NATURE OF MANAGEMENT CONTROL SYSTEMSNATURE OF MANAGEMENT CONTROL SYSTEMSBasic ConceptsBasic Concepts• Control: Devices should be in place to ensure that strategic intentions are achieved Elements of control system:Detector or sensor – to measure actual behaviour Assessor – compare actual with standardEffector – called ‘feedback’, it alters behavior if assessor indicates need to do soCommunications network – transmit information between detector and assessor & assessor and effectorManagementManagement• CEO or team of senior managers decides on overall strategies that enable the organisation to meet its goals• Various business unit managers formulate additional strategies for their respective units subject to CEO’s approval• Number of layers in organisation are based on its Complexity• Management control process is the process where managers at all levels ensure that the people they supervise implement their intended strategies Management Control ProcessesManagement Control Processes• Standard is not preset• Management control is not automatic manager must personally be the assessor• Management control requires coordination among individuals• Connection from perceiving the need for action to determining the action required to obtain the desired result may not be clear System works like a “Black Box• Much management control is self-controlSystemSystem• It is a prescribed and usually repetitious way of carrying out an activity or set of activities• Here, more or less routine decisions are taken for which recurring series of steps are available• Management control systems: far more complex & judgemental rules are not well-defined managers have to use their best judgement to decide on best course of actionManagement ControlManagement Control• It is the process by which managers influence other members of

the organisation to implement organisational strategies• Its activities include: planning coordinating communicating evaluating

deciding influencingManagement ControlManagement Control• Goal Congruence• Tool for implementing strategy

Management ControlManagement Control• Financial and non-financial emphasis financial – ‘bottomline’ of the company non-financial parameters like product quality, market share, customer satisfaction etc.• Aid in developing new strategies: Interactive control focuses management attention on positive and negative developments, which signal the need for new strategy formation information of non-financial nature is used to make strategic decisionsStrategy FormulationStrategy Formulation• It is the process of deciding on goals of the organisation and the strategies for attaining those goals• Strategies are important, big plans, showing the direction in which senior management wanted the organisation to move• Need for formulating strategies usually arises in response to a perceived threat or opportunity• Complete responsibility should never be assigned to a particular person or organisational unit Strategy Formulation v/s Management ControlStrategy Formulation v/s Management Control

• Definition• Strategy formulation is essentially unsystematic while management control is systematic• Strategy formulation involves much judgement and numbers are usually rough estimates while management control has a series of steps in a predictable sequence and with reliable estimates• Strategy formulation involves relatively few people, while management control involves managers & staff at all levels in the organisation

Task ControlTask Control• It is the process of assuring that specified tasks are carried out effectively and efficiently• Task control is transaction-oriented• Many task control activities are scientific i.e. using management science and OR techniques• Most of the information in an organisation is task control information• Many activities performed by managers in the past have been automated and are task control activities Task Control v/s Management ControlTask Control v/s Management Control

• Task control is scientific but management control can never be reduced to a science• Managers interact with other managers in management control; in task control, either human beings are not involved at all or the interaction is between a manager and a non-manager• Management control focuses on organisational units while task control focuses on specific tasks performed by these organisational unitsInternet for Management ControlInternet for Management Control• Instant access• Costless communication• Multi-targeted communication• Ability to display images• Shifting power and control to the individual• Facilitates coordination and control• Availability of large amounts of dataElements of Management ControlElements of Management Control• Judgements required to design & operate optimal control system involve: understanding relative importance of competing goals developing specific objectives for business units, functional areas and departments determining key variables for an individual’s contribution to strategic goals evaluating actual performance designing right reward structure

UNDERSTANDING STRATEGIESUNDERSTANDING STRATEGIESGoalsGoals• Profitability: measured as product of 2 ratios: Revenues – Expenses * Revenues Revenues Investment investment refers to ‘shareholders investment’ ‘profitability’ refers to long run profits Focus of CEOs may differ e.g. Jack Welch stressed on sales revenue as important component for profitability GoalsGoals• Maximising shareholder value: here, ‘maximising’ implies that there is a way of finding maximum amount that company earns, which is not the case ‘profit maximisation’ requires calculation of marginal costs and demand curve and generally managers do not know about it clearly course of action adopted in any case has to be ethical and consistent with corporation’s other goalsGoalsGoals

• Risk: degree of risk-taking varies with personalities of different managers management’s primary responsibility is to preserve company assets with profitability as a second goal• Multiple Stakeholder Approach: organisations participate in 3 markets: capital, product and factor markets management should identify goals for each of these stakeholders and track their performance

Concept of StrategyConcept of Strategy• Strategy describes general direction in which an organisation plans to move to attain its goals• A firm develops strategies by matching its core competencies with industry opportunities• Strategies can be found at: corporate level and business-unit level• Corporate level strategies plan right mix of industries in present and future for the company• Business-unit Strategy talks about mission and the methodology involved behind achieving itCorporate Level StrategyCorporate Level Strategy• Corporate strategic analysis results in decisions like businesses to add or retain, businesses to emphasize or de-emphasize etc.• Single Industry Firms: e.g. Infosys in Softwares, Wrigley Chewing Gum, Nucor Steel etc.• Unrelated Diversified Firms: operating synergies across businesses based on common core competencies and on sharing of common resources are very low e.g. Tata EmpireCorporate Level StrategyCorporate Level Strategy• Related Diversified Firms: common resources like sales force, manufacturing facilities, procurement function can be shared e.g. Procter and Gamble firms grow by leveraging core competencies developed in one business when they diversify such firms grow internally through R & D In such firms, Chief Executive must make resource allocation decisions across business units and also identify, deepen & leverage corporate core competencies to benefit multiple unitsCorporate Level StrategyCorporate Level Strategy• Core Competency and Corporate Diversification: research has shown that on average, related diversified firms perform the best, single industry firms next best and unrelated diversified firms do not perform well over the long term

