 RESEARCH METHODOLOGY

Research is a systematic method of finding solutions to problems. It is essentially an investigation, a recording and an analysis of evidence for the purpose of gaining knowledge. According to Clifford woody, research comprises of defining and redefining problem, 50

formulating hypothesis or suggested solutions, collecting, organizing and evaluating data, reaching conclusions, testing conclusions to determine whether they fit the formulated hypothesis Sampling Design. A sample design is a finite plan for obtaining a sample from a given population. Simple random sampling is used for this study. Universe. The universe chooses for the research study is the employees of Lubrizol India Pvt Ltd. Sample Size. Number of the sampling units selected from the population is called the size of the sample. Sample of 50 respondents were obtained from the population. Sampling Procedure. The procedure adopted in the present study is probability sampling, which is also known as chance sampling. Under this sampling design, every item of the frame has an equal chance of inclusion in the sample. Nature of Research. Descriptive research, also known as statistical research, describes data and characteristics about the population or phenomenon being studied. Descriptive research answers the questions who, what, where, when and how. Although the data description is factual, accurate and systematic, the research cannot describe what caused a situation. Thus, descriptive research cannot be used to create a causal relationship, where one variable affects another. In other words, descriptive research can be said to have a low requirement for internal validity. Questionnaire.

51

A well defined questionnaire that is used effectively can gather information on both overall performance of the test system as well as information on specific components of the system. A defeated questionnaire was carefully prepared and specially numbered. The questions were arranged in proper order, in accordance with the relevance. Sample A finite subset of population, selected from it with the objective of investigating its properties called a sample. A sample is a representative part of the population. A sample of 50 respondents in total has been randomly selected. The response to various elements under each questions were totaled for the purpose of various statistical testing. Presentation of Data. The data are presented through tables

Research Hypothesis
Based on the theoretical frame and the previous studies, the following hypotheses were formed: HO1: the Lubrizol India Pvt. Ltd. do not divide the organizational structure into centers of 52

responsibility. HO2: the Lubrizol India Pvt. Ltd. do not authorize the managers of responsibility centers with clear powers. HO3: the costs and the revenues are not distributed to the centers of responsibility according to each centers capability and powers in the Lubrizol India Pvt. Ltd. HO4: the Lubrizol India Pvt. Ltd. do not link previously the estimated budgets with the centers of responsibility. HO5: the estimated budgets are not used for control and performance evaluation in the Lubrizol India Pvt. Ltd. Research For achieving the objectives of the study, the descriptive analytical method was used. In addition, the suitable statistical procedures, MS Excel were used for testing the hypotheses and for presenting and analysis of the data. Methods for Collecting Data The researcher depended on two kinds of data during collecting it Secondary data: the related studies of auditing about the subject of the study were reviewed from different references, magazines, studies, periodicals, etc. for developing the theoretical background of the study.

Primary data: the researcher made a comprehensive field survey for the population of the study by using a questionnaire to collect data and test the hypotheses of the study. The questionnaire consisted of two parts. The first part aimed at collecting general data to identify the characteristics of the sample of the study. The second part aimed at getting data related to study 53

hypotheses. The population and the sample of study The population of the study is represented by all the Lubrizol India Pvt. Ltd. of the sample was represented by a random sample consists of 50 assistants of the general managers. 55 questionnaires were distributed but 50 were retrieved with a percent 91%.
Table (1) The description of the sample Scientific qualification N Portion Diploma 3 6% Bachelor 35 70% Master 10 20% Doctorate 2 4% Age Less than 25 years 7 14% 25-34 8 16% 35-44 26 52% More than 45 years 9 18% Practical experience Less than 5 3 6% 5-9 years 9 18% 10-14 years 28 56% More than 15 10 20% Job title Assistant of general 2 4% manager Head of department Branchs manager Head section Employee 8 18 15 7 16% 36% 30% 14%

Statistical analysis of data The following statically methods were used to analyze data and test the hypothesis according to SPSS: 1- Testing the reliability of the tool of the study: It was used to measure the internal reliability 54

of the questionnaires items and the internal consistency among the responses of the respondents which was 72% and this value is acceptable as it is higher than 60% so the results could be generalized. 2- Normality Distribution Test: It was used to test the normality of the distribution of data. And the results showed that the data was distributed normally. It is illustrated from the table that the significance level 5% for all the hypotheses of the study which was bigger than the level of significance Z, was distributed normally. Normality Distribution Test Hypothesis 1st 2nd 3rd 4th 5th 6th 7th 0.737 1.176 0.855 1.079 0.945 0.835 0.829

3- Testing the hypothesis One Sample T-Test at the level of significance 5% was used to test the hypotheses of the study, and according to the rule of the acceptance of the hypotheses if the calculated T was less than the tabulated one. The descriptive analysis, which includes frequencies means and the standard deviations of accepting or rejecting the hypothesis, was used.

The first hypothesis: The Lubrizol India Pvt. Ltd. do not divided the organizational structure to centers of responsibility. This hypothesis was tested through the first seven items of the questionnaire, and the results were as follows: Results of testing the first hypothesis

T calculated 11.95

T tabulated 1.96

Sig

Result of null hypothesis 0 Rejection

Mean 3.76

Std 0.451

55

As the calculated T is bigger than tabulated T, this means rejecting the null hypothesis and accepting the alternative one and the mean of the hypothesis is more than 3 which means it is acceptable. So the Lubrizol India Pvt. Ltd. divide the organizational structure to centers of responsibility. And table shows the mean and the standard deviation of the items of the first hypothesis The items of the first hypothesis Item Mean 1 There is an organizational structure divided into administrative units according the nature of the activity. 2 There is clarity in dividing the work in the administrative units. 3 There is a clear description to the centers of responsibility. 4 There is a coordination and clarity in the relation between the centers of responsibility 5 There is a specialized manager for each center of responsibility. 6 Every center of responsibility has one type of activity 7 The operations inside the center of responsibility are characterized by homogeneity 3.88 2.44 3.7 0.98 0.97 1.05 4.2 0.67 4.02 4.28 0.84 0.755

Std 3.96 1.02

The second hypothesis: The Lubrizol India Pvt. Ltd. do not authorize the managers of responsibility centers with clear powers. And this hypothesis was tested through the items (8 - 13) of the questionnaire. And the results were as follows: Results of testing the second hypothesis

56

T calculate d 12.085

T tabulated 1.96

Sig T

Result of null hypothesis 0 Rejection

Mean

Std

3.97

0.57

As the calculated T is bigger than tabulated T, this means rejecting the null hypothesis and accepting the alternative one and the mean of the hypothesis is more than 3 which means it is acceptable according Lickert scale. So the Lubrizol India Pvt. Ltd. authorized the managers of responsibility centers with clear powers. The table showed the mean and standard deviation of the items of the second hypothesis: The items of the second hypothesis Item Mean Std 8 The manager is told his duties in the center of 3.86 responsibility 9 The manager of the center is granted appropriate authorities to do his work. 10 There is a description and identification of the responsibilities and the authorities of every job 11 The employees of the center of responsibility have the needed expertise to do their work in the center 12 The manager of the center is given enough time to do their work. 13 The employees accountability suits their responsibilities. 4.02 4.08 0.74 0.96 4 0.92 3.94 0.99 3.92

0.92 0.98

The third hypothesis: The costs and the revenues are not distributed to the centers of responsibility according to each centers capability and powers in the Lubrizol India Pvt. Ltd. This hypothesis through the items (14 - 18) of the questionnaire, and the results 57

were as follows: Results of the third hypothesis T calculated 11.9 T tabulated 1.96 Sig T Result of null hypothesis 0 Rejection Mean 3.92 Std 0.54

As the calculated T is bigger than tabulated T, this means rejecting the null hypothesis and accepting the alternative one and the mean of the hypothesis is more than 3 which means it is acceptable according Lickert scale. So there is a distribution of the costs and the revenues to the centers of responsibility according to each center and its powers in the Lubrizol India Pvt. Ltd. Table showed the mean and the standard deviation of the items of the third hypothesis The items of third hypothesis N Item Mea n 14 All the revenues regarding the center of responsibility are identified and recorded. 15 All the costs regarding the center of responsibility are identified and recorded. 16 There is clarity in the system of comparing the revenues with the costs of the
center of responsibility 17 There is a clear policy regarding the indirect costs distribution to the centers of responsibility

Std 0.97

3.68

4.04 1.009 3.8 4.1 1.1 0.88

18 There is a clear and identified system of the costs distribution and the revenues.

3.9 0.839

The fourth hypothesis: The Lubrizol India Pvt. Ltd. do not link previously the estimated budgets with the centers of responsibility. This hypothesis was tested through the items ( 19-23) of the questionnaire and the results were as follows: 58

Results of the fourth hypothesis T calculated 6.805 T tabulated 1.96 Sig T Result of null Mean 3.37 Std 0.39

hypothesis 0 Rejection

As the calculated T is bigger than tabulated T this means rejecting the null hypothesis and accepting the alternative one and the mean of the hypothesis is more than 3 which means it is acceptable according Lickert scale which means that the Lubrizol India Pvt. Ltd. link the estimated budgets with each of the center of responsibility previously. Table 10 showed the mean and the standard deviation of the items of the 4th hypothesis The items of the fourth hypothesis N Item 19 A clear and a realistic objective is identified for every center of responsibility in the organization complies with the performance standards. 20 Necessary adjustments on the estimated budgets of the centers are carried out wherever there is the need 21 The estimated budgets are prepared regarding every center separately. 22 The organization trains the employees of the centers and encourage them to achieve these centers objectives 23 All the employees of the center participate in preparing the centers budget according to their job The fifth hypothesis: The estimated budgets are not used for control and 59 2.42 1.21 3.48 3.65 1.03 0.92 3.62 0.87 Mean Std 3.8

0.92

performance evaluation in the Lubrizol India Pvt. Ltd. This hypothesis was tested through items ( 24-28) of the questionnaire and the results were as follows: Results of testing the fifth hypothesis T calculated 11.243 T tabulated 1.96 Sig T Result of null Mean 3.79 Std 0.49

hypothesis 0 Rejection

As the calculated T is bigger than tabulated T, this means rejecting the null hypothesis and accepting the alternative one and the mean of the hypothesis is more than 3 which means it is acceptable according Lickert scale. So the estimated budgets are used for control and evaluating the performance in the Lubrizol India Pvt. Ltd. And table 12 showed the mean and standard deviation of the items of the 5th hypothesis. N Item 24 Comparing the employees Actual performance with the planned one in every center facilitates the communication between the administrative levels. 25 Comparing the employees Actual performance with the planned one in every center helps in evaluating the employees performance 26 Comparing the employees Actual performance with the planned one in every center provides appropriate information in the proper time. 27 Comparing the actual performance of the employees supports the policies of control. 28 Comparing the employees Actual performance with the planned one in every 60 3.88 3.84 0.91 0.97 3.9 0.9 3.64 0.66 Mean 3.72 Std 0.99

center aims to

Chapter No. 7 Findings

The Lubrizol India Pvt. Ltd. are committed to the application of the elements of the responsibility accounting regarding the division of the organizational structure into centers of responsibilities in terms of a clear existence of centers of responsibility in the organization. There is a coordination and clarity between the centers of responsibility in the organization, clarity in dividing the work between the administrative units in the organizations, division of the organizational structure in the organization into administrative units according to the nature of the activity and there is a specialized manager to every center of responsibility in the organization, and the operations inside the center are homogeneous while the samples attitudes were negative towards having one type of activity in every center of responsibility. The Lubrizol India Pvt. Ltd. committed to the application of the responsibility accounting features regarding delegation of clear authority for the managers of the centers of responsibility which are represented by the employees accounting in the responsibility centers that suit their responsibilities, granting the manager of responsibility center the sufficient time to achieve his missions and the employees have the expertise of their work. And the manager of the center is shown his responsibilities and granted the proper authorities to do his work. There is also a description and 61

identification to the responsibilities and authorities of every job in the organization. The Lubrizol India Pvt. Ltd. commit to the application of features responsibility accounting regarding the distribution of the revenues and the costs to the centers of responsibility according the capability of every center and its authorities which are represented by having clear policy in the organization concerning distributing the indirect costs to the centers of responsibility and determining and recording all the centers costs. there is also an identified and clear system for the distribution of costs and revenues in the organization and clarity in the system of comparing the revenues and the costs of the centers of responsibility in the organization and identifying all the revenues regarding the center of the responsibility. The Lubrizol India Pvt. Ltd. commit to the application of the responsibility accounting concerning linking previously the estimated budgets with every center of responsibility which is represented through identifying clear and realistic objective for every center that complies with the standards of performance, and the organizations commit to train the employees of these centers and encourage them to achieve these centers objectives, to carry out all the necessary adjustments of the estimated budgets of these centers whenever there is a need. But these organizations do not commit to involve all the centers employees in preparing the budgets according to every ones work.

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Chapter No. 8 Recommendations

It is necessary for the banks to have the employees in the centers of responsibility and this is a motive to the involved in setting the objectives and preparing the estimated budgets of their centers according to every ones specialization and capability employees to work harder which affects positively the banks performance. To is necessary to have a coordination between the Central Bank and the administrations of the banks to develop a guide recommended for application in the Jordanian banks that includes objectives and advantages in using responsibility accounting to enhance applying this method in the banks. It is necessary for the professional organizations as the association of the banks to encourage the banks to use the other modern administrative accounting methods in its business as the application of Activity Based Costing system (ABC) and the balanced Scored card (BSC) because of the importance of the role that these methods may play in the operations of planning, control and performance evaluation which will improve the revenues through achieving the best investment of the resources. It is necessary for the banks to adopt systems of incentives that correlated with efficiency and the good performance of the employees and achieved him satisfaction and self-comfort.

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It is necessary for the Jordanian banks to revise regularly the system of dividing the organizational structure into centers of responsibility to verify the appropriateness of the centers objectives with the general objectives of their banks.

It is necessary for the Jordanian banks to activate the principle of reflexive feedback to investigate the employees opinions in different administrative levels according their evaluation of the system of the responsibility accounting and to listen to their suggestions.

Chapter No. 9 Conclusion

Assigning the right kind of autonomy and responsibility to employees will result in creative ideas. But a manager should be able to strike the right balance between autonomy and control. To understand autonomy, it is important to identify the variables that influence autonomy. They can be grouped under three heads: Management style and process, responsibility structure and reward systems. Management style, policies and procedures, diversification and business strategy fall in the first group. Reward systems are designed on the basis of the manager's ability to manage costs and investments. Responsibility structure consists of responsibility centers and related performance measurement systems. Responsibility structure establishes the physical, human and financial resources that are entrusted to the profit center manager. The availability of resources influences the decision-making authority of the responsibility center managers. Responsibility centers can be classified into revenue centers, expense centers, profit centers, investment centers and cost centers. Revenue center are mainly responsible for raising the revenue, and assume no responsibility for profits. In expense centers, inputs are measured in monetary terms, whereas outputs cannot be easily quantified. There are two types of expense centers: Engineered expense centers and discretionary expense centers. In profit centers, financial performance is measured in terms of the numerical difference between revenues and expenditures. An investment center is a measure of economic performance and it analyzes all elements of profit and investments. Cost centers are supposed to minimize the variance between standard costs and actual costs. When divisional autonomy is provided to centers, it becomes important to measure the performance of decentralized 64

operations. Factors ROI, are important for measuring performance. Managing inter-profit center relations is a major task in an organization. It is necessary to integrate the activities of the different responsibility centers so that they work towards the accomplishment of the goals of the organization.

Bibliography Books C.R.Kothari,Research Methodology, Methods & Techniques, 2nd edition, 2004, New Age International Publication. Hehner, Barbara, ed. The Spirit of Canada. Toronto: Malcolm Lester Books, 1999. Puzo, Mario. The Family: A Novel. Completed by Carol Gino. New York: HarperCollins Publishers Inc., 2001. Newspaper, journal, periodical The Hindu Business Line Sunday,18 December 2005 Maruti Insurnace ramps up sales Deccan Herald, Online edition of Sunday, 20 March 2007 Maruti Suzukis First driving school in Bangalore Websites

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 IBM. Advertisement. 23 Mar. 2003 http://www.bharatiyahockey.org/2000Olympics/ ibm.htm http://www.hul.co.in

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