Management Control Systems

Prof Ashish K Mitra

Result of lack of control at Organizational level .

In 2001, Enron Corporation , the global energy giant, collapsed , in what was one of the largest case of bankruptcy in US Corporate history. WorldCom, the telecom giant , had artificially inflated its earning that rocked the corporate world & shook investors confidence in the stock markets. WorldCom deliberately misrepresented expenses as Capital expenditures, in order to inflate its profits.

Barings Bank
Founded in 1762 Britains Oldest Merchant Bank Financed United States of America to buy Louisiana, then a French Territory, from France in 1803 (Deal value US $ 15 million) Was a very powerful bank. In 1818, then French Foreign Minister, Duc de Richelieu said: There are six great powers in Europe: England, France, Prussia, Austria, Russia and Baring Brothers (the old name for Barings Bank) It was the official bank of British Queen

Barings Bank
Nick Leeson was a trader with Barings banks Singapore office from 1992 to 1995. At the age of 27, in 1994, he got an annual compensation of GBP 2,00,000 He single handedly pulled down the Barings Bank in 1995 His illegal trading activities resulted in a loss of US $ 1.3 billion (GBP 837 million) for the Bank The bank declared bankruptcy and shut its doors in Feb 1995

Barings Bank
It did not happen suddenly. Leeson was accumulating losses since 1992 in a fake account number 88888. By the end of 1992, the 88888 account was under water by about GBP 2 million. By the end of 1993 losses had mushroomed to GBP 23 million. By the end of 1994, 88888 account had lost a total of GBP 208 million. Barings Banks Head Quarters in London did not know what was happening in Singapore. A classic example why business organizations need to ensure control over their activities

The lesson
It is not enough to prepare a good plan and implement it. The organization should have a proper system to control to ensure that everything is implemented as per the plan

 Every control system has at least four elements:

A detector or sensor : that measures what is actually happening in the process being controlled An assessor : that determines the significance of what is actually happening with expectation of what should happen An effector: that alters behavior if the assessor indicates need to do so. A communication network : that transmit information between the detector and the assessor and between the assessor and the effector.

 How does the Air conditioner maintains temperature in a room? Control System : Thermostat
Detector / Sensor - Thermometer Assessor compares current temp with set standard, Effector shuts off compressor when set temp reached, Communication Network the connecting circuit

How does the driver controls the car? ( Car Brake system)
Eyes Sensor Brain Assessor Foot Effector Nervous System Communication network

Management Control
The same logic of Detector, Assessor, Effector and communication network But several times more complicated Unlike AC the standard is not always preset, it is result of a conscious planning process. Management Control involves both planning & control. The control is not automatic . Managers often detects important information with their own eyes, ears & other senses Unlike Car- not controlled by single individual, requires coordination among individuals. Unlike AC or Car required action to obtain the desired result may not be clear Much of Management Control is self- control using judgment rather than following instruction from superior.

 Many management actions are unsystematic. Manager often encounter situations for which rules are not well defined. Best judgment & skills in dealing with people determine effectiveness of their actions. If all systems ensured the correct action for all situations, there would be no need for human managers. In this course we focus primarily on the systematic ( ie, formal) aspects of management control function.

Definition of Management Control

The process by which the managers influence other members of the organization to implement the organization strategies (Anthony & Govindarajan) Management Controls are only one of the tools managers use in implementing desired strategies. Other important tools are the organizations structure, its management of human resources, and its particular culture.
Management Control systems encompass both Financial and nonfinancial performance measures. The financial dimensions focus on the monetary bottom line net income, return on equity, and so forth. But virtually all organizational subunits have nonfinancial objectives customer satisfaction, market share, quality, employee morale etc

Activity Strategy Formulation Management Control

Nature of End Product Goals, strategies, & policies. New organizational directions, unsystematic & judgmental Implementation of Strategies, more predictable & systematic, all actions need not be to a previously defined plan such as a budget.
Efficient & effective performance of individual tasks. Transaction oriented according to rules established under Management Control. Task control are quantitative in nature

Task Control

General Relationships among Planning & Control functions

Strategy Formulation ( eg; Enter a new business, Add direct mail selling as a new channel) Management Control ( Expand a plant within the agreed Capital budget, Determine advertising budget) Task Control ( Schedule production, Book TV commercials)

 An enterprise has to use its resources effectively & efficiently in order to achieve its objectives. In management context , traditional concept of control generally refers to the activities of establishing standards of performance, evaluating actual performance against these standards, and implementing corrective actions. This approach assumes a stable environment within which standards have been established. Todays business environment due to intense competition & dynamism, requires control systems to monitor external market place development and adapt to them. Management Control has been defined as a process whereby management & other groups are able to initiate & regulate conduct of activities so that results accord with the goals.

 A Management Control System may also be viewed as a collection of controls that addresses one or all of the weaknesses of following situations:
Managers & employees do not have a clear idea of what is expected of them They have a fair idea of what is expected but do not feel motivated , ie; conditions in the organization ( for eg; Reward system) fail to provide impetus for performance ; and In spite of knowing about expectations and having sufficient motivation for performance, managers / employees are unable to perform.

Objectives of Management Control

The modern MCS seeks to reasonably answer contextual issues that impact an organizations short term success and long term survival by integrating the diverse activities of the organization. It deals with detecting environmental variables that can sufficiently affect organizations, ensuring efficient resource utilization, sustaining competitive advantage, translating corporate goals into business unit objectives, maintaining transparency and clarity of financial reporting, and preserving conformity with relevant regulatory framework. It is also concerned with operational efficiency issues.
An adaptive MCS facilitates organizational learning resulting in improved processes and better responsiveness to market conditions.

Maciariello & Kirby View

Management Control Includes Strategy Control and Operational Control Suggests Control framework Mutually Supportive management Systems Model (MSSM) Infrastructure, Management Style and Culture, Control Process, Rewards and Coordination & Integration

Goal Congruence
Management control systems influence human behavior. Good management control systems influence in a goal congruent manner; i.e; they ensure that individual actions taken to achieve personal goals also help to achieve the organizations goal.

Behavior in Organizations
Goal Congruence : Senior management wants the organization to attain the organizations goals. But the individual members of the organization have also their own personal goals, and they need not necessarily be consistent with those of the organization. The central purpose of a MCS , then, is to ensure ( in so far as is feasible) a high level of what is called goal congruence. In a goal congruent process, actions people take in accordance with their perceived self-interest are also in the best interest of the organization. Obviously , in our imperfect world, perfect congruence between individual and organizational goal does not exist.

 In evaluating any management control, two important questions to be probed are:

What actions does it motivate people to take in their own self-interest? Are these actions in the best interest of the organization?

Formal and Informal Control

Management Control Involves controlling human beings with emotions Therefore, behavioral Issues, motivation are very important Both Formal systems and Informal processes influences human behavior and thereby goal congruence in Organizations. Hence control has to be exercised through formal and informal means.

 Formal Control systems are laid out in writing by the management. Formal controls , also referred to as bureaucratic controls, involve establishing standard rules & procedures for control of activities and their outcomes. Formal controls entail delegation of tasks ( authority & responsibility) in a structured manner within a well defined framework. Policies, Standard Operating Procedures ( SOPs), budgetary controls, financial reporting, audit , performance measurement systems, incentive systems, reward & punishment systems, strategic plans, & quotas, are example of Formal Controls.

 Informal controls, as the name suggests, are not about any fixed rules & regulations. They are exerted by establishing a corporate culture and value system in which there is an interactive exchange of information .
Informal controls arise as a result of employees behavior , and include work ethic, group norms, management style, organization culture & general socio-cultural factors. For Informal Control to develop and be effective, interpersonal relationship among individuals & groups be encouraged so that a feeling of trust pervades the firm. Informal controls are generally found in organizations which rate high on learning, innovation & creativity. Informal controls co-exist with formal controls & complement formal controls and in ways , dilute some of drawbacks of formal control ( lack of trust due to formal inspection, which may be interpreted as prying) by encouraging peer interaction, self initiation & creativity.

 Formal Control Systems can be classified into three types, based on the nature of management intervention. They are Input controls : these measures help the company to select the right activities or right approach to undertake ( before a planned activity has begun /implemented). Input controls include selection criteria, recruitment & training programs, manpower allotments, strategic plans and resource allocation. Process Controls : these measures are taken when an activity has begun but before the process of transformation is completed and the output is produced . The process control involves tracking certain variables while activity is underway, & take corrective action when ever there is a any deviation beyond specified limits.

 Process control involve influencing the ongoing activity / behavior to achieve desired result before end results are reached. Eg; under a feed forward system of inventory control, when the sales rate begins to decline, the level of finished goods inventory is controlled by reducing production rate. Output controls: Output control takes place when the control action takes place based on the comparison of actual outcome and planned outcome. Such controls are applicable when it is easy and inexpensive to measure the output and when there are few elements of uncertainty. In this type of control, management expects the employees to perform their tasks in a result oriented way ( without much management intervention).

 Informal Control Systems : These are unwritten, typically employee initiated mechanisms, arising due to factors external as well internal to the organization. External factors
External factors are norms of desirable behavior in the society ( societal control). These are set of attitudes, collectively referred to as work ethic, which manifests in employees loyalty to the organization, their diligence, spirit & pride in doing a good job. These are often local/ regional / country specific. Other attitudes / norms could be industry specific.

Internal Factors
Cultural controls : the organizations own culture, common belief, shared values, norms of behavior, and assumptions that are implicitly accepted and explicitly manifested throughout the organization.. Certain practices become rituals, carried almost automatically, others are taboo.

 Management Style : usually subordinates attitudes reflect what they perceive their superior s attitude to be, and their superiors attitudes ultimately stem from the CEO. Self-control: self-control can be beneficial to an organization if the organizations goal are in congruence with the individuals goal.

Subsystems and components of management control systems

The subsystems and components of control systems can be discussed on the basis of formal and informal processes. Formal Control Process : the formal control process has two dimensions formal planning and formal reporting
Formal planning process: The formal planning process has two dimensions : strategic planning & operations planning. A strategic planning systems is necessary to assist the organization in the planning and control of projects ( including decides its goals, objectives, and key strategies). An operational planning system undertakes activities that are short term in nature Formal Reporting process : detailed reports help the organization to assess the progress of its strategic and operational planning.

 Informal Control Process :

Informal control processes are formed based as a result of interactions between people. The informal control process helps in development of new goals and objectives. There are number of mechanisms for control through informal systems. One mechanism is the use of ad hoc teams or crossfunctional groups to solve problems , achieve organizational change. Informal systems evolve as people develop work relationship. Fostering informal communication is critical to the development and maintenance of effective informal controls. Informal reward and recognition of key team members strengthen power of informal control process.

School of thoughts / approaches to MCS

Cybernetic approach to MCS : In 1940s, mathematician Nobert Weiner coined the word cybernetics, derived from the Greek word kybernetes, which means steersman a person who directs the movement of the ship. Cybernetics is the study of the entire field of control and communication theory, whether in the machine or the animal. It deals with self regulating principles in a variety of systems ranging from human biological system, to robotics, radar control, artificial intelligence. The human brain is a complex structure that helps in regulating the body function s and helps body perform complex activities. Organizations too are complex as they are made up of different individuals.

Cybernetic paradigm and the control process.

The cybernetic paradigm helps in capturing the essential elements of the repetitive control process. The essential elements are : 1. Set goals and performance measures 2. Measure achievement 3. Compare achievement with goals 4. Compute the variances as the result of the preceding comparison 5. Report the variance 6. Determine the cause(s) of the variance 7. Follow up to ensure the goals are met All goal-oriented controls reflect the basic elements of the cybernetic paradigm.

 Paradigm begins with the assumption that decisions are the result of the interaction between the decision maker and the environment faced by the decision maker Environment includes the outside world as well as other organizational units internal to the firm Each manager of an organizational unit scans the environment either formally or informally, so as to absorb the information or feedback pertaining to its condition The manger comes into contact with the environment through the sensors of the organization Sensors are mechanisms used by managers to collect data. The mechanisms include reports that are reproduced as a result of formal and informal attempts

Cybernetics Approach to Management Control

The manager constructs from these data certain beliefs (factual premises) concerning performance and state of external environment The Factual premises are formed by passing these data through a cognitive process referred to as perception Comparison with organizational goals and desired performance measures (Value premises) . The comparator represents the comparison process When a performance gap exists, decision makers are forced to search for course of action that will close the gap and take them closer to their goals (behavioral choice) The set of alternative actions can be drawn from a behavioral repertoire

 If no alternative is expected to reduce or close the gap, the decision maker will expand the search process The search process is motivated by the presence of gap and stops when a feasible alternative is found that will close the gap The effector , manager, activates the decision thus serving as a change agent The manager seeks to determine the effect of the action taken This new information is referred to as feedback

Key Issues in Designing Management Controls

The process of establishing controls should be seen as a constructive process ( enhancing performance ) and not punitive . The standards set should be challenging but at the same time attainable. Objectives should be measurable to enable evaluation of performance. Controls should focus on the objectives & key results of an activity. Key control objectives/standards should be limited in number Standards should have balance among themselves mix of short & long term orientation There should be a single individual responsible for each control standard Should establish a accepted range of variation for the value of each key variable.

Control Process Hierarchy communication &

reporting structures The control process in an organization involves relationship between superior & subordinate The goals of subordinates should be congruent to the goal of the superior. Congruency in goals can be achieved through negotiations, and depends on the style of management and the communication process in the organization.
Superiors get the goal and develop means to achieve it. The means become goals for the persons next in hierarchy If Over all goal is G ( goal at the topmost superior level) Then G1, G2, G3, G4 ( goal of 4 subordinates at the next hierarchy level) Then G11, G12, G13, G14 ( goal of subordinates of first person viz; G1)

Control process hierarchy communication & reporting structures contd

Superior meets the subordinate- to analyze past performance and set new goals and targets for key variables Meets at regular intervals for review prepare action to correct deviations Reviews efficiency of corrective actions Subordinates goals are defined from the goals and behavioral choice of superior Subordinates perceptions are influenced by the perceptions of superior Corrective actions (Effector) from the superiors Behavioral Repertoire also is used.

Contingency Approach to Management Control System

Contingency theory is based on the premise that the design and use of control system is contingent upon the particular context of the organizational & environmental setting in which the controls operate. This was propounded in response to the universalistic approach which that argues that there is an optimal scheme for control design which is applicable in all settings & firms. The term contingency implies that the structure and process are contingent on various external and internal factors. Contingency theory focuses on the interaction between the organization and its environment .

Contextual Factors
Different contextual factors influence the design and use of management control systems. These factors include: Nature and purpose of organization
For profit vs not-for-profit organization return on equity vs use of grants to achieve social objectives customer needs vs design of services & delivery of services Motivation through tangible rewards & punishment vs motivation for service delivery through intangibles

Organization structure and Size

centralization vs decentralization Degree of uncertainty - ability to adapt to unstable conditions Size of the organization large size may make specialization, division of labor viable
Large organizations need more controls in shape of rules, documentation, specialized roles, & higher degree decentralization.

 National Culture : culture of the host country should be considered when designing MCS.
Hofstede identified 4 dimensions along which national culture vary. The dimensions are: power distance ( acceptance of hierarchical levels), Uncertainty avoidance ( risk & ambiguity), individualism / collectivism, and Masculinity ( competitive spirit, assertiveness) / femininity ( interdependence, nurturing nature).

Corporate strategy and Diversification: MCS should have

good fit with the corporate strategy in order to achieve goal congruence. Management controls also differ depending upon related or conglomerate ( un related) diversification.

Managerial styles : ( autocratic or democratic, permissive or

directive) play an important role in influencing behavior of employees & thus design and implementation of MCS
External control vs Internal control

 Technology Shareholder expectation Organizational slack

Design of Control Systems

Designing an optimal MCS is important for the effectiveness and long term sustainability of an organization. A very low degree of control (control looseness) can result in confusion & chaos; on the other hand too great a degree of control ( control tightness) can erode creativity & entrepreneurship. A right MCS improves the desirable assurance or degree of certainty of success of achieving organizational objective. A MCS should fit with the organizations internal & external environment to a considerable extent. It also involves identifying the role of each individual from CEO to each employee at the lowest level in achieving organizational goals.

 Designing an MCS involves an understanding of expectations from the organizational units and employees in terms of Key actions ( what activities the unit must perform), or the Key results ( the outcome the unit must achieve for the organization to succeed) or both. Problems may arise due to lack of knowledge of expectations of actions and / or results, lack of motivation to perform as expected, and lack of capability to perform as expected. It is also important to anticipate the likely actions and results in absence of the control system.
Depending on the degree of variance between the desired and the likely, and the costs of control, the management has to make a choice from the control alternatives & the extent of control tightness or looseness.

Control Alternatives
Based on object of control, the classification of controls can be done into Action Control, Results Control , and Personnel / Cultural control These types of controls are not mutually exclusive substitutes. A single type of control type of control cannot usually address all problem areas & hence various types of control coexist in an organization. Set of control alternatives is based on analysis of the structural & contextual factors which influence MCS and also making a cost-benefit analysis.
( Positive benefit of controls include the extent to which variance between desired and likely action or result is minimized. Harmful behavioral side effect of control can be depletion of trust among managers & employees)

 After deciding on the set of control alternatives, the organizations policies and practices should be framed to fit control alternatives. This has significant implication for HR management e.g; employee selection criteria, performance appraisal, and design of reward systems.

Personnel / cultural controls

Personnel / cultural controls are primary control alternatives usually in situations where, by selecting the right people and placing them in right jobs, by providing training, by creating a conducive culture, and by designing group based reward systems, it is possible to address most of the problems which come in the way of attaining organizational objectives. The variance between the desired and the likely outcomes can be restricted by encouraging an environment where employees monitor them selves and their peers.
This type of control incurs lower monetary costs & usually has less harmful side effects. Before considering other types of control, an organization should first assess the extent to which these controls may be used.

 Small, single business organizations find it easier to use tight personnel / cultural controls compared to large multibusiness establishments. These controls work only when employees have clearly defined roles, understand their goals & expected performance levels. Lack of formal accountability for actions and their results may make employees too sure of themselves and may also result in a loss of direction and a decrease in effectiveness or efficiency. Tight control based only on personnel / culture controls is not easy to achieve as these controls could get affected by environmental changes. In order to achieve tightness of control, personnel / cultural control are usually used alongside Action controls and/ or Result controls , depending on given setting.

Action Control
Action control try to ensure that the activities that individual or the organizational unit undertakes, themselves are in line with the objectives , so that results need not be monitored. Tight action control is achieved when only those activities are allowed which are beneficial to the organization and detrimental activities are prevented.
Identification of key actions at each individual / units level is an important requirement. Key actions differ from firm to firm. For lower level employees, such as production lines personnel, KAs are easy to identify because they are routinized and mechanical. KAs of higher level employees which involve identification of problems, team building, making investment decisions may not be easily understood as they need professional judgment & it is not easy to judge whether actions taken are appropriate. However most companies have standard set of actions for investment proposals / business plans.

Action controls work on the standard sets of procedures. The advantages of action controls are: They are directly linked to the task being performed. They direct managerial attention towards the actions within the firm. Their application in an organization is uniform in nature and hence they aid in organizational co-ordination. Even when key managers leave the organization, action control guides organizational process. They help in attaining efficiency, as they are a key element in the bureaucratic form of organization These controls also have their own disadvantages
Useful primarily routinized jobs

 This type of controls do not foster creativity & innovation, as employees follow rigid rules Because of the rigidity of rules, companies have difficulty in adapting to the changing external business environment.. The various sub-classification of action control behavioral restrictions, pre-action appraisal , and action accountability. Rewards & punishments are integral part of controls in form of action accountability.

Result Controls
Result controls are directly focused the output of actions. Result controls are useful , if the outcome from actions can be assessed or measured, even in situations in which accepted norms for actions can not be formed or are difficult to enforce or knowledge as to what actions are desirable is lacking. These controls do not restrict creativity as they do not place limits on actions. Employees are given the authority to use their discretion. This leads to greater dedication among employees towards their role in the organization. They can make mistakes as long these provide valuable on-the-job training.

 The information which needs to be generated for Result control are very often already exists as it is also needed for financial reporting & strategic planning. Hence costs additional involved are generally less than Action controls. However, pecuniary costs relating to performance bonuses should be added. Result controls, in order to be tight ,require setting of targets against which performance /output / outcome may be measured. These targets should be realistic and in congruence with the organizational goal. A well designed reward- punishment ( individual or group) system is required for meeting or not meeting targets. These targets should be set in consultation with individual employees.

 Results controls should take into consideration the fact that results may be affected by factors external to the organization and beyond the skill or motivation level of employees. One disadvantage could be that erroneously any problem/ deficiency that arises as a result of this control is attributed to employees mistake. Emphasis on measurable outcomes does not mean that important qualitative aspects should be ignored. IN THE MEDIUM TERM, REWARD SYSTEMS BASED ON RESULTS ( Result Control) HELP IN ATTRACTING HIGH PERFORMERS (PERSONNEL CONTROL) and nurturing a performance culture ( cultural control)

 Control Alternatives & their impact on HRM

 Classification of MCS based on Time of implementation of Controls

Open loop : Organization has a plan for achieving a set of goals / objectives, but does not have a system for adjustments to plan once the activities have commenced. It is not feasible or economical to monitor outcomes at regular interval & taking actions if deviation occur. Closed loop Control
Feed back control : deviations from plan are measured periodically , and if significant corrections to the plan are applied to next cycle. Most important aspect of feed back control process is the diagnosis of the reasons for deviations & development of strategies to avoid them in future. Feed Forward control: Continuously scrutinizing various processes & environment . Proactively modifications are made to either process or environment or both as need arises. Feed forward is anticipatory type control cash flow forecasting management systems, feed forward inventory management systems

 Managerial styles of managing employees

External control : works on premise that subordinates can be motivated through rewards this is authoritative style
Set difficult goals so that employees have to stretch Form strict regulations Assessment systems with attractive rewards / punishment

Internal Control : belief that subordinates will be motivated & committed if they are involved in decision making process. They will experience a sense of achievement, recognition & self esteem Mixed control

 Organizational Structure : assigns employees to specific value creation tasks and roles and specifies how these are to be linked together in a way to improve competitive advantage. Structure coordinates and integrate efforts of employees at all levels - and across a companys functions and business units so that they work together to achieve specific set of strategies. Structure help institutionalize the strategy. Structure brings balance between need for specialization (specific competencies) to develop functional competencies and the need for integration . Managers also use reward systems, planning processes, information and budgetary systems to bring greater efficiency

 Structure serves as a means to centralize and decentralize authority and responsibility according to the organizational and control needs of the strategy

Structural types
Structures define the levels and roles in an organization. In turn, structures facilitate or constraint how the processes and relationships work. Each structure type might be suited a particular type of business environment, where rapid change, growing uncertainty, the power of knowledge and globalization are norms rather than exception.

 Organizational culture is the specific collection of values, norms, beliefs, and attitudes shared by people and groups in an organization that control the way they interact with each other and with stakeholders outside the organizations. If organizational control has an impact on how a particular kind of organizational structure will work, the organizational culture has a major influence which determines how both structure and control will work in practice. Organizational design identifies right organizational structure and control systems for integrating people, information and technology of an organization.

Types of Organizations : based on type of structures

The Functional structure A functional organization is based
on the primary activities that have to be undertaken by an organization such as production, finance and accounting, marketing, HR etc. A Manager is assigned responsibility for each function.

The Business Unit Structure OR Multidivisional structure - Is built up of separate Business Unit or divisions on
the basis of products, services or geographical areas . Business unit managers are responsible for most activities of their particular unit ( or division) . The Business Unit functions as semiindependent part of the company.

The Matrix Structure is a combination of structures which

could take the form of Product and Geographical divisions OR Functional and Divisional structures operating in tandem. Team based structures Project-based structures

Functional Organizations
Involves notion of a manager who brings specialized knowledge to bear on decisions related to a specific function. Hence likely to make better decisions in his field as contrasted to generalist manager & better supervise subordinates in that function. There is no unambiguous way of determining the effectiveness of the separate functional managers ( e.g., the managers of marketing and of production) because each function jointly contributes to the organizations success. Functional organizations tend to create silos for each function, there by obstructing cross-functional coordination in areas such as new product development. Disputes between lower level employees of two different functions , who may be working side by side, can not be easily resolved since they have to travel up the two functional hierarchies up to the top. Functional structures are inadequate for a firm with very diverse products and markets. Functional managers with sound equally good understanding of diverse businesses & geography may be difficult to get.

Business Unit or Divisional structure

A Business Unit , also called a division, is responsible for all the functions involved in producing and marketing a specified product line. A clear-cut nature of profit responsibility is apparent. Although business unit managers exercise broad authority over their units, Headquarters certain key prerogatives, allocating funds, approving budgets , judging performance of BU managers & determining their compensations, managing public relations, legal affairs, treasury matters, policies in area of HR etc. This form of structure provides training ground in general management, bringing in entrepreneurial spirit that characterizes the CEO s.
Business unit is closer to the market than HQ is, its manager may make sounder production and marketing decisions.

 Disadvantage of BU structure could be the possibility that each BU staff duplicate some work that in a functional organization is done at HQ, providing economy of scale. Business Unit manager who is a generalist has to handle issues of subordinates who could be functional specialists. There may be issues around one business infringing upon the charter of another, leading to disputes between two business units.

 Matrix structures are quite common with global / multinationals. For example , a multi-national may prefer geographically defined territories or divisions as the operating unit for local market ( because of their specialist local knowledge of customer). But at the same time they still may want global product divisions responsible for world-wide co-ordination of product development, distribution to these geographical divisions In professional services organizations, project management consultancy organizations also Matrix Structures are very commonly deployed. Matrix structure due to dual channels of authority, responsibility may lead to degree of conflict, chances of unclear job-task and cost-profit responsibilities, longer time to take decisions etc

Issues with Matrix Functional personnel Vs Program manager Additional layer of management Problems in identifying responsibility Problems in temporary assignments

Function of Controller
The person who responsible for designing and operating the management control system is referred to a the Controller. In many organization this person has the title Chief Financial Officer (CFO) . The controller usually performs the following functions:
Designing and Operating Control Systems & Information systems. Prior to the advent of computers, the Controller ( or CFO) was usually responsible for processing the information required for Management Control systems. Now, CIO have this responsibility. Preparing financial statements & financial reports ( including tax returns) for share holders & other external parties. Preparing & analyzing performance reports, and analyzing programs & budget proposals from the various segments of the company & consolidating them into overall annual budget.

 Supervising accounting control procedures, performing operational audits & arranging internal audits. Ensuring the integrity of the accounting system , and safeguarding company assets from theft and fraud. Developing personnel in the controller organization& promote understanding of the controller function amongst management personnel.

The controllership function is a staff function i.e., advisory, it may recommend actions to management. But use the of information generated by MCS is the responsibility of line management. Controller does enforce or make management decisions in primary activities of the company..
Controller does make decision , primarily those that implement policies decided on by the line management. (e.g., propriety of expenses listed on a travel voucher). Controller plays a vital role in Strategic planning, budgeting & hence is a part of top management.

The Business Unit Controller

Decentralized responsibility centers have Business Unit Controller (BUC) BUCs may report to the Corporate Controller ( with dotted line relationship with Business GM ) or Business Unit manager ( with dotted line report to Corporate)
Corporate Controller Corporate Controller

Business Unit manager

Business Unit manager

BUC

BUC

Pros & Cons of reporting relationships

BUC reporting to Corporate Controller Business Unit manager treats the BUC as a spy from HQ BUC reporting to the BU General manager BUC may try to hide facts from Corporate Controller

Key Success Variables

The top management cannot look into all the parameters that might create problems for the performance of the organization They choose and monitor few critical measures which would indicate the potential problems in Performance measures Those critical parameters are called key success variables

Concept of Key Success Variables

A key variable is a significant indicator of business activity ( present performance or the likely future performance). Any change in its value is expected to have an impact on organizations performance. Hence every organization should identify key variable , as they are indicators /fore warning to its likely success or failure. Goals, strategies & objectives of the management are most sensitive to the key variables. Key variables differ from organization to organization, depending on the nature of the task, technology used & the environment of the organization. Key variables have certain characteristics that help managers to identify them. Their actual selection requires a thorough understanding of the business, its operating environment & management goal.

 The management can identify key variables either for the whole organization or for major responsibility centers. Common characteristics of Key variables are as follows: They are important in explaining success or failure of the business unit. Can be identified by analyzing those strategic factors that directly influence attainment of business goal by in-depth evaluation of possible variables that affect the strategic factors. They must be measurable , either directly or via a surrogate or substitute. For example, client satisfaction for a non-profit counseling organization can not be measured directly , but a surrogate such as number of follow-up appointments or cancellations, can be selected as a key variable.

 Key success variables are volatile; often for reasons beyond control of the manager Changes in Key variables are not easily predictable. Management action is required when a significant change occurs in any key variable, The manager should select as many key variables as required to run the business , possibly two or three but no more than six. If too many selected then significance of each diminishes. Predictable variables are of little use as key variables . If predictable, then appropriate planning should take care of them in advance.

Identifying Key Variables

The most common method of identifying key variables is input-through put-output model. The input variables are related to raw materials; the throughput variables to production, processing and manufacturing, and the output variables to marketing. A generalized list of key variables is given below.

Identifying Key Variables

Key input variables could include the following: Raw Materials

Raw material availability : lack of timely availability leads to lower capacity utilization. Lower capacity utilization leads to difficulty to recover firms fixed costs; losses or even closure of firm. Raw material Quality: critical for quality of the end product, and for the profitability of the firm. Raw material costs : Close watch needs to be kept on raw material costs, particularly when they constitute a large percentage of the total cost

Production Variables the key variables related to production are :

Capacity utilization : Capacity utilization is an important variable and is affected by either marketing variables or procurement variables. What to produce, how much to produce and when to produce are important decisions in Product oriented firms. In service-oriented organizations, it is necessary to decide on appropriate measures to indicate the utilization of resources. Foe e.g., in movie theatre or hotels, % of occupancy is a key indicator of capacity utilization. Yield / production wastage or loss: In manufacturing industries the management should monitor the yield % closely.

 Maintenance: this is crucial to ensure smooth production & better capacity utilization. Preventive maintenance vs breakdown maintenance. Costs : Appropriate measures indicating the impact of costs should be developed. Delivery : Timely delivery is critical important & very crucial particularly when item is perishable.

Marketing Variables: some important marketing variables are:

Order book position : The order book position in very important for made-to-order manufacturing. Crucial for Capital goods, engineering projects . Planning & scheduling is helped by healthy order book position. Market Share: indicates companys performance & its competitive strength. Institutional Sales: If institutional sales comprise a significant part of total sales, the orders received from institutional buyers is a key variable. A decline in institutional sales is a sign of trouble in the marketing area.

Asset Management Variables : the management of fixed & current assets is important for an organization Asset turnover: A decrease in asset turnover is not a good sign for the organization & needs immediate managerial attention. Working Capital turnover: the inventory turnover and accounts receivable turnover can also help in the analysis of working capital.

Sources of Key Variables

Key variables arise on the basis of some of the following : Industry characteristics: in a given industry, there are certain general requirements for success, which apply to all firms. E.g., In hotel industry , the occupancy rate is the criteria for
success; in Real Estate land bank & its location, liquidity; Labor intensive industriesSoftware per hour

Environmental factors: economic & political factors.

Foreign Exchange Rates Export Oriented Industry Change of interest rate affects demand in interest rate sensitive sectors like Car sales, Home sales

Competitive strategy : The strategy adopted usually determines the variables that must be monitored & emphasized. E.g., low cost strategy will require an strong control on costs - analysis of product cost structure. Discount StoreChains- Retailer supply chain cost Rural players Monsoon

 Stakeholders: key stake holders perspective. These may be different some may want aggressive growth, some may require steady performance & dividend distribution. Significant functions : in function based structure each manager would identify key variables related to function

Control Paradigm
The control system should be designed to fit in with the hierarchical structure of an organization. Centralization vs decentralization. Decentralization gives autonomy to managers of different units of organization. Responsibility centers are set up to co-ordinate & control various activities. Each responsibility centre has its own goals & strategies. Control system designers should help managers to achieve units goals without conflict with overall organizations goals. A control system has two sets of dynamic interactions :
Reinforcing interactions Balancing interaction

 An organization that is open to new ideas and encourages employee creativity & continuous learning can be termed as a learning or adaptive organization. A participative management style supports a learning organization. A study by Kirby on the dynamics of controlling a management team showed following key findings:
Successful teams have a culture of trust & openness. Leaders of successful teams have a shared vision about objectives to be achieved , and use free interchange of ideas to promote better ways of achieving targets Further, this sharing of ideas leads to improved performance and environment which increases team learning. Providing the right feedback also increases the level of trust & openness in the teams.

 The level of trust and openness reduces the gap between current performance and the goal of team members by striving hard. This is referred to as creative tension . In some organizations team members are unable to achieve goals because of distractions on account of ambiguous roles. This is referred a emotional tension

Some Key variables in selected Industries

Sugar Industry
Cost of cane per ton ( including transportation) Number of production days Cane crushing yield Fuel consumed per ton of sugar produced Support price Price of sugar sold in open market Room Occupancy rate Assured Corporate bookings Amount of food wasted in the restaurant % of revenue contributed by the restaurant Number of customer complaints % of absenteeism among employees

Hotel Industry

 Power Industry
Quantity & quality & cost of Coal Availability of wagons for transportation of coal. Availability of water Capacity utilization PLF ( Plant Load Factor) Preventive & breakdown maintenance performance Sale price to Power distribution companies / Open market sale ( PTC)

Insurance Industry
Growth rate of the business Market share Number of policies processed in a given period Number of claims settled in a given period of time & nos of claims settled Return of its investment portfolio

 Publishing industry
Annual subscription rate ( renewals / new subscriptions) Advertising rates of the publishers Annual expenditure incurred for promoting the magazine Size ( pages) of the magazine

Airline
Paid seats / Capacity of the aircraft Fuel cost / miles

 Till sixties, Performance parameters were essentially financial parameters Profitability ROI - Pioneered by Dupont for its Responsibility centers helped them in decentralization

Problems with profitability

Profitability may go up due to some external reasons, which may hide some internal problems Profitability may be higher because of depreciated plant Bajaj Auto Akurdi (1960), Waluj(1985) and Chakan (1999) plants They fail to capture the changing customer requirements Poor profitability does not mean a poor performance

Performance measures
Financial indicators generally show the past performance of the organization A performance measurement system should help the company to understand how it did in the past; how it is performing currently; and how it will do in the future (lagging, current, and leading indicators)

 They should indicate the internal and external performance parameters Multi-dimensional and continuous They are generally called comprehensive performance measurement system

Many western companies have developed such comprehensive performance measurement system ADI, GE The most famous one is Balanced Scorecard

Balanced Scorecard
It covers four aspects in a business entity Financial Perspective, Customer Perspective, Internal Process perspective and Innovation and Learning Perspective It has lead and lag indicators at all the four aspects

Performance indicators
Financial statements and financial ratios are extensively used as tools of financial control P&L account, cash-flow , financial ratios,Liquidity, leverage, turnover, profitability, valuation ratios are all towards financial performance indicators Economic value added ( EVA) Consultants Stern Stewart & co brought this concept, which is now widely used in industry It captures wealth creation by the organisation

EVA
EVA is net operating profit minus an appropriate charge for the opportunity cost of all capital invested in the company. EVA= Net operatiing profit after tax (NOPAT)-(capital x Cost of capital) It does not include income from investment and good will amortization which are non operating in nature

 A sustained increase in EVA will increase the market value of the company and this results in increase in shareholders wealth

How to increase EVA

Improving operating efficiency, so that higher NOPAT can be achieved Invest in capital in projects where the rate of return is greater than cost of capital. Withdraw capital from projects where the return is less than cost of capital.

Advantages of EVA
It makes adjustments to conventional earnings in order to eliminate accounting anomalies and bring them closer to true economic results. Helps in designing compensation system for managers based on EVA It brings goal congruence or matching of employees and shareholders It provides comprehensive information beyond traditional accounting measures like ROA , ROCE, EPS etc.

 Under EVA management system all corporate processes like planning, goal setting, strategic reviews, and incentive compensation, capital budgeting are linked to one measure improving EVA The EVA bonus program helps employees acquire a long term vision

 Limitations It is based on financial accounting methods which can be manipulated Too high emphasis on EVA can result in managers focus on short term results . It may reduce expenditure towards innovation, plant maintenance etc. Companies which are capital intensive and in growth stage EVA compensation system may not suit

Balance Sheet of Indus Ltd ( as on 31 March ,2007) Liabilities Equity Debt Rs Million 200 200 400 Assets Fixed assets Net currents asset Rs Million 250 150 400

P & L Account of Indus Ltd ( year ended 31 March 2007) Rs Miillion

Net Sales
Cost of goods sold PBIT Interest Profit before Tax PBT Tax @50% PAT

400
312 88 20 68 34 34

Cost equity - 20% , Interest rate on debt 10%, Tax rate -50%

NOPAT = PBIT (1 Tax Rate) Capital = Rs (200 + 200) Cost of Capital = [(cost of equity)x (proportion of equity in capital employed)] + [(Pre tax cost of debt)x(1-tax rate)x(proportion of debt in capital employed)] =(20 x 0.5) + 10 x (1-0.5) x 0.5 =10 + 2.5 =12.5% EVA = NOPAT (Capital x cost of capital) = 44 (400 x 12.5%) = 44 50 =-6 Negative EVA value indicates company failed to create Shareholder Wealth.

Inadequacy of accounting profit

It doesn't measure the impact of all the constituencies that are important to the success of the business eg employees, suppliers and government The values assigned as per GAAP do not recognize change the values as per economy. They do not reflect accurately the future economic prospects of the firm

 EVA is almost a tailor made performance metric for the knowledge industries Lack of correlation between EVA and MVA in sunrise sectors then can be attributed to improper market valuation techniques

How to achieve better EVA? Companies have to acquire the expertise to manage their cost of capital. They need to explore emerging sources of finance that can lower their overall cost of capital. They need to focus focus on ROCE They need to understand that there is more to value addition than mere post tax profits

Responsibility Structure
Responsibility Structure is a collection of responsibility centers ( and related performance measurement system)..Responsibility centers constitute the structure of a control system. The responsibility structure includes an accounting system. Responsibility accounting is a system of management accounting which helps managers to record the plans and performances of the responsibility center for which the manager is accountable. Responsibility center is defined as a segment of an organization where an individual manager is held responsible for the segments performance. It is a function, division , or unit of an organization headed by a manager who is directly answerable for its performance.

 Performance evaluation of each of these centers is done on certain criteria ( specific to each type of center) to assess & pinpoint its contribution towards achievement of goals of the organization as a whole. Measurement of performance of a responsibility center is done through cost, profit, revenue, investment and quality goals set by the organization. Responsibility accounting systems information to be used directly in motivating & controlling the manager in charge of the responsibility center. While designing the responsibility structures & performance measurement systems, two major aspects to be considered are controllability and goal congruence.

 The controllability principle says that each manager should be assessed and rewarded only for those factors that are under his control. Goal congruence is achieved when managers ( and employees) , while working towards their best self interest as perceived by themselves, take decisions that are successful in attaining over all organizational goal This is achieved when individual & organizations goal are aligned. Transfer pricing is a tool used in responsibility accounting to assign monetary values to transactions taking place between two or more responsibility centers.

Hierarchy of Responsibility Centres The responsibility centers form a hierarchy. At the lowest level are the centers for sections, work shifts, and other small organizational units. Departments or business units comprising of several of these smaller units are higher in the hierarchy. From board of directors standpoint, the entire company is a responsibility center, though the term is usually used to refer units within the company.

NATURE OF RESPONSIBILITY CENTRES

Responsibility centers receive INPUTS in the form of material, labor, and services. Using working capital ( e.g; inventory, receivables), equipment , and other assets, the responsibility centre performs its particular function.

In a PRODUCTION Plant the OUTPUTS are Goods ( tangible).

In STAFF units, such as HR, engineering, accounting, transportation , and administration , the OUTPUT are SERVICES

Goods & services produced by a responsibility center may go to another center Where they are inputs, OR outside marketplace, where they are outputs of the Organization as a whole.

INPUTS WORK (Resources used measured by cost)

OUTPUTS ( GOODS or SERVICES)

Relationship between INPUTS and OUTPUTS

In some responsibility centers, the relationship between inputs and outputs is causal and direct, as in production centers In many situations, however, inputs are not directly related to outputs. Advertisement expense as input are intended to increase sales revenue. But since revenue is affected by many other factors other than advertising, there is no exact direct relationship. Management has to use judgement.

ENGINEERED EXPENSE CENTERS

Optimal relationship Can be established

Manufacturing function OUTPUT

INPUT (dollar) WORK

(physical)

Discretionary EXPENSE CENTERS

Optimal relationship Cannot be established

R&D function OUTPUT

INPUT
(dollar) WORK

(physical)

Expense Centers two types

In engineered expense centers, it is possible to estimate the right amount of costs that should be incurred to produce a given level of output. In Discretionary expense centers, budgets describe the amount that can be spent, but not possible to determine exactly the optimum level of these expenses.

Performance measurement - Efficiency and Effectiveness

Performance of a responsibility centre can be judged using effectiveness and efficiency criteria Efficiency ratio of outputs to input or the amount of output per unit of input Not always expressed in absolute terms can be in relative terms

Effectiveness Ability to meet the objectives - relationship

between responsibility centers output and its objectives/goals

Efficiency- doing things right Effectiveness Doing the right things

Profit is a measure of both efficiency and effectiveness

 Expense centers are responsibility centers whose inputs are measured in monetary terms, but whose outputs are not. There are two general types of expense centers :
Engineered costs right amount of inputs ( like labor, material, utilities etc) can be estimated with reasonable reliability for a given output. Discretionary costs are those for which no such engineered estimate is feasible. Managements judgment appropriate amount of input under the circumstances to deliver the desired output.

Types of Discretionary expense Centers ( DECs)

The principal types of discretionary expense centers are: Administrative and support centers ( like Administration function, Finance function, legal function etc) R & D centers Marketing Centers

Budget preparation prepared by determining the

broad magnitude of the job to be done.

Control issues with Discretionary Expense centers

Work done by DECs fall in two categories:. Continuing work -done consistently from year to year and special works- once off projects The planning function for DECs is usually carried out in one of the two ways
Incremental budgeting OR zero-base budgeting

Control Issues with DECs Measuring performance

In DECs , generally there is a difficulty in measuring output. financial control is primarily exercised at the planning stage before the costs are incurred. Getting the desired output and spending an amount that is on budget is considered satisfactory. However, in DECs as opposed to Engineered cost centers, the financial performance report is not a means for evaluating the efficiency of a manager. Complete control over DECs is achieved primarily through non-financial performance measures. For example , the best indication of the quality of service for some DECs may be the opinion of their users.

Control Issues with DECs Lack of Goal Congruence

Typically, managers of DECs say Administrative & support offices, R&D centers will strive for functional excellence ( like building the best research organization money can buy, perfect legal department etc ) Superficially this may look like goal congruence, the ideal function or department may be too costly relative to the additional profits that perfection may generate. The severity of the two problems difficulty of measuring output and lack of goal congruence is directly related to the size & prosperity of the company.

Responsibility Center
Functional Organization Revenue and Expenditure centers

REVENUE CENTERS

Inputs not related to outputs

Marketing func INPUTS (dollar only for costs directly incurred) WORK OUTPUTS (dollar revenue)

PROFIT CENTERS
Inputs are related to outputs Business Unit

INPUTS
(dollar costs) WORK

OUTPUTS (dollar profit)

Revenue Centers
In a Revenue center, output ( i.e., revenue) is measured in monetary terms but no formal attempt is made to relate input ( i.e., expense or cost) to output.
expense was matched with revenue, the unit will be a profit center) ( if

Typically revenue centers are Sales units that do not have authority to set selling prices and are not charged for the cost of goods they market. Actual sales or order booked are measured against budgets or quotas, and the manager is held accountable for expenses incurred directly within his unit, but primary measurement is revenue.

Profit centers
A Responsibility center for which performance is measured in terms of profit, i.e. by the difference between revenues and expenses , is called a Profit Center. A profit centre, thus is any organizational unit in which, both revenues and expenses are measured in monetary terms , and the manager has control over both the input ( cost of resources) as well as the output ( revenue earned)
Profit centers are not synonymous with business units . Trend towards converting traditional cost centers into profit centers ( e.g; I T departments)

PROFIT CENTERS
Inputs are related to outputs

INPUTS
(dollar costs) WORK

OUTPUTS (dollar profit)

 Business Units are mostly created as Profit Centers since managers in charge of such units typically control product development, manufacturing, and marketing resources. This managers are in a position to influence revenues and costs and as such can be held accountable for the bottom line Managements decision as to whether a given unit should be a profit center is based on the amount of influence ( even if not total control) the units manager exercise over the activities that affect bottom line. In setting up a profit center, a company devolves decision making power to those lower levels that possess relevant information for making expense / revenue trade-offs.

Advantages of Profit Centers

Establishing organizational units as profit centers can
increase the speed of decision making, improve the quality of decisions, HQ management relieved of day-to-day management decision making, can concentrate on more broader / strategic issues Because Profit centers are similar to independent companies, they provide excellent training ground for general managers Profit consciousness is enhanced, managers will seek ways to increase it Profit centers provide top management with ready information on the profitability of companys individual components ( help judge competitive performance.).

SOME disadvantages : decentralization , some loss of control of HQ, possible friction on arguments over appropriate transfer pricing, internal rivalry between subunits , possible loss of scale.

Conditions for helping profit center creation

Right to make all operational decisions Full access to relevant information to make the optimum revenue / cost tradeoffs A clear transfer pricing policy in case inter divisional dependence . The transfer price charged to the profit center should be based on standard cost, rather than the actual cost.

Functional Units as Profit centers

Is it possible?
Marketing department can be turned into profit
center

By charging a standard price for the cost of products sold, based on the quality Why should a marketing division made as profit center?
When the marketing manager is the best position to make the principal cost / revenue trade-offs.

 For example , for a company, which has foreign marketing activity in several countries, it is difficult to control from HQ,
how to market a product, how to set price, how much to spend on sales promotion, when to spend, which media How to train dealers

It is best to turn marketing activity into a profit center in foreign country

Why Manufacturing units as profit centers? Manufacturing units

Manufacturing activity is usually a expense center, with manager being judged on performance versus standard costs and overhead budgets. The above measure does not necessarily indicate how well the manager is performing on all aspects of his job. For example
A manager may reduce quality to obtain standard cost credit A manager may be reluctant to interrupt production schedule in order to accommodate a key customer need A manager may lack incentive to manufacture products that are difficult to produce

Therefore advisable to make separate evaluation of other factors

Manufacturing as profit center To convert manufacturing unit in its entirety to a profit center and give it credit for the selling price of products minus estimated marketing expenses. Calculate the profit after adjusting for marketing expenses

What about other support and service units? Not all can be made as profit center

Transfer pricing
Large companies , in practice, are often divisionalized, for having better control over them. Todays organizational thinking is towards decentralization. There is likely to be transfer of goods or services from one division to another OR between one profit center or investment center, to another profit center or investment center in the same division or company.. If two or more profit centers are jointly responsible for product development, manufacturing , and marketing, each share in the revenue generated when the product is finally sold. The transfer price is the mechanism for distributing this revenue.

 Transfer price is the price at which the supplying division/ profit center / investment center PRICES ( charges) its transfer of output to the user entity. As it is only internal transfer and not a sale, transfer price is different from the normal sales price. The Transfer price charged is the revenue to the selling division / profit center /responsibility center AND cost to the buying entity. Thus, the price charged affects the profit of both, the selling as well as buying entity. In fact, the benefit ( revenue) to one division ( or profit center) can be created at the expense of the other division or profit center. The transfer pricing thus affects financial performance of different divisions / profit centers. Hence it should be free from all the biases, and has to be as equitable as possible to the different divisions / profit centers in the company concerned .

Some criteria for designing of transfer pricing system

Transfer price should help in accurate measurement of divisional or profit center economic performance. Transfer pricing should motivate the divisional/profit center managers into maximizing the profitability of their division / profit centers and make decisions which are in the best interest of the organization as a whole ( goal congruence business unit profit will also improve company profit). The transfer pricing system should ensure that divisional autonomy and authority is preserved &all relevant information to determine optimum trade offs between company costs and revenues provided. The system should be simple to understand and easy to administer. International groups may resort to manipulation of transfer pricing between countries with a view to minimize the overall tax burden.

 Two decisions are involved in designing a transfer price system.

First is the sourcing decision: should the company

produce the product inside the company or purchase it from outside?. Second is the transfer price decision : At what price should the product be transferred between profit centers?

The Ideal situation

A market price based transfer price will induce goal congruence if all the following conditions exist in practice
Competent people Good atmosphere sense of fairness, judgment A market price : the market price could be adjusted downward to reflect savings accruing to the selling unit from dealing inside the company. For example saving in advertising and selling costs, fear of bad debt Freedom from source : managers should be permitted to choose alternatives that exist Full information : managers must know about the available alternatives and relative costs and revenues of each. Mechanism for negotiation

 Constraints on sourcing Limited Markets Excess or Shortage of Industry Capacity

 Several methods are used for transfer pricing. However, there are two basic approaches to determination of transfer price. They are : (i) Market based; (ii) Cost based.

Market Price
Most popular method of determining transfer pricing is the market price. When there is a well established market for the goods or services to be transferred, it can be easily determined on the market price basis. However, such market price should be taken as ceiling limit for transfer price. When transfer price is at market price, the profit center or divisional performances are more likely to represent the real economic contribution of the division to total company profit.

 Deviations may be allowed

Highly specialized products and ready market does not exist Consideration of advantage of economies of scale in production When consideration of taxation are applicable

Advantages of Market based transfer pricing

Most simple & easy to understand Minimizing the complication for performance evaluation Reduce points of conflict between various divisions

 Cost based Prices a)Variable Cost b)Actual Cost : transfer at full cost of production. However, it is quite appropriate for profit center analysis. c) Cost plus a normal mark-up : but can be arbitrary or questionable. d)Standard cost: encourages efficiency in selling division e)Opportunity Cost f) Negotiated price

 Dual prices Two step Prices

Cost based pricing

Cost plus profit Problems How to calculate the cost and the profit ? Actual cost or standard cost ? What about the fixed cost

Limitations
Negotiations has to happen in a fully informed environment

Example issues - determining transfer price

The Apparels division of Fortune Apparels uses yarn from Fortune Yarns, the spinning division, which is operating at full capacity. The yarns division sells part of its output to regular outside customers at Rs 15 per unit. Apparels division, which sells its products in the open market only, has offered Rs 10 per unit to the Yarn division & wants this to be transfer price . The cost structure of Apparel division is estimated as: Selling price Rs 100 Cost structure ( total cost) Rs 95
Outside supplies Fortune Yarn supplies Other variable costs Fixed overheads Rs 40 Rs 10* Rs 30 Rs 15

Estimated surplus per unit

Rs 5

 Apparel division is operating at about 50% of its capacity and the divisional management believes that a saving of Rs 5 per unit of yarn which is a major part of the Apparel divisions input, can give it a price advantage in the market and will be able to increase its capacity utilization if selling price is reduced by Rs 5 per unit. 1. Assuming that you are the divisional manager of Fortune Yarns, will agree to selling yarn at Rs10,000 to Apparel Division? Why or why not? 2. Can you evaluate the management issue involved in this situation? What will be your stand if you were the President of Fortune Company?

 The nature of Rs 15 per unit fixed cost is the key to the question of deciding what is good for Apparel division. These costs are to be incurred, irrespective of the volume of operations. Thus, even if the yarn in purchased at Rs 15 per unit and a price cut of Rs 5 is effect to increase the sales the contribution will still be positive as shown below: Selling price Rs 95 Less:
Outside supplies Fortune Yarns supplies Other Variable costs -Rs 40 - Rs 15 - Rs 30

Contribution margin

Rs 10

 The Apparel division has a positive contribution of Rs 10 per unit even after obtaining at the market price & effecting the required reduction in price to gain increased sales volume is still possible. Correct analysis will show that it is not necessary to obtain Rs5 relaxation from Yarn division to make a price reduction possible. Increased volume will in fact reduce per unit fixed cost.. The best interest of the Fortune company is served by the apparel division effecting a price cut to increase sales volume & thereby reduce per unit incidence of fixed costs. Forcing the Yarn division to supply at Rs 10 per unit is not a valid argument since there is no real advantage to the company as a whole.

 As the President of the company one would ask the Apparel division to look elsewhere for maximizing the margin rather than artificially increasing the same by temporary bail out by another division.

Transfer Pricing
Inter divisional/departmental pricing Fundamental principle Transfer pricing should be similar to the price that would be charged if the product were to be sold to outside customers or purchased from outside vendors

Profit sharing
Product is transferred to the buying unit at standard variable cost After the product is sold, the business units share the contribution earned

Limitations
How to divide the profits is a contentious issue Works against the principle of decentralization The individual department may blame each other for the inability to attain target

Two sets of pricing

Calculate the profit of Mfg unit based on the final selling price and the actual cost (excluding marketing cost) Calculate the profit of Selling unit based on standard production cost

Limitations
Sum of business unit profits are greater than the organizations profit. It may create problems in budgeting Company might be making losses while the individual business units make profits

Negotiation
Divisions fix transfer price through negotiations Full information should be available to all the department A well defined conflict resolution mechanism

Transfer pricing of services

Standard variable cost Problems - ICICI Bank Full cost Problems Railways Market price Problems SPIC SMO

Cash
Cash balances are lesser with Business Units They are only the float between daily receipts and daily disbursements Hence certain percentage sales is taken as cash balance Why include higher cash than balance? To compare with outside companies

Receivables
Managers can influence the level of accounts receivables Whether to include accounts receivable at selling price or at the cost of goods sold

Inventories
FIFO or LIFO Whether to deduct accounts payable from inventory

INVESTMENT CENTERS
Profits are related to Capital employed

INPUTS
(dollar costs) CAPITAL EMPLOYED

Business Unit OUTPUTS (dollar profits)

Investment Centers
A special category of profit center where the manager is given authority to make investment decisions Measures Return of on Investment (ROI) EVA

Property, Plant and Equipment

Depreciation methods Disposition of Assets Leased Assets Idle assets Intangible assets

Budget as an Instrument of Control

A budget is a financial & quantitative statement , prepared and approved, prior to a defined period of time, of the policy to be pursued during that period for the purpose of attaining a given objective. Budgeting refers to the process of designing, implementing and operating budgets. Budgetary control refers to the establishment of budgets that relate the responsibilities of the executives to the requirement of a policy, and the comparison of actual results with budgeted figures, either to secure by individual action the objective of the policy or to provide a basis for its revision.

Nature of a Budget
Budgets are an important tool for effective short term planning and control in organizations. Characteristics of budgets: 1. A budget estimates the profit potential of business unit 2. Stated in Monetary terms (backed by nonmonetary measures like units sold etc). 3. Operative budgets usually covers one year 4. It is a Management commitment (like MOU); managers accept responsibility for attaining budgeted objectives.

5. Budget proposal are reviewed and approved by an higher authority than budgetee. 6. Once approved can be changed only under specified circumstances. 7. Periodic actual performance review vs budget and variance are analyzed and explained.

Uses of a budget
Fine tuning of strategic plan Strategic plan prepared in fairly broad terms. Budget provides opportunity to take into account latest inputs & fine tuning before a firm commitment on resources are made. Participation of larger set of employees than for strategic planning. Coordination every responsibility center manager participates in budget preparation, it ensures that the plans for different units / functions of the organization are in sync to achieve overall objectives. Inconsistencies smoothened out. Assigning responsibility the approved budget authorizes responsibility center managers to spend specified amounts of money for designated purpose Basis for performance evaluation. budgeting process helps in the drive towards continuous improvement.

Types of BUDGETS
REVENUE BUDGETS Production cost & cost of sale budget(COGS) Marketing expenses budget General admin budget R& D budget Capital budget Budgeted balance sheet Budgeted cash flow

Master Budget

Capital Budget Operating Budgets Financial Budgets Cash Budgets

Budgeted Balance Sheet

Operating Budget
For organization as a whole and for each business unit Classified by responsibility center Typically includes:
Revenues Production costs& cost of sales Marketing expenses Logistic expenses General & administrative R&D Income Tax ( some times) Net income

Capital Budget
Each major capital project listed separately

Expenses may be
Flexible or discretionary or fixed

For one year ( divided monthly or quarterly) ( reconciled with strategic

plan)

Long term investments Total project expenditures by quarter

CASH Forecast Budgeted Balance Sheet

Operating Budget categories Revenue Budgets:

A Revenue budget consists of Unit sales projection multiplied by expected selling prices. Of all elements of a profit budget, Revenue budget is most critical & is also subjected to most uncertainty ( market forces, state of economy etc). Also the amount of budgeted revenues influences the amount of many other items of budget. Usually based on forecasts by sales managers & their teams, anticipated state of economy etc.

Budgeted production cost & cost of sales :

budgeted production multiplied by standard cost is taken as budgeted production cost.

 Marketing Expenses are incurred o obtain sale ( includes hiring & training sales force, advertisement etc) Logistics expenses usually are reported separately from order getting expenses. They include order entry, warehousing , order picking, transportation to the customer, and collection of accounts receivable. Many of these are engineered costs. General and Administrative expenses - pertain to staff functions both at HQ and business units. Most of these are discretionary expenses , although some components are engineered expenses. These items are much debated before approval. R &D Expenses Income Tax - corporate HQ may make policies affecting I .Tax outgo

Other Budgets
Capital budget: states the approved capital projects plus a lump sum for small projects that do not require highlevel approval. IT is usually prepared separately from the operating budget and by different people. Capital budgets are often part of the strategic planning process. An estimate of cash that that will be spent each quarter is prepared, which is goes into making of the Cash Flow statement. Budgeted balance sheet : It shows the implications of the items included in the operating budget & capital budget. It also projects the sources and uses of financial resources. Over all it is not a management control device, but some part of it is useful for control. Operating managers who can
influence the level of inventories, accounts receivable, or accounts payable are often held responsible for the level of these items.

Budgeted cash flow Statement The budgeted cash flow statement shows how much of cash needs during the year will be supplied by retained earnings and how much, if any, must be obtained by borrowings or from other outside sources (usually by quarters). This is important for financial planning. from borrowing or other outside sources. The treasurer needs an estimate of cash requirements for monthly ( or even shorter) intervals a basis for planning line of credit and short term borrowings.

Budget preparation process

Budget department:
Publishes procedures and forms for preparation of budget Basic Assumptions e.g., about economy , competition. Assistance to budgetees in budget preparation Analyse proposed budgets ,make recommends to budgetee & later to senior management Administers the process of making budget revisions Analyses performance vs budget at the intervals specified

 Budget committee:
Consists of senior members of management (CEO,CFO,Dept heads etc). It reviews and either approves or adjusts each of the budgets proposed by budgetee. For divisional structures each SBU head may meet the budget committee and finalize the budget

 Issue of guidelines Strategic plan provides inputs in developing guidelines that govern the preparation of budget. Like assumed inflation in general & inflation specific for items like wages, policies for promotion / compensation, employee benefit Initial budget proposals using the guidelines, responsibility centre managers, assisted by their staff , prepare initial budget. Generally starting point is based on current level of performance , modified in accordance with guidelines & taking into account
Changes in external forces. Changes in internal policies and practices. Negotiation budgetee discusses with superior who judges validity of proposals / looks for improvement over past. This is heart of the process. Superior will become the budgetee at next level of the budget process.

 Review and approval - proposed budgets go

through successive levels in the organization. Till they reach the top of a business unit. Studied for consistency between different parts of the unit & overall profitability. Final approval is recommended by the budget committee to the CEO.

Budget revisions generally must be justified on

the basis of significantly changed conditions from those existing when the original budget was approved.

Contingency budgets - Management action

required if there is a significant change in volume etc, decrease some costs etc

Quantitative techniques:
Simulation

Probability estimates.

Zero based budgeting

All the activities are re-evaluated each time the budget is prepared. Budget preparation for each function starts with the basic premise that each activity is being performed for the first time and that the cost of each activity is zero. What will be the impact or result if the activity is dismantled

 Flexible budget
A static amount is provided for discretionary and committed fixed costs and a variable rate is determined per unit of activity for variable cost. For example: The static part : salaries, depreciation , property tax, planned maintenance. Flexible part : direct material, direct labor, and variable overhead. Costs related to sales commissions & travel

Budget control
Budget control focuses attention on deviation from budget standards and points out where corrective action is necessary. When actual results donot tally with the budget a variance is said to have occurred Overall variance of the business unit is divided in to revenue variance and expense variance

VARIANCE ANALYSIS for control actions Variances occur due to three reasons.
A managerial decision to respond to some new developments which were not initially anticipated Uncontrolled exogenous factors Controllable factors that need to be investigated

Analytical framework for variance analysis

Identify the key causal factors that affect profits. Break down the overall profit variances by these key causal factors Focus on the profit impact of variation in each causal factor Try to calculate the specific, separable impact of each causal factor by varying only that factor while holding other factors constant Add complexity sequentially , one layer at a time, beginning at a very base level Stop process when added complexity is not justified by added useful insight.

VARIANCE ANALYSIS DISAGGREGATION

Total Variance

Non Manufacturing Costs Variance

Manufacturing Costs Variance

Revenue Variance

Adminstrative

Marktng R&D

Variable Cost Variance

Fixed Cost variance

Sales Price Variance

Sales Volume Variance

Sales Mix Sales Quantity Variance Variance Material Direct Labor Variable Variance variance Overhead Variance

Market Share Variance

Market Size Variance

 A thorough Variance Analysis help identify the causes of the variances and the organization unit responsible. This type of analysis is a powerful tool without which the efficacy of profit budget will be limited. Effective systems identify variances down to the lowest level of management. Variances are hierarchical. They begin with the total business unit performance, which is divided into Revenue variances and Cost / expense variances. Revenue variances are further divided into Sales Price and Sales Volume Variances for the total business unit and for each Marketing responsibility center within the unit. They can further be divided by sales area and sales districts. Cost /Expense variances can be divided between manufacturing expenses and Other expenses ( nonmanufacturing).

 Manufacturing expenses can be further sub-divided by factories and sub-units within factories. Hence, it is possible to identify each variance with the individual manager who is responsible for it. This type of analysis is a powerful tool without which the efficacy of profit budget will be limited. The Profit budget is prepared under premise / assumptions about the state of the total industry and about the companys market share., its selling price, and its cost structure. Results from Variance Analysis are more actionable if changes in actual result ( vis--vis budgets) are analyzed against each of these expectations

Revenue Variances Revenue variance - covers selling price, volume, and mix variances. The calculation is made for each product line, and the product line results are then aggregated to calculate total variance. A positive variance is favorable , since it indicates actual profit exceeds budgeted profit. Three principal reasons for deviation from budgeted sales are
Actual price realised is different from the price envisaged at the time of budget formulation Actual sales volume of product sold is different from planned volume Actual sales mix is different from the budgeted sales mix

 Selling price variance: is calculated by multiplying the difference between the actual price and the standard price multiplied by the actual volume

BUDGET FOR Jan'2011

Product A Unit Sales Standard Variable cost: Material labor Variable Over head Total Variable cost Contribution Fixed Costs: Fixed Overhead Selling expense Administrative expense Total fixed Costs PROD B 100* Total Unit $1.00 $100 0.5 0.1 0.2 0.8 $0.20 50 10 20 80 20 25 17 8 50 $2.00 0.7 0.15 0.25 1.1 $0.90 100* Total $200 70 15 25 110 90 25 17 8 50 PROD C Unit $3.00 1.5 0.1 0.2 1.8 $1.20 100* Total $300 $600 TOTAL Budget

150 270 10 35 20 65 180 370 120 $230.00 25 17 8 50 75 50 25 150

Profit Before Tax

($30)

$40

$70

$80

SELLING PRICE VARIANCES, Jan 2011

PRODCT A Actual Volume ( units) Actual Price per unit Budget Price per unit Actual over / (under) budget per unit Favorable / (unfavorable) price var 100 $0.90 1 ($0.10) ($10) B 200 $2.05 2 C 150 $2.50 3 Total

0.05 ($0.50) 10 ($75) ($75)

 Mix and volume variance: Often Mix & volume variances are not separated. The equation for combined mix & volume variances is: Mix & Volme var =
( Actual volume budgeted vol ) *budgeted unit contribution

SALES MIX and VOLUME VARIANCE, Jan 2011 *(1) *(2) *(3) *(4) *(5) *(6)

Actual
Product Volume

Budgeted
Volume

Diff
(2) -(3)

Unit

Variance

Contribution (4)*(5)

A
B C Total

100
200 150 450

100
100 100 300

0
100 50 $0.90 $1.20

0
$90 $60 $150

Separating Mix Variance & Sales Volume Variance

The volume variance results from selling more or less units than budgeted. The Mix variance results from selling a different proportion of products from that assumed in the budget. Since different products earn different contributions per unit, this results in a variance. If the business unit actually sells a richermix ( i.e., a higher proportion of products with a higher contribution margin), the actual profit will be higher than the budgeted profit. The Volume & mix variances are joint, so techniques for separating them are somewhat arbitrary.

MIX Variance Mix Variance = [(Actual Volume of sales) ( total vol of sales * budgeted proportion) * budgeted unit contribution.

MIX VARIANCE, Jan 2011 *(2) *(3) Budgeted PRODUCT Budgeted Production A *1/3 Mix at actual Volume 150 Actual Sales 100 *(4) *(5) *(6) *(7)

Differe nce Unit

Variance

(4) - (3) Contribution (5) * (6) -50 $0.20 ($10)

B
C TOTAL

*1/3
*1/3

150
150 450

200
150 450

50
0

$0.90

$45
0 $35

VOLUME Variance The volume variance can be calculated by subtracting the Mix Variance from the combined mix & volume variance. It can also be calculated for each product as follows: Volme Var= [(Total actual sales volume)*budgeted percentage) (budgeted sales)] * (budgeted contribution) Revenue Variance by Products

Sales Volume Variance,

*(1) *(2) Budgeted

Jan 2011
*(3) *(4) *(5) *(6)

Mix at
Actual PRODUCT A B C Total Volume 150 150 150 450 Budgeted Difference Unit Volume 100 100 100 300 (2) - (3) 50 50 50 150 Contribution $0.20 $0.90 $1.20 Volume Variance $10 $45 $60 $115

Revenue

Variances by PRODUCTS
PRODUCT A B

Jan'11

Total

Price Variance Mix Variance Volume Variance Total

$(10)* $(10)* $10 ($10)

$10 $45 $45 $100

($75) 0 60 ($15)

($75) $35 $115 $75

Market Share(penetration) and Industry Volum Variances The principle is that the business unit manager is responsible for market share , but industry volume is largely influenced by state of the economy. Therefore managers may not be in control of industry wide factors which may be related to economy Market share variance: needs market data Market Share variance = [(Actual sales vol) (Industry vol)* budgeted market share] * Budgeted unit contribution Industry vol variance=[(Actual industry vol budgeted industry vol)*budgeted market share] * budgeted contribution per unit The variance for each product is calculated seperately, and then the sum of variances of all the products give the total variance.

 Expense variance Fixed cost: actual-budgeted Variable cost: The budgeted manufacturing expense is adjusted to the amount that should have been spent at the actual of production by multiplying each element of standard cost for each product by the volume of production for the product.

 Summary of variances to top management Time period comparison Budgeted gross margin: Managers focus on gross margin to take care fluctuation in sales prices in market, effect of inflation on production costs etc. The variance analysis is done by substituting gross margin for the selling prices in the revenue equation. Gross margin is the difference between actual selling prices and the standard manufacturing cost.

Evaluation Standards

Predetermined standards or budgets Historical standards External standards: these are the standards derived from the performance of other responsibility centers or of other companies in the same industry It is also called bench marking

 Although it identifies where a variance occurs , it does' not tell why the variance occurred or what is being done about it. Whether the variance is significantvariance is significant but uncontrollable. (icicibank customer complaints). Problem of aggregation- individual departments performance may be overlooked or un recognised

 Finally reports show only what happened but will not show what is the future repercussion of those actions-short term vs long term Monthly reports should not contain surprises.

 One of the most important benefits of formal reporting is that it provides the desirable pressure on subordinate managers to take corrective action on their own initiative. Profit reports are worthless unless they lead action, compliments /or advice to improve

MSSM
Mutually Supportive management Systems Model (MSSM) 1. Infrastructure 2. Management Style and Culture 3. Rewards 4. Coordination and Integration 5. Control Process

MSSM Formal

MSSM Informal

Indian Bank

Indian bank
Indian Bank was setup in 1907 with an authorized capital of 20 lakh rupees Head quarters in Chennai (Madras) Nationalized in 1969 GoI and RBI introduced prudential norms for banks in 90s

Problems
Employees whose average age is above 40 risk averse -to meet the prudential norms The CMD Gopalakrishnan, in mid nineties lend huge loans to unviable projects which are turned out to be NPAs

Problems
In December 1998, T.S.Ragavan was appointed as CMD. The Bank stopped lending in 1998 Criminal cases were filed against the exCMD and top officials That dented credibility of the bank among the customers Morale of the employees touched the nadir

Problems
In 1998, the bank was given a capital infusion of Rs 1750 crores Another 100 crores in 1999. Nothing changed In 1999-2000 accumulated losses touched Rs 3181.88 crores against the net worth of Rs 2898.63 crores. 44 % of the loans were non-performing in September 1999

 27,000 employees, 1504 branches 3 overseas branch Singapore branch was on the verge of forced closedown Ranjana kumar took over as CMD in May 2000

To bring back control

Realized that bank already had targets to achieve, but not a proper strategy and controls Use all the factors of control it is restructuring

Infrastructure
Merge 119 branches - bring down the number of branches to 1385 Delayering 4 layers Head office, zonal office, regional office and branch Three layers Zonal offices (12) were abolished Regional offices were renamed as circle offices (total 30) VRS was introduced and availed by 3200 employees including 2000 officers

Infrastructure
Earlier all branches were doing all business but all branches were not equipped to conduct risk analysis- particularly commercial lending above Rs 1 crore 66 branches above Rs 1 crore Only 10 of the above 66- corporate branches above Rs 25 crores Most Others - personal banking The rest agricultural banking

Management Style and Culture

Average age of employees 47 years Took MBA students for summer projects- young and energetic people Later hired many of them first time a PSU bank hired MBA directly Employees encouraged to do a door to door mass campaign in holidays to inform people that they are back in business helped the employees to understand the changed customers needs from banks Computerization around 80 % business activities were computerized in 2 years

Control Process
Head office audit committee review the performance all branches that were making repeated losses Credit Monitoring and Review Department to review loan sanctioning and approvals Audit department was given teething powers (earlier it was considered as a punishment department with no powers)

Reward
Revised salary scales were implemented but arrears not paid in one go it was subjected to branch performance The branch managers who performed well were called for a presentation and were appreciated by the top management. They were given appreciation certificates Promotions were based on performance rather than seniority

Reward
Fringe benefits like LTC were cut and would revived subject to banks turn around Training programs for employees on prudential norms and credit risk management SBI training centers

Coordination and communication

All the above actions would result serious opposition from Trade Unions CMD and ED personally traveled all over the country and met employees in all the branches in the disguise of inaugurating training programs (earlier done by the regional managers) addressed themexplained what was happening in the bank-

Coordination and communication

Audio cassettes were made, explaining the reasons for the harsh measures and circulated Minutes of monthly meetings of senior executives were circulated among all the employees

Result
CAR in March 2003 10.85 % against the required norm of 9%. In March 2002 The bank has shown a net profit (Rs 33 crores) for the first time in 8 years In March 2003 Rs 188 crores net profit (Rs 1008 Crore is the net profit for the FY 2008)

How to measure asset base

Measuring asset base of a business unit is more tricky than that of a company

Two step pricing

Two charges One is for standard variable cost Periodic charge for fixed cost associated with the facilities reserved for the buying unit based on negotiations Periodic charge for profits made by the buying unit based on negotiations