business units of a related diversified firm might be worse if they were split into separate companies• Implications of control system design: how does structure & form of control differ across different types of firms ?Business Unit StrategiesBusiness Unit Strategies• Strategy here depends on two interrelated aspects: mission and competitive advantage for every company• Business unit mission: BCG MatrixBusiness Unit StrategiesBusiness Unit Strategies• Components of BCG Matrix: Build: increase market share at expense of short-term earnings and cash flow Hold: protect business-unit’s market share and competitive position Harvest: maximize short-term earnings and cash-flow, even at expense of market share Divest: withdraw from the business either through process of slow liquidation or outright sale

Business Unit StrategiesBusiness Unit Strategies• BCG matrix mainly takes market share as primary strategy variable due to importance placed on experience curve• According to BCG matrix, cost per unit decreases predictably with number of units over time• Association between market share and profitability has also been empirically supported by Profit Impact of Market Strategy Database• Control system designers need to know what is mission of particular business unit Business Unit StrategiesBusiness Unit Strategies• Although experience curve is a powerful analytical tool, it has limitations like: concept applies to undifferentiated products in certain situations improvements in process technology may have greater impact on per-unit cost reduction than cumulative volume Aggressive pursuit of reducing cost can lead to loss of flexibility in the marketplace not suitable for new technologies in industry along with experience, other cost drivers are scale, scope, technology and complexityBusiness Unit StrategiesBusiness Unit Strategies• General Electric Company/Mckinsey & Co. grid differs in methodology from BCG matrix: industry attractiveness in GE grid is based on weighted judgements about factors like market size, market growth, entry barriers, etc.

GE grid uses multiple factors like market share, distribution strengths and engineering strengths to assess competitive position of business unit BCG uses industry growth rate as a proxy for industry attractiveness and relative market share as proxy for current competitive positionBusiness Unit Competitive AdvantageBusiness Unit Competitive Advantage• Michael Porter has described two analytical approaches – industry analysis and value chain analysis to develop a superior and sustainable competitive advantage• Industry analysis: intensity of rivalry among existing competitors bargaining power of customers bargaining power of suppliers threat from substitutes threat of new entrantsBusiness Unit Competitive AdvantageBusiness Unit Competitive Advantage• Observations with regard to industry analysis: more powerful five forces, less profitable an industry is likely to be depending on relative strength of five forces, key strategic issues facing business unit will differ from one industry to another understanding nature of each force helps the firm to formulate effective strategies• Generic competitive advantage: low cost differentiationBusiness Unit Competitive AdvantageBusiness Unit Competitive Advantage• Industry analysis:

Business Unit Competitive AdvantageBusiness Unit Competitive Advantage• Value chain analysis: competitive advantage in market place derives from providing better customer value for an equivalent cost or equivalent customer value for a lower cost value chain is complete set of activities involved in a product, from extraction of raw material and ending with post delivery support to customers firms within same industry vary in proportion of activities that they carry with own resourcesBusiness Unit Competitive AdvantageBusiness Unit Competitive Advantagefor each value-added activity, key questions are: can we reduce costs, holding revenues const ant can we increase revenue, holding costs constant can we reduce assets, holding costs and revenue constant Most importantly, can we do (1), (2) and (3) simultaneously Value chain framework breaks down the chain from basic raw materials to end-use customers into specific activities to

understand cost behaviour and sources of differentiationBusiness Unit Competitive AdvantageBusiness Unit Competitive Advantage• Value chain helps the firm to understand the entire value delivery system• Supplier/customer actions can significantly influence firm’s cost/differentiation position

BEHAVIOR IN ORGANISATIONSBEHAVIOR IN ORGANISATIONSGoal Congruence(Goal Congruence(related related • Actions people take are in accordance with their perceived self-interest are also in best interest for the organisation• In this imperfect world, perfect congruence does not exist between individual and organisation• An adequate control system will motivate individuals to act in best interests of organisation• In evaluating any management control system, two important questions are: what action can motivate people for their self-interest ? and whether that serves the organisation alsoInformal Factors For Goal CongruenceInformal Factors For Goal Congruence• External Factors: Norms of desirable behavior including set of attitudes referred to as ‘work ethic’ Local attitude e.g. specific to place industry-specific norms and attitudes• Internal Factors: Culture: influenced by personality and policies of CEO Management Style: different managerial styles

MBWA v/s written reportsInformal Factors For Goal CongruenceInformal Factors For Goal Congruence Informal Organisation:

reporting relationshipsofficial authority and responsibilities of each managermanagerial performance evaluation

Perception and Communication:information transmission through formal and informal

channelsmessages from different sources may conflict with one

another or may subject to different interpretationsFormal Control SystemFormal Control System• Rules: All types of formal instructions and controls including standing instructions, job descriptions, SOPs, manuals etc. Some rules are positive requirements/guides Specific types of rules are as under:

Physical controlsManualsSystem safeguards

Task Control SystemsFormal Control SystemFormal Control System• Formal Control Process: A strategic plan implements organisation’s goals and strategies Strategic plan is converted into an annual budget to focus on planned revenues & expenses for individual responsibility centres Responsibility centres are guided by rules & other formal information Actual results are compared with the budget to determine deviations and if required, corrective actions are takenTypes of OrganisationsTypes of Organisations• Functional Organisation: Here, Manager brings specialised knowledge to take decisions related to a specific function like production, marketing, finance etc. Efficiency is an important advantage Disadvantages include: There is no ambiguous way of determining effectiveness of

separate functional managers Disputes between managers of different functions can be

resolved only at the top, even if it has originated at much lower level

Types of OrganisationsTypes of Organisations• Functional structures are inadequate for a firm with diversified products and markets• Such organisations tend to create “silos” for each function, preventing cross-functional coordination in areas like new product development

Such problem can be solved by supplementing vertical functional structure with lateral cross-functional processes such as cross-functional job rotation and team-based rewards

Types of OrganisationsTypes of Organisations• Business Unit Organisation: It is responsible for all the functions involved in producing and marketing a specified product line Managers handle units as separate companies Performance of managers is measured by profitability of the unit Headquarters reserve certain key prerogatives e.g. obtaining and allocating funds Headquarters establish company-wide policiesTypes of OrganisationsTypes of Organisations Advantages of Business units:It provides training in general managementManager may make sound production and marketing decisions than headquarters mightUnit can react to new threats or opportunities more quickly

Disadvantages of Business units:Each staff may duplicate some workDisputes between business units, their personnel and headquarters staff Types of OrganisationsTypes of Organisations• Implications for System Design: Along with ease of control, business units have other criteria also to run their businesses Once management has decided that a given structure is best, all things considered, system designer must take that structure as given Business units require broader type of manager and functional organisations provide benefit of economies of scale System designer should exist to serve the systemFunctions of ControllerFunctions of Controller• Controller or CFO is responsible for designing and operating management control system• Functions of a controller are: designing & operating information and control preparing financial statements and reports for shareholders and other parties preparing and analysing performance reports supervising internal audit and accounting control procedures developing personnel in controller organisationController – Line OrganisationController – Line Organisation• He may be responsible for developing and analysing control measurements• He may monitor adherence to spending limitations given by Chief Executive• He may control integrity of accounting system• He may safeguard company assets from theft and fraud• He plays an important role in preparation of strategic plans and budgets• He implements policies that are decided by line managementController – Business unitsController – Business units• He owes some allegiance to corporate controller and also to the managers of their own units, for whom they provide staff assistance• In some companies, controller reports to business unit manager and in other companies, to the corporate controller, but there are problems in both these relationships• It is expected that controller will not condone or participate in the transmission of misleading information or in concealment of unfavorable information

RESPONSIBILITY CENTERSRESPONSIBILITY CENTERSResponsibility CentersResponsibility Centers• It is an organization unit, headed by a manager, who is

responsible for its activities• Nature of Responsibility Centers: They implement strategies, decided by senior management to accomplish organization goals It receives inputs in the form of materials, labor and services and produces output in form of goods or services Products may be provided to outside market or to another responsibility centerResponsibility CentersResponsibility Centers• Relation between inputs and outputs: management is responsible for ensuring optimum relationship between inputs and outputs in some cases, relationship is casual and direct, while in situations, inputs are not directly related to outputs• Measuring inputs and outputs: Cost is a monetary measure of amount of resources used by the center it is much easier to measure cost of inputs than to calculate the value of outputsResponsibility CentersResponsibility Centers• Efficiency and effectiveness: in many centers, efficiency is measure by comparing actual costs with standard costs Effectiveness is determined by relationship between a responsibility center’s output and its objectives, generally it tends to be measured in subjective, non-analytical terms• Role of profit: profit measures both efficiency & effectiveness how to compare profligate perfectionist with frugal manager

Types of Responsibility CentersTypes of Responsibility Centers• Revenue centers: Output is measured in monetary terms No formal attempt is made to relate input to output They are marketing or sales units not having the authority to set selling prices and are not charged for the cost of goods that they market Actual sales or orders booked are measured against budget or quotas and manager is held accountable for expenses incurred within unit

Types of Responsibility CentersTypes of Responsibility Centers• Expense centers: Their inputs are measured in monetary terms There are two types of expense centers – engineered and discretionary Engineered costs are those, where proper amount can be estimated with reasonable reliability e.g. direct labour, components etc.

Discretionary costs are those, where no engineered estimate is feasible and costs incurred depend on management judgements

Engineered Expense CentersEngineered Expense Centers• Their input can be measured in monetary terms• Their output can be measured in physical terms• Optimum rupee amount of input for one unit of output can be determined• Output multiplied by standard cost of each unit produced measures cost of finished product• Their supervisors are responsible for quality of products and volume of production with efficiency• There are actually few, if any, responsibility centers in which all cost items are engineeredDiscretionary Expense CentersDiscretionary Expense Centers• It reflects management’s decisions regarding certain policies, whether to match or exceed marketing efforts of competitors, level of service company should provide and appropriate amounts to spend for R & D, financial planning etc.• One company may have a small headquarters staff, while other company of similar size and in same industry may have a staff 10 times as large• Difference between budget & actual expense is not taken as efficiency but simply difference between the budgeted input and actual inputGeneral Control – Expense CentersGeneral Control – Expense Centers• Budget preparation: management makes decisions for engineered centers based on proposed operating budget representing unit cost of efficient performance For discretionary center, management determines magnitude of the job to be done Work done by discretionary center is either Special or Continuing For discretionary center, MBO is done, where budgetee proposes to accomplish specific jobs and suggests performance evaluation measuresGeneral Control – Expense CentersGeneral Control – Expense Centers• Incremental Budgeting (Discretionary Center): Current level of expenses are adjusted for inflation, anticipated changes in workload of continuing job etc. Center’s current level of expenditure is accepted & not reexamined during budget preparation process Managers typically want to increase level of services and thus request for additional resources which are usually providedGeneral Control – Expense CentersGeneral Control – Expense Centers• Zero-Base Review (Discretionary Center): Resources actually required to carry out each activity are estimated from scratch

New base is established at which annual budget review attempts to keep costs in line with base until the next review after five years Certain basic questions are often raised like:Should review be performed ? Does it add value from customer’s viewpoint ?What should be quality level ?General Control – Expense CentersGeneral Control – Expense CentersShould function be performed in this way ?How much does it cost ? Information from other sources like similar units, trade associations, is useful for comparison Zero-based reviews are time-consuming and likely to be traumatic for managers Manages may try to show that such reviews are worthless, justifying current level of expenses In later 1980s and 1990s, companies conducted such reviews, which were called downsizingGeneral Control – Expense CentersGeneral Control – Expense Centers• Cost Variability: Costs in discretionary centers are insulated from short-run volume changes unlike engineered Once managers of discretionary centers hire additional personnel or plan for attrition, it is uneconomical to adjust work-force for short-term fluctuations• Type of Financial Control: For engineered center, objective is to become cost competitive by setting a standardGeneral Control – Expense CentersGeneral Control – Expense Centers For discretionary center, costs are controlled by manager’s participation in planning regarding tasks to be done and level of effort required• Measurement of Performance: In discretionary centers, unlike engineered, financial performance report is not the measure of efficiency of the manager For discretionary centers, control over spending is done by requiring superior’s approval before budget is overrun, however, certain overrun ( 5%) is permitted Administrative and Support CentersAdministrative and Support Centers• Control Problems: difficulty in measuring outputsome staff activities e.g. payroll accounting are so routinised that their units are engineered centersIn other activities, principal output is advice and service- impossible to quantify and evaluate lack of goal congruenceTypically managers of administrative staff strive for functional excellence, but, how to define excellence, is a big question

Administrative and Support CentersAdministrative and Support Centers• Severity of these two problems, is directly related to size and prosperity of the company• In small & medium-sized businesses, senior management is in close personal contact with staff units and can determine what they are doing• In businesses with low earnings, regardless of size, discretionary expenses are kept under tight control• Support centers often charge other responsibility centers for their services e.g. MIS department charging others for computer servicesAdministrative and Support CentersAdministrative and Support Centers• Budget Preparation: Proposed budget contains section covering basic costs of the center – including costs of being in business plus costs of all necessary activities for which no decisions are required A section covers discretionary activities of center, including objectives and estimated cost A section explaining all proposed increases in the budget other than inflation is also there Amount of detail depends on importance of expenses and desires of managementResearch & Development CentersResearch & Development Centers• Control Problems: difficulty in relating results to inputs:Output is semi-tangible like patents, new productCompleted product may take several yearsFor evaluation, technical nature of function may defeat management’s attempts to find efficiency lack of goal congruence:Research manager typically wants to build best research organisation money can buyResearch people lack sufficient knowledge to determine optimum direction of research effortsResearch & Development CentersResearch & Development Centers• R & D Continuum: Basic research and product testing are at the two extremes of the continuum Basic research is unplanned and often introduction of a new successful product takes a long time In some companies, basic research is included as a lump sum in budget, while, in others, there is no specific allowance but an understanding that scientists and engineers can devote part of their time in exploring interesting directionResearch & Development CentersResearch & Development Centers For product testing, it is possible to estimate time and financial requirements with sufficient accuracy to permit comparison with actuals

As project moves along continuum, amount spent per year tends to increase and decision has to be taken to either continue or terminate the project• R & D Program: There is no scientific way of determining size of budget Many companies take it as % of revenuesResearch & Development CentersResearch & Development Centers Program consists of list of programs plus a blanket allowance for unplanned work; usually reviewed annually by senior management Such reviews are conducted by a research committee having CEO, research director and production & marketing managers, who will make broad decisions as to projects to expand, to cut back and to discontinue• Annual Budgets: If company has decided on a long-range R & D program, then preparing the budget is simpleResearch & Development CentersResearch & Development Centers Calendarisation of the expected expenses for the period is done If budget is in line with strategic plan, approval is routine – helps in cash & personnel planning• Measurement of Performance: In many companies, management receives 2 types of financial reports One type compares latest forecast of total cost with approved amount for each active projectResearch & Development CentersResearch & Development Centers Second type of report consists of comparison between budgeted and actual expenses for each responsibility center Neither report gives information regarding effectiveness of research effort, such information is available in progress reports At regular intervals, usually monthly or quarterly, most companies compare actual with budgeted expenses and summary is available for managers at higher levels to assist in planning future expenses and keeping at approved levelsMarketing CentersMarketing Centers• In many companies, two different activities are grouped under marketing – order filling or logistics and order getting or marketing• Logistics Activities: Responsibility centers here are engineered expense centers that can be controlled through imposing standard costs and adjusting budgets to reflect these costs at different volumes In most companies, paperwork involved in filling orders and collecting receivables is done quickly and at low cost by using Internet Marketing CentersMarketing Centers• Marketing Activities:

It is much more difficult to evaluate marketing effort’s effectiveness than measuring its output In any case, meeting budgetary commitment for marketing expenses is not a major criterion in evaluation process as impact of sales volume on profits tends to overshadow cost performance Control techniques applicable to logistics are not generally applicable to marketing activities Most companies budget marketing expenses as % of budgeted sales due to hopes of higher salesMarketing CentersMarketing Centers• In short, there are three activity measures• Order-filling or logistics has engineered expenses as costs• Generation of revenue is usually evaluated by comparing actual revenue and physical quantities sold with budgeted revenue and budgeted units respectively• Order-getting costs are discretionary as no one knows what should be the optimum amount, hence measurement of efficiency & effectiveness for these costs is highly subjective in nature

PROFIT CENTERSPROFIT CENTERSGeneral ConsiderationsGeneral Considerations• Companies create business units to delegate more authority to operating managers• Conditions for delegating profit responsibility: manager should have access to relevant information needed for making such a decision there should be some way to measure the effectiveness of the trade-offs done by manager A major step is to determine lowest point in an organisation where above two conditions prevail All responsibility centers fall into a continuum ranging from clear profit centers to those not clearProfit CentersProfit Centers• Although E.I. Du Pont de Nemours & Company and General Motors Corporation divisionalised in early 1920s, most companies in US remained functionally organised until end of World War II• Many major US Corporations have after World War II decentralised profit responsibility at business unit level• Financial control systems have had considerable criticism over past 20 years and now scorecard with mix of financial & non-financial measures is usedAdvantages of Profit CentersAdvantages of Profit Centers• Quality of decisions may improve• Speed of operating decisions may increase• Headquarter is freed from daily decisionmaking• Managers are freer to use their imagination and initiative• Excellent training base for general management• Profit consciousness is enhanced

• Top managers get information on profitability of company’s individual components• They are particularly responsive to pressures to improve their competitive performanceDifficulties with Profit CentersDifficulties with Profit Centers• Some loss of control due to control reports• Quality of decisions at unit level may be reduced• Friction may increase due to transfer pricing etc.• Past functional units may compete with each other now• Divisionalisation may impose additional costs• Competent general managers may not exist• Too much emphasis on short-run profitability at expense of long-term profits• No complete satisfactory system to optimise profitsBusiness Units as Profit CentersBusiness Units as Profit Centers• Constraints on Business Unit Authority: Structures represent trade-offs between business unit autonomy and corporate constraints Effectiveness of such organisation largely depends on how such trade-offs are handled• Constraints from other Business units: Profit center can be managed in terms of control for three types of decisions:Product decision, marketing decision and procurement or sourcing decisionBusiness Units as Profit CentersBusiness Units as Profit Centers In general, greater degree of integration within a company, more difficult it is to assign all three activities to a single responsibility center in a given product line• Constraints from Corporate Management: They can be grouped into three types:those from strategic considerationsthose where uniformity is requiredthose from economies of centralisation Major Constraint is corporate control over new investmentsBusiness Units as Profit CentersBusiness Units as Profit Centers Each business unit must refrain from operating beyond its charter, even at expense of profit Maintenance of proper corporate image may require constraints on quality of products or on public relation activities Business units must conform to corporate accounting and management control systems Corporate headquarters may also impose uniform pay and other personnel policies as well as uniform policies on ethics, vendor selection, computers etc.Other Profit CentersOther Profit Centers• Functional Units: Multi-business companies are typically divided into business units, each of which is independently profit-generating unit

It is desirable to constitute one or more of functional units e.g. marketing, manufacturing and service operations - as profit centers Management’s decision for a unit to be profit center depends on amount of influence exercised by unit manager on activities affecting bottom lineOther Profit CentersOther Profit Centers• Marketing: Here, cost of the products sold is charged to the activity This transfer price provides marketing manager with relevant information to make optimum revenue/cost trade-offs and should be based on standard cost of the sold products When different conditions exist in different geographical areas e.g. foreign marketing, it is difficult to control decisions centrally and hence marketing can be taken as a profit center Other Profit CentersOther Profit Centers• Manufacturing: It is usually an expense center with judgement on performance v/s standard costs and overhead budgets For performance v/s standard costs, separate evaluation of activities like quality control, production scheduling etc. should be made One way to measure activity is to turn it into a profit center and give credit for selling price of products minus estimated marketing expensesOther Profit CentersOther Profit Centers Some authors say that manufacturing units should not be made profit centers unless they sell large portion of their output to outside customers• Service and Support units: Units for maintenance, IT, transportation, engineering etc. can be made profit centers They may operate out of headquarters and service corporate divisions or they may fulfill similar functions within business units They charge customers for services rendered, to generate revenue equal to their expenses Other Profit CentersOther Profit Centers When service units are profit centers, their managers are motivated to control costs in order to retain their customers, while managers of receiving units are motivated to take decisions about whether service is worth the price• Other Organisations: A company with branches responsible for product marketing in a particular geographical area is natural for a profit center Profit measurement is an excellent motivating device e.g. individual retail stores, restaurants etc.Measuring ProfitabilityMeasuring Profitability• There are two types of profitability measures: management performance – shows planning, coordination of

daily activities of a manager economic performance – conditions• System must be designed to measure management performance routinely with economic information derived from these performance reports and other sources• Types of measures: Contribution margin: spread between revenue and variable expensesMeasuring ProfitabilityMeasuring ProfitabilityArgument is that since managers cannot control fixed costs, this measure is usefulA focus on contribution margin tends to divert attention away from responsibility of profit center to keep discretionary expenses in line with the amounts as per the budgetFurther,even if an expense e.g. administrative salaries, cannot be changed in short run, profit center manager is still responsible for controlling employee’s efficiency and productivity

Measuring ProfitabilityMeasuring Profitability Direct profit:Here, profit center’s contribution is seen to general overhead and profit of corporationIt incorporates all expenses, either incurred by or directly traceable to profit center, regardless of these items are under the manager’s controlIt does not recognise motivational benefit of charging headquarter costs Controllable profit:Expenses are controllable, at least to a degree, by business unit manager e.g. IT servicesMeasuring ProfitabilityMeasuring ProfitabilityIf such costs are included in measurement system, profit remains after deduction of all expenses that may be influenced by profit center managerA major disadvantage is that it excludes non-controllable headquarters expenses Income before Taxes:Here, all corporate overhead is allocated to profit centers based on relative amount of expense each profit center incursFavorably, performance of each profit center will become more realistic and readily comparableMeasuring ProfitabilityMeasuring ProfitabilityAlso, corporate service units have a tendency to increase their power base and enhance their own excellence without regard to their effect on company as a wholeWhen managers know that their centers will not show a profit, unless all costs, including allocated share of corporate overhead, are recovered, they are motivated to make optimum long-term marketing decisions for product, pricing mix etc.

Demerit is that it may be difficult to allocate corporate services to reflect costs incurred by each profit center

Measuring ProfitabilityMeasuring ProfitabilityAlso, managers cannot be accountable for costs incurred by corporate staff departments such as finance, accounting & HR mgt.If profit centers are to be charged for a portion of corporate overhead, this item should be calculated on basis of budgeted, than actual costs Net Income:Domestic profit centers are evaluated using net profit after tax as performance measureArgument against measure is that after tax income is often a constant % of pretax income

Measuring ProfitabilityMeasuring ProfitabilityAlso, since many of decisions that affect income taxes are made at headquarters, it is not appropriate to judge profit center managersThere are situations where effective income tax rate does vary among profit centers – here it may be desirable to allocate income tax expenses to profit centers to measure economic profitability and to motivate managers to minimise tax liability Revenues:Shipping of order v/s cash received – recognition of revenueMeasuring ProfitabilityMeasuring ProfitabilityThere are other issues like common revenueMost companies take the position that identifying precise responsibility for revenue generation is too complicated and sales people must realise that they work for benefit of companyOther companies attempt to handle responsibility by crediting business unit that takes an order for a product handled by another unit with equivalent of a brokerage commission or a finder’s fee or as in case of bank, by granting explicit credit to the branch that performs the service Measuring ProfitabilityMeasuring Profitability Management considerations:Most companies in US include some, if not all, of the costs in evaluating business manager, irrespective of whether he can control or notManagers should be measured against those items they can influence, even if they do not have total control over those itemsEven best variance analysis system requires exercise of judgement and one way to make this more reliable is to eliminate all items over which manager has no influence

TRANSFER PRICINGTRANSFER PRICINGObjectives of Transfer PricesObjectives of Transfer Prices• It should provide each business unit with relevant

information needed to determine optimum trade-off between company costs and revenues• It should induce goal congruent decisions• It should help measure economic performance of individual business units• System should be simple to understand and easy to administer• If two or more profit centers are jointly responsible for product development, marketing and manufacturing, each should share in revenue

Transfer Pricing MethodsTransfer Pricing Methods• Transfer price is referred to the amount used in accounting for any transfer of goods and services between responsibility centers• One of the two parties involved is a profit center• Fundamental Principle: transfer price should be similar to price that would be charged if product were sold to outside customers or purchased from outside vendors Classical economics talks on selling prices equal to marginal costs and some authors advocate transfer price based on marginal costTransfer Pricing MethodsTransfer Pricing Methods two decisions must be made periodically for profit centers to buy and sell products from one another:sourcing decisiontransfer price decision• Ideal Situation: competent people:Staff people involved in negotiation & arbitration good atmosphere:profit as significant consideration in performance Transfer Pricing MethodsTransfer Pricing Methods a market price:should reflect same conditions e.g. quantity, delivery time and qualityAdjusted downwards to reflect savings to selling units from internal dealings e.g. no bad debts freedom to source:manager of each profit center has the right to deal with either insiders or outsiders at his or her will full information:Relevant alternatives and related costs & revenues

Transfer Pricing MethodsTransfer Pricing Methods negotiation:a smooth working mechanism for contracts• Constraints on Sourcing:

limited markets:existence of internal capacity might limit development of external salesif company is sole producer of a differentiated product, no outside source existsIf a company has invested in facilities, outside sources will not be used unless selling price approaches company’s variable cost Transfer Pricing MethodsTransfer Pricing Methodscompetitive pricing, which can best satisfy profit center requirements, measures contribution of each profit center to total company profits Some ways to find competitive price are: based on published market prices set by bids for a production profit center selling similar products in outside market for a buying profit center purchasing similar products from outside market

Transfer Pricing MethodsTransfer Pricing Methods excess or shortage of industry capacity:excess capacity – selling profit center cannot sell to outside marketshortage of capacity – buying profit center cannot obtain product it requires from outsideEven if no. of intracompany transfers is significant some senior management do not intervene on the theory that benefits of keeping profit centers independent offset loss from suboptimising company profits

Transfer Pricing MethodsTransfer Pricing MethodsSome companies allow either buying or selling profit center to appeal a sourcing decision to a central person or committeeGiven the option, buying profit center would prefer to deal with an outside sourceIf the market price exists or can be approximated, use itIn transfer pricing calculation, companies avoid advertising, financing & other expenses that seller does not incur in internal deal and same benefits pass on to the buyer also

Transfer Pricing MethodsTransfer Pricing Methods• Cost-based transfer prices: cost basis:standard costs should be used so that production inefficiencies are eliminated profit mark-up:base of mark-up and level of profit allowedbase – % of costs v/s % of investmentconceptual solution is to base profit allowance on investment ( at standard level), required to meet volume needed by buying profit

centersTransfer Pricing MethodsTransfer Pricing Methods• Upstream Fixed Costs and Profits: agreement among business units:Some companies establish a formal mechanism where representatives from buying & selling units meet periodically to decide on outside selling prices and sharing of profits for products with significant upstream fixed costs and profitThis mechanism will work only when review process allows significant business to atleast one of the profit centersTransfer Pricing MethodsTransfer Pricing Methods two-step pricing:first, for each unit sold, a charge equal to standard variable cost of production is takena periodic charge is made equal to fixed costs associated with facilities reserved for buying unitIt would be appropriate under some circumstances to divide investment into variable (e.g. receivables and inventory) and fixed (e.g. plant) componentsThen a profit allowance based on return on variable assets would be added to standard variable cost for each unit soldTransfer Pricing MethodsTransfer Pricing MethodsFollowing are some points about above method: monthly charge for fixed costs and profit should be negotiated periodically & will depend on capacity reserved for buying unit questions may be raised about accuracy of cost and investment allocation manufacturer’s unit profit allowance is not affected by sales volume of final unit conflict between interests of company and manufacturing unit this method is similar to “take or pay pricing”Transfer Pricing MethodsTransfer Pricing Methods profit sharing:this system can induce goal congruence between business unit and company interestshere, product is transferred to marketing unit at standard variable costafter product is sold, business units share contribution earned, which is selling price minus variable manufacturing and marketing costsThis method is useful if demand for manufactured product is not steady enough to warrant permanent assignment of facilities

Transfer Pricing MethodsTransfer Pricing Methodsthis method has some practical problems:There can be arguments over contribution divided over two profit

centers; this is costly and time-consuming for management to interveneArbitrarily dividing up profits among units does not give valid information on unit’s profitabilitySince contribution is not allocated until sale is made, manufacturing unit’s contribution depends on marketing unit’s ability to sell as well as the actual selling priceTransfer Pricing MethodsTransfer Pricing Methods two sets of prices:In this method, manufacturing unit’s revenue is credited at outside sales price and buying unit is charged total standard costsDifference is charged to a headquarters account and eliminated when business unit statements are consolidatedThis method is sometimes used when there are frequent conflicts between buying & selling units that cannot be resolved by one of other methods; both units benefit under such arrangementTransfer Pricing MethodsTransfer Pricing MethodsThere are some disadvantages to this method:Sum of business unit profits is greater than overall company profitsThis system creates an illusive feeling that business units are making moneySystem might motivate business units to concentrate more on internal transfersThere is additional bookkeeping involvedFact that conflicts would be reduced here can be taken as a weakness Pricing Corporate ServicesPricing Corporate Services• If these costs are charged at all, they are allocated and allocations do not include a profit component• There are mainly two types of transfers: for central services that receiving unit must accept but can atleast partially control amount used for central services that business unit can decide whether or not to use• Control over amount of service: business units can use company staffs for IT services and R & D, efficiency can’t be controlledPricing Corporate ServicesPricing Corporate Services one school of thought says that business unit should pay standard variable cost of discretionary services second school of thought advocates a price equal to standard variable cost plus a fair share of standard fixed costs – i.e. full cost third school advocates a price that is equivalent to market price or to standard full cost plus a profit margin• Optional use of services: often used for IT, maintenance, consulting

Pricing Corporate ServicesPricing Corporate Services in some cases, management may decide that business units

can choose whether to use central service units business units may procure service from outside, develop their own capability or choose not to use the service at all• Simplicity of pricing mechanism: prices charged for corporate services needs straight methods to be calculated computer experts are used as they already solve complex equationsAdministration of Transfer PricesAdministration of Transfer Prices• Negotiation: in most companies, transfer prices are decided by business units on negotiated basis also, many transfer prices require a degree of subjective judgement business unit usually have best information on markets and costs and consequently, are best able to arrive at reasonable prices business unit must know ground rules for negotiation of transfer pricesAdministration of Transfer PricesAdministration of Transfer Prices in some companies, headquarters inform units that they are free to deal with one another or with outsiders, subject to qualification that if there is a tie, business must be kept inside line managers should not spend time on transfer price negotiations• Arbitration and Conflict Resolution: a procedure should be in place for arbitrating price disputes responsibility may be assigned to a single executive – financial VP or executive VPAdministration of Transfer PricesAdministration of Transfer Prices a committee can be set up to settle disputes, review sourcing changes and change transfer price rules when appropriate arbitration can be conducted by a formal system, where both parties submit a written case in less formal system, presentations may be largely oral irrespective of degree of formality of process, type of conflict resolution process will influence effectiveness of a transfer pricing systemAdministration of Transfer PricesAdministration of Transfer Prices there are four ways to resolve conflict:forcing, smoothing, bargaining and problem solving conflict resolution mechanisms range from conflict avoidance through forcing and smoothing to conflict resolution through bargaining and problem solving• Product Classification: extent and formality of sourcing and transfer pricing rules depend on number of intracompany transfers and availability of market and prices

Administration of Transfer PricesAdministration of Transfer Prices

some companies divide products into 2 classes:Class I: products for which senior management wants to control sourcing e.g. large volume onesClass II: all other products, that can be produced outside the company without any significant disruption to present operations e.g. small volume sourcing of class I products can be changed only with permission of central management, while, class II sourcing is determined by business units involved; both buying & selling units can freely deal either inside or outside the company

MEASURING AND CONTROLLING MEASURING AND CONTROLLING ASSETS EMPLOYEDASSETS EMPLOYEDStructure of AnalysisStructure of Analysis• Purposes of measuring assets employed are: to provide useful information in making sound decisions about assets employed and to motivate managers to make decisions in interest of company to measure performance of business unit as an economic entity• Focusing on profits without considering assets employed to generate these profits is an inadequate basis for control• There are two ways to relate profits to assets employed – ROI and EVAStructure of AnalysisStructure of Analysis• It is difficult for senior management to compare profit performance of one business unit with another or similar outside companies• Business unit managers should generate adequate profits from resources at their disposal• Also, they should invest in additional resources only when investment will produce an adequate return• EVA is calculated by subtracting a capital charge from net operating profitMeasuring Assets EmployedMeasuring Assets Employed• Headquarters asks two questions to decide base to evaluate investment by center managers what practices will induce business unit managers to use their assets most efficiently ? what practices will help managers acquire proper amount and kind of new assets ?• Cash: most companies control cash centrally as it permits use of smaller cash balance than usual balances may be float between daily receipts and daily disbursements

Measuring Assets EmployedMeasuring Assets Employed

many companies use a formula for cash in investment base e.g. GM was reported to use 4.5% of annual sales higher cash balance is necessary to allow comparisons to outside companies some companies omit cash from investment base as they reason that amount of cash approximates current liabilities• Receivables: whether to include it at selling prices or at cost of goods sold is debatable ?Measuring Assets EmployedMeasuring Assets Employed business unit managers can influence level of receivables directly, by establishing credit terms and approving individual credit accounts and credit limits and indirectly, by ability to generate sales receivables are often included at end-of –period balances, although average of intraperiod balances is a better measure of amount that should be related to profits for business units not controlling credit and collections, it may be calculated by formulaMeasuring Assets EmployedMeasuring Assets Employed• Inventories: they are recorded at end-of-period amounts if company uses LIFO for financial accounting purposes, a different valuation method like standard or average costs is used for business unit profit reporting if work-in-process inventory is financed by advance payments or by progress payments from customer, these payments are either subtracted from gross inventory or reported as liabilitiesMeasuring Assets EmployedMeasuring Assets Employed some companies subtract accounts payable from inventory as accounts payable represents financing of part of inventory by vendors, at zero cost to business unit• Working Capital in general: at one extreme, companies include all current assets in investment base with no offset for any current liabilities this method is motivational, but it overstates amount of capital required to finance business unitMeasuring Assets EmployedMeasuring Assets Employed at other extreme, all current liabilities may be deducted from current assets this method provides a good measure of capital provided by corporation, on which it expects business unit to earn a return, but business unit managers are responsible for certain current liabilities over which they do not have control• Property, Plant and Equipment: Acquisition of new equipment: if depreciable assets are included in investment base at net book value, business unit profitability is misstated Measuring Assets EmployedMeasuring Assets Employed

business units having old, almost fully depreciated assets tend to report larger EVA than units having newer assets Gross Block Value:include depreciable assets at gross book value to avoid fluctuations in EVA and ROI year to yearROI calculated on gross book value always understates true return Disposition of Assets: Business units able to make most replacements will show greatest improvement in profits

Measuring Assets EmployedMeasuring Assets Employedif assets are included in investment base at their original cost, then business unit manager is motivated to get rid of them- even if they are useful, as business unit’s investment base is reduced by full cost of the asset Annuity depreciation:This depreciation actually matches recovery of investment that is implicit in PV calculationVery few managers accept idea of a depreciation allowance that increases as asset agesMeasuring Assets EmployedMeasuring Assets EmployedIt presents some practical problems like:should depreciation schedule change every year to conform to actual pattern of cash flows ?this method is not desirable for income-tax purposesThis method has an advantage of being rational and systematic to be used for financial accounting Other Valuation methods:some companies use net book value but set a lower limit, say 50%, as amount of original cost, to be written off

Measuring Assets EmployedMeasuring Assets Employedother companies depart entirely from accounting records and use asset’s approximate current valuea major problem with non-accounting values is their subjectivity as compared to accounting values having objectivitya related problem with non-accounting amounts in internal systems is that business unit profits will not be consistent with corporate profits reported to shareholdersAnother problem with current market values is determination of their economic values

Measuring Assets EmployedMeasuring Assets Employed• Leased Assets: many leases are financing arrangements i.e. they provide an alternative way of getting to use assets that otherwise would be acquired by funds obtained from debt and equity financial leases are similar to debt and are so reported on

balance sheet business unit managers are induced to lease, whenever interest charge built into rental cost is less than capital charge applied to investment base of the unitMeasuring Assets EmployedMeasuring Assets Employed• Idle Assets: if such assets can be used by other units, they may be permitted to be excluded from investment base if it classifies them as available if there is no alternative use for equipment, any contribution will improve company profits• Intangible Assets: some companies tend to be R & D intensive, others tend to be marketing intensive, such assets can be capitalised and then amortised over a selected life

Measuring Assets EmployedMeasuring Assets Employed by accounting for these assets as long-term investments, unit managers will gain less short-term benefit from reducing outlays on such items• Noncurrent Liabilities: ordinarily, a business unit receives permanent capital from corporate pool of funds for business unit, total amount of these funds is relevant, not sources from which it was obtained in unusual situations, however, a business unit’s financing may be peculiar for the situation

Measuring Assets EmployedMeasuