Understanding Management Control Systems

Management Control Systems
Kiran Kothare
Syllabus
Understanding Strategic Perspective of Management Control Systems Basic concepts, Boundaries of Management control , Goals, The concept of Corporate & Business units strategy. 1. Financial goal setting EVA, Free Cash Flow, Market Cap, RONW, P/E, EPS & their interrelationship, ROI & Sensitivity Analysis Organizational hierarchies & behaviour. Goal Congruence, Informal factors that influence Goal Congruence. Types of Organizations & formal control systems. Function of Controller. 2. Responsibility centers - Expenses & investment Centres, Administrative Support & R & D Centres, Responsibility Budgeting 3. Profit Centers - General Consideration, Concept identification and creation, Matrix Structure, Profit Centres for control & decentralization 4 Transfer Pricing Objectives, Cost, Market & Margin based methods. Pricing Corporate Services. Administration of TPs.
Syllabus
5. Measuring & controlling Profits & Assets EVA, Free Cash Flow, ROI,& Residual Income , Measuring Assets deployed, Alternatives for Managerial Performance Management. 6 Performance Measurement & Control -- Information for performance Control, Interactive Control, Balance Score Card, 7 MCS in Service & non Profit Organizations -Professional & non profit organizations Service organizations in general,
8 Summing Up- Controls for Differentiated Strategies, Top Management Styles, Summing Up. 9 Audit Efficiency Audit & Management Audit case study - West Port Electric Company. (revenue centre) North Country Auto or any other similar case. (profit centre ) Birch Paper Company., ( transfer price) Quality Metal Service. (Investment Centre ) General Electric ( performance measurement)
Syllabus
Suggested Readings 1) Management Control Systems by Robert Anthony & Vijay Govindrajan (TATA McGraw Hill) 2) Management Control Systems Dr. R.S. Aurora & Prof. S.R. Kale (Jaico Publishing House ) For quantitative topics , basic application is required but advanced techniques are not expected to be covered Emphasis should be covering the subject of Management Control as a Process & not as Techniques Due attention will be given to the behavioural aspects of all topics. Reference Text Anthony & Govindrajan - Management Control Systems (TATA McGraw Hill) Maciareills & Kirby - Management Control Systems (Prentice Hall India) Management Control Systems - N. Ghosh (Prentice Hall India)
Scheme of Assessment
This is the only critical subject in semester IV which is assessed at University level. It also has the conventional 40:60 break up for internal & external assessment Internal Assessment 1 ) Internal test 10 marks 2) Assignment 10 marks 3) Presentation to class 10 marks 4) Attendance 10 marks Total Internal 40 marks University paper 60 marks Passing criterion - Individual passing in internal as well as external assessment
Project / Assignment
Background This subject is directly related to corporate world irrespective of area of specialization. Therefore it is expected that the project work will be carried out in an operating & live organization. Approach Identify the organization from where you can get the relevant inputs & /or access to its plans, policies, practices, procedures or control measures. The organization where summer internship project has been carried out for two months can be the first as well as the best choice for availability of practical information. From 9 major topics & their sub topics given in the syllabus, select a suitable topic. Study the Management Control System currently prevalent in relation to the topic selected.
Project / Assignment
Methodology Compare the current practices with the theoretical aspects studied in the curriculum. Critically evaluate the existing system by identifying the - positive factors - areas of improvement. Make recommendations on countermeasures for improvement. Capture these points in a word document for submission. Present it to the class in brief in a powerpoint presentation. The class is expected to ask pertinent questions on the topic for improving the comprehension of the subject matter.
Structure of University Paper

Total marks 60 36 marks for descriptive questions 6 questions of 6 marks each to be attempted out of a choice of 9 questions. 14 marks for numerical questions 2 questions of 7 marks each to be attempted out of a choice of 3 questions. 10 marks for 1 compulsory question of case study . One case to be attempted out of choice of 2 internal options. The cases can be either numerical or descriptive but generally numero-analytical.
May 2009 descriptive questions

1)Explain briefly various stages of Management Control Process citing salient features of each. 2) What is Responsibility Centre? List & explain different types of responsibility centres with sketches. 3)Every SBU is a profit centre but every profit centre is not a SBU ? What are the conditions that should be fulfilled for an organization unit to be converted into a profit centre? What are the different ways to measure the performance of profit centres? Discuss their relative merits & demerits. 4a) Transfer pricing is not an Accounting Tool comment with illustrations. 4b) Market price is ideal transfer price in limited markets . Comment. 6)Enumerate the differences among following types of Audits a) Financial audit ( statutory), b) Cost audit, c) Efficiency audit, d) Management audit

5)XYZ Ltd. has two divisions A & B. ROI for both divisions is 15%. Details are given below. Divisional sales 40 L 96L. Divisional Investment 20L. 32 L. Profit 3 L. 4.8 L. Analyze & comment on divisional performance of each w.r.t. Operational Excellence & Marketing Effectiveness.

7)Organizations with Business Divisions (Profit Centre)format have observed that Divisional Controllers experience divided loyalty in carrying out their functions , causing a possible dysfunction. How could such a situation be resolved? Define role of Controller which suits your suggestion. 8) What do you understand by Goal Congruence ? What are the informal factors that influence goal congruence? 9)Write short notes on any 2 a) Zero Bases Budgeting b) Free Cash Flow c) MCS in the Matrix Organization.

1)Briefly describe overall framework of Management Control . How does it relate it to Strategic planning & Operations Control? 2)Briefly describe Engineered Expense Centres & Discretionary Expense Centres. How is budget prepared in each & how is performance evaluated in each? 3) Write short notes on a) Zero Based Budgeting (repeated from 09) b) Free cash Flow ( repeated from 09) 4)What is Strategic Business Unit ?What are the conditions required for creating an SBU? How is performance of SBU measured? What are the advantages & disadvantages of creating SBUs. 5) What are objectives of Transfer Pricing? What are the different methods to arrive at TP? Discuss the appropriateness of each method . Explain with example.

6)How is an investment centre different from a profit centre ? What are different methods of judging their performance ? Which is a better method? 7)What do you understand by balance score card? Explain with an example. 8) How does a service organization differ from a manufacturing organization? How does a professional service organization differ from normal service organization? How is pricing & marketing done by a professional service organization? 9)How does corporate level strategies differ from Business level strategies? How is budgeting done at SBU under different strategic Mission?
December 2010 paper

1) All the questions of May 2009 repeated . 2) Theory / descriptive questions identical 3) Numerical questions almost the same with names, numbers marginally changed but the approach and methodology of solving the sum remains the same.

1) 2) 3) 4) 5) Define Management Control System. Which levels of managers are involved in it. How does MCS differ from Simpler Control Process? Briefly describe Responsibility Centre, Engineered Expense Centre, Discretionary Expense Centre, Revenue Centre, Profit Centre. How is the performance of the Head of these centres evaluated? Every SBU is a profit Centre but every profit centre may not be SBU. Explain. Under what conditions Production , Marketing and Service Departments are converted into Profit Centre? When are market based Transfer Prices most appropriate? How do we deal with the condition of Limited Market, Situation of excess / shortage of capacity? What do you understand by Investment Centre? Explain two different methods by which the performance of these centres are measured? Also discuss their relative merits and demerits.

6) Briefly describe functional, divisional and matrix organization. Which is the most appropriate from the point of control? Where are the other two suitable? 7) What do you understand by a Not for Profit Organization, How do these organizations price their products? What criteria are used to measure their performance? 8) What are Organization Structure and Management Control Implications of Corporate Level Strategies? 9) Write short notes on any two of the following, a) Approach to marketing by Professional service organization b) Balance Score Card c) Interactive controls
Introduction
For understanding Management Control System we need to revisit all three terms separately viz. Management Control System Then we try to decipher its meaning as a collective noun when these independent terms are synthesized together or integrated with each other
Management
What is Management ? Management refers to the team of people at the helm of affairs of an organization which is responsible for running & guiding the destiny of the enterprise. An organization consists of a group of people who work together to achieve certain desired results called goals.
An organization is an inanimate creature. It therefore needs people to run it & shape its destiny. These people are its leaders & are collectively known as its Management.
It is headed by a Chief Executive Officer who is also known by various other designations like Managing Director, Executive Chairman etc. Below him there is a hierarchy of managers.
The team has the responsibility for planning, organizing, activating & formulation of the organizations strategies which are expected to attain its objectives.
Control
What is Control ? Control means making events conform to plans. Thus it presupposes the existence of plans. Hence management has to consciously plan the activities of the firm or decide what it should do. Essentially control involves identification of variances , their causes and corrective actions. Control is regulating, directing, restraining & also a unifying action in an organization that brings unity out of the diverse activities performed by various units & subunits. It is a system of ensuring that the actual state of affairs is in line with the desired state of affairs. It is a process of ensuring that the efforts & activities are producing the desired results which ultimately reach the objectives & goals. Desired result is difficult to achieve without adequate control over activities.
System
What is a system? A system is a prescribed manner of carrying out an activity or a set of activities which are usually repetitive. It is a group of interacting, interrelated or independent functional elements forming a collective entity. System involves coordinated & recurring series of steps intended to accomplish a specified purpose. It has a structure & a process. An organization is a system by itself & consists of number of subsystems. Modern organizations & the environment in which they operate is quite complex. As a result of this complexity no single individual or a group can evolve a solution which is considered optimal. Therefore there arises a need for various systems.
Management Control System

What is Management Control System? Management Control is a process of Planning & Control by which management influences other members of the organization to implement organizations strategies effectively & efficiently. It provides the concepts, framework & tools for the same. Management control system is a logical integration of management accounting tools to gather and report data and to evaluate performance MCS therefore is concerned with Planning & Control functions & mainly deals with human beings.
It is a systematic method used by the management to exercise control over the activities of the organization for implementing its strategies.
Recapitulation of Basics
What is an organization ? An organization consists of a group of people who work together to achieve certain desired results called goals. What is an organization chart ? The organization is divided into several units & sub units like Finance, Operations, Marketing, Human Relations , Secretarial, R & D. etc. The Organization chart or organogram shows the units / sub units , their functions, responsibilities, hierachy & reporting relationships.
What is the hierarchy of management ? From the top most person of the organization designated as Chairman/ President / M.D./ C.E.O. to the lowest supervisor at the operating level, there is a continuous chain of units & sub units which is headed by a responsible person called manager. A manager has a superior above him to report & subordinate below to get the work done. Except the top man, each manager is both a superior & a subordinate. This is a hierarchy of managers . The layers of hierarchy depend upon the nature, size & complexity of the organization.
What is a strategy? It is a plan to achieve organizations goals. It describes the general direction in which an organization plans to move to attain its goals. High performance companies excel at execution of their strategies . Mediocre companies are weak ( or flounder ) in implementation - i.e their strategies either never come into being or get distorted during implementation. This may be due to either higher expenses involved & /or more time required than anticipated. Why organization needs control? An organization needs to be controlled to ensure that its strategic intentions are achieved.
MCS Introduction, Basic concepts & Overview
Related Questions
1) Briefly describe overall framework of Management Control . How does it relate to Strategic Planning & Operations Control ? ( May 2010) 2) Explain briefly the various stages of management control process citing salient features of each. ( May 2009 & Dec. 2010) 3) Define Management Control System. Which levels of managers are involved in it ? How does MCS differ from simpler control process ? ( May 2011) 4) Write short notes on Interactive controls ( May 2011)
Introduction & Overview

An Overview of Management Control System involves1) Elements of Control System 2) Elements of management Control system 3) Activities in management Control 4) Expectations from a sound MCS 5) Characteristic features of MCS 6) Purpose of MCS 7) Structure and process of MCS 8) Prerequisites for implementation of MCS 9) Boundaries or limits of MCS 10) Stages of Management Control process
Elements of a control system

Every control system has four basic elements 1) A sensor ( detector) A device that measures what is actually happening in the process being controlled. 2) An Assessor - A device that determines the significance of what is actually happening in the process being controlled. It operates by comparing the information on what is actually happening with some standard or expectation of what should be happening. 3) An Effector - A ( Feedback ) device that alters the behaviour if the assessor indicates the need to do so. 4) A communication network The devices that transmit information between the detector & the assessor & between the assessor & the effector. These elements are generic in character and are present in any control system. It is generally depicted by a block diagram.
Elements of Management Control System

The major elements of MCS are - Strategic Planning. - Budgeting. - Resource allocation - Performance Measurement - Evaluation & reward - Responsibility Centre allocation - Transfer Pricing. It therefore draws upon the concepts from - Strategic Management. - Organizational Behaviour. - Human Resources. - Management Accounting.
Activities in Management Control.

The management control process begins after the formulation of the organizations goals & strategies. It is a broad concept involving all interrelationships between managers & their subordinates. An effective MCS addresses to following activities . 1) Planning what an organization should do during a given period of time. 2) Coordinating the plans & activities of various units & sub units to ensure that they are working for the same purpose. 3) Communicating the Information processed between the units & sub units. 4) Evaluating the information received. 5) Deciding what action, if any, should be taken as corrective measure . 6) Influencing the people to change their behaviour.
Expectations from sound MCS

1)Strategic plan & its communication- After strategies are formulated MCS should be able to communicate them to subordinates who are responsible for their execution. 2)Profit Plan & Budget MCS should ensure that they are prepared on the basis of responsibility centres & communicated to the people down the hierarchy who are responsible for executing it because they - Provide proper direction to the organization. - set forth the standards of measurement. - shows the desired profit cost relationship. 3) Motivation of subordinates - MCS should motivate subordinates to make them act effectively & efficiently. 4) Effective Management Information System MCS should provide for a good MIS so that performance of subordinates is measured & objectively evaluated.
Characteristic features of MCS

1) MCS focuses on programs & responsibility centres. The programs cover products, goods, services & projects the organization undertakes to achieve its goals. Responsibility Centre is a unit / sub unit of an organization headed by a manager who is responsible for its activities. 2) For the purpose of control, managers use two types of data viz. planned & actual. Planned data relate to estimates, budgets, standards & forecast of future events or activities. 3) Control is an ongoing or continuous process which includes a set of actions like programming, budgeting, monitoring, evaluating, analyzing & reporting. 4) Management Control is a total system covering all aspects of companys operations. This system is a set of multiple interlocking subsystems fully integrated into a single system so that the same information is used by various functions for different purposes.

5) The system is usually designed with financial figures. However the reports of non monetary measures related to physical units of input & output are also included as they form important parts of the system. 6) The system is neither ad-hoc nor one time nor occasional but is a rhythmic one, which follows a regular frequency like daily, weekly, monthly, quarterly, annually etc. for all the processes. The time table for completion of each step of the process, the responsibility for generation of reports, the formats to be used, their circulation to different managers etc. are all contained in the policy & procedure manual.

7) Both line & staff managers are equally involved in the control process. Staff people collect, summarize & present information that is useful for planning process & system design. Line mangers are the focal points in management control because they influence others and approve plans based on their judgments. 8) Though systematic , MCS is not mechanical because it involves interactions among individuals & there is no standardized mechanical way for human interactions. 9) The purpose of MCS is to encourage managers to take actions that are in the best interest of the company to achieve its goals. The mangers have their personal goals too. MCS has to achieve goal congruence in that when mangers seek to fulfill their personal goals / ambitions, they help to attain organizational goals also.
Purpose of Management Control System

Purpose of MCS is to - clearly communicate the organizations goals - ensure that every manager and employee understands the specific actions required of him/her to achieve organizational goals - communicate the results of actions across the organization - ensure that the management control system adjusts to changes in the environment It thus assists management in - coordination of the parts of the organization. - allocation of its resources . - steering those parts towards achievement of objectives & goals of the organization, its Mission & ultimately Vision.
Structure & Process of MCS

The structure of MCS is made up of a number of responsibility centres which are different units & sub units in the organization, through which information flows. Each responsibility centre is headed by a manager who is responsible for its activities as well as results of such activities. The process of MCS is what the mangers do with the information. It involves communications of information & interactions arising out of them. Therefore it is essential to have a well knit organization structure so that an effective & efficient control system can be installed. MCS operates at 3 levels of resource allocation process concerned with 1)Formulation of expectations upon which resource allocation decisions are to be made. 2)Allocation of resources to ensure that the goals & objectives are met. 3) Monitoring performance & taking corrective action to ensure that the organization remains on track in pursuit of its overall purpose.
Prerequisites of MCS
An organization is subdivided into simpler, homogeneous sub units or functions or departments which carry out the process of converting the inputs ( men , materials, money ) into desired output ( profit). A manager exercises control or authority over the inputs & the process is responsible for generating the desired output. Each department & the process carried out by it is quite different from the other & these differences are extremely important from the view point of MCS. Recognition of these distinguishing features of various sub units is a prerequisite for design of a sound MCS. Based on these two considerations of - output (quantifiable / measurable or not) & - process ( sharply defined & well understood or not) we get a four cell process output matrix. Different types of departments can be classified into different cells.
Process Output Matrix

Quadrant & Characteristics Proces s( X axis) Un known Output (Y Axis) measur able measur able Not measur able Not measur able Functions (& focus)
1 Easy to manage
Some staff functions like legal, market development, (output) Most manufacturing departments, ( input output relationship, efficiency some staff functions like HR ( procedures & practices )
2, Need control mechanism to known estimate the extent to which desired output is achieved 3, Difficult to manage, yardstick is timely & meticulous compliance with procedures & practices , result measurement not possible 4 Process as well as output is vague & unclear, can be managed by controlling quality & quantity of inputs. known
Un known
Some staff functions like R & D ( Inputs or Resources allocated)
Boundaries or Limits of Management Activities

The complete management function which involves Planning & Control activities varies as per its levels. This three tier structure involving - Top management, - Middle Management & - Operating or lower management carries out different activities which vary in the extent of Planning & Control function used. The dominance of Planning function & emphasis on Control aspect in their respective activities decide the limits or boundaries of these processes viz. 1) Strategy Formulation 2) Management Control 3) Task or Operational Control This is better represented by a pyramid structure.
Strategy Formulation
Strategy Formulation or Strategic Planning It is a process of deciding the goals of the organization & methodology for achieving them. It aims at long term policy with no specific time frame . It deals with identification of Threats & Opportunities. The process starts when some threat is perceived or an opportunity is identified in terms of a new idea or product. Since they do not occur at regular intervals, it is less systematic & irregular but more judgmental. Strategic Planning is carried out by top management level. Hence the communication process is simple & straight forward because Strategy is generally confided with few top managers only.
Strategy Formulation
It is primarily based on external information collected from outside the organization like government notification, new enactments, technical journals, market research papers etc. Analytical bend of mind is essential prerequisite for assessing the implications of this external information. Strategic plan generally does not cover the entire business but relates to some particular part of the organization like production, marketing, product line, new business, M & A activities etc. It focuses on long term horizon. Therefore data & estimates used in Strategic planning are less accurate & relate to rough approximations of the future happenings. Panning Process is the most important ingredient of this activity.
Management Control
Management Control Systems help the managers move an organization towards its strategic objectives. Thus Management Control is a process of implementing the strategies wherein Planning & Control are equally important activities. It involves a series of steps that occur in a predictable sequence, with fixed time table & with reliable estimates. The sequential steps or stages in Management Control process consist of Strategic Planning , Budgeting, Analysis of financial performance, Development of Balanced Score Card addressing to financial and non financial measures, and finally rewards or management compensation. It is concerned with broadly defined activities of the managers deciding what is to be done within the general constraints of the strategies. However it is one of the tools mangers use in implementing the desired strategies.
Management Control
Strategies are also implemented through organization structure, its management of human resources & its particular culture as shown in the block diagram. Organization structure specifies roles, reporting relationships & division of responsibilities that shape decision making within an organization. Human resource management is the selection , training, evaluation, promotion & termination of employees so as to develop the knowledge & skills required to execute organizations strategy. Culture refers to the set of common beliefs, attitudes & norms that explicitly or implicitly guide managerial actions. MCS encompass both financial & non financial performance measures. Financial dimensions focus on top line ( total income ) & bottom line ( Net Profit, ROI etc. ) Non financial objectives are product quality, market share, customer satisfaction, on time delivery, employee morale etc.
Management Control (an aid in Strategy Development)

The primary role of MCS is to ensure execution of chosen strategies . However in industries that are subject to rapid environmental changes management control information of non financial nature can provide the basis for considering the new strategies. This function is referred to as interactive control because it draws managements attention to both positive & negative developments. e.g. opening up of new market due to change in government regulation, loss of market share, customer complaints etc. This interactive control is an integral part of the MCS which indicates the need for new strategic initiatives. Management has to respond to these developments highlighted by todays control system to formulate tomorrows strategy as shown in the block diagram.
Task / Operational Control

It is a process of ensuring that specified tasks are carried out effectively & efficiently. It is transaction oriented process dealing with performance of individual tasks as per the rules prescribed by MCS. Some of the most common transactions or specified tasks are scheduling a job, procuring an item of inventory, taking an interview for selection & recruitment. It focuses on short run activities, deals with current accurate data & control is the most important aspect of it. Task Control systems are scientific because the emphasis is on the tasks wherein an out of control condition can be brought back to the desired state within acceptable limit by optimal decision or appropriate action. They require little judgment.
Task / Operational Control

Direct activities of manufacturing plants where input output relationship can be established & definite tasks can be identified are covered under operational control. In such cases the inputs that should be used in a certain set of circumstances can be programmed & output can be measured & compared against such input. These expenses whose optimum amount can be estimated objectively are therefore called as programmed cost or engineered cost or managed cost. Operational control is a rational system because the action to be taken is decided by a set of logical rules. Hence it is the focus of many management science models & mathematical OR techniques. Control is easier because of use of scientific standards with which the actuals can be compared.
Operational & Management Control

When the relationship between input & output is a matter of subjective judgment like legal expense or advertisement & sales promotion expense, it comes under the purview of Management Control because these are discretionary expenses. Indirect activities (& expenses ) like production planning, purchasing, inventory control, order processing, billing, payroll accounting etc come partly under management control. The part of the activity that can be programmed / pre-decided / predetermined like number of purchase orders to be prepared or the number of bills to be released on daily basis is covered in operations control. Therefore generally the control on the operating departments is basically management control but in some areas or activities where input output relationship can be programmed, operational control can be exercised.
Operational & Management Control

While many operational control systems are scientific, management control system can never be reduced to a science. By definition , MCS involves the behaviour of managers which can never be explained by equations. Therefore serious errors will be made if principles developed for operations control situation are applied to management control situation because here the manager interacts with other manager whereas in operational control either human beings are not involved at all or Interaction is between manager & a non manager( like job/ order, part etc. It is never between persons) The focus in management control is on organizational units whereas in task control it is on tasks performed by these organizational units. Hierarchy of decisions / activities / actions involved in three layers of management can be explained by examples in the table shown.
Hierarchy of Decisions / Actions

Strategy Formulation Acquire an unrelated business Enter a new business Add direct mail selling Change debt/equity ratio Management Control Introduce new product or brand within product line Expand a plant Determine advertising budget Issue new debt Task Control Coordinate order entry Schedule production Book TV commercials Manage cash flows
Adopt affirmative action policy

Devise inventory speculation policy Decide magnitude and direction of research
Implement minority recruitment program

Decide inventory levels
Maintain personnel records

Record an item
Control research organization
Run individual research project
Stages in Management Control

The broad steps involved in Management Control process are 1) Strategic Planning 2) Budgeting ( process carried out before the period or the year begins) 3) Measurement and Analysis of Financial Performance ( process carried out after the completion of the period or occurence of the event) 4) Measurement of financial and non financial performance through Balanced Score card 5) Rewards or Management compensation as related to management control process

1)Strategic Planning This is the first activity in Management control. It is the process of deciding on the programs that the organization will undertake and on the approximate amount of resources that will be allocated to each program over the next several years. It is distinctly different from strategy formulation which is the process of deciding on new strategies. Here management decides the goals of the organization and creates the main strategies for achieving those goals. The strategy formulation involves taking strategic decision. Strategic planning is the process of deciding how to implement the strategies. It considers the goals and strategies as given and develops programs that will carry out the strategies and achieve the goals efficiently and effectively. The document that describes how the strategic decision is to be implemented is the strategic plan. There is considerable overlap between strategy formulation and strategic planning.

2) Budgeting It is discussed in details separately 3) Measurement and analysis of financial performance Here the variances are calculated between budgeted and actual data of expenses and revenues for business units. It considers the revenue centres and expense centres for this purpose. The report of variance analysis is used by senior management to evaluate business unit performance 4) Development of Performance Measurement system. It blends financial information with non financial information. Non financial performance measures are discussed in balanced score card approach 5) Reward system It focuses on incentive mechanisms and compensation systems and their function in influencing the behaviour of employees to achieve goal congruence. Mangers put in great efforts on activities that are rewarded and less efforts on activities that are not rewarded. ( Refer last few slides of MCS 4 as supplementary input)
Strategies
Levels, Development Tools
Related questions
1) How do Corporate level strategies differ from Business Unit level strategies? How is budgeting done at SBU under different strategic Mission? ( May 2010) 2) What are organization structure and Management Control Implications of Corporate level strategies? ( May 2011)
Strategy
Strategy indicates the direction where the organization wants to go to fulfill its purpose & achieve its Mission. It provides the frame work for guiding choices which determine the organizations nature & direction. These choices relate to organizations products & services, markets, key capabilities, growth, return on capital & allocation of resources. Strategy can be implied or stated explicitly. A firm does not develop its strategy in vacuum. The top management evaluates its strengths & weaknesses in the light of threats & opportunities present in the environment & then formulate strategy that is in keeping with its core skills & environmental opportunities. This is represented in the block diagram. There is a three tier structure for strategies. 1) Corporate level ( for the entire organization or the firm as a whole) 2) Business Unit level ( for specific B.U.) 3) Functional level ( for operating functions )
Corporate Strategy
Corporate Strategy is the determination of businesses in which the firm will compete & the allocation of resources among the business. At the corporate level, the key strategic question is what set of businesses should the firm be in? i.e. It is concerned with being in the right business. By choosing the right mix of businesses, an organization takes the conscious decision to compete in certain businesses. Hence it involves the decision regarding businesses - to enter, - to be emphasized, - to be retained, - to be de emphasized - to divest The generic options for the corporate level strategic question are - A single industry firm - A related diversified firm - An unrelated diversified firm Key concept for selecting the right option is core competence which is the intellectual asset in which a firm excels.
Corporate Strategy based Categorization

1) Single Industry firms- They are operational in only one line of business. Such firms leverage their core competence to pursue growth within the industry 2) Related diversified firms - They operate in a number of industries & there exists a common set of core competencies which benefit the business units. When a firm diversifies into other businesses, it is the existing core competencies which are being leveraged for the benefit of new businesses. They share common resources, common production facilities. common purchasing, sales and marketing, common HR etc. This sharing of available pool of common resources & core competencies gives rise to operating synergies & leads to economies of scope and economies of scale for the firm. 3) Unrelated diversified firms - There is nothing in common among their lines of business. They are known as conglomerates and generally they grow through M&A.
Business Unit ( B.U.) Strategy

The corporate office does not generate any profit. It is the B.U. that is engaged in production & sales and generates profit. Therefore it is essential that B.U. should formulate its own strategies for survival, growth & prosperity. At B.U. level there are two key strategic questions 1) What should be the B.U.s Mission ( overall objective) ? 2) How should it compete to accomplish its Mission ( identify competitive advantage )? B.U. strategy is multi dimensional & competitive. It involves taking offensive or defensive actions to create a defendable position in the industry, to cope successfully with five competitive forces & thereby yield a superior R.O.I. for the firm. It deals with creation & sustenance of competitive advantage in each of the industries in which the firm is engaged.
B.U. Strategy to Mission / Vision

Business Unit strategy relates to the resource deployment. It makes decisions regarding the use of cash generated from some business for which it depends upon the Mission or goals. A Mission statement is an enduring statement of purpose that distinguishes one business from other similar firms. It enables a business to set objectives, develop strategy & allocate resources. It emanates from Vision & describes an organizations purpose, customers, products, services, markets, philosophy & basic technology.
Vision
It indicates a dream which is to be achieved over a long term horizon. It is a wishful thinking about a lofty & ultimate goal showing where or what you want to be at macro level. It expresses the intent of the organization.
Mission
It indicates the purpose for which the business is started or is existing today. It is related to the long term objective the organization should strive to achieve . It can not & does not remain static . As the Market Environment changes, it has to be revisited & redefined to reach the dream envisaged in Vision quickly. A clear thoughtful Mission statement - describes an organizations purpose, its customers, products & services, markets, philosophy & basic technology, - provides the sense of purpose, - gives the direction to employees , customers & all the stake holders. Good Mission Statement should - focus on limited number of goals. - narrow the range of discretion so all stakeholders & employees act consistently on important issues. - define the major competitive spheres within which the company will operate.
Goals & Objectives

Mission defines the specific strategies needed to attain the crucial goals. The goals are timeless & exist till they are changed. The organization may seek different ways to attain its goals for which objectives are set. Goals are different from Objectives. Goals are broad statements of what organization intends to achieve in general without time reference. Management then decides the strategy or set of actions to be initiated to achieve the goals. Objectives are more specific in terms of time period within which the planned action is expected to be completed. They are measurable. Thus the difference between goals & objectives lies in measurability & specificity of time period. Goals are developed in Strategic Planning Process while Objectives are determined in the Management Control Process.
Goals
Every organization functions to attain its goals. Organization may be a profit oriented business unit or a non profit organization providing services to the community. Profit or profitability is the principal goal of the most of the businesses. It is an economic goal. Big Business units are now becoming more concerned about their social responsibilities. Thus goals can be classified as - economic goals, - social goals.
Economic Goals
Different organizations have different goals. Some of the normal or common economic goals of commercial organizations are 1) Profit & profitability 2) Earnings per share 3) Shareholders value 4) Market Share 5)New products & product line 6) Adding new Business
Economic Goals
Profit & Profitability It refers to the profit earned in the long term & is expressed as R.O.I. It connects sales Revenue, expenses & capital investment through following Return on Sales = Profit / Sales Return on Investment = Profit / investment Capital Turnover = Sales / Investment Hence ROI = ROS x Capital Turnover From these equations two basic parameters emerge which needs to be watched carefully 1) Business must earn an adequate profit on every rupee of sales. 2) Sales volume should be adequate to produce an acceptable capital turnover. These two factors inter related.
Economic Goals
ROI is the most important yardstick or the indicator of the profitability of any business unit. Profitability refers to profits in the long run rather than the current year. Many times organizations incur heavy expenses on advertisement, sales promotion, R & D, employee training which may depress that years profit but it is essential for its growth & generation of long term profit. Growth / preservation of assets with controlled risk is now emerging as an objective of sorts because of bankruptcy of many firms over a period of time. Hence companies tend to put ceiling on risk they can take while trying to achieve profitability.
Other Economic Goals

2)Maximization of Shareholders value Earnings per share, Shareholders value, Market Value are all interrelated and they are indicated by the market price of the companys share . This is not a desirable goal because what is maximum is difficult to decide. Hence sometimes it is expressed as Optimizing share holder value. This goal is not appropriate because - There are other stakeholders in the business like customers , suppliers, employees, creditors, society / community etc., - Market value of share is obtained only when the share is traded in the stock exchange. - Market value is not an accurate measure of the worth of shareholders investments.
Other Economic Goals contd.

For optimizing shareholders value, company tries to improve the market price of its shares by various means. It can undertake activities like brand building, sales promotion, quality control etc. which can increase its revenue more than proportionately. It can also reduce expenses by reducing / eliminating non value added activities without affecting sales & market share. It can increase profit by less than proportionate increase in investment or by keeping investment unchanged. The other economic goals are actually related to normal organizational growth.
Social Goals
Every organization has its share of responsibility to the public at large in general & towards the local community where it is situated in specific. It is difficult to address to such goals in Management Control System. However any concrete structural programme indicating- nature of service - its operational expenses , - methods of providing service, - personnel involved in rendering service can be addressed through appropriate control system
Goals of non profit organizations

When the organization declares its goal as other than profit it becomes service rendering organization. Measuring the quality & quantity of its service is difficult. Therefore measuring attainment of goals in non profit organizations is much less precise than similar measurement in a business. Though such organizations can not accumulate large profits, they have to earn enough revenues to recover all expenses of running the services & to leave a surplus sufficient to provide for a) Some unforeseen expenses & b) Additional working capital or additions to fixed assets if needed.
B. U. Strategy Development Tools

At Business Unit level there are two key strategic questions 1) What should be the B.U.s Mission? 2) How should B.U. compete to accomplish its Mission? There are three tools which address to these questions & help B.U. in developing its strategy. They are a) Portfolio Matrices They position the business on a grid & are useful in deciding business unit Mission. b) Industry Structure Analysis - It is a tool to systematically assess the opportunities & threats in the external environment. It is accomplished by analyzing the collective strength of five competitive forces. c) Value Chain analysis Value chain for a business is a linked set of value creating activities to produce a product. Value chain analysis is a useful tool in developing competitive advantage.
Business Portfolio
In diversified firm, resource deployment or allocation of resources is a major issue . It involves decisions regarding the use of the cash generated from some business units to finance growth in other business units. Several planning models are developed to help in these decisions. If a firm has business units in several categories, identified by their Mission, the appropriate strategy for each category would differ based on its risk / reward characteristics. The several business units together make up a portfolio (similar to investment portfolio)
Portfolio Analysis
Corporate Portfolio Analysis is a set of techniques that help Strategists in taking Strategic decisions with regard to individual products or businesses in a firms portfolio. It is primarily used for competitive analysis& Strategic Planning in multi product multi business firms. The main advantage of adopting a portfolio approach is that the resources could be targeted at corporate level to those businesses that possess the greatest potential for creating competitive advantage. For instance , a diversified company may decide to divert resources from its cash rich business to more prospective ones that hold promise of a faster growth so that the company achieves its corporate level objectives in an optimal manner.
Portfolio Analysis
contd.
Portfolio Analysis is a two dimensional technique. One dimension is external variables & the other dimension is organizational variables. Various methods of portfolio analysis consider these two dimensions in different forms and & with different nomenclature but essentially their approach remains the same. They guide the corporate management in decisions pertaining to what to do with different businesses or products by developing or selecting the appropriate Mission for them. Two most prominent techniques are 1). BCG Matrix & 2) GE Matrix.
Mission Categories
BCG model as well as GE Model choose the Mission from four basic categories. 1) Build This Mission implies an objective of increased market share even at the expense of short term earnings & cash flow. 2) Hold This strategic Mission is geared to the protection of B.U.s market share & competitive position. 3) Harvest This Mission has the objective of maximizing the short term earnings & cash flow even at the expense of market share. 4) Divest - This Mission indicates a decision to withdraw from the business either through a process of slow liquidation or out right sale.
BCG Matrix
Boston Consulting Group of USA developed this matrix with two dimensions of Market Growth Rate as an external dimension on vertical axis & Market share as an internal dimension on the horizontal axis. The vertical axis denotes the annual growth rate of the market in which the business operates. Horizontal axis shows the market share of the business w.r.t. its largest competitor. This is an indicator of the strength of the business in that market segment. Both the axes are divided into two segments High & Low , thus giving rise to 4 cells into which different products fall. Each cell indicates different category with different strategic approach as shown in the figure below.
BCG Model
Market Growth Rate High
Star ( Hold)
Low
Question mark (Build) Cash cow Dogs (Harvest) (Divest)

High Relative Market Share Low
Stars
Businesses with high market share in a high growth market are labeled as STARS because they usually represent the best profit & growth opportunities in the organizations portfolio. They are the businesses the organization needs to nurture & groom for the long run. Such products generate significant amount of cash because of their market leadership but also need lot of cash outlays to maintain their competitive strength in a growing market. Generally they are self sufficient & do not need cash from the other parts of the organization but sometimes they are likely to require capital over & above their cash flow to maintain their market share. They are assigned the Mission HOLD market share.
Cash Cows
Businesses with high market share in a low growth market are known as Cash Cows. These businesses tend to yield substantial cash surplus over & above their investment requirement. Cash cows are not very attractive for their long term development but they are needed for generating cash to meet organizational requirements. There may be two types of cash cows strong & weak. Strong cash cows are those who were Stars in the near past & generate substantial amount of cash surplus. Weak cash cows are those who might have been Stars in the remote past.
Question Marks
These Businesses are characterized by the low market share in a Growing market. Low market share makes them questionable whether profit potential associated with growth can realistically be. This cell derives its name because such businesses pose a question mark by offering two alternatives To grow them into Stars if additional investment can bring them into such a position. To divest them , if cost of strengthening them are quite high as compared to returns they give.
Dogs
Businesses with low market share in low growth market are referred to as dogs. These businesses have very low competitive position, may be because of high costs, low quality. Less effective marketing, & have very low profit potential as market has low growth potential. Therefore they are not attractive from long term point of view . Sometimes they do not generate enough cash to maintain their position in the market specially in highly competitive market. Therefore such businesses are the right candidates for divestment.
Advantages of BCG Matrix

BCG Matrix is a useful technique & makes valuable contributions to Strategic Choice at the corporate level, It helps in assigning a specific role to a business unit e.g. Cash Cows may support Stars at the initial stage. It helps in providing integration of multiple businesses into a total corporate strategy to exploit the effects of competitive advantage. As per this matrix the balanced business portfolio would have the largest sales in Cash Cows & Stars. There should only be few Question Marks & very few Dogs with some of them having favourable surplus .
Limitations of BCG Matrix

The four cell matrix is based on the classification of business into high & low. This classification does not truly reflect the nature of business even if only two dimensions of measurement are taken into account. The four cell matrix gives consideration only to relative market share position& growth rate of Sales. No doubt, these are important dimensions but other dimensions are equally important from Strategic Management point of view. These may bethe stage of product / market evolution. Strategic posture of different businesses. Presence of Competitive advantage. Distinctive competence Emerging Opportunities & Threats. Capital Requirement Size of Market etc.
1. 2. 3. 4. 5. 6. 7.
Limitations of BCG Matrix

Long term profitability is subject to a variety of influences not directly tied to growth & market share. This fact is not considered adequately by the four cell matrix. The two dimensions selected by this model are relevant to matured or established product. It means any new business of the company which can not command requisite market share because of gestation period falls in the category of the dogs. However this business may have a great potential to remain in the portfolio. The success of business is not measured purely in terms of market share & the market growth. There are other considerations to keep a business such as its synergistic effect on other businesses. In order to overcome the weakness of BCG portfolio matrix General Electric Company ( GEC ) has developed a nine cell grid with the help of Mckinsey & Company. This is an advanced & more refined approach
G.E. Nine Cell Planning Grid

GE Grid draws its inspiration from BCG Matrix only & tries to overcome some of its limitations.1) GE Matrix is also a two dimensional matrix like BCG Matrix but instead of four cells in BCG, it has 9 cells. 2) Here also the Y axis shows the dimension from External environment X axis from internal environment. However unlike BCG where each axis represents only one or single parameter, GEC Matrix considers a number of relevant & important factors ( 7 nos. in the example shown) for the formation of X & Y axis dimensions. The external dimension is Industry Attractiveness & internal dimension is Business Strength.

3)Each of these factors that constitute the dimensions of two axes of the matrix , are attached weights depending upon its influence & criticality towards success of the business. All the weights add up to 100. 4)Each factor is also given rating which is a subjective judgmental figure that reflects upon the current standing or the status of the business or a product in each of external & internal environment related parameter. The rating scale is from zero to one . One is the highest rating any factor can get under ideal conditions. 5)The weightage multiplied by its rating quantifies the score of that individual factor. 6)The sum total of all these scores for each of the seven factors provides the X & Y co-ordinates for placement of that business in the Matrix.

7)Both X & Y axes are divided into three zones or segments , thus giving rise to 9 cells 8)The three regions , the X axis (i.e. Business Strength which throws light upon the Organizational Capability ) is categorized into are designated as. Strong, Average & Weak. The score of 50 indicates the average strength. 9)The three levels , Y axis (i..e. Industry Attractiveness ) is categorized into are High, Medium & Low. Here also the score of 50 indicates the medium level of attractiveness. 10)These 9 cells are regrouped into three different zones w.r.t. central diagonal passing through the L.H. Bottom corner to R.H. Top corner. 11)Each Zone is indicated with a traffic light colour scheme. 12)For every zone a Strategic signal is associated which provides the direction to the business strategist. i.e, Green shows Go ahead, Yellow shows Wait & Red shows Stop

Business Strength Factor Market Share Profit Margin Ability to Compete Market Knowledge Competitive Position Technology Management Calibre Total Weight 15 10 20 15 15 10 15 100 Rating 0.8 0.6 0.8 0.5 0.7 0.8 0.7 Score 12 6 16 7.5 10.5 8 10.5 70.5

Business IndusStrength try Attractiveness
Strong Winners Winners
Average Winners
Weak Question Marks
High Average Low
Average Losers Businesses Losers
Profit Losers Producers
Industry Attractiveness
Recommended Business Strategies
High
Invest / grow Strongly (build)
Invest/grow selectively (build)

Earn/Protect (Hold)
Dominate/delay/ Divest
Average
Invest/grow selectively (build)
Harvest/Divest
Low
Earn/Protect (Hold)
Harvest/Divest Average
Harvest/Divest Weak

As shown in the diagram, each zone of the grid presents a specific type of strategy. Invest / Expand In this zone the business has opportunity to grow through further investment & expansion. The zone is characterized by the presence of both- business strength & industry attractiveness though each cell represents different combinations of these. Select / Earn This zone presents a mixed situation in which much growth possibly does not exist. However it presents an opportunity for selective earning because either one of the two determinants is high or both stand in the middle.

Harvest / Divest In case of red cell , the organization has to stop & harvesting or divesting strategy is suitable. Harvesting involves a decision to withdraw from the business gradually. At the initial stage the focus may be on cost cutting particularly on those items which have long term impact such as R & D, Advertising etc. The main objective is to earn short term profit as business is not attractive over a long term. The business located in the extreme right hand bottom corner cell, the decision is to divest immediately as any further delay may result into lower attractiveness to a prospective buyer.

Critics of GE matrix point out that it does not consider the stage in the product ( market ) life cycle. Hence another model with 15 cells has been proposed. Here the Y axis shows five different stages of product evolution viz. Development, Growth, Shakeout, Maturity/ Saturation, Decline. The X axis is for competitive position & has same three categories viz. Strong, average& weak. The portfolio analysis helps in rationalizing the allocation of resources among different businesses.
B.U. Competitive Advantage

Every Business Unit need to develop a competitive advantage in order to accomplish its Mission. Three inter related questions have to be addressed in developing BUs competitive advantage. 1) What is the structure of the industry in which BU operates.? 2) How should BU exploit the industry structure? 3) What should be the basis of BUs competitive advantage? Michael Porter has described two analytical approaches to develop a superior & sustainable competitive advantage. They are a) Industry Analysis b) Value Chain Analysis
Porters model of five forces

Industry conditions play an important role in the performance of the individual firm. The performance of the firm is determined by the conditions prevailing within the industry i.e. average profitability of the industry reflects the performance of the firms . The profitability of industry is dependent upon the power of five forces. The more powerful they are, less profitable would be the industry. The combined strength of five collective forces forms the basis of analysis of industry structure as shown in the block diagram. Relative strength of the five forces makes the strategic issues facing different business units in various industries differ. A proper understanding of these forces provides clearer picture of the opportunities available & the threats lurking With this knowledge company can go ahead with the formulation of strategies that are effective in development of competitive advantage.
Five forces
1) Threat of new entryThere are number of factors like government policy, capital required, complexity of product & process technology, scale economics, availability of distribution channels, product differentiation etc. which affect the entry of new player. 2) Intensity of rivalry among existing competitors It depends upon exit barriers, industry growth, ability to differentiate products , temporary overcapacity, level of fixed overheads, number & diversity of competitors etc. 3) Bargaining power of suppliers Availability of substitutes for being used as inputs, number of suppliers & their capability to carry out forward integration, importance of the volume of business firm gives to supplier influence bargaining power.
Five forces
4) Bargaining power of customers The power of customers or buyers is affected by factors which are the counterpart of those in point number 3 above like number of buyers & their capability to carry out backward integration, switching costs of the customers, significance of the volume of business unit to its customers etc. 5)Threat from substitutes Switching cost of the buyers, propensity of the buyer to resort to substitution, relative price performance of substitutes are some of the factors which bear on the threat from substitutes. For coping with these five competitive forces , there are three potentially successful generic strategic approaches to outperform other firms in an industry by responding to the opportunities in the external environment & developing a sustainable competitive advantage..
Generic Competitive Strategies

Competitive strategies of generic nature are 1) Overall cost leadership 2) Differentiation 3) Focus. Strategic advantage & strategic target for each of them can be shown on the diagram. Though in todays volatile & extremely competitive markets more & more companies are shifting away from classical theory of competitive strategies, their understanding is essential. Successful companies of today have displayed their capacity to respond & act quickly which have given them sustainable competitive advantage in their globalized operations.
Overall Cost Leadership

It is achieved through a set of functional policies which include - Aggressive construction of efficient scale facilities, Vigorous pursuit of cost reductions from experience, Tight cost & overhead control, Avoidance of marginal customer accounts , Cost minimizations in areas like service sales force, R & D, advertizing etc. A great deal of managerial attention to cost control is necessary to achieve this position which can give the firm above average returns in its industry despite presence of competition. To attain cost leadership, low overall costs relative to competitors has to become the theme running through the entire strategy,
Differentiation
This involves differentiating the product or service offering of the firm creating something that is perceived as being unique. Approaches to differentiation can take many forms. Ideally the firm should differentiate itself along several dimensions. Successful differentiation is a viable strategy for earning above average returns in an industry because it creates a defensible position for coping with the five competitive forces. It provides insulation from competitive rivalry because of brand loyalty by customers resulting in lower sensitivity to price. It avoids need for low cost competition & improves margins . If hypothetically the firm is able to achieve cost cum differentiation position for the entire market, it will be the ideal strategic posture as shown in the diagram
Focus
It may take many forms but essentially consists of focusing on a particular buyer group, segment of the product line, or geographic market. This strategy is built around serving the particular target effectively & efficiently than competitors . Hence each functional policy is developed with this in mind with the result that the firm achieves either differentiation from better meeting the needs of the target or lower cost in serving this target or both. Even though the focus strategy does not achieve low cost or differentiation from the perspective of the market as a whole, it does achieve one or both of these positions vis a vis its narrow market target.
Value Chain Analysis

The most attractive competitive position is to achieve cost cum differentiation. However the competitive advantage in the market place is derived from providing either - better customer value for an equivalent cost or - equivalent customer value for a lower cost. Competitive advantage can not be meaningfully examined at the level of the business unit as a whole. Therefore Value chain analysis is carried out in order to ascertain the activities in which the firm can create customer value or reduce costs.
Value Chain Analysis

The value chain dis-aggregates the firm into its distinct strategic activities from design to distribution as shown in the diagram. It is a complete set of activities connected with a product which starts with the extraction of raw materials & ends with after sales service. It helps in understanding the entire value delivery system of the end product & not the part of the value chain which the firm carries out. Since the ultimate customer bears all the costs & profit margins , it is essential to know the costs incurred & margins earned at each stage by suppliers & their suppliers, by customers & their customers. This study facilitates identification of differentiation points.
Functional Strategies
A firm consists of a number of specialized departments which exist to fulfill the goals of the organization. Cascading from the corporate strategy &/or business unit strategy, all the functional departments formulate their own strategies. These are known as functional strategies which form the lowest rung of strategy ladder. These strategies are concerned with major operational areas of the function concerned & in turn give rise to departmental objectives.
Functional Strategies 1
Financial Strategies are concerned with: - Financial performance goals in terms of profit, operating margin, ROI, - Mode of financing viz. debt, equity, retained earnings considering the business risk. - Extent of management s share in ownership of the firm, public ownership, employees participation in firms equity. - Financing of R & D. - Risk tolerance level of the firm
Marketing strategies are concerned with : - Products that should be handled ( manufactured, represented, traded) by the company. - Positioning of products . - Pricing of products. - Advertizing & product promotion. H.R. Strategies are concerned with : - Type of people the firm will seek to employ. - compensation structure - corporate culture
Manufacturing / Operations strategies are concerned with : - Manufacturing process to be selected, - Location of manufacturing, warehousing & distribution facilities, - Continual versus seasonal production, - Role of new technologies in Operations, - Nature of R & D efforts - Corporatization v/s divisionalisation of R & D - Mass production v/s quality production.
Behaviroural Aspects in MCS

Formal & Informal Factors & Controls
Related Questions
What do you understand by goal congruence? What are the informal factors that influence goal congruence. ( May 2009 and Dec 2010)
Organization Behaviour
Control in an organization is exercised through interaction of human beings Human behaviour is not simple. It gets influenced by many factors & becomes complex As organizations pursue their goals & objectives, control systems are designed to favourably influence human behaviour. Since control is achieved through the action of managers who are human beings, two main behavioural issues need to be considered - Perception - Motivation
Human Behaviour & Goals

1) Perception Operating managers receive information or directions as to what they are supposed to do, from the top management through hierarchy of management. This communication flows through formal as well as informal channels ( grapevine). Formal communication is generally clear & normally free from any ambiguity. However it is informal communications that may lead to confusion & complication due to erroneous perception. Though organization chart clearly indicates the hierarchy, the manger receives informal communications through his interactions with his peers ( parallel managers) as well as those in higher & lower levels.

The relationship that constitutes an informal organization is not shown in the organization chart, but they are part of the formal management control systems. The strength of perception of one manager differs from the other. As a result the degree of importance given to a course of action expected by the top management depends on the managers own perception about it. Sometimes erroneous perception may arise due to some strange reasons. Functional fixation is one such phenomena. Fixation means advance idea in mind overruling actual matter. It happens when one gets fixed with an idea in mind which may have a second meaning or interpretation but he does not care to check the actual one. Eg for an employee salary may mean net take home pay but firm may consider cost to company

2) Motivation Individual action depends upon how a manager reacts to the information or reports received by him . His reaction depends upon his perception of the matter as well as his motivational level. Motivation is influenced by some external stimuli & it reflects the individuals reaction to the stimuli. Motivation to engage in a given behaviour is determined by a) Persons belief or expectancy about the likely outcome from that behaviour. b) The importance the person attaches to those outcomes, which shall satisfy his needs. Individuals join organization to fulfill their personal goals like career growth, financial stability, status in the society etc. They are called as needs & are classified into a) Materialistic like money perquisites, fringe benefits etc. b) Psychological like praise, recognition, promotion etc.
Goal Congruence
The organization & the people working within it both have their own goals. Top Management would like to attain the goals of the organization. Individual actions aim at achieving their own goals. Therefore it is essential to balance the goals of the individual with the goals of the organization. When an organizations goal coincides with the personal goal of the manager, it is called goal congruence. Then only the actions people take according to their personal interest are also in the best interest of the organization. However perfect congruence between individual goals & organization goals does not exist in reality.
Goal Congruence & MCS

The purpose of MCS is to attain goal congruence as far as Feasible.
It means MCS should encourage people to work in the best interest of the organization by channelizing their time & energy in the right Direction, i.e. MCS motivates people to take actions for their self interest, but the same is in the interest of the organization too. Factors affecting goal congruence: Human behaviour in the organization which has effect on goal congruence is influenced by - formal & informal factors. - positive and negative incentives, A person can be motivated by positive incentives such as rewards, fast promotions, transfer with higher status etc. Incentives could be negative also such as punishment, stopping increment or reward etc. There are many formal & informal factors.
Informal factors
Both formal system & informal processes influence human behaviour in the organization which in turn affect the degree to which the goal congruence can be achieved. The designer of the formal MCS must take into account the informal processes or factors because for effective implementation of strategies, the formal mechanism must be consistent with informal ones. The informal factors influencing human behaviour may be internal or external. Both play a key role in achieving goal congruence.
Informal factors
External factors are the norms of desirable behaviour that exists in the society of which the organization is a part. These norms include a set of attitudes collectively referred to as work ethic which is manifested in employees loyalty to the organization, their diligence, their spirit & their pride in doing a good job. Some of the attitudes are local i.e. specific to the region. Internal factors are more critical & include 1) Management Style, 2) Organizational climate, 3) Perception & Communication, 4) Cooperation & conflict, 5) Informal organization.
Informal factors - 1
1) Management Style This is one of the major internal factor influencing the behaviour of the members of the organization. The attitude of managers superior towards control is known as Management style. Usually subordinates attitude reflect what they perceive their superiors attitude to be & their superiors attitude ultimately stem from CEO. Different managers display different characteristics while running the organization. Some of them are aggressive, some are charismatic , some rely more on written reports & other documents, some prefer to walk around, see things with their own eyes, form opinion or perception & then engage with people through informal contact & conversation. This in turn gets reflected to some extent in the attitude of ubordinates. However the formal system must be consistent with informal system & top management preference.
Informal Factors - 2
2) Organization climate or culture It refers to a set of common beliefs, attitudes, norms, relationships, assumptions that are implicitly or explicitly accepted and evidenced throughout the organization. The culture of the firm is everlasting. CEOs may come & go but the companys culture continues for ever. The head of the organization has a major influence on the culture of the organization. In family run business, one of the family member is at the helm of the affairs. He & other family members greatly influence all decisions & other managers do not have much power or authority. Organization culture affects the design of MCS. If two organizations have MCS designed on sound principles, but vary in their organization culture, one with a desired climate will be in a position to exercise better control.
3) Perception & Communication Managers are informed about their goals & the actions they have to take to achieve these goals through number of channels. Information coming through different channels of communications may be interpreted by managers in various ways. This information may sometimes be in conflict with one another. People have a tendency to interpret the meanings of phrases & words in accordance with definitions they are accustomed to use or based on their previous background. This phenomenon which gives rise to wrong perception is known as functional fixation.
4) Informal Organization The organization chart lays down the responsibility & authority of all managers working in an organization. This is known as formal organization. The lines in organization chart show the reporting or superior subordinate relationship. It also happens that the manager interacts with other managers, his peers, colleagues, superiors & juniors from different functions, subordinates etc. This constitutes the informal organization which has great influence on managers abilities to comprehend the realities in the organization & tailor his response to different situations.
5) Conflict & Co-operation When more than one manager has the responsibility for discharging the duties arising out of senior management communication, the interaction among these managers have effect on what happens & how the plans get executed. Many actions the manager may want to take to achieve his personal goals may have adverse effects on other managers plans & may lead to suboptimum results in some areas which can give rise to conflict among them. Sometimes the circulars carrying instructions to responsibility centre managers spark off a reaction among them depending upon the manner they affect their personal needs and leads to conflict. Thus conflict is a part & parcel of organization life.
contd.
Co operation is the reverse of conflict. Quite often responsibility centre managers who are having personal relations or mutual interdependence on each other work harmoniously & cooperate with each other in order to achieve organizations goals. Thus conflict as well as co-operation is inevitable part of the organizational behaviour of the people. Some degree of conflict is not only inevitable but desirable too. Conflict arising from need satisfaction & competition among the members of the organization for increments or promotions is healthy if it is kept within limits. Too much emphasis on co-operation is dysfunctional as members would not be in a position to utilize their talent fully. For smooth functioning of the organization, maintaining a fine balance between forces of conflict & co-operation is a delicate issue.
Formal Control System

The informal factors seen so far have a major influence on the effectiveness of an organizations management control. The other major influence is the formal control systems which has two types. 1)MCS itself 2)Rules The generic term rules includes all types of formal instructions & controls. Some rules are guidelines i.e. organization members are permitted to depart from them either under specified circumstances or when their own best judgment indicates that the departure will be in the best interest of the organization. e.g. credit policy guidelines Some rules are positive requirements that certain actions be taken ( mock drills for emergency preparedness)
Formal factors & controls

Some rules are prohibitions against unethical , illegal, or other undesirable actions . They should never be broken under any circumstances e.g. code of conduct. Formal controls & instructions include - strategic plans, budgets, reports, - standing instructions, job descriptions, standard operating procedures ( SOP ), manuals, code of conduct or ethics etc. Barring first three, the others do not change frequently. Formal controls & instructions exist for all matters right from critical issues to trivial subjects.
Formal factors & controls

Most common example of formal controls & instructions pertain to data processing systems. They exist to ensure that flow of data & information through the system is accurate & there is no fraud or defalcation. They are collectively known as system safeguards. There are also fixed rules & procedures which are included in manuals. Government departments & public sector undertakings generally have detailed & comprehensive manuals. Good MCs ensures that manuals are updated on regular basis to take into account environmental changes & top management thinking. Apart from formal controls & instructions, some times there also exist physical controls such as safes, security checks, entry restrictions through swipe cards or biometric identification etc.
Formal Control Process

Formal management control process has four major components as shown in diagram. 1) Strategic Plan & programme- Strategic plan is prepared, after conducting SWOT analysis & using all the information available, to implement strategies for achieving organizations goals. Strategic plan & programme form the guideline to Bugeting. 2) Budgeting The strategic plan is converted into an annual budget incorporating the planned expenditures & revenues for individual responsibility centres. 3 Operations & Measurement Responsibility Centres operate within the framework of the budget, established standards, standing instructions, practices and operating procedures embodied into rules & manuals.
Formal Control Process

3) Operations & Measurement ( contd.) Thus besides budget the responsibility centres are also guided by large number of rules & other formal information. They carry out the operations assigned to them & their outcomes are measured & reported. The records are made for the resources actually used & revenues earned. They also classify the data for performance measurement. 4)Reporting Actual performance is analyzed, measured & reported against plan, indicating variances & highlighting the areas of weaknesses. If performance is satisfactory, the responsibility centre receives feedback in the form of praise or other reward. If performance report is unsatisfactory, the corrective action is to be initiated & needs to be included in the budget which is revised to give effect to the changed position. If required the plan itself can be revised.
Emerging perspective
The parameters or approach to measurement of managerial performance have changed over a period of time. Control is no longer viewed as a regulatory function but is perceived as a facilitator. Control does not necessarily create restrictions but rather it assists in successful performance of the task. In the process of control, the focus should be on the activity & not on the person doing the job. Criticism should be directed to the problem relating to the task or operation or environment & casting aspersion on an individual should be avoided. Suitable motivation through adequate incentives can give amazing results & make control process highly effective. If some person needs to be punished for better control, it is equally important to reward another worthy person.
Organizational Structures
Related Questions
Write short notes on MCS in Matrix Organization ( May 2009 & Dec 2010) Briefly describe Functional, Divisional and Matrix organization. Which is the most appropriate form from the point of view of control? Where are the other two suitable. ( May 2011) What is a strategic business unit? What are conditions required for creating a SBU? How is performance of SBU measured? What are the advantages and disadvantages of creating a SBU? ( May 2010)
Organizational Structures
An organizational structure is a network of formal authority, responsibility & reporting relationships. It is an instrument for implementation of organizations strategy. A good organization structure provides the foundation for an effective control system. It can not remain static As company grows, along with size, complexities multiply with diversities. Hence it becomes essential to develop new approaches, redesign the systems & work out more effective organization structure. Centralized rigid control from the top management level suitable for small organization needs to change with more autonomy to the middle management level. The structure of any organization depends upon the nature of business, its size & complexity, inter functional relations & extent of control needed. The major types of structures used by big organizations are Functional, Divisional / B.U. , Matrix & Network.
Functional Organization
This is the oldest form of organization structure. In functional organization the departments are organized according to the functions performed in the organization. Each manager is responsible for a function such as Marketing, I.T, Operations, H.R. Finance, R & D etc. as shown in the diagram. These functions or departments are staffed by specialists who are expected to be experts in their respective fields. They are headed by responsible people who possess specialized knowledge, qualifications, expertise, skills essential to run such departments. It is generally found in older, single product, non enlightened firms & public sector undertakings.
contd.
Advantages- Functional organization leads to division of labour & specialization . - Each specialized function has potential to operate with great efficiency & advantage. - Efficiency can increase further as the size of activities grows . - Economics of scale allow utilization of increasingly specialized inputs & quality of service. Limitations - Primarily this structure is suitable for single industry firm. When product lines are limited & size of the organization is medium or small, it is quite effective. But when the firm diversifies its products or markets, this structure does not prove adequate to respond to the change. Performance evaluation of separate functional managers also poses problem because all functional managers are collectively involved in achieving the goals of the organization
contd.
The responsibility of earning profit can not be assigned to individual managers because expense centres and revenue centres are under the responsibility of two or more managers. This structure has a tendency to create water tight compartments which prevent co-ordination among various functions. Therefore issues which need co-ordinated efforts or cross functional team approach as in setting up new project, new product development, diagnostic reviews for problem solving etc. tend to suffer. The disputes between different functional managers can only be resolved by Chief Executive. All functional managers concentrate on their own area of specialization & lack general overview of the business. No single functional manager has a broader perspective of business as that of a CEO. Hence it poses problems for the succession of the position of CEO.
Divisional & B.U. Organization

This form of organization has evolved to overcome the problems of functional organization. It can take two shapes viz. - Division or - Strategic Business Unit ( SBU or simply BU ) The main differentiating feature in this form is that SBU has near total strategic autonomy which divisions do not have. A Business Unit , also called a Division sometimes, is responsible for all the functions involved in producing & marketing a specified product line. It is considered as a company operating within a company & treated almost like an independent entity with all the functions being controlled by the Divisional or B.U. Manager responsible for the results of the unit. He develops his own strategy with his senior executives within the overall frame work of the organization & is not concerned with the strategies pursued by other divisions.

BUs are headed by responsible persons who have all round experience in main areas of business viz. Manufacturing & Marketing. They are known as BU managers & have the responsibility for planning, organizing, directing, staffing, co-ordinating & budgeting of the business. BU managers are evaluated on the basis of profitability & certain long range goals of the organization. B.U. as well as Division is organized into various functional departments like a functional organization as shown in the organization charts & the employees have knowledge, experience, skills in the products the division is dealing in. As responsibility centres within a Division or BU perform like functional units, the control problem is same for the units as for a whole firm that is functionally organized except that it is on a lower scale. Although BU & Division may function in a manner which creates the impression that they are functioning as independent companies , the fact remains that they do not have complete autonomy because the corporate head quarter is sitting over their head.

Corporate Head Quarter ( CHQ) CHQ is vested with some powers & has right to make certain decisions. The strategic plans & budgets of BU are approved annually by the CHQ. CHQ raises funds for the same & the same is allocated to BUs or Divisions based on sound judgment. CHQ has a say in product lines BU should engage in, the geographic territory it can operate etc. It has the authority to carry out hiring & firing of BU or Divisional managers . CHQ establishes the companys policies under the direction of CEO. It also carries out certain common and specialized services like treasury, legal, public relations, exports, secretarial etc which are availed of by BU/Divisional Managers

Advantages Since they are staffed with people having specialized knowledge and experience pertaining to particular products or product groups, sound decisions in production marketing finance etc are made and the business runs properly and prospers BU Managers make sounder decisions owing to their proximity to the markets than the corporate head quarters. This enables them to gauge customer habits, tastes, demands as also the present and potential competitors, market threats, opportunities available in the market. This enables them to formulate more effective strategies They impart training to BU Managers in general management . In order to grow and prosper, the BU Manager who runs a complete business must possess an entrepreneurial spirit. These are the characteristics of the CEO of a company which makes succession planning of CEO less problematic compared to that in functional organization

Disadvantages There are likely to be disputes among business units which may arise out of transfer price fixation involving inter divisional transfer pricing, marketing territories etc. The conflict can also arise due to friction between CHQ staff and BU staff This structure is more expensive because BU is staffed with functional people and they may deal with mostly the same problems that their counterparts handle in other BUs and CHQs This creates duplicate staff layers in the organization which proves to be expensive
Matrix Organization
Matrix form of organization is a combination of functional and divisional structures Here the product lines or projects are arranged along one arm of the matrix, across the other arm could be arranged either functions or geographical divisions. Thus it is virtually a marriage between two types of organization structures one arranged by function & the other arranged by projects Thus each cell in the structure belong both to a product / project and to either a function or a division as shown in the organogram. A project is any task or group of tasks involved in reaching a specified end objective. Project Managers are responsible for dealing with the customers & the functional units provide resources to the projects. Responsibility centres are arranged by functions such as purchase, engineering, operations, HR, etc.
Matrix Organization
Project managers use resources like materials, persons, services from various functional units in accomplishing their objectives. The resources are moved up & down between functions or regions according to mutual adjustments. The need for matrix organization arises due to compulsions from collaboration between businesses operating in different regions products / projects with low margins and highly competitive markets unpredictability of resource requirements
Hence this structure is more suited organizations like consultancy firms , R & D units, construction companies, manufacturers of complicated plant & machinery where business flow is not steady but moves in pulsating manner .
Matrix Organization
Advantages This structure generally speeds up growth. Setting up a new product line or unit or starting a new business through Divisional or BU structure means investments in fresh functional lines which is expensive & time consuming. However the matrix form allows new businesses to plug into existing business resources. This structure is more appropriate for the management of products when - the number of products grow to be relatively large. - products need close co-ordination among many specialized disciplines. - the markets are too small to justify separate divisions for each product. Disdavntages
Matrix Organization
Disadvantages This structure is very difficult to manage. The configuration dilutes priorities & creates conflict between product lines / projects & functions over the allocation of resources. Hence planning has to harmonize the requirements of projects with resources that are available at the functional units. Co-ordination of exceptionally high order is essential to ensure that the projects are completed in time without incurring any liquidity damages and at the same time personnel are not idle. ( in fact the nature of business of big consultancy firms employing this kind of structure is such that the specialized persons of different disciplines are either overworked or enjoy lazy hours ) Profitability is the joint responsibility of several managers.
Network Organizations
The network form is most suitable where -the products are characterized by commoditization - market is having lot of competitors which necessitates cost cutting to the rock bottom level - large capital investment is required Here business exists as an independent units within the corporate framework but with links with a web of other companies. The configuration focuses on the operation of business only on that part of the value chain which it does the best and outsources all other functions This structure is being adopted by increasing number of companies operating in fast changing markets
Network Organizations
Changing all the processes every time the market changes can be time consuming and counter productive It is much better to simply outsource all functions except those where a firm has core competence The network from organization structure can lead to explosive growth since the virtual structure is never inhibited from responding to market demand by the lack of in house facilities It needs vendors and service providers on whom the firm can depend and with whom it can cooperate In other words the network structure proves to be unrealistic when the vendors cannot meet product standards and outsourcing is not possible
Controller
Controller or Financial Controller or Chief Financial Officer is the person who has the responsibility for design & operation of management control system. It is a staff function & does not have responsibility to enforce management decisions. Its functions are 1) Preparation of Strategic plans & Budgets 2) Design & operation of MIS & MCS. 3) Preparation of financial statements & financial reports like tax returns to be submitted to external government agencies like Income tax, Sales tax, Excise etc. 4) Supervision of internal audit which should provide safeguards against threat & defalcation, check validity of information & conduct operational audit.
B.U. Controller
B.U. Controllers inevitably have divided loyalty. They owe some allegiance to the corporate controller, who is responsible for the overall operation of the control system. They also owe allegiance to the managers of their own units for whom they provide staff assistance. Two types of relationships are possible with each having its pros & cons as shown in the diagram. In organogram the direct reporting relationship is shown by the full or solid line & the dotted line indicates the functional reporting. Therefore in companies organized into Business Units the appropriate relationship between B.U. Controller & the corporate controller is always subject to debate.
B.U. Controller
1) B.U. Controller reporting to B.U. Manager Here G.M. of the B.U. is the controllers immediate boss. He has the ultimate authority in hiring, training, transfer, compensation, promotion & firing of controller within that B.U. though such decisions are rarely made without consultation with corporate controller. In this relationship there is a possibility that B.U. controller may not give completely objective reports on B.U. budgets & B.U. performance to corporate management.
B.U. Controller
2) B.U. Controller reporting directly to corporate controller Here the corporate controller is the direct boss of the B.U. Controller . This reporting relationship creates apprehension in the mind of B.U. management about the controller being the spy from the corporate office. Therefore he does not get accepted as a trusted aide. However irrespective of reporting relationship it is expected that the controller will not condone or participate in the transmission of misleading information or in the concealment of unfavourable information. The overall ethical responsibilities inherent in the position do not countenance such practices.
Management Information in MCS
Information
In management control process, Information is required & used for planning, for co-ordinating & for control. Information is a fact, observation, perception or anything that adds to knowledge. It is obtained either by direct observation or by communication. Information generation & transaction involves cost but information itself has value Most of the information the responsibility centre manger gets is obtained by communication ranging from informal conversation to formal reports. Mangers regularly receive two types of reports viz. 1) Information reports 2) Control reports.
Reports
1) Information reports They tell managers what is going on. They may or may not lead to any action. Reports of orders received, accounts receivables, inventory statements, stock market quotations, news on government regulation, competitors news fall in this category. 2) Control reports They are specifically designed to facilitate the management control process. Although they differ greatly in the nature & in the way they are reported, they have the common characteristic feature of comparing actual performance with some measure of planned or expected performance. The flow of information in management control process is shown in the block diagram.
Management Information System (MIS)

Management Information System MIS is a formal system for providing management with accurate and timely information required for decision making MIS is a planned and integrated system for gathering relevant data, converting it into the right information and supplying the same to the concerned executives The basic objective of MIS is to provide the right information to the right people at the right time. Management Information System is described as an input-processoutput system with distinctly different stages viz. 1) Input 2) Processing 3) Output It gathers relevant data, converts it into right information & supplies the same to the concerned executives.
Management Information System (MIS)

1) Input Input of the system are data collected from various sources both inside and outside of the organization Such data may be financial and non-financial gathered from its operations as well from environment. 2) Process Collected data is processed and stored in a scientific manner so as to be available for preparing output , that is repots to the various levels of management. Actually, from the collected information, a database is created for maintaining records, which covers past, present and future happenings, plan and programmes, standard budgets etc. 3) Output Outputs are appropriate reports prepared and circulated to the functional mangers for decision making in their respective areas.
MIS & Management Levels

MIS is designed as per the requirement of management at different levels The form and control of information varies widely between top, middle and lower levels. 1) MIS for Top Management The top management formulates goals, strategies and policies Strategic planning activities primarily involve future interaction between the organization and its external environment. Thereafter , strategic information such as market analysis, business growth, demographic information, technological development , politics and government policies etc. is required at the top level These reports should be brief, concise and yet covering all the important points
MIS & Management Levels

2) MIS for Middle management The middle management or the Department heads level require more information on their respective areas of operation such as production, sales Analysis of monthly operational results with their comparison against Standard or budget or previous period, indicating monthly as well as cumulative data are normally included in such reports The same information is also sent to the top management in a summarized version. 3) MIS for Operating management At the lower level of managements Operational Control is exercised by the Supervisors. Here, information is collected more frequently depending on the item of operation to be controlled. Daily, weekly or fortnightly reporting is required in some areas with more detailed information . Daily production , sales, inventory, overtime, absenteeism, cash and bank position are some of the information which must reach the desk of the unit head by next morning.
Characteristics of MIS
MIS should be user oriented, i.e. it should fulfill the needs of the users Co-operation & participation of different levels of managers is essential for design of MIS. Aims & objectives of MIS should be communicated to all managers & supervisors to make them aware of the system. Also through series of training programs they should be trained to operate it. It should be available in the form of a system manual which is accessible to all the users. This comes handy for training the new recruits. Periodic review of the system is essential to identify if the system fits the needs of the users as desired. If any deficiency is observed it should be revised to make it more user friendly.
Responsibility Centres
General Characteristics Revenue Centres Expense Centres
University Questions
Briefly describe Engineered expense centres and Discretionary Expense centres. How is budget prepared in each and how is performance evaluated in each ( May 2010) What is Responsibility Centre? List and explain different types of responsibility centres with sketches ( may 2009 and Dec 2010) Briefly describe Responsibility Centre, Engineered Expense Centre, Discretionary Expense Centre, Revenue Centre, Profit Centre. How is the performance of the Head of these centres evaluated? ( May 2011)
Responsibility Centres (General Characteristics)

An organization is composed of a number of financial responsibility centres which are created by the management based on the needs of the business enterprise. A responsibility centre is an organizational unit headed by the manager who is responsible for its activities. Responsibility Centres form a hierarchy with sections, work shifts etc. existing at a lower level & department, business units at a higher level. RCs are created in the organization for implementation of its strategies to accomplish its goals. Since the total firm is the aggregate of its RCs, if each RC is able to meet its objectives, the entire enterprise would stand to achieve its goals
Responsibility Centres (General Characteristics)

Management Control focuses on behaviour of managers in RCs Inherent in the concept of control of RC is the ability to measure its performance For understanding the performance measurement in RC we have to focus on following parameters. 1) Input 2) Process 3) Output 4) Effectiveness 5) Efficiency
(Inputs, Process)
Inputs A responsibility centre uses some inputs & generates an outputs. Inputs are the resources it uses in doing its work in specified period of time such as week or month. Inputs are always expressed in monetary terms (Rs.) by assigning cost to them i.e. cost. Cost is the monetary value of the resource consumed. These costs provide a common denominator that enables the aggregation of individual resources. The inputs may assume various forms viz. hours of labour, quantities of material and services. Process It uses or processes the said resources by using plant, machinery, other fixes assets & working capital into necessary output. Input & output are the two sides of a coin.
(Outputs)
Output are the results of its work or performance of some function. The output could be intangible or tangible. Output which is intangible in nature is called services while tangible form of output is called goods. Thus output of production department of processed materials, finished parts are goods Output from finance, accounts, HR, administration, logistics, marketing, plant engineering are services . The output of a responsibility centre may be either sold in the market or used by another responsibility centre. The amount that a responsibility centre earns by selling the output is known as revenue. The relationship between input & output may be direct & causal in some cases, while in others no such relationship can be established
(Outputs)
In production department, raw material input forms a physical part of the output of finished goods. However in R & D department no relationship can be established between inputs ( expenses incurred) & output (invention of new product or technology or process etc.) In profit oriented organization , important measure of output is revenue But this measure does not encompass all the activities of organization & hence there are problems in measuring the output of many responsibility centres. In functions like legal, secretarial, P.R., Q.C., market research, there is no way of measuring output satisfactorily. i.e. when output is service ,it is difficult to relate cost with revenue. In many non profit organizations output can not be measured in quantitative terms.
(Efficiency)
The criteria used for judging the performance of responsibility centres are efficiency & effectiveness. Efficiency is the ratio of output to input or it is the amount of output for each unit of input. This necessitates that the output has to be measured in quantitative terms which poses problems in host of situations. Therefore for many RCs the measure of efficiency is developed by relating actual cost to some standards. However it is not a perfect measurement tool because standards are approximations of ideal use of resources in a given situation. Also cost which are recorded by the system may not be an accurate measure of resources that have been consumed.
(Effectiveness)
Effectiveness tries to establish a relationship between output & objectives of responsibility centre. A unit is said to be effective when its output contributes towards its objective. i.e more the output contributes towards it objectives, more effective is the unit. But output as well as objective are often difficult to express in quantitative terms. Therefore measurement of effectiveness becomes difficult and quite often it is stated in subjective and non quantifiable form or expressed as human judgement.
A responsibility centre is expected to be both efficient & effective. RC is said to be efficient when it performs its work with the lowest consumption of resources
(Effectiveness)
. However if its output i.e the task it has performed does not contribute adequately in fulfilling the goals of the organization it is said to be ineffective. If marketing function books orders at lowest possible cost it is efficient but in the process if it antagonizes the customer and spoils the relationship built it is said to be ineffective. In profit oriented companies, earning profit is a major objective and therefore amount of profit is the indicator of effectiveness. It however indicates efficiency too.
( Effectiveness & Efficiency)
Profit is excess of revenue earned over expense incurred. But revenue is the monetary measure of output and expense is the monetary measure of input. Since amount of output for each unit of input is the measure of efficiency, profit indicates efficiency too. It can therefore be said that profit is a measure of both efficiency and effectiveness. In other words in such cases it is not necessary to ascertain which is more important efficiency or effectiveness In situations where no such measurement tool is possible performance measure should be classified into two different categories viz : efficiency and effectiveness
Viewed in terms of input output relationship & the functions performed by them, responsibility Centres are divided into two. 1) Revenue Centre 2) Expense Centre In profit oriented companies, where profit is considered as output, we get two types of responsibility centres. 1) Profit Centre 2) Investment Centre. Thus there are four types of responsibility centres which can be shown in the table or diagram form. The measurement criterion is different in different RCs. Revenue Centre - Output is measured in monetary terms. Expense centre Input is measured in monetary terms. Profit Centre Both revenues(output) & expenses (input)are measured. Investment Centre The relationship between profit & investment is measured. Therefore planning & control system required for different RCs is different.
Revenue Centres & Expense Centres
Revenue Centre
Revenue is the monetary measure of output. Here the out put is measured in terms of revenue earned but is not related to input cost i.e. revenues are measured in monetary terms but expenses are not matched with these revenues. Though the RC manager is held accountable for expenses incurred directly within the unit, primary measurement for control purpose is revenue. Revenue Centres are typically found in marketing operations where no responsibility for profit exists because generally revenue centre manager does not have authority to establish selling price. They are in effect selling units having no responsibility for the cost or the profit of products sold. Orders booked & sales achieved are compared with the budget to measure their performance i.e. comparison of actual & budgeted revenues indicate their effectiveness . Thus there is no relationship between inputs & outputs
Expense Centre
Although every organizational unit or RC has output, in many cases it is neither feasible nor necessary to measure these outputs in monetary terms. If the control system measures the expenses incurred by an org. unit but does not measure the monetary value of its output, it is an expense centre. Expense centres are opposite to revenue centres wherein inputs are measured as monetary costs. However outputs are either not measured at all or measured in qualitative, non monetary terms i.e. physical units. Expense centre must be distinguished from cost centre. Cost centre is location, person, or item of equipment in relation to which costs are ascertained & used for the purpose of control. Cost centre need not be headed by a manager. Manufacturing cost centres are expense centres where the manager is primarily responsible for expense control. They are classified into two, in such a manner that their lables relate to two types of costs. - Engineered expense centre - Discretionary expense Centre
Engineered Expense Centre

These are organization units where inputs (or costs) can be measured in advance with reasonable accuracy in monetary terms. The outputs can be measured in physical units. The optimum amounts of inputs which are required to produce one unit of output can be established. Their output when multiplied by the standard cost of each unit gives the standard cost of finished goods. They are usually formed in manufacturing operations where standard cost system is used. They are called Engineered expense centres because valid engineering estimates can be made for each & every cost item. e.g. Direct Materials, Direct Labour, Direct Expenses In these centres actual costs are compared with standard costs to determine its efficiency.

Engineered expense centres do not necessarily relate to manufacturing activities alone. They may be applicable to other functions like warehousing, distribution, accounts receivables, payrolls etc. There are few, if any, RCs in which all cost items are engineered. Even in highly automated production departments , the use of indirect labour & various services can vary with managements discretion. Thus the term Engineered Expense Centre refers to RCs in which engineered costs predominate , but it does not imply that valid engineered estimates can be made for each & every cost item. EECs have other important tasks not measured by costs alone. They are responsible for Quality of Product, volume of production as well as for efficiency.

In EECs the costs are strongly affected by short run volume changes. The control focuses on using the minimum input necessary to produce the required output according to correct specifications & quality standards, at the time requested & in quantities desired. The management decides whether the proposed operating budget represents the unit cost of performing its task efficiently Here the objective in financial control is to become cost competitive by setting a standard & measuring actual costs against this standard. Hence financial performance report is the means of evaluating the efficiency of the manager.
Discretionary Expense Centre

(general)
Discretionary cost is the cost which depends upon the mangers judgment & the circumstances decide what is accurate. It is incurred as per organizations policies. Discretionary expense Centre has no way to estimate reliable standard costs because optimal relationship can not be established between inputs & outputs & the expenses vary at the discretion of the manager. Here neither efficiency can be measured nor performance can be evaluated satisfactorily. Therefore generally the difference between the budgeted input and actual input is measured but it is not a measure of efficiency because the budget does not purport to predict the actual amount of spending. What is proper level of discretionary cost is a subjective judgment which can change when the responsibility centre manager changes or a new manger takes over.

(general)
DECs include - administrative & support units ( such as secretarial, financial, accounting, legal, P.R., I. R.,H.R. Etc. ) - R & D operations, - most marketing activities whose output can not be measured in monetary terms. Special considerations are involved in designing systems for these three most common types of DECs. The term discretionary does not imply that managements judgment as to optimum cost is haphazard, rather it reflects management decisions regarding certain policies related to above areas.

(general)
Primary job of a DEC manager is to obtain the desired output. The financial performance report is not a means of evaluating efficiency of DEC manager. Hence on budget spend is considered as satisfactory, overspending than budget is a cause of concern & under spending may indicate that planned work is not being done. The financial control in DEC is primarily exercised at the planning stage before the costs are incurred. The total control is achieved primarily through non financial performance measures
Administrative and Support Centers

(Specific DEC 1) Administrative centers include senior corporate management and BU management along with the managers of supporting staff units. Support centers are units that provide services to other responsibility centers Control Problems The control of administrative expense is especially difficult because of Problems inherent in measuring output Frequent lack of congruence between the goals of departmental staff and of the company as a whole
Administrative and Support centers

Difficulty in measuring output In some staff activities the principal output is advice and service function that are virtually impossible to quantify, much less evaluate Since output cannot be measured it is not possible to set cost standards against which to measure financial performance Lack of Goal Congruence Typically, managers of administrative staff offices strive for functional excellence Striving for excellence can lead to empire building or to safeguarding ones position without regard to the welfare of the company
Administrative and Support centers

The severity of these two problems is directly related to the size and prosperity of the company In small and medium sized businesses, senior management is in close personal contact with staff units and can determine from personal observation what they are doing and whether a unit is worth its cost In businesses with low earnings, regardless of size, discretionary expenses are often kept under tight control In a large business, however senior management cannot possible know about, much less evaluate all staff activities; and if that company is also a profitable one, there is temptation to approve staff requests for constantly increasing budgets
Research and Development Center

(Specific DEC -2)
Control Problems The control of research and development centers presents its own characteristic difficulties Difficulty in relating results to inputs The results of research and development activities are difficult to measure quantitatively R&D usually has a semitangible output in the form of patents, new products, or new processes; but the relationship of output to input is difficult to appraise on an annual basis because the completed product of an R&D group may involve several years of effort Thus, inputs as stated in an annual budget may be unrelated to outputs Lack of Goal congruence The goal congruence problem in R&D centers is similar to that in administrative centers Research people often do not have sufficient knowledge of (or interest in ) the business to determine the optimum direction of the research efforts
Marketing Centers
(Specific DEC -3 )
In many companies, two very different types of activities are grouped under the heading of marketing, with different activity measures & controls being appropriate for each category. 1) Logistics Activities One group of activities relate to the execution or fulfilling of sales orders received. These are referred to as order filling or logistics activities and , by definition, take place after sales order has been received. 2) Marketing Activities The other group of activities relate to efforts to obtain sales orders, and obviously, take place before an order has been received. These are the true marketing activities. There is third activity of generation of revenue. This is usually evaluated by comparing actual revenue and physical quantities sold with budgeted revenue and budgeted units, respectively
Marketing Centers
Logistics Activities ( EEC) Logistics activities are those involved in moving goods from the company to its customers and collecting the amount due from customers in return These activities include transportation to distribution centers, warehousing, shipping and delivery, billing and the related credit function, and the collection of accounts receivable. The responsibility centers that perform these functions are fundamentally similar to the expense centers in manufacturing plants Many are engineered expense centers that can be controlled through imposing standard costs and adjusting budgets to reflect these costs at different levels of volume
Marketing Centers
Marketing Activities (DEC) Marketing activities are those undertaken to obtain orders for company products . These are discretionary costs because no one knows what the optimum amounts should be. Consequently the measurement of efficiency and effectiveness for these costs is highly subjective. These activities include test marketing; the establishment, training and supervision of the sales force; advertising; and sales promotion all of which have characteristics that present management control problems While it is possible to measure a marketing organizations output , evaluating the effectiveness of the marketing effort is much more difficult. This is because changes in factors beyond the marketing department's control ( e.g. economic conditions or the actions of competitors) may invalidate the assumptions on which the sales budgets were based
Profit Centres
University Questions
Every SBU is a profit centre but every profit centre may not be SBU. Explain. Under what conditions Production, Marketing and Service Departments are converted into profit centre?( May 2011) What do you understand by investment centre? Explain two different methods by which the performance of these centres are measured ? Also discuss their relative merits and demerits. ( May 2011) Every SBU is a profit centre but every profit centre may not be SBU. What are the conditions that should be fulfilled for an organization unit to be converted into a profit centre? What are the different ways to measure the performance of profit centres? Discuss their relative merits and demerits ( May 2009 & Dec 2011) When are Market based Transfer Prices most appropriate? How do we deal with the condition of limited market , situation of excess / shortage of capacity? Transfer pricing is not an accounting tool Comment with illustrations. Market price is ideal transfer price even in limited markets Comment ( May 2009 & Dec 2010) What are the objectives of transfer pricing ? What are the different methods to arrive at transfer price ? Discuss the appropriateness of each method. Explain with example. ( May 2010) How is an investment centre different from a profit centre? What are the different methods of judging their performance? Which is a better method? ( May 2010)
Profit Centres
(Introduction)
In Profit centre, the system tracks both inputs & output in monetary terms. Inputs are the expenses & the output is the revenue. The difference between them is the profit. Actual profit w.r.t. budgeted profit is the measure of efficiency. If the performance of the responsibility centre is measured in terms of profit which is the difference between the revenue earned from the sale of products & the costs of goods sold in a given period, it is called a profit centre & the profit is ascertained for a period. In management accounting revenue is defined as the value of output of the centre whether realized or not. Thus factory can be a profit centre selling its production to marketing or Sales Department. Service department like maintenance may sell its output or service to other departments who receive them to become profit centre. In non profit organizations, the term profit centre is inappropriate & hence it is called as financial performance centre.
Recapitulation
( Background to Profit Centres)
Functional organizations are managed by specialist staff members who have expertise in their respective field of specialization such as Marketing, production, Finance , H.R. etc. In these organizations, similar products are manufactured in one or more units & marketed through a distribution channel over a wide geographical area. Knowledge & expertise of each of functional heads direct the organization to achieve the best results. However profit performance of each of the functional heads can not be determined or pinpointed easily& exclusively, since no functional head controls both input & output of the responsibility centre. This is one of the contributory cause for the emergence of Divisional or SBU or BU organization.
Recapitulation
( Background to Profit Centres)
Divisional or BU organizations are managed by business experts who look after the different segments of the business. When the business is diversified into unrelated products, each product group calls for manger of different technical & managerial abilities. Head of each division or BU may be a specialized engineer or a specialist, but he controls the overall business of that division having total access to its inputs & outputs. In such divisional organizations, the head of each division or BU remains responsible for the profits of the division & hence it is called as profit centre. estimated profit for the year is distributed among the divisional mangers as their profit targets for each of the business they manage, unlike the case of functional managers, where pinpointing the profit responsibility is difficult.
Profit Centres
( characteristics)
Most BUs are created as profit centers since mangers in charge of such units typically control product development, manufacturing and marketing resources. Since they are in a position to influence revenues / costs, they can be held accountable for the bottom line. In setting up a profit centre a company devolves the decision making power to those lower levels that possess relevant information for making expense / revenue trade offs. This move can increase the speed of decision making, improve the quality of decisions, focus greater attention on profitability & provide a broader measure of management performance. Its autonomy is constrained by other business units & by corporate management. These constrains need to be recognized explicitly in its operations. Under appropriate circumstances, even the production or marketing function can be constituted as a profit centre although considerable judgment is required to accomplish this successfully.
Profit Centres
(Advantages)
Quality of decisions is improved as they are made by managers who have specialized knowledge, skills & are closest to the point of decision. Speed of operating decisions is increased because it is not necessary to refer many of them to CHQ. Headquarters management, relieved of day to day decision making, can concentrate on broader issues Managers are subject to fewer corporate restraints Because profit centers are similar to independent companies, they provide an excellent training ground for general management & result in creation of pool of managers from which future general manager can be selected. Profit consciousness is enhanced since managers who are responsible for profits will constantly seek ways to increase them Profit centers provide CHQ with ready made information on the profitability of the companys individual components
Profit Centres
(Difficulties / drawbacks)
Decentralized decision making will force top management to rely more on management control reports than on personal knowledge of an operation, entailing some loss of control. It is not possible for CHQ to ensure that each profit centre will try to optimize the overall organizations profit while maximizing its own profits. If headquarters management is more capable or better informed than the average profit center manager, the quality of decisions made at the unit level may be reduced Friction may increase because of argument over the appropriate transfer price, the assignment for common costs , and the credit for revenues that were formally generated jointly by two or more business units working together. A profit centre manager generally heads a functional organization under his control which is not able to develop future general managers or a profit centre manager.
Profit Centres
It leads to competition among profit centres which may prove detrimental to some of them. Organization units that once cooperated as functional units may now be in competition with one another . An increase in profits for one manager may perhaps give rise to unhealthy or negative behaviour from others whose profit is negatively impacted. This may manifest in - failure to refer sales leads to another business unit better qualified to pursue them; - hoarding personnel or equipment that, from the overall company standpoint, would be better utilized in another unit; - making production decisions that have undesirable cost consequences for other units
Profit Centres
Divisionalization may impose additional costs because of the additional management , staff personnel and record keeping required and may lead to task redundancies at each profit center. There may be too much emphasis on short turn profitability at the expense of long run profitability. In the desire to report high current profits, the profit center manager may skimp on R&D, training programs or maintenance. This tendency is especially prevalent when the turnover of profit center managers is relatively high . In these circumstances managers may have good reason to believe that their actions may not affect profitability until after they have moved to other jobs.
Profit centre
( emergence/ evolution )
Recapitulation - coping with growth & diversification Normally CEO of an organization exercises his own concept about how to run & control the business. As the business grows, the reign of control looses & the autonomy at the profit centre gradually increases. If the growth is in the same business, it is only problem of controlling the size of the units. But when the business diversifies into unrelated products & services , then apart from specialists, more general managers having strong business acumen are required to manage the growth of the business. Then striking the balance between centralized control & decentralized action becomes more difficult & complicated. In a centralized control , most of the key decisions are taken by the top management & direction for performance is given to the middle & lower staff members as is evident in functional organizations.
Profit centre
( emergence / evolution )
Recapitulation - BU set up & CHQ operation In a decentralized action, substantial autonomy is given to divisional mangers to utilize all the resources at their command & to show performance as expected by the top management, subject to utilization of some of the centralized corporate functions that are either essential or economically viable. e.g. any legal or secretarial matter in the division has to be referred to the CHQ before any action can be taken by the division. Also materials required in bulk quantities by branches at different locations can be clubbed together by the central purchase function at corporate level & the bulk orders can be placed centrally for obtaining sizeable quantity discounts.
Profit centre
( emergence / evolution )
Recapitulation decentralized management The CEO of a company has to distribute the responsibility for profit earning among the top executives, keeping the control with him. In a big company with diversified products manufactured & distributed through number of units scattered over wide geographical locations , there is a danger of responsibility for profit being diffused. Under functional structure, the management of profit is a hard task & may even cut into the efficiency of the firm. Decentralization is an effective means to overcome this diffusion of profit responsibility. Therefore a large integrated multi product company is conveniently divided into independent operating units that act like business entities free to trade outside as well as inside the company. Given right incentives, each profit centre, by maximizing its own profit contribution, will do what will also maximize the profit of the entire company.
Profit centre
(Requirements for performance measurement) To make the Profit Centre system achieve the desired results, following conditions have to be fulfilled. 1) Correct marking of the boundaries of each profit centre. 2) Economic transfer prices. 3) Correct measurement of profit contribution of the profit centre. 4) Realistic standards of contribution profit performance. 5) Incentive & compensation to the executives including non monetary rewards. They constitute the essential requirements for performance measurement of profit centre manager.
Profit Centre
( essential requirement no.1)
1) Boundaries of profit centre The responsibility structure establishes the physical, human & financial resources that are entrusted to the profit centre manager to run the business of the profit centre. The balance consists of the corporate resources that are shared by all profit centre managers. The custody of resources will influence the decision making process of the profit centre manager. However to make profit performance more meaningful, the divisional or BU manager must have : a) Operational independence - It provides authority over buying, production, scheduling, inventories, product mix & pricing decisions. He has to exercise discretion in these areas under broad rules of the game fixed by CHQ. b) Access to sources & markets - essential for arriving at make or buy decisions as well as make or sell decisions ( i.e choice between selling a product at an early stage of processing as it happens in case of joint products)
Profit Centre
( essential requirement no.1)
Boundaries of profit Centre - contd.
c) Separable costs & revenues Profit centres should be marked off in such a away that costs & revenue are separable for each of the profit centres, thereby minimizing the necessity for costs & revenue allocations on arbitrary basis. Contribution profits of the division can be defined so as to exclude central & other costs outside the control of the divisional or BU managers. The phrase contribution profit is used to differentiate overall companys profits from that of profit centre or BU / Division. d) Managerial intent BUs contribution can not be measured solely by its profits, although this must be a good measure of performance. The managerial intent also must be kept in mind for this purpose.
Profit Centre
( essential requirement no. 2)
2) Economic Transfer Price Competitive intra company transfer price negotiated by profit centre manager is another prerequisite. Transfer pricing must preserve the profit making autonomy of the divisional managers so that divisional profit performance will coincide with the interests of the company. Small differences in unit TP of products make big difference in divisional profits & executive bonuses. It is obvious that conflicts of interest can be held at minimum by transfer at marginal cost. But this prevents meaningful divisional performance. Ideally TP should approximate the normal outside market price with adjustments for costs not incurred inter company transfers. Even when sourcing decisions are constrained , the market price is the best transfer price.
Profit Centre
3) Measurement of contribution profitThe next requirement for profit centre control is good measurement of profit contribution of the division or BU. The broad principle of design of performance measurement system should be financial & be based on ROI which is a dominant objective of the owners of the organization. To apply ROI measurement to profit centre, the firm must decide the revenue , expenses & investment base assigned to the RC. Also the performance measurement yardstick must be geared to the multiple & overlapping goals of the organization in that the RC manager must know which are the key performance areas whether current profits, or sales growth or market share or progress in other areas. In whatever parameters it is measured, RC manager must be clear about decision criterion as to whether to sacrifice short term high profit for attaining long term distance profit with growth & progress.
Profit Centre
4 ) standards of profit performanceAnother prerequisite to a profit centre concept is the standard of profit performance expected from each of the profit centres. This is quite a complex issue & hence instead of formalizing the standard of profit performance, it is generally left to the informal judgment of the corporate management or CHQ. Sometimes the standard is worked out roughly by comparison with the earnings of independent firms dealing approximately with the same or similar product line. ( Refer the assumptions underlying Porters model of five forces about average profitability of industry segment deciding the performance of the firm) But this is tentative measure & other dimensions of long term profit performance associated with growth, progress & executive development may also be considered.
Profit Centre
5 ) incentive compensation The final requirement for effective profit centre operation is the incentives which will power the profit centres mangers to maximize their divisions contributions. Incentive compensation should fit the organization environment & personality of the profit centre management. Generally it is decided by the group judgment preferably at the board level based on multiple measurement of profit performance, compared with objectively determined standards when feasible. Incentive is a reward for extra ordinary performance & its quantum has some parity with the base salary of the concerned manager. These payments are made either in cash or in kind or in deferred payments or stock options keeping in view the financial position of the manager concerned.
Issues in Profit Centres

(Constraints on B.U. Authority)
To realize fully the benefits of profit center concept the business unit manager would have to be as autonomous as the president of an independent company As a practical matter, however, such autonomy is not feasible If a company were divided into completely independent units the organization would lose the advantages of size and synergy. Furthermore in delegating to business unit management all the authority that the board of directors has given to the CEO, senior management would be abdicating its own responsibility. Consequently business unit structures represent trade offs between business unit autonomy and corporate constraints The effectiveness of a business unit organization is largely dependent on how well these trade offs are made.

(Constraints from other B.U.s)
One of the main problems occurs when business units must deal with one another. It is useful to think of managing a profit center in terms of control over three types of decisions The product decision (what goods or services to make and sell) The marketing decision (how, where, and for how much are these goods or services to be sold?) The procurement or sourcing decision (how to obtain or manufacture the goods or services) If a BU manager controls all three activities, there is usually no difficulty in assigning profit responsibility and measuring performance If production, procurement, and marketing decisions for a single product line are split among two or more B.U.s, separating the contribution of BU to the overall success for the product line may be difficult.
1. 2.
3.


(Constraints from Corporate Manager)
Most companies retain certain decisions, especially financial decisions, at the corporate level at least for domestic activities One of the major constraints on BUs results from corporate control over new investments BUs must compete with one another for a share of the available funds Thus a BU could find its expansion plans thwarted because another unit has convinced senior management that it has a more attractive program Each BU has a charter that specifies the marketing and/or production activities that it is permitted to undertake, and it must refrain from operating beyond its charter, even though it sees profit opportunities in doing so The maintenance of the proper corporate image may require constraints on the quality of products or on public relations activities
Formation of Profit Centers

Profit Centres can be formed by using different approaches or yardsticks. They are 1) Functional Units Management's decision as to whether a given functional unit should be a profit center is based on the amount of influence (even if not total control) the units manager exercises over the activities that affect he bottom line. Here Marketing, Manufacturing, Service & support units can be considered. 2) Branch Operations 3) Outlet chains
Profit Centres
( Marketing as a Functional unit as )
A marketing activity can be turned into a profit center by charging it with the cost of the products sold. This transfer price provides the marketing manager with the relevant information to make the optimum revenue/ cost trade-offs and the standard practice of measuring a profit centers manager by the canters profitability provides a a check on how well these trade-offs have been made The transfer price charged to the profit center should be based on the standard cost, rather than the actual cost, of the products sold. Using a standard cost base separates the marketing cost performance from that of the manufacturing cost performance, which is affected by changes in the levels of efficiency that are beyond the control of the marketing manager A foreign marketing activity is generally a profit centre because it may be difficult to control centrally a host of decisions as how to market a product, how to set the price, how much to spend on sales promotion, when to spend it, & on which media; how to train sales people or dealers; where to and when to establish new dealers.
Profit Centres
(Manufacturing as a Functional unit as )
The manufacturing activity is usually an expense center, with the management being judged on performance versus \standard costs and overhead budgets This measure can cause problems , however since it does not necessarily indicate how well the manager is performing all aspects of his job Therefore where performance of the manufacturing process is measured against standard costs , it is advisable to make a separate evaluation of such activities of such activities as quality control, production scheduling and make or buy decisions One way to measure the activity of a manufacturing organization in its entirety is to turn it into a profit center and give it credit for the selling price for the products minus estimated marketing expenses. Such an arrangement if far from perfect, partly because many of the factors that influence the volume and mix of sales are beyond the manufacturing manager's control However it seems to work better in some cases than the alternative of holding the manufacturing operation responsible only for costs.
Profit Centres
( Other service & support units as )
Units for maintenance, information technology, transportation, engineering, consulting, customer service, and similar support activities can all be made into profit centers These may operate out of headquarters and service corporate divisions, or they may fulfill similar functions within business units. They charge customers for services rendered, with the financial objective of generating enough business so that their revenues equal their expenses. Usually the units receiving these services have the option of procuring them from an outside vendor instead, provided the vendor can offer services of equal quality at lower price When service units are organized as profit centers, their mangers are motivated to control costs in order to prevent customers from going elsewhere, while mangers of the receiving units are motivated to make decisions about whether using the service is worth the price.
Profit Centres
(Other Organizations as ) A company with branch operations that are responsible for marketing the companys products in a particular geographical area is often a natural profit center. Even though the branch managers have no manufacturing or procurement responsibilities, profitability is often the best single measure of their performance . Furthermore, the profit measurement is an excellent motivating device . Even the individual stores of chains operating in organized retail space , the individual restaurants in fast food chains, and the individual hotels in hotel chains are considered as profit centers.
Profit Centres
(performance measurement) For measurement of profit centre performance, there are five essential conditions. Divisional managers enjoy certain autonomy in directing their responsibility centres within the overall control by the Corporate Head quarters. In the process they use available resources & generate adequate revenues to contribute profits in the profit pool of the company. To measure the comparative performance of BU managers, some standard or scale is required. Investment made in each division or profit centre provide the basis of measurement & ROI is one of the measures used widely for this purpose.
Profit Centres
(Measurement of Profitability)
There are two types of measures for performance evaluation of profit centres. 1) Measure of Managerial performance. 2) Measure of Economic performance. 1) Managerial performance This measures focuses or directs attention on how well the manager is doing his job under certain conditions. It is used for planning, coordinating and controlling the profit canters day-to day activities. It is also used as a device for providing the proper motivation for its manager. 2) Economic performance It focuses on how well the profit center is doing as an economic entity. Measurement & evaluation of economic performance of profit centre is discussed in Investment Centres
Profit Centres
(Measurement of Profitability)
. The messages conveyed by these two measures may be quite different from each other eg. The management performance report for a branch store may show that the stores manager is doing excellent job under the circumstances, while the economic performance report may indicate that because of economic and competitive conditions in its area the store is a losing proposition and should be closed. Thus measurement of both types of performance require different type of data &reports The management report is used frequently. Considerations related to management performance measurement have first priority in systems design. The economic report is prepared only on those occasions when economic decisions must be made which are more relevant for investment centre. Hence it is discussed in investment centres.
Profit Centres
(Types of Profitability Measures)
Measurement of profitability of a division entails the following three considerations A) Concept of profits B ) Form of profits C) Measurement of profits. There are 5 bases for measuring the managerial performance. viz. 1) Contribution Margin (Sales income - variable cost of sales) 2) Direct profit, (Contribution - fixed costs attributable to profit centre) 3) Controllable Profit , ( Direct profit Controllable corporate charges) 4) Income before taxes, (Contr. profit other corporate allocated o/h) 5) Net profit , ( Income before tax - corporate taxes) Each of the above profit figures can be expressed in terms of rupee value or as percentage sales or as a rate of returns on investment
Profit Centres
( Concept of Profit )
Items amount % on revenue Measure Income revenue 1000 100.0 Less: variable cost of sales 680 68.0 Contribution margin 320 32.0 I Less : fixed expense incurred by the profit center 909.0 Direct profit 230 23.0 II Less. Controllable corpo.Charges 25 2.5 Controllable profit 205 20 .5 III Less : Corporate & other Allocations 35 3.5 Income before tax 170 17.0 IV Less : Taxes 70 7.0 Net Profit 100 10.0 V managerial performance can be measured by any of the above five bases, viz. contribution margin, direct profit , controllable profit ,income before taxes and profit after tax or net profit.
Transfer Price
Transfer price
In decentralized organizations, often goods & services which are output of one division is transferred to another division as inputs. In such cases there is a need to set the price for goods or services sold or transferred. This price applicable for interdivisional sale or transfer is called transfer price. In other words if profit centre provides output to or receives input from other responsibility centres within the company, the price established for or the value associated with these inputs & outputs is called transfer price. It is different from market price which is charged to outside customers. Transfer price forms the cost for the buyer & provides an income for the seller. Transfer pricing is relevant for 1) Product Costing 2) Decision Making 3) Performance Evaluation
Transfer Price
( objectives)
Transfer Price is not only an accounting tool but also an useful tool in the hands of management. A properly designed TP accomplishes following objectives : 1)Goal Congruent decisions The decisions which lead to improvement in BUs profits should also improve firms profits. 2) Simple to understand and easy to administer 3) Provision of relevant information- It should provide for optimum trade off between BU costs & revenues and the system should provide relevant information to each segment for this purpose. 4) It should enable management to measure the economic performance of individual profit centre.
Transfer Price
( principles for fixing)
Transfer price is the value placed on a transfer of goods & services in transactions in which at least one of the two parties involved is a profit centre. One of the fundamental principles underlying transfer price is that it should be similar to the price that would be charged if the product were sold to outside customers or purchased from outside suppliers. The method of fixing TP should provide freedom & autonomy for B.U. managers to come to an agreement on internal transactions & establish TPs with minimum intervention of CHQ. It should be set in such a fashion that the profit arising from the transactions should be shared equitably between the buying & selling divisions. This would improve the profit performance of the manager of the supplier business unit. A fair TP should lead to goal congruence in that whatever decisions BU managers take in the interest of their own BUs, should be in the best interest of the firm too.
Methods of Transfer Pricing

There are number of methods used for determination of transfer prices. 1) Market price Method 2) Cost based transfer price 3) Negotiated price method. 4) Two step pricing method. 5) Profit sharing method. 6) Two sets of prices method.
Market Price Method

Here TP is determined on the basis of a well established , normal market price for a similar product being transferred. The market price reflects the same conditions (delivery time, quality and the like) as the product to which the transfer price ia applicable Downward adjustment may be made to the market price to consider savings arising to the selling unit from dealing inside the company. For instance, there would be lower advertisement, publicity, and selling expenses and no bad debts when there is a transfer of products from one business unit to another. The market price will be determined intermediaries he long run by demand and supply and nay profit arising there from is a sound indicator of overall efficiency of various units. This method assumes the freedom to source and the existence of external markets. This is a highly popular method of transfer pricing
Market Price Method - Merits

1. 2. Easily available market prices are available with relative ease from published sources, suppliers etc Measurement of BU performance the market price is an impartial measure of overall efficiency of both the purchasing and selling divisions No need for central administration there is no need for corporate headquarters to intervene in price fixation. this results in saving of precious time and money. Opportunity cost the market price represents the opportunity cost of producing the product
3.
4.
Market Price Method - Demerits

1. 2. 3. 4. 5. 6. Problem of interpretation the term market price is subject to a number of interpretations. It could be wholesale price, ex-factory price, price to consumers etc No market price for intermediate and semi finished products it is possible that intermediate and semi- finished products may not be available in the market and as a result it is impossible to get their market price Inflation during a period of inflation, market prices tend to fluctuate frequently. Consequently, it would not serve as a good guide in fixing transfer prices. Audit problems market price includes a profit element and the valuation of stocks using market price would lead to the inclusion of profit inc losing stock. This would invite objections from statutory auditors. Failure to reflect opportunity cost where the form which intends to use transfer price is a market leader or a monopolist, the market price does become opportunity cost. Additional cost in the absence of ready availability of market information, additional costs have to be incurred to procure the same.
Market Price Method

(market price determination)
1. Market price determination where product is not bought or sold in an outside market can be done in three different ways. Published market prices in case published market prices are available, the same should be used for determining transfer prices provided thy are prices actually paid in the marketplace and the conditions that exist in the external market should be similar to those prevailing within the firm.
2)
Replication of competitive price In case similar products are bought from the outside market by buying profit center, it could be possible to replicate competitive prices for its proprietary products. By calculating the cost of the difference in design and other conditions of sale between the competitive products and the proprietary products, this can be achieved.
Market Price Method

(market price determination)
Where the production profit center sells similar products in external markets, it is possible to use the outside price to replicate a competitive price. For instance if a production profit centre usually earns 5% over the standard cost of products that it sells in external markets, a competitive price can be replicated by it by adding 5% to the standard cost of its proprietary products.
3) Bidding The purchasing profit center may invite bids from prospective sellers by advertising in newspapers etc. In this manner, it is possible to determine market price for the purpose of transfer pricing. However, it should be noted that bidding should not be done only for the sake of obtaining market prices as it will soon be found that either there is no bidder or that the bids are of questionable value.
Cost Based transfer pricing

1. Transfer prices maybe established on the basis of cost or cost plus a profit in case competitive prices are not available Actual cost basis under this method of transfer pricing, transfer price is arrived at on the basis of actual cost of production. While determining the transfer price, firms exclude financing, advertising, bad debts, and other expenses that the vendor does not incur in internal transactions Merit As transfer price is based on actual cost, the selling business unit is in a position to recoup the cost incurred. Demerit The use of actual costs transfer price will lead to the transfer of production inefficiencies to the purchasing profit center.

2. Standard cost basis the standard cost of a product is used for the purpose of fixing the transfer price. Standard cost is a scientifically predetermined cost based on managements assessment and view of efficient operations and relevant expenditure. Variances between standard and actual cost is not passed on to the buying unit but absorbed by the vendor. While determining the transfer price, financing, advertising, bad debts, and other expenses that the vendor does not incur on internal transactions are eliminated. Where standard costs are used, it is necessary to provide an incentive to set tight standards and to improve standards Merit The standard cost is a sound method of establishing transfer price when market price is not available as production inefficiencies are not passed on to the purchasing unit.

Demerits The vendor profit center may not possess the competence to fix transfer price Inventories lying with the vendor and purchasing profit center at year end have to be adjusted to actual cost to prepare statutory annual accounts 3. Cost plus markup This method of transfer pricing envisages the recovery of all costs plus a markup or allowance for profit The profit performance of each unit can therefore be measured and it is possible to determine their efficiency with reasonable degree of accuracy. There are two decisions to be made while calculating the profit markup a) Base for computing profit markup b) Level of profit allowed

a) Base for computing profit markup In so far as the base for calculating profit markup is concerned, the percentage of costs is one of them. It is simple to understand and easy to use and as a result it is widely used. However it ignores the capital employed Another method is percentage of investment. This method calculates the profit markup based on the capital employed in manufacturing and selling the product It is conceptually sound and superior to the percentage of costs method However its drawbacks that the calculation of capital employed of a specific product poses a problem. Similarly if fixed assets are valued at historical cost, investments in new plant, equipment , and facilities which are meant to reduce cost and prices would end up increasing costs owing to the under valuation of old assets

b) Level of profit The second decision that needs to be made with the profit markup is the level of profit. The financial performance of a profit center is judged by the profit it earns Hence the profit allowance should be such that it should ensure that the business unit earns a rate of return as if it were an independent firm selling to the external customers The profit allowance should be calculated on the investment necessary to produce the volume of products required by the purchasing profit centers. The calculation of investment required would be done at a standard level with inventories and fixed assets being valued at replacement costs

Cost based transfer pricing method also has its own merits & demerits. Merits 1. Profit is the main yardstick on the basis of which the efficiency of the management is judged 2. This facilitates inter firm comparisons as profit and return on investment are good indicators Demerits The inclusion of profit element in closing stocks are not allowed by statutory auditors
Negotiated price method

Under this method, periodical meetings between the representatives of the purchasing and vendor units are held to make decisions on external selling process and on the sharing of profit in respect of products which have major amount of upstream foxed costs and profit A firm could establish a formal mechanism for this purpose The review should be conducted only in respect of decisions that involve a significant amount of business to at least one of the profit centers Merits it is an effective method of dealing with a situation where upstream fixed costs and profits are involved. Demerits it is possible that the review process may go beyond decisions relating to business profit center and as a result it will cease to be workable.
Two step pricing method

The two step pricing method is another way to solve the problem arising from upstream fixed costs and profits Under this a charge if firstly made for each unit sold This is equal to the standard variable cost of production Secondly a charge is made periodically that is equal to fixed costs of the facility reserved for the buying unit A profit margin should be included in either of these components. Generally, a month is chosen as the period for the periodic change
Profit sharing method

This is another method of transfer pricing where upstream fixed costs and profits are involved Under this method, the product transferred to the marketing profit center at standard variable cost Once the product is sold the contribution) sale price = variable costs) earned is shared by the business units Where the demand for the manufactured product is not stable enough to justify the reservation of facilities this method happens to be a suitable one It results in goal congruence between the interests of marketing profit center and the firm
Profit sharing method

1. Implementing a profit sharing method of transfer pricing is beset with problems Valid information on the profitability of each segment of the firm cannot be obtained by division of the profits between business units in an arbitrary manner Disputes can arise owing to the manner in which contribution is divided between the two business units and this may have to be settled by corporate headquarters leaving to loss of time and expense The contribution of the manufacturing profit center is dependent on the ability of the marketing profit center to sell the product and the actual sale price realization
2.
3.
Two sets of prices method

This method envisages credit of the manufacturing profit centers revenue at the external sale price and purchasing profit center is charged the total standard costs in respect of the product transferred The corporate headquarters account is charged with the difference During the consolidation of business unit statements, the same is eliminated The two sets of pricing method is occasionally used when the frequency on conflicts between the vendor and purchasing units cannot be settled by any other method.
Pricing Corporate Services

In a divisional company or in SBU form of organization, CHQ renders various types of services to Bus for which the later must be charged. However the cost of central service staffs over which BUs can not exercise control viz. administration, central accounts, P.R., corporate finance are not included in transfer price because these costs are allocated & allocations do not include a profit element. Hence they are not transfer prices. Transfers to Divisions or BUs comprise of two types : 1) Partial control over amount of service . 2) Discretionary use of services. Both are governed by different set of approaches

1) Partial control over amount of service There are certain types of services which BUs have to use & they can not control the efficiency with which such services are performed or provided. The only thing that they can do is to control the amount of service that it receives e.g. R & D, Management Information or IT etc. Here the transfer is governed by three different bases or schools of thoughta) Standard V.C. - BUs should be charged with standard variable cost of performing the service. Charging this lowest price will motivate the BUs to use more of the service. On the other hand any charge more than the v.c. would lead to their skipping of certain services considered worth while by top management from the firms angle. b) Standard Full Cost - The charge to BU should comprise of firms long run cost i.e. standard full cost ( i.e. V.C. + F.C. ) c) Market price equivalence - The charge should be equivalent to market price or std. V.C. + a profit markup. This provides for earning a return on capital invested by the unit rendering such service similar to capital employed by the manufacturing units.

2) Discretionary use of services : There are some categories of services which divisions have discretions to use. They may develop their own capability or source the service from outside agency , if cost effective, or refrain from using the service altogether e.g. information processing, maintenance etc. BU managers thus can exercise control both on the amount of service & their efficiency. Consequently these central service units are profit centres and the transfer price should be established on the same basis as other transfer prices. However this practise is not followed in Indian companies.
Investment Centre
Investment Centres
Investment Centres
(characteristic features)
Divisional managers considered as profit centres enjoy certain autonomy in directing their responsibility centers within the overall control by the CHQ They use available resources and generate adequate revenues to contribute profits into the profit pool of the company To measure the comparative performance of the divisional managers, some standard or scale is required An investment Centre is a R.C. in which the manager is held responsible for the use of assets as well as revenues & expenses. It is the ultimate extension of the responsibility idea because the manager is expected to earn a satisfactory return on capital employed in the responsibility centre. Here the control system applies monetary measures to both inputs & outputs and the investment used within the R.C. itself. The profits are related to the capital employed during the period & R.O.I. is calculated to ascertain the efficiency of the business unit.
Investment Centres
(characteristic features)
In Profit Centre the focus is on profits. But when the profit is compared with the assets employed in earning it, the RC is referred to as Investment Centre. Thus investment Centre is a special type of profit centre & in real world the companies use the term Profit Centre loosely rather than investment centre. Management Control in Investment Centre, therefore, raises additional problems regarding how to measure the assets employed - specifically which assets to include, how to value fixed assets & current assets, which depreciation method to use for fixed assets , which corporate assets to allocate & which liabilities to subtract. To measure the comparative performance of the divisional managers, some standard or scale is required
Investment Centres
( issues in performance measurement)
The focus on profits without considering the assets used to generate the same is not an adequate basis for exercising control. It is difficult for top management to compare the profit performance of one business unit with that of other units or with similar firms in the industry without considering the assets employed. Comparisons of absolute differences in profits are meaningless if BUs employ different amount of resources. BU managers performance objective generally address to : 1) Generation of satisfactory profits from the resources which are at their disposal. 2) Investment in additional resources provided they are expected to earn an adequate return. 3) Disinvestment where the expected annual profits of any resource after discounting at firms required earning rate, is less than the amount that could be realized from its sale.
Investment Centres
( steps in performance measurement)
Two principal steps are involved in gauging the performance of an investment centre. 1) Measurement of assets employed The aggregate of assets is termed investment base . It helps in measurement of performance of the BU as an economic entity. It also provides useful information for decision making relating to assets employed & motivation of managers in making decisions which are in the best interest of the company. 2) Relating profit to assets employed The methods used for relating profits to assets employed are : a) Return on Investment b) Economic Value Added ( EVA) EVA is a trademark of M/S Stern Stewart & Co. The generic term for this measurement yardstick is Residual Income. Both the terms essentially denote the same entity .
Investment Centres
a)ROI It is a ratio of Income / Gross Investment The numerator can be either PBT or PAT & denominator is generally owners investment i.e. Equity + Reserves. b)EVA. It is an absolute amount stated in monetary terms EVA = net operating profit a capital charge & capital charge = Amount of assets employed x rate. When these two measures are to be used for comparative performance measurement, the numerator in ROI concept has to be matching with that used in EVA i.e. PBT. Even though EVA is conceptually superior to ROI , It is the ROI concept that is widely used by Industry and Business. In such absolute workings, without any correlation with EVA, generally PAT is used in numerator of ROI.
Investment Centres
( steps in performance measurement) P & L statement Particulars Sales for the year ended 31.3.2000 Amount (Rs) 500
Expens. (exclu.depre. 350 Depreciation 10 360
Profit before tax

Income tax at 50% Profit after tax
140
70 70
Investment Centres
Balance sheet of X Co Ltd as on 31.3 2000
Capital and liabilities Share capital
Amount (Rs)
Assets Fixed assets : cost 500
Amount (Rs)
Paid up
Reserves Current liabilities Sundry creditors Bills payable others
200
80
Less :accumulated depreciation

Current Assets
200
300
150 50 120 600
Cash at bank Debtors Inventories
50 100 150 600
Investment Centres
Given Rate to be used for calculating capital charge is 10% flat. 1) ROI = PAT / Gross Investment( equity + reserves) = 70 / 280 = 25% (expressed in percentage terms) This value is for isolated working. However if it is to be used as a comparative measure in conjunction with EVA, the numerator can be PBT which is used as Net operating Profit in EVA calculation below. Then ROI will be 50% 2) EVA = Net operating Profit capital charge = 140 10% of 280 = 140 - 28 = 112
Investment Centres
( performance measurement)
Return on Investment (ROI) ROI is an attempt to express the economic desirability of an investment proposal in terms of a percentage return on the original outlay. Most Investment Centres evaluate the BUs on this basis. It is also called as Accounting rate of return method or financial statement method. It is simple to calculate & easy to understand. It is a comprehensive measure which reflects anything that affects financial statements. It is a common denominator that can be used for any organizational unit, irrespective of size or nature of business, having profit responsibility. It facilitates intra firm & inter firm comparisons because ROI data is readily available.
Investment Centres
( performance measurement) Capital Charge CHQ has the responsibility for establishing the rate which is used for computing the capital charge. It is calculated by considering all the sources of permanent capital viz. equity & debt. Generally the rate is fixed below the firms estimated cost of capital so that the economic value added of an average business unit is above zero. Some firms use a lower rate for working capital compared to fixed assets because the former is less risky owing to its shorter period of commitment. This lower rate compensates for the inclusion of inventory & receivables at the gross value by the firm.
Investment Centres
( performance measurement)
Economic Value Added ( EVA ) This concept has many names & is also called as economic profit, value based management, shareholder value analysis. residual income EVA fulfills the need for a performance measure that is both highly correlated with shareholder wealth & responsive to actions of companys managers. Shareholders are the important stakeholders of the company & shareholder value creation related to companys market value of shares is critical for the firm because - it reduces the risk of takeover - creates currency in aggressiveness in M & A - reduces cost of capital which allows fast investment for future growth. Since shareholders value measures the worth of the consolidated enterprise as a whole , it is nearly impossible to use it as a performance criterion for an organizations individual RCs. The best proxy for shareholder value at BU level is EVA.
EVA
(comparative benefits)
Unlike ROI which is a ratio, EVA is an absolute amount stated in monetary terms which is derived by deducting a capital charge from net operating profit. With EVA all business units have the same profit objective for comparable investments. This contrasts with ROI approach which provides different incentives for investments across BUs. e.g. a BU that is currently achieving an ROI of 30% would be reluctant to expand unless it is able to earn the same or more ROI on additional assets because lesser returns would decrease its overall ROI below its current level. Thus the BU may forego the investment opportunities whose ROI is above the cost of capital but below 30% Similarly a BU that currently is achieving a low ROI say 5 % would benefit from anything over 5 %on additional assets. As a consequence ROI creates a bias towards little or no expansion in high profit BUs while at the same time low profit BUs tend to make investments at rates of return well below those rejected by high profit units.
EVA
(comparative benefits)
Also decisions that increase a centres ROI may possibly decrease its overall profits e.g. for an Investment Centre where the current ROI is 30 %, the manager can increase its overall ROI by disposing an asset whose ROI is 25%. However if the cost of capital tied up in IC is less than 25%, the absolute profit in rupee terms after deducting capital costs will decrease for the centre. The use of EVA as a measure deals with both these problems which relate to asset investment whose ROI falls between the cost of capital & the centres current ROI. If an ICs performance is measured by EVA, investments that produce a profit in excess of the cost of capital will increase EVA & therefore will be economically attractive to the manger.
Comparative Analysis
(differences between ROI & EVA approaches)
These benefits can be explained with the help of a numerical example given below which highlights comparative analysis of two approaches . Given 1) Companys required rate of return for investing in fixed assets is 10% after taxes. 2) Company wide cost of money tied up in inventories & receivables is 4% after taxes 3) The numerical values relevant for ROI approach ( Refer first table ) 4) The figures required for EVA approach ( Refer second table.) Requirement Highlight relative merits & demerits of two approaches.
Numerical Data for ROI( Rs. 000 )

1
B.U. Cash
4
Fixed Assets
5
Total investment
6
Budgete d profit
7=6/5
ROI objective
Receivab Inventori les es
A B
10 20
20 20
30 30
60 50
120 120
24.0 20% 14.4 12%
C
D E
15
5 10
40
10 5
40
20 10
10
40 10
105
75 35
10.5 10%
3.8 5%
(1.8) (5)%
Numerical Data for EVA ( Rs. 000 )

curr ent 1
B.U.
2 60
3
Rate
ass ets 4 2.4 2.8
fixe d 5 60 50 6
Rate
ass ets 7
1 [(4) + (7)] =
8 15.6 6.6
Profit p- Amount otential
Reqd e- Amount arnings
Reqd e- Budget arnings ed EVA
A B
24
4% 4%
10% 6.0 10% 5.0
14.4 70
C
D E
10.5 95
3.8 35
(1.8) 25
4%
4% 4%
3.8
1.4 1.0
10
40 10
10% 1.0
10% 4.0 10% 1.0
5.7
(1.6) (3.8)
(differences between ROI & EVA approaches) Columns 1 to 5 in the first table show the amount of investment in assets that each business unit budgeted for the coming year. Column 6 is the amount of budgeted profit. Column 7 is the budgeted profit divided by budgeted investment. Therefore this column shows the ROI objectives for the coming year for each of the business units. Only in Business Unit C is the ROI objective consistent with the company wide cut off rate. In no unit is the objective consistent with the companywide 4% cost of carrying current assets.
Business Unit A would decrease its chances of meeting its profit objective if it did not earn at least 20% on added investment in either current or fixed assets. Units D & E would benefit from investments with a much lower return. EVA corrects these inconsistencies. The investments multiplied by appropriate rates are subtracted from budgeted profit & the resulting amount is the budgeted EVA. Periodically the actual EVA is calculated by subtracting from actual profits the actual investment multiplied by the appropriate rates. For example if B.U. A earned Rs. 28,000-/ & employed average current assets of Rs 65,000-/ & average fixed assets of Rs. 65000-/ its actual EVA would be EVA = 28,000 0.04 (65000) 0.10 (65000) = 28000 2600 6500 = 18900-/ This is better than its objective by Rs 3300 i.e. 18900 15600
(differences between ROI & EVA approaches) If any business unit earns more than 10% on added fixed assets , it will increase its EVA. In the cases of Business Units E & D, the additional profit will decrease the amount of negative EVA. A similar result occurs for current assets. Inventory decision rules will be based on a cost of 4% for financial carrying charges. ( here additional costs for physically storing the inventory are not considered) In this way the financial decision rules of the business units will be consistent with those of company. EVA also solves the problem of differing profit objectives for the same asset in different business units & the same profit objective for different assets in the same unit.
The method makes it possible to incorporate in the measurement system the same decision rules used in the planning process. The more sophisticated the planning process, the more complex the EVA calculation can be, e.g. the capital investment decision rules may call for a 10% return on general purpose assets & a 15% return on special purpose assets. Business Units fixed assts can be classified accordingly & different rates applied when measuring performance. Managers may be reluctant to invest in improved working conditions, pollution control measures or other social goals if they perceive them to be unprofitable. Such investments will be much more acceptable to B.U. managers if they are expected to earn a reduced return on them.
EVA
( as a performance measurement tool)
Under EVA or Residual Income ( R.I.) method of performance evaluation, divisions are charged with an opportunity cost of capital for the various categories of assets they employ The terminology of Economic Value Added or Residual Income indicates Income after expenses, including the capital charges, Bringing capital costs into the divisional income statement as an explicit expense yields a total cost calculation that is practically identical to the true cost. EVA. then becomes true profit after proper provision for capital cost adjustment for risks associated with assets employed & motivates mangers to increase EVA by taking actions consistent with increasing stock holder value . Under this approach of performance measurement, each division is assigned a budgeted EVA / R.I. & the divisional manger then has to concentrate on decisions that maximize EVA while pursuing goal-congruent behavior
EVA
( as a performance measurement tool)
EVA = Net profit capital charge Capital charge =cost of capital x capital employed. (1) Multiplying and dividing the net profit by capital employed we restate this equation i.e. Another way to state the equation (1) is EVA = capital employed( ROI cost of capital) (2) EVA in equation (2) can be increased by one or more of the following actions which are in the best interest of the shareholders. a) Increase ROI through BPR & productivity gains without increasing the asset base. b) Divestment of assets, products & /or businesses whose ROI is less than the cost of capital. c) Aggressive new investments in assets , products & /or businesses whose ROI exceeds the cost of capital. d) Increase in sales, profit margins, capital efficiency ( sales /capital employed) or decrease in cost of capital without affecting other variables in equation (2)
Investment Centre
( measurement of economic performance)
Performance measurement of investment centre manager is different from the evaluation of the economic performance of the investment centre itself. Economic reports are a useful tool in the hands of management. While management reports are prepared on the basis of historic information, economic reports use quite different type of information. The former focuses on what profitability is or has been, the latter deals with prediction of future profitability. Therefore management performance reports use book value of assets for computing depreciation but this information is of no relevance to economic performance report which is more concerned with replacement costs. Economic reports serve as an instrument for diagnosing maladies. The strengths & weaknesses of strategies that are currently being pursued are also revealed.
Investment Centre
( measurement of economic performance - contd.) Whether the current strategies of investment centre are sound or whether a decision should be taken regarding a business unit viz. contraction, expansion, divestment etc. is indicated by such a diagnosis ( Recapitulate different Missions - Build, Hold, Harvest Divest ) It is possible that the economic analysis of an investment centre may show that the existing plans for new products, new distribution channels ,new capital equipment or other new strategies when considered in totality, will not generate a figure of profit which is considered satisfactory, although each separate decision was considered sound when the same were made.
Investment Centre
( measurement of economic performance - contd.)
Economic performance reports have another utility. They are used for deriving the value of the firm as a whole viz. the break up value . The break up value which is also known as shareholder value is the estimated amount that the shareholders are expected to receive if each business unit were sold separately. While considering making a takeover bid, for a company, the break up value proves useful to an outsider. Similarly it is invaluable to the management of a firm in evaluating how attractive the said bid is. The report may come forth with the revelation about the relative attractiveness of BUs. It may also pin point that top management is devoting undue amount of time & energy to investment centres which do not have the potential of contributing significantly to the profitability of the firm . The need for changes may be indicated where there is a gap between existing profitability & shareholder value.
Other Financial Goals
Introduction to Financial Goals

A managers primary goal is to maximize the market value of his firms stocks or shares. Value is based on the stream of cash flows the firm will generate in future. But how does a manger decide which actions are most likely to increase cash flows? This can be estimated from the study of financial statements that publicly traded companies provide to their investors ( both institutional & individual). The information contained in the annual reports is used by investors to form expectations about future earnings & dividends. The value of any business asset whether it is a financial asset like a share or bond or a real physical asset such as land, building, plant, equipment depends upon the usable after tax cash flows the asset is expected to produce.
Cash Flow
( introduction )
There is a difference between accounting income & cash flow. A businesss cash flow generally differs from its accounting profit because some of the revenues & expenses listed on the income statement are not received or paid in cash during the year. Net Cash Flow = Net Income Non cash revenue + non cash charges The primary examples of non cash charges are depreciation & amortization. These items reduce net income but are not paid out in cash so we add them back to Net Income ( N.I.) when calculating Net Cash Flow. Another example of a non cash charge is deferred taxes. In some instances the companies are allowed to defer tax payments to a later date even though the tax payment is reported as an expense on the income statement. Therefore deferred tax payments would be added to N.I when calculating net cash flow. Since depreciation & amortization are by far the largest non cash items Net Cash Flow = Net Income + depreciation & amortization
Cash Flow Statement

Even if a company reports a large net income in the income statement during the year , the amount of cash reported in its year end balance sheet may be same or even lower than its beginning cash. This is because the firm may use its net income for variety of purposes like to pay dividends, to increase inventories, to finance accounts receivables, to invest in fixed assets, to reduce debt, or buy back common stock & not just keep it as cash in the bank. These factors are reflected in cash flow statement which summarizes the changes in companys cash position. It separates companys activities into three categories:
Cash Flow Statement

1) Operating Activities They include Net Income depreciation, changes in current assets & liabilities other than cash, short term investments & short term debt. Investing Activities - They include investment in or sales of fixed assets. Financing Activities They include raising cash by selling short term investment or by issuing short term debt, long term debt or equity. Also the dividends paid & the cash used to buy back outstanding shares or bonds reduce the companys cash, such transactions are included here.
2)
3)
Cash Flow Statement

Profits as reported in the income statement can be doctored by such tactics as depreciating assets too slowly, not recognizing bad debts promptly etc. However it is far more difficult to simultaneously doctor profits & working capital accounts. Hence it is not uncommon for a company to report positive net income right up to the day it declares bankruptcy. In such cases the net cash flow from operations almost always begin to deteriorate much earlier & analyst who keeps an eye on cash flow can predict trouble. In other words the trend in net cash flow provided by operating activities can tell more than any other statement.
Modification to Accounting Data

( for managerial decision making)
Thus the net cash flow from operations is quite an important parameter. It is the after tax cash flow that is more relevant. Financial statements as they are presented in the annual report are designed more for use by external stake holders like share holders, creditors, tax authorities etc. For their use in corporate decision making by managers, stock investment analysts, certain modifications are needed. In other words accounting data needs to be modified for ; - Extracting valuation related information. - Calculating FCF & Cash Flow available to investors - Getting a perspective on the drivers of FCF & ROIC The financial analyst combine share prices & modified accounting data to draw inferences.

Different firms have different financial structures, different tax situations & different amounts of non operating assets. These differences affect traditional accounting measures such as the rate of return on equity ( or net worth i.e. RONW). They can cause two firms or two divisions within a single firm that actually have similar operations to appear to be operated with different efficiency. This is quite important from the view point of Management Control System because if the managerial compensation systems are to function properly, operating managers must be judged & compensated for those things that are under their control & not on the basis of things outside their control. Therefore to judge managerial performance, we need to compare mangers ability to generate operating income ( EBIT) with the operating assets under his control.

The first step in modifying the traditional accounting framework is to divide the total assets into two categories : 1) Operating assets These are the assets necessary to operate the business. 2) Non operating assets - They include cash & short term investments above the level required for normal operations, investments in subsidiaries, land held for future use etc. The operating assets are further subdivided into a) Operating current assets like inventory b) Operating Long term assets like plant & machinery. If a manger can generate a given amount of profit & cash flow with a relatively small investment in operating assets, then the amount of capital the investors must put up is reduced & the rate of return on that capital increases.

Most capital used in business is supplied by investors- shareholders, bond holders & lenders like banks & financial institutions. Investors must be paid for the use of their money. These payments are a) Interest in case of debt b) Dividends + capital gains in case of shares. So if a company buys more assets than it actually needs & thus raises too much capital, then its capital cost will be unnecessarily high. It is not necessary to obtain all of the capital used to acquire assets from investors. Some of the funds are provided as a normal consequence of operations like accounts payable are provided by suppliers & accrued wages & accrued taxes amount to short term loans from workers & tax authorities.i.e.non interest bearing current liabilities They are termed as operating current liabilities. When they are subtracted from the total need of the assets of the firm we get investor supplied capital

Those C.A. used in operations are called operating working capital. Similarly when we subtract operating current liabilities from it we get net operating working capital which is acquired with investor supplied funds. NOWC = Operating C.A. Operating C.L. Total Net Operating Capital = NOWC + Operating Long Term Assets It is also = Total assets in B/S - (Non operating F.A. Like surplus land + non operating C.A. like surplus cash & marketable securities) a) Operating C.A. Current Assets like cash, inventory & accounts receivables are required for normal operations. However any short term investments like marketable securities the firm holds generally result from investment decisions made by the treasury / CFO & they are not used in the core operations. Hence they are excluded from Operating C.A. when calculating NOWC

b) Operating C.L. Some current liabilities like accounts payable & accruals arise in the normal course of operations. They are the non interest bearing C.L. Hence to that extent the company has to raise less funds from investors for acquiring current assets. Therefore we deduct these Operating C.L. from Operating C.A. to calculate NOWC. Other C.L. that charge interest such as short term loans from ( notes payable to) banks are treated as investor supplied capital & hence are not deducted when calculating NOWC. The ground rule for deciding about the particular item is to ask the question whether it is a natural consequence of operations or it is a discretionary choice? ( e.g. particular method of financing or an investment in a financial asset ) If it is discretionary, it is not an operating asset or a liability. These concepts & terms can be explained with a numerical example.
Balance Sheet
( as at 31.12. 20XX)
Assets 2010 2009
Rs millions
2010 2009
Liabilities & equity
Cash & equivalents

Short term investments A/Cs Receivables Inventories
10
0 375 615
15
65 315 415
Accounts payable
Notes payable Accruals Total C.L.
60
110 140 310
30
60 130 220
Total C.A.
Net Plant & Eqpt.( after Subtracting cumulative Depreciation)
1000
1000
810
870
L.T. Bonds
Total Liabilities Pref.shar 400,000no Eq. sh.50,000,000no
754
1064 40 130
580
800 40 130
Retained Earnings
Eq+ Res Comon eq Total Assets 2000 1680 Tot. Lia. & Equity
766
896 2000
710
840 1680
Income statement for the period ended 31.12 20XX

Net Sales
Operating Cost excluding Depreciation & amortization Earnings Before Interest, Taxes, Depr. & Amort. ( EBITDA) Depreciation ( Amortization nil for both the periods) Depreciation & Amortization Earnings Before Interest & Taxes (EBIT or Operating Income) Less interest Earnings before taxes (EBT or PBT, Net income before preferred dividends (PAT after 40% tax provision)
Rs. millions
2010 2009
3000
2616.2 383.8 100 100 283.8 88 195.8 117.5
2850
2497 353 90 90 263 60 203 121.8
Preferred dividends
Net income Common dividends Addition to retained earnings
4
113.5 57.5 56
4
117.8 53 64.8
Common stock price per share

Earnings per share (EPS) dividends per share (DPS) Book value per share (BVPS) Cash flow per share (CFPS)
23
2.27 1.15 17.92 4.27
26
2.36 1.06 16.8 4.16
Income Statement
(workings per share basis) Earnings per share = EPS = net income/common shares outstanding = 11,35,00,000/5,00,00,000 = 2.27 Dividends per share = DPS = dividends paid to common stockholder/common shares outstanding = 5,75,00,000/5,00,00,000 = 1.15 Book value per share = BVPS = total common equity/common shares outstanding = 89,60,00,000/5,00,00,000 = 17.92 Cash flow per share = CFPS = net income + depreciation + amortization/common shares outstanding = 21,35,00,000/5,00,00,000 = 4.27
Retained Earnings
Balance of retained earnings as on Dec 31, 2009 = 710 Add Net Income 2010 = 113.5 Less Dividend = (57.5) Balance of retained earnings as on Dec. 31, 2010 = 766
This shows that out of 2010s earnings of 113.5, dividend distribution consumed 57.5 & 56 million were ploughed back into the business. It means the shareholders allowed the company to re invest 56 millions as corporate savings instead of distributing them as dividends. Management spent this money on buying new assets, hence retained earnings represent a claim against assets & not an asset per se. i.e. this figure as reported in B/S does not represent cash & is not available for payment of dividends or any other purpose.
Statement of cash flow

Operating activities : Net income before preferred dividends
Adjustments : Non cash adjustments : Depreciation Due to changes in working capital Increase in accounts receivable Increase in inventories Increase in accounts payable Increase in accruals Net cash provided by operating activities Long term investing activities - Cash used to acquire fixed assets Financing activities Sale of short term investments Increase in notes payable Increase in bonds outstanding Payment of preferred and common dividends Net cash provided by financing activities Net change in cash (60) (200) 30 10 (2.5) (230) 65 50 174 (61.5) 227.5 (5)
117.5
100
Adjustments : Non cash adjustments : Depreciation Due to changes in working capital Increase in accounts receivable
100 (60)
Increase in inventories
Increase in accounts payable Increase in accruals Net cash provided by operating activities
(200)
30 10 (2.5)
Long term investing activities - Cash used to acquire fixed assets

Financing activities Sale of short term investments
(230)
65
Increase in notes payable

Increase in bonds outstanding Payment of preferred and common dividends Net cash provided by financing activities
50
174 (61.5) 227.5
Net change in cash

Cash at the beginning of the year Cash at the end of the year
(5)
15 10
Numerical workings
Using balance sheet data NOWC = (cash + A/c receivables+ inventory) (A/c payable + accrual) = (10 + 375 + 615) ( 60 + 140) = 800 ( for 2010) & = (15 + 315 + 415 ) (30 +130) = 585 ( for 2009) Total Net Operating Capital =NOWC + operating long term assets = 800 + 1000 = 1800 (for 2010) & = 585 + 70 = 1455 (for 2009) This approach is in terms of operating assets & liabilities. However TNOC can also be calculated by adding up the funds provided by investors i.e. notes payable + Long term bonds + pref. shares + Equity Shares. At the end of 2009 it is 60 + 580 + 40 + 840 = 1520 out of this 65 was tied up in short term investments which is not related to operations. Hence 1520 65 = 1455 of investor supplied capital was used in operations.
Analysis of numerical workings

It is observed that during 2010, the company has increased its operating capital to Rs.1800 from Rs. 1455 million previous year.( +345) Also most of this increase went into working capital which rose from Rs. 585 to Rs. 800 million.(+215) This 37% increase in NOWC has resulted into a sales increase of only 5% ( 2850 to 3000) Why the concerned Divisional manager has tied up so much additional cash in working capital? The possible reasons could be either one or more from following 1) The B.U.is gearing up for a big increase in sales. 2) The inventories are not moving. 3) The receivables are not being collected promptly. The answer to this question throws light on the performance of the B.U. manager
Analysis of numerical workings

( relevance for MCS )
Thus Total Net Operating Capital can be calculated by using two different approaches. 1) NOWC + Operating Long Term Assets 2) Investor supplied funds. Different authors use different terms to denote TNOC like Operating Capital Net Operating assets or simply Capital. All these terms represent the same entity viz. capital employed by business unit. It is distinctly different from Investor supplied capital In performance evaluation of an Investment Centre in MCS, we deal with capital deployed by the particular division for relating it to its profits. The first approach is more useful in MCS because it is possible to perform this calculation for a division whereas using second approach for an operation of a B.U. is not possible.
Net Operating Profit after Taxes

( workings & analysis)
If two companies are having different amounts of debt & hence different amounts of interest charges, they could have identical operating performances but different net incomes the one with more debt would have a lower net income. Net income is certainly important but it does not always reflect the true performance of a companys operations or effectiveness of its managers. A better measurement for comparing managers performance is Net Operating Profit after Taxes or NOPAT which is the amount of profit a company would generate if it had no debt & held no financial assets. i.e. no investments in non operating assets. Because it excludes the effects of financial decisions , it is a better measure of operating performance than is Net Income. It is also called as Net Operating Profit Less Adjusted Taxes (NOPLAT) = EBIT Taxes on EBIT
NOPAT / NOPLAT
( elaboration) EBIT is the pre tax operating income the firm would have earned if it had no debt. Therefore while calculating EBIT, interest expenses, interest income & non operating income (or loss) are excluded or not considered. Taxes on EBIT represent the taxes the firm would pay if it had no debt, excess marketable securities, or non operating income (or loss) Taxes on EBIT can be calculated by adjusting the income tax provision for the income tax attributable to interest expense, interest & dividend income from excess marketable securities & non operating income (or loss)
NOPLAT / NOPAT
(Mathematical formula approach)
Mathematically NOPLAT = EBIT - Taxes on EBIT is as follows Profit Before Taxes + Interest Expense - Interest Income (if any) - Non Operating ( other) Income ( if any) = EBIT_________________________________ Tax Provision from Income statement + Tax shield on interest expense ( 0. 6 X Interest expense) - Tax on interest income (if any) @ 40% - Tax on non operating income = Taxes on EBIT
Net Operating Profit after Taxes

( workings & analysis)
Mathematically NOPAT = EBIT ( 1 tax rate) Using data from income statement NOPAT = 283.8(1 - 0.4) = 170 .3 ( for 2010) & = 263 ( 0.6) = 157.8 ( for 2009) Though NOPAT or after tax operating profit of 170.3 in 2010 is little better than its previous NOPAT of 157.8, its Earnings Per Share ( EPS ) have actually declined. This decrease in EPS has happened due to increase in interest expense & not because of decrease in operating profit. Moreover the balance sheet shows an increase in debt. Why did debt go up? Can financial statement throw light on the performance of the manger concerned? Because its investment in Net Operating Capital has increased dramatically during 2010. This increase was primarily financed by additional borrowings or debt.
Free Cash Flow

Net cash flow is net income plus non cash adjustments, which typically mean net income plus depreciation. The cash flows can not be maintained over a period of time unless depreciated fixed assets are replaced. Hence management is not completely free to use net cash flows however it chooses. Therefore another term Free Cash Flow (FCF ) is coined. FCF is the cash flow actually available for distribution to investors after the company has made all the investments in fixed assets & working capital necessary to sustain ongoing operations. The conventional P & L account indicates the firms net income which is its accounting profit. But the value of companys operations is determined by the stream of cash flows that the operations will generate now & in the future. To be more specific, the value of operations depends on all the future expected future free cash flows which is after tax operating profit minus the amount of new investments in working capital and fixed assets necessary to sustain the business
Free Cash Flow

In other words it is the post tax cash flow generated from the operations of the firm after providing for investments in fixed assets & net working capital required for the operations of the firm. Thus free cash flow represents the cash that is actually available for distribution to investors. Therefore the way for managers to make their companies more valuable is to increase free cash flow. The cash flow available to investors ( shareholders and lenders) = FCF + Non operating cash flow. Non operating cash flow arises from non operating items like sale of assets, restructuring, settlement of disputes etc. Such items must be adjusted for taxes.
Free Cash Flow

(uses)
There are 5 main uses 1)Pay interest to lenders / debt holders ( net cost of borrowing is the after tax interest expense) 2) Repay the loans, i.e. pay off some debt or reduce borrowings. 3)Pay dividends to shareholders. 4) Repurchase shares from shareholders ( extinguish some types / categories of shares) 5) Buy marketable securities/ make investments in other non operating assets In practise, most companies combine these five activities in such a way that the net total cash flow from them is equal to FCF. Mathematically FCF = NOPLAT Net Investment = ( NOPLAT + Depreciation) ( Net Investment + Depreciation) = Gross cash flow - Gross Investment ( Note thata) FCF is not used to acquire operating assets - why b) Five activities may involve both outflows & inflows - give example)
Free Cash Flow

( uses elaborated )
a) FCF is not used to acquire operating assets - why b) Five activities may involve both outflows & inflows - give example By definition, FCF already takes into account the purchase of all operating assets needed to support growth. Examples of cashOutflow : payment of interest , Payment of dividend, retiring old debt with higher rate of interest Inflow : issue of bonds ( new debt) & sell marketable securities. Some times companies with high FCF but limited growth prospects tend to make un necessary investment that do not add value. From the perspective of the investors, the value of a company depends on the present value of its expected FCFs, discounted at the companys Weighted Average Cost Of Capital ( WACC) The cash flow available to investors can also be viewed as the financing flow which is worked out as shown.
Free Cash Flow

( Net result of inflows & outflows)
Cash flow available to investors ( Shareholders + lenders) = Free Cash Flow + Non Operating Cash flow arising from non operating items like sale of assets, restructuring & settlement of disputes. Such items are adjusted for taxes. The cash flow available to investors can also be viewed as Financing Flow = After tax interest expense + Cash dividend on equity & preference shares + Redemption of debt - New borrowings + Redemption of preference shares + Share buy backs - Share issues + delta excess marketable securities - After tax income on excess market securities. Here the excess marketable securities are regarded as negative debt.
Free Cash Flow

( working)
The company has Rs.1455 million of total net operating capital at the end of 2009 but Rs 1800 million at the end of 2010. Therefore during 2010, it made a net investment in operating capital of 1800 -1455 = Rs. 345 million. Its free cash flow in 2010 was : FCF = NOPAT net investment in operating capital = 170.3 345 = - 174.7. New fixed assets rose from Rs 870 to Rs. 1000 million. However there is 100 million of depreciation. Hence gross investment in fixed assets in 2010 was 130 +100 = 230 million. Therefore gross investment in operating capital = net investment + depriciation = 345 + 100 = 445 Rs. Millions. Also FCF = ( NOPAT + Depreciation ) gross investment in operating capital = (170.3 +100 ) -445 = - 174.7. The two equations are equivalent because depreciation is added to both NOPAT & Net Investment.
Evaluation Parameters
(interpretation & Inter relation)
Higher level of financial parameters for performance evaluation are 1) Operating Capital or Invested Capital 2) NOPAT / NOPLAT 3) ROIC 4) FCF Interpretation of the numerical example brings out & highlights the relationship among them. Even though the company has a positive NOPAT, its very high investment in operating assets has resulted in a negative FCF. What does it mean ? It means not only that no amount was available for distribution among investors, but investors actually had to provide additional money to keep the business going. Investors provided most of this additional funds as debt ( i.e borrowings have gone up)
Does negative FCF mean inefficient operation or deficiency in operation? Not necessary If FCF is negative, because of large investments the company has made in operating assets to support growth, it is not a bad sign. But for this to happen, NOPAT has to be necessarily positive. In other words +ve NOPAT & -ve FCF means profitable growth which is a hall mark of a healthy organization. By examining the Return on Invested Capital ( ROIC), we can get the idea of whether the growth is really profitable. ROIC = NOPAT / Total Operating Capital. If ROIC exceeds the Rate of Return required by the investors i.e. WACC , then the firm is adding value & one should not get perturbed by negative FCF. However if FCF & NOPAT are both negative, it is a matter of concern. (Here ROIC = 170.3 / 1800 = 0.0946 = 9.46% Is it satisfactory?)
Invested capital is usually measured at the beginning of the year or as the average at the beginning & end of the year. While calculating ROIC, we need to consider numerator & denominator consistently. If an asset is included in the invested / operating capital, income related to it should be included in NOPAT to achieve consistency. ROIC focuses on true operating performance of the firm. It is a better measure compared to : 1) Return on Equity which reflects operating performance as well as financial structure. & 2) Return on Assets which is internally inconsistent because numerator & denominator are not consistent.
Net Investment is the difference between Gross Investment & Depreciation i.e. = Gross Investment Depreciation. Gross Investment is the sum of incremental outlays on capital expenditures & Net Working Capital. Depreciation refers to all non cash charges. Alternately Net Investment during the year is worked out as below. (Net F.A. at the end of the year Net F.A. at the beginning of the year.) + ( Net C.A. at the end of the year - Net C.A. at the beginning of the year)
Drivers of FCF
FCF = NOPLAT Net Investment = NOPLAT (1 - Net Investment / NOPLAT ) = Invested Capital(NOPAT/ Invested Cap)(1 Net Investment/ NOPAT) The quantity in second bracket can be re written after multiplying & dividing the last term by same entity i.e. Invested capital Hence second bracket = (1 - Net Investment by Invested capital / NOPAT by Invested capital) =( 1 Growth rate / ROIC) Therefore FCF = (Invested Capital) (ROIC) ( 1 Growth Rate / ROIC) Thus Invested Capital, ROIC & Growth Rate are the basic drivers of FCF
ROIC
( break up or desegregation)
ROIC = NOPAT / Invested Capital But NOPAT = EBIT ( 1 tax rate) Hence ROIC = EBIT / Invested Capital ( 1 tax rate) Pre tax ROIC can be broken down into two components EBIT/ Invested Capital =(EBIT/Revenues) (Revenues/ Invested Capital) = Operating margin x capital turnover Here Operating margin measures how effectively the firm converts revenues into profits & Capital turnover reflects how effectively the company employs its invested capital.
(Addition of market dimension)
The primary goal of management is to maximize shareholders wealth which is reflected in the market value of the companys shares. Neither the traditional accounting data nor the more advanced & refined parameters seen so far reflect on stock market prices. Hence a new or additional performance measures have been formulated in terms of MVA & EVA. Market Value Added ( MVA) is the difference between the market value of the companys shares & the amount of equity capital that was supplied by shareholders. MVA = Market Cap - Total Equity ( i.e. Equity + Reserves) Higher the MVA, better is the job done by management for its shareholders. Total equity shows the money the shareholders have invested in the company till date since its incorporation. Market cap indicates the money they could get if they sold the business today.
Market Capitalization
Market capitalization or market cap denotes the aggregate value of the stock of any listed company. It is arrived at by multiplying the number of shares outstanding of a company with its current market price per share. Market cap helps investors determine the value or size of the equity portion of the company, e.g. If company As current share price is Rs 100-per share & it has 1000 lakh shares outstanding, its market cap is Rs.1000 crores. If company Bs share price is Rs. 50 & it has 1000 crore shares outstanding, its market cap will be Rs. 50, 000 crores. Investor looking at just the market price would have thought company A was bigger.
Market Capitalization
Though market cap indicates the size of the company, it only tells us the value of equity portion & does not include the debt component. Stock prices are also impacted by macroeconomic factors which eventually reflect in the market cap. During economic slowdown & financial crisis, share prices of many financially healthy companies were hit badly impacting their market caps. Hence market cap is a rough measure to figure out what the market thinks is the value of a particular company. While analyzing stock, investor should avoid looking at market cap in isolation. In Indian context, a company that has market cap of at least Rs. 10,000 crores is considered as large cap. The companies with a market cap of at least Rs. 500 crore & less than Rs. 10,000 crore are mid caps. Companies with market cap of less than Rs 500 crore are generally referred to as small cap.
EVA A yardstick for Performance Measurement

The aim of every company is to maximize the wealth of its shareholders who own the company. As rational investors , they expect a good long term yield on their investment. Popular yardsticks or commonly used metrics for performance measurement have been ROI, EPS etc. However they do not theoretically correlate with shareholder value creation very well. EVA as a financial performance measure comes closer than any other in capturing the true economic profit of the enterprise. It is a performance measure most directly linked to the creation of shareholder wealth over time. It seeks to measure the periodic performance in terms of change in value. Maximizing value means the same as maximizing long term yield on shareholders investment.

EVA differs from traditional performance measurement system parameters 1) EPS It is calculated by dividing net profits after interest, depreciation, taxation (PAT) by number of shares issued by the company. This measure is flawed because accounting profit can be subject to manipulation and the parameter does not consider the equity cost of capital employed. If the cost of capital is say 16%, then EPS of 14% is actually a reduction in economic value. Also profits increase taxes and reduce cash flow. Thus profit figure engineered through accounting tricks can drain economic value. 2) ROI It is more realistic measure of economic performance but it ignores the cost of capital . Leading firms can obtain capital at low costs via favourable interest rates and high stock prices. They invest them in their operations at decent rates of return on assets. It tempts them to expand without paying attention to the real return i.e. economic value added.

3) Discounted cash flow This measure is very close to Economic Value Added with discount rate being the cost of capital. DCF calculates the Net Present Value which is arrived at by taking into consideration the cost of capital. Hence there is a close relation between the concepts of EVA and DCF. Though the concept of EVA is very established in financial world, its entry into the mainstream of corporate finance is comparatively recent. It is only now that more and more firms have started using it as the base for business planning and performance monitoring.
MVA & EVA

MVA measures the effects of managerial actions since the very inception of the organization. EVA focuses on managerial effectiveness in a given year. Using the terminology of advanced financial performance parameters as well as standard accounting like : CAPITAL = Total net operating capital in the business c* = WACC , INT = Interest expenses, EQUITY = Equity employed r = ROIC t = marginal tax rate Ke = Cost of equity EVA = NOPAT c* x CAPITAL = CAPITAL ( r c*) =| EBIT ( 1 - t) | - c* x CAPITAL = |PAT + INT( 1 t)| - c*X CAPITAL = PAT Ke x EQUITY
EVA
(elaboration & discussion)
The equations indicate that the firm adds value or has a positive EVA if (r - c* ) is positive, i.e. if its return on invested capital is greater than its weighted average cost of capital. However if WACC exceeds ROIC, then new investments in operating capital will reduce the firms value. EVA is an estimate of a businesss true economic profit for the year & it differs sharply from accounting profit. EVA represents the residual income that remains after the cost of all capital including equity capital has been deducted. However accounting profit is determined without imposing a charge for equity capital. Equity has opportunity cost which is more relevant than the accounting cost
EVA
Equity capital has an opportunity cost, because the funds provided by shareholders could have been invested elsewhere, where they would have earned a return. EVA shows greater alignment with shareholder wealth When shareholders provide capital to the firm , they give up an opportunity to invest them elsewhere & the return they could have earned with investment in some other instrument of equal risk represents the cost of equity capital. When calculating EVA, we do not add back depreciation. Even though it is not a cash expense, depreciation is a cost since the worn out assets must be replaced. Therefore it is deducted when determining both Net Income & EVA. It means that EVA assumes that the true economic depreciation of the companys Fixed Assets exactly equals the depreciation used for accounting and tax purpose.
EVA
EVA measures the extent to which the firm has increased the shareholders value. Therefore if manager focuses on EVA, it will help to ensure that he operates in a manner that is consistent with maximizing shareholders wealth. The manger would start thinking like owners and would worry about where capital is employed and what returns are generated from it. EVA can be determined for the division as well as for the company as a whole. Hence it provides a useful base or datum for determining managerial performance at all levels. Therefore there is a growing trend among the companies to use EVA as the primary basis for determining managerial compensation.
EVA
EVA takes into account all the capital costs including the cost of equity which shows the excess amount of wealth a business has created or destroyed in each reporting period. therefore a sustained increase in EVA will bring an increase in the market value of a company. This approach is proved effective in all types of organizations. This is because the level of EVA is not what really matters It is the EVA and not earnings determine the value of the firm EVA as an economic approach is a modified accounting approach to determine profits earned after meeting all financial costs of all the providers of capital. It reflects the true profit position of the firm Sometimes the profit picture is illusory because of presence of positive PAT figure in conventional income statement , which ignores the cost of shareholders funds and may give an erroneous impression to owners as well as outsiders that firms operations are profitable, when the firm is in fact destroying shareholders wealth.
2010
2009
Market price of shares

Number of shares in millions Market value of equity
23
50 1150
26
50 1300
Book value of equity ( equity + reserves)

MVA = Market value Book value EBIT Tax rate (t)
896
254 283.8 40%
840
460 263 40%
NOPAT = EBIT (1 t )
Investor supplied Operating capital - ref. note Weighted average cost of capital WACC % Cost of capital = operating capital x WACC EVA = NOPAT capital cost ROIC = NOPAT / operating capital ROIC Cost of capital (WACC)
170.3
1800 11% 198 (27.7) 9.46% (1.54%)
157.8
1455 10.8% 157.1 0.70 10.85% 0.05%
EVA = Operating capital( ROIC WACC)
27.7
0.7
MVA & EVA

(Calculations & Analysis)
Investor supplied operating capital = (notes payable + long term debt + preference shares + equity shares) (Short term investments) It is same as Total net operating capital = ( Total liabilities & Equity ) ( accounts payable + accruals + short term investments) EVA in 2009 was just barely positive & in 2010 it was negative. Operating Income (NOPAT) rose, but EVA still declined, primarily because the amount of capital rose more sharply than NOPAT, by about 26% v/s 8% & cost of this additional capital pulled EVA down. Net income ( N.I ) also fell but not nearly so dramatically as the decline in EVA. N. I. doesnt reflect equity capital employed but EVA does. Therefore N.I. is not as useful as EVA for setting corporate goals & measuring managerial performance.
MVA & EVA

(Calculations & Analysis)
There is a relationship between MVA & EVA but it is not a direct one. If a company has the history of negative EVAs , then its MVA will probably be negative & vice versa if it has positive EVAs. However the market price of its shares which is the key ingredient in MVA calculation, depends more on expected future performance than on historical performance. Therefore a company with a history of negative EVAs could have a positive MVA if investors expect a turnaround in the future. EVA which shows the value added during the given year is applicable to individual divisions or separate units of a large organization is used to evaluate managerial performance as a part of incentive compensation program. MVA that is applied to entire organization & which reflects the performance over the companys entire life perhaps including the times before the current mangers were born is of little use for incentive purpose.
Management Control Process
Control in Responsibility Centres

Formal MCS is essentially the same in all types of RCs or throughout the length & breadth of the organization. The differences pertain to the manner in which the system is utilized because the process of management control is mainly behavioral as there is interaction among & between managers & subordinates. The details of management control process vary from firm to firm and among RCs because of the differences in management style, interpersonal skills, technical competence, experience ,approach to decision making of managers. It generally involves 5 steps viz. 1) Strategic Planning. 2) Preparation of Budgets. 3) Financial performance report analysis. 4) Measurement of performance. 5) Managerial compensation as related to management control process
Strategic Planning
Future is uncertain & difficult to predict, hence managers have to spend lot of time thinking about future. The result of this activity is a formal statement of plans which is technically known as a strategic plan. The process involved in preparation, revision & deciding the manner of implementation is termed strategic planning. Sometimes it is also known as long range planning. Strategic planning process in large sized organization consisting of corporate HQ and a number of profit centres or investment centres is characterized by strategic planning both at CHQ & BU level. In case of smaller organizations having no BU structure, only senior executives belonging to planning department or top management is involved in this activity. In very small firms only C.E.O. & Financial Controller are involved. The adoption of formal strategic planning process gives number of benefits to the organization
Strategic Planning
(benefits)
1)Tool for management development It fosters management training & education by making them think of chalking out strategies & manner of implementation. 2) Development of operating budget It provides a frame work for developing operating budgets which facilitate resource allocation decisions. 3)Alignment with corporate strategies The discussions, debates, negotiations taking place during this process help the organization in unifying & aligning managers with corporate strategies & project their implications for individual managers. 4)Framework for short term actions. Strategic plan brings out the effect of all programs. The impact of programming decisions for short term action plans are highlighted in strategic plan. 5)Long term thinking Generally managers have a tendency to worry about short term or day to day issues. In this process they generally do not have time or inclination about creating future plans. But formal strategic planning activity induces them to long term thinking.
Strategic Planning
Strategy formulation is unsystematic or sporadic activity. However Strategic Planning is a systematic exercise having timetables & prescribed procedures. Therefore it has few limitations or drawbacks too. 1) It is time consuming & expensive process because it is an exercise that involves people from different parts of the organization. Senior management at corporate HQ & BU level have to devote considerable amount of time & energy to this activity. 2) Bureaucratic process Strategic planning may tend to lose its strategic thinking & may degenerate into a bureaucratic process involving mere form filling etc. 3) Creation of large planning department sometimes organizations tend to create a large planning department & delegate the responsibility of strategic planning to it. However strategic planning being a line management function, the quality of strategic plans suffer in such cases. In practice, strategy formulation & strategic planning tend to overlap.
Strategic Planning to budgeting

Approval of the strategic plan signals the commencement of the budget preparation process. Budgeting process helps the firm in charting out its future after - determining where it has been in the past, - identifying where it is at present & - deciding the direction in which it should move. It involves analyzing the firms financial flows, costs, revenues & forecasting outcome of different investments, financing & other decisions. It must not only determine the most likely course of events but deviations from optimistic outcomes should also be considered and a contingency plan be prepared to take care of unfavourable events. Formulation of the master budget is the end product of the budgeting process which involves preparation, implementation & operation of budget for allocation of resources.
Budget & Budgetary control

Budget, budgetary control & standard costing system are the most effective tools for short term planning & control in an organization. An operating budget is usually prepared for one year & states the revenues & expenses planned for that year. Budget is a plan & blue print for future management action quantified in monetary terms, prepared & approved prior to a defined period of time, usually showing planned income to be generated & /or expenditure to be incurred during that period, and capital to be employed to attain a given objective. It defines the objective of the firm as well as each responsibility centre in concrete & quantitative terms & lays down guidelines for the accomplishment of said objective. standard costing is applied in manufacturing or operational areas where costs vary in proportion to volume whereas budgetary control is applied throughout the organization in all the activities. Standard costing uses standard for cost & revenue for the purpose of control through variance analysis.
Budgeting
The process of preparation, implementation & operation of budgets is known as budgeting. It is a method of looking ahead & attempting to solve problems before they arise. In essence it is a process of resource allocation which can be applied in any revenue generating entity whether it is small proprietary or large complex set up, manufacturing or service, profit or non profit organization. Operating or revenue budgets allocate the current revenue stream generated by normal flow of goods & services. Capital budgets redistribute the total resources of an entity in a manner that maximizes total revenue over the long term planning horizon. Fundamentally, the budgetary process is a method of improving operations. It is a continuous effort to specify what should be done & to get the job done in the best possible manner. The modern approach views budgeting process as a tool for obtaining the most productive & profitable use of the firms resources.
Budgetary Control
Budgetary control is a systematic & formalized approach for accomplishing the planning ,co-ordination & control responsibilities of management. It is a system which uses budgets as means of planning accounting & controlling all aspects of production & sale of goods & services. It implies a constant & continuous ( either daily or weekly / monthly/ quarterly/ annually) monitoring on all the phases of the business activities. It is exercised either financially or physically or both ways by incorporating both financial & physical commitments / targets. All the budgets financial or physical are assigned to specific individuals who are responsible for conforming to them. Without such a fixation of responsibility , deviations become no bodys responsibility.
Budgetary control
(purpose)
1) PlanningBudget involves more detailed work on strategic plan to achieve goals & objectives which are to be dissipated among various responsibility centres performing different functions. It provides opportunity to all managers to use the latest available information & incorporate them in budget for next accounting year. It also expects the operating managers to anticipate the problems that would make the process of reaching its goals difficult & shall try to identify some ways to overcome them. 2) Co-ordination Every responsibility centre manager in the organization participates in the preparation of the budget. When all the sectoral budget proposals are assembled into an overall plan or Master Budget, inconsistencies & / or anomalies surface. For their resolution , Budget controller plays an important part of coordination among managers of different responsibility centres for final figures agreed upon.
Budgetary Control
3) Responsibility Approved budget makes it clear what manager is responsible for. All managers are expected to keep a watch over activities & take immediate action at the first sign of deviation from the plan. 4) Performance evaluation Budget represents commitment by manager to his superiors. Hence it provides a bench mark against which actual performance is judged. Thus it becomes an excellent starting point for performance appraisal. This system helps in identifying the principal budget factor or the limiting factor which is a key factor which will limit the activities of the undertaking during budget period. The influence of this factor needs to be considered while drawing functional budgets. Even though budget is a plan prepared prior to the period during which it will operate, it differs from strategic plan as well as forecast.
Budget and Strategic Plan

Characteristic
Time frame
Strategic Plan
Several years
Budget
Normally one year
Sequence
Use Structure
Precedes budget
Succeeds strategic plan Provides framework Small part or slice of for budgeting strategic plan
As per product line As per responsibility center
Budget & Forecast

Characteristic Forecast Budget
Type of document
Responsibility
Prediction of what is most likely to happen
Plan for management action
Forecaster is not responsible Budgetee takes steps to for shaping events forecasted make events conform to plan
Management function involved

Time period Unit of measurement
It is a planning device.
It is made for any time period Can be made in monetary or physical characteristics.
It is a tool for planning & control

Made for defined period, generally one year. Usually expressed in monetary terms
Updating practice
Updated when new inputs show change in conditions
Not updated unless drastic change in conditions.
Types of budget - Fixed & Flexible

This type of classification is important from the control standpoint. A fixed or static budget is designed to remain unchanged irrespective of the volume of output or turn over attained, i.e. it is prepared for one single level of activity for a definite time period. Hence such a budget is prepared in respect of expenses of fixed nature where variations in the levels of activity does not have any effect during a short period. Its usefulness as a control tool is limited. A flexible budget changes according to the levels of activity. Here the budgeted expenses are adjusted to actual activity level before comparing it with actual expenses incurred. A flexible budget recognizes the difference between variable, semivariable & fixed expenses. During budget preparation, all semi variable / semi fixed expenses are segregated into fixed or variable expenses & then budgets are prepared for different activity levels. From control point of view , flexible budget is very effective in those industries in which significant changes occur in activities due to market fluctuations, seasonal variations or other reasons.
Rolling Budget
It is a budget which is continuously updated by adding a further period say a month or a quarter & deducting the earliest period. It is also known as continuous budgeting & is used by the firms which operate in environment that is subject to frequent changes. Continuously changing environment renders annual budget unrealistic but rolling budget helps to overcome this problem. It is developed in details for short periods & revised frequently which reduce risk / uncertainty of future by addressing to current situation. However it needs a good deal of administrative effort which is not justified if the changes are not continuous. In each quarter the budget is prepared in great details for the first 3 months of the budget period & in lesser details for balance period. Before the end of three months , the budget for the first three months is dropped & the detailed budget is prepared for the next three months & a lesser detailed budget for the balance period. It provides managers with targets which are realistic & attainable & helps to motivate them.
Performance Budgeting
Here the budget is classified in terms of functions but its aim is to carry out the evaluation of performance at various cost centres. It is widely used in PSUs & government departments wherein work programs are prepared & performance criterion developed for achieving the goals of the firm & measuring performance at various levels of organization or at all responsibility centres. Here the targets are set both in terms of money value & physical units which enables the firm to compare the actual performance against targets set. Variance is also reported in monetary terms & physical characteristics. Functions, activities & projects direct attention on achievements & form the basis of performance budget. Performance budgeting is definite improvement over traditional or conventional budgeting where targets are fixed only in terms of money value, It is more relevant at lower & middle management levels for measurement of operational effectiveness & efficiencies.
Program Budgeting
Program budgeting addresses itself to the selection of a program & is concerned with planning. It was introduced in the U.S. department of defense which then got extended to other government departments. It aims to make the operations of government more effective & efficient by ensuring optimal utilization of available resources in order to get maximum benefit. For government programs achievement of specific predetermined goal is known as effectiveness. The efficiency is measured by input output ratio & if the same increases, it can be said that efficiency has increased. In program budgeting which is mostly used for planning programming & budgeting in government, the classification of budget is done in terms of programs. Its time horizon is long enough to extend over the life of a program. Program budgeting is oriented towards achieving social objectives & involves output analysis.
Program Budgeting
Program Budgeting has its own terminology in hierarchical order of goal, function, program & activity. e.g. 1) Goal to be achieved has to be defined specifically e.g. flood control. 2) Function will then be dredging of the rivers i.e. functions are the broad classifications of operations which are essential for accomplishment of well defined goals. 3) Programs are subdivisions of functions. They are different options for achieving goal like building dams or constructing canals . It is essential to define the costs, benefits & output of the programs for their proper evaluation. They are then ranked on the basis of their cost benefit analysis. The program which is expected to yield highest net benefit is selected and the funds available are allocated to the best program. 4) Activity is a segment or group of work which is homogeneous i.e. digging the earth for construction of canal is an activity.
Methods of budgeting
Principal methods are incremental budgeting & Zero base review. 1) Incremental budgetingHere the expenses incurred during a particular budget period are taken as given, i.e. the present level of expenses is assumed as starting point Proper adjustments are made for special tasks, for expected changes in the work load of continuing tasks, for inflation, for cost of comparable work in similar units etc. While this method is simple & saves time in budget preparation, it has a tendency to increase overhead expenses from period to period. Hence during a business downturn such budgets can be substantially reduced without making much adverse impact on the business. 2) Zero base Review It is analytical approach to budgeting wherein all activities are duly re evaluated each time the budget is formulated
Methods of budgeting
Each functional budget starts with the assumption that the function does not exist & is at zero cost. Increments of costs are compared with incremental benefits culminating into planned maximum benefit , given the budgeted cost. It is best suited for discretionary expenses which involves thorough analysis of each discretionary cost for a specific period of last few years. It builds up from scratch the resources that an activity needs It raises fundamental questions, challenges established norms, critically analyzes & seeks justification for the activities & expenses of the preceding years & commences planning from zero base. It relies heavily on different techniques for deriving a new base like - Intra firm comparison ( within the firm between two similar RCs) - Inter firm comparison ( w.r.t. outside firms) - bench marking ( comparing performance with that of another firm which is believed to be outstanding in that segment) However such reviews are difficult & take lot of time & energy.
Management By Objectives
The budgets contain the financial objectives that managers are responsible for accomplishing during the budget year. However certain specific objectives are implied in the budget figures viz. introduce automation in the plant, open new sales office, launch new product etc. Some companies follow the practice of putting down such objectives explicitly in writing & the process of doing so is called management by objectives. The objectives of each responsibility centre are set forth in quantitative terms wherever possible & the mangers of RCs accept the same with the approved budgeted amounts. However if non financial objectives can be stated in concrete terms , they may serve a useful purpose of motivating the mangers & in appraisal of their performance. Budgeting & M.B.O. together form parts of the same planning process.
Responsibility Accounting & Budgeting

The essence of responsibility accounting is the accumulation of costs & revenue according to areas of responsibility so that deviations from the standard cost & budget can be identified with the person or the groups responsible. The objective of responsibility accounting is not to find fault but to provide means to locate those activities & people in the organization in need of help so that assistance can be rendered & the scarce resources of the firm can be utilized more effectively. The concept of responsibility accounting & cost control is based on the premise that it is appropriate to charge to an area of responsibility only those cost which are subject to the control of the person in charge of each area of responsibility The cost which are not controllable by one individual or group are always controllable by another individual or group. In the framework of responsibility accounting there is no place for the idea of non controllable cost All the cost are controllable in some point in time by some person or group. Within an individual firm there is responsibility for each and every cost element

The control procedures for fixed and variable cost differ significantly. Variable cost deviations are controlled by way of their elimination i.e by making sure that variances do not occur or are minimized. Fixed costs are subject to control in terms of whether or not commitments are made or allowed to continue till the point where changes in commitments can be made. When the costs controllable by individual workers are added up, they form a total which is the responsibility of the foreman with one exception, that is the cost applicable to the foremans functions which do not pertain to any individual worker. They pertain only to the foremans direct responsibilities which he cannot or does not delegate to the individual workers under his jurisdiction. Thus the cost included within the foremans responsibility are the cost controllable directly by him and those controllable indirectly by him through his subordinates The same analogy is used when referring to the sum total of the cost controllable by different levels of organization.

Responsibility accounting is in essence a communication system which is designed to aid an enterprise in achieving its cost and profit goals It deals with the accumulation of cost and revenue according to areas of responsibility so that deviations from standard cost and budget can be identified with the person or groups responsible The idea of responsibility accounting is that a person should be charged only those cost factors that he can control Standard costing and budgetary control system are complementary. If the variable cost and revenue budgets are created with use of standard costs, and fixed overhead expenses are developed with flexible budgets then the management will have strongest tool for cost and operational control
Responsibility Budgeting
After approval of annual budget the fixed overhead portion of the department budgets are segregated into three parts showing expenses which are 1) controllable by Responsibility Centre 2) non controllable by Responsibility Centre 3) allocated and transferred by other centres This is done to identify the extent of the control possible over the total expenditure incurred by each centre 1) Controllable expensesThese are the items of expenditure over which each RC has some authority to spend and control such as wages and salaries, stores and spare parts, indirect material, telephone, postage , printing and stationery etc Non controllable expenses are incurred by RC which have no access to regulate them because these expenses are determined and charged by external sources such as rent, rates and taxes
Responsibility Budgeting
2) Non controllable expenses They are incurred by RC which have no access to regulate them because these expenses are determined and charged by external sources such as rent, rates and taxes. 3) Allocated expenses These type of expenses are simply absorbed by RC because actual expenses are incurred by a different RC such as computer centre, central purchase, R&D , training etc. These (latter) RCs actually distribute the total expenses incurred over the receiving centres which have utilized the services Similarly H.O. expenses are distributed over the branches on some basis. The RCs have no control over it and therefore should utilize these available services as best as possible. Allocated expenses are therefore shown separately source wise i.e H.O expenses and other expenses in the budget.
Financial Performance Report Analysis

Here the focus is on analyzing financial performance measures. Actual results are compared with budget & variances are ascertained by causes & responsibility centres. The budgets for business units include both expense & revenue budgets & hence they fall within its ambit. Even Revenue Centres & Expense Centres are also covered in it. Variance is the difference between the actual costs & revenues w.r.t. their budgeted figures. They are worked out at fixed or predetermined periodic intervals in respect of each business unit & for the whole firm. Reports on variances are prepared & forwarded to appropriate levels of management periodically & on time. Senior management use these reports for evaluating business unit performance.
Financial Performance Report Analysis

Variance analysis involves : - decomposition of variances into its minute constituent parts, - their analysis by causes & by responsibility centres, - their report to appropriate levels of management for taking corrective actions which would eliminate waste, inefficiencies, introduce a sense of discipline & accountability, foster the feeling of mutual interdependence& co-operation. The variances are hierarchical & can be identified down to the lowest managerial level or the individual manger. Variance analysis then serves as a powerful tool for enhancing the efficiency of profit budgets ( profit budget is the master budget prepared by the business unit or a firm as whole)
Performance measurement
Financial performance report analysis deals with the manner in which financial performance of an organization is measured. Unfortunately financial performance measures only one aspect of performance. There are other aspects of performance measurement also. The objective of performance measurement is to enable management to assess the extent to which the firms strategy has been implemented. The traditional financial accounting measures like return on investment and earnings per share have worked well in the early part of industrial era. But they give misleading signals for continuous improvement and innovation activities todays competitive environment demands by mastering different skills & competencies. Financial measures are indicators of past decisions Non-financial measures are leading indicators of future performance and are also known as critical success factors
Performance Measurement Systems

Performance measurement systems which strongly affect the behaviour of managers & employees are the effective tools for the implementation of an organizations strategies Many leading companies of the world do not rely on one set of measures to the exclusions of the other because no single measure can provide a clear performance target or focus attention on the critical areas of the business Manager want a balanced presentation of both financial and operational measures. A performance measurement system uses a combination of financial and non-financial measurements at all levels in the organization. It is vital that a professionally designed performance measurement system must have properly aligned performance measures at all levels in the firm. Two performance measurement systems namely the balanced scorecard and interactive control are important.
Balanced Scorecard
( Introduction)
Balanced scorecard is a performance measurement system which allows managers to look at the business from four important perspectives. It provides answers to four basic questions 1. How do customers see us? (customer perspective) 2. What must we excel at? (internal prospective) 3. Can we continue to improve and create value? (innovation and learning perspective) 4. How do we look to shareholders? (financial perspective) While giving senior managers information from four different perspectives, it minimizes information overload by limiting number of measures used. It guards against sub optimization by forcing them to consider all important operational measures together It brings together in a single management report, many of the seemingly disparate elements of a companys competitive agenda; becoming customer oriented, shortening response time, improving quality , emphasizing teamwork, reducing new product launch times, and managing for the long term.
Balanced Scorecard
(overview)
It makes an effort to accomplish goal congruence by striking a balance between otherwise strategic measures. It lets them see whether improvement in one area may have been achieved at the expense of another. Thus employees are encouraged to act in the best interest of the organization. Apart from this , it serves as a tool in the hands of management for establishing the organizations objectives , bringing about improvement in communication, focusing the organization, and giving feedback, pertaining to strategy Each of the measures seek to address an aspect of a firms strategy & indicate how non financial measures affect long term financial results. When senior management creates balanced scorecard, they must essentially select a set of measurements which will : 1. Give a broad view of the firms present position. 2 Reflect accurately the critical factors that are essential for the success of the firm .
Balanced Scorecard
( strategic measures)
It provides a rich combination of strategic measures namely : External and internal measures. Driver and outcome measures. Financial and non financial measures. External and internal measures External measures have to do with customer satisfaction while internal measures refer to productivity Efforts must be made by management to bring about a balance between external measures and measures of internal business processes It is often found that internal development is sacrificed for the sake of external results At times external results are ignored under the impression that good internal measures are adequate
Balanced Scorecard
( External & Internal measures) Customer concerns tend to fall into four categories : quality , time , service and performance The internal measures for the balanced scorecard should stem from the business processes that have the greatest impact on customer satisfaction Companies should also attempt to identify and measure their core competencies, the critical technologies needed to ensure market leadership Companies should decide what processes and competencies they must excel at and specify measures for each.
Balanced Scorecard
(Driver & Outcome measures)
Driver measures show the progress that has been made in key areas during the process of strategy implementation . They show changes on an incremental basis and such charges are expected to finally have an effect on the outcome They are known as leading indicators & can be used at the lowest level which can be conveniently called granular level. Throughput ratio, production cycle time are some examples of driver measures Outcome measures are also known as lagging indicators They denote what has happened or the outcome of strategy. Thus, improvement in quality, higher sales revenue etc are examples of outcome measures. When the amount of revenue increases or there is an improvement in the quality of products, it can be said that the same is the result of the succeeded implementation of the organizations strategy. In other words, outcome measures can only tell you about the ultimate result.
Balanced Scorecard
(Driver & Outcome measures)
There is an inextricable linkage between outcome and driver measures When a problem is shown by the outcome measures but the indicators given by driver measures is that the strategy is being implemented properly, then there is a good deal of chance that the strategy is in appropriate and needs to be changed.
Balanced Scorecard
( Financial & Non financial measures)
Financial performance measures indicates whether the companys strategy , implementation and execution are contributing to bottom line improvement. Cash flow, growth in sales, operating income, market share and return equity are the financial measures used. Non-financial measures denote customer satisfaction, innovation, quality etc.
Balanced Scorecard
(benefits)
The figure shows a balanced scorecard The measures have been divided in to four broad categories This enables the company to be viewed from four different perspectives namely financial, internal business process, customer and innovation and learning Thus an explicit balance is provided pertaining to the needs of selected series of parties who have stake in the organization
Balanced Scorecard
(benefits)
All the measures given in the companys balanced scorecard are specifically related to its strategy. The measures selected by the firm are wide and varied. They vary between external measures (e.g. market share, customer ranking survey) and internal measures (e.g. project performance index, safety incident index) There are also driver measures namely staff attitude survey, project closeout cycle or time spent with customers on new work and outcome measures such as return on capital employed. Ultimately, some measures are related to the dimension (e.g.. Number of suggestion from employees) These measures taken together focus on what the management feels the firm needs to improve so as to enable it to implement its strategy in a successful manner.
Balanced Scorecard
(benefits)
The manner in which the balanced scorecard measures drivers and outcomes causes the firm to take actions on the basis of its strategies. This is the most important aspect of the balanced scorecard. By providing a link between the overall strategic objectives and financial objectives with objectives at lower levels that one can observe and affect at various organizational levels, the firm achieves goal congruence. The manner in which the actions of employees have an impact on the firms strategies can be readily understood by them, The measures in the balanced scorecard are explicitly linked to the strategies of an organization. Consequently, it is desirable that these measures must be strategy specific and also specific to the organization. Although there is a generic balanced scorecard framework, a generic scorecard does not exist.
Balanced Scorecard
(benefits)
Specific targets existing throughout the length and breadth of the organization are tied to the balanced scorecard measures which are linked from the top to the bottom. A strategy is provided an additional level of clarification by objectives. This enables an organization to know the things they are required to do and the extent they have to get done. That there is a cause and effect relationship among the measures is emphasized by the balanced scorecard. This emphasis provides an understanding as to how non financial measurements namely manufacturing cycle time, product quality drive financial measures such as revenue. While these relationships must be understood by each employee in the organization, it is essential that a linkage should be established between the individual measures and the four broad perspectives in an explicit and cause and effect way. This would enable it to serve as a tool to translate strategy into action.
Balanced Scorecard
(Problems)
Although it is a useful tool in the hands of the management, there are certain problems inherent in it & unless they are dealt with in a suitable manner, its utility would be limited. 1. Trade off is difficult While some firms prepare as single report by suitable combining financial and non financial measures and giving weights to each of the measures, no weights are assigned explicitly to the measures on most of balanced scorecards. Consequently making trade offs between non financial and financial measures is difficult owing to the lack of weights 2 Poor Correlation between non financial measures and results The underlying assumption in the balanced scorecard is that the achievement of measures in the scorecard leads to future profitability. This is far from true There is no certainty that accomplishing targets in any non financial area would give rise to profitability in the future
Balanced Scorecard
(Problems)
3. 4. Failure to update measures While changes and adoption of different strategies necessitates updation measures to bring about alignment, it is surprising that many firms lack formal mechanisms to update the measures Consequently measures based on past strategy are being still developed by firms Bias towards financial results Senior managers are highly trained and fully conversant with measures used for gauging financial performance of a firm The balanced scorecard is often linked up in a poor manner to an incentive scheme As a result the compensation of senior management is based on financial performance
Balanced Scorecard
(Problems)
5. Managerial overload The success of the balanced scorecard depends upon the number of critical measures selected for the scorecard There is a optimum number which a senior manager can track at a time without loss of focus While the selection of a few measures could lead to the neglect of measures that are critical for the success of an organization, the selection of too many measures could lead to the loss of focus and managerial overload as he tries to do too many things at a time requires mechanism for improvement In today's dynamic environment stretch goals are essential for organizational success This requires the existence of a mechanism for improvement Unfortunately one of problems of the balanced scorecard is that a firm is not in position to accomplish stretch goals where no mechanism for improvement exists
6.
Interactive control
We know that there are certain industries which are influenced by extremely rapid changes in the environment In the case of such industries the idea about new strategies can evolve from management control information Extensive research in this field has been referred to as interactive control Survival of firms in a rapidly changing and dynamic environment demands the creation of a learning organization When we use the term learning organization we mean the employers capacity to learn to deal with environmental changes on a continuing basis
Interactive control
1. 2. 3. 4. 5.
6. 7.
A learning organization is said to be effective when it possesses the under noted characteristic features Employees at all organizational levels scan the environment This is done on a continuous basis They identify potential problems They also seek to identify potential opportunities These employees freely and frankly exchange information about the environment Alternative business models are experimented with The objective is to adapt them in a successful manner to the emerging environment The primary objective underlying interactive control is to help in creating a learning organization
Managerial compensation
We know that the primary role of management controls is to assist in the execution of organizational strategies. Strategies are implemented by managers. In order to ensure that the strategies are correctly executed, managers must be motivated properly. Incentive compensation is an important tool for motivating and encouraging managers for achieving the objectives formulated by the organization.
Features of incentive compensation plan

Incentive is an extremely valuable tool in the hands of a firms management for furthering the goals of the organization While incentives are of two types positive and negative, both exert their influence on individuals A positive incentive is also called a reward. It leads to increased satisfaction of the needs of the individual On the contrary a negative incentive also called punishment. It decreases the satisfaction of personal needs people employed in an organization are given rewards to achieve performance considered desirable by the organization
Features of incentive compensation plan

1. 2. 3. 4. The features are Short term and long term duration Payment in cash or stock option Forms substantial part of base pay Link between bonus and financial performance 5. Incentive compensation ration varies from organization to organization and industry to industry

Understanding Management Control Systems

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Management Control Systems

Structure of University Paper

May 2009 descriptive questions

May 2009 descriptive questions

May 2009 descriptive questions

May 2010 descriptive questions

May 2010 descriptive questions

December 2010 paper

May 2011 descriptive questions

May 2011 descriptive questions

Management Control System

MCS Introduction, Basic concepts & Overview

Introduction & Overview

Elements of a control system

Elements of Management Control System

Activities in Management Control.

Expectations from sound MCS

Characteristic features of MCS

Characteristic features of MCS

Characteristic features of MCS

Purpose of Management Control System

Structure & Process of MCS

Process Output Matrix

Some staff functions like R & D ( Inputs or Resources allocated)

Boundaries or Limits of Management Activities

Management Control (an aid in Strategy Development)

Task / Operational Control

Task / Operational Control

Operational & Management Control

Operational & Management Control

Hierarchy of Decisions / Actions

Adopt affirmative action policy

Implement minority recruitment program

Maintain personnel records

Control research organization

Run individual research project

Stages in Management Control

Stages in Management Control

Stages in Management Control

Corporate Strategy based Categorization

Business Unit ( B.U.) Strategy

B.U. Strategy to Mission / Vision

Goals & Objectives

Other Economic Goals

Other Economic Goals contd.

Goals of non profit organizations

B. U. Strategy Development Tools

Question mark (Build) Cash cow Dogs (Harvest) (Divest)

Advantages of BCG Matrix

Limitations of BCG Matrix

Limitations of BCG Matrix

G.E. Nine Cell Planning Grid

G.E. Nine Cell Planning Grid

G.E. Nine Cell Planning Grid

G.E. Nine Cell Planning Grid

G.E. Nine Cell Planning Grid

Strong Winners Winners

Weak Question Marks

High Average Low

Average Losers Businesses Losers

Profit Losers Producers

Recommended Business Strategies

Invest / grow Strongly (build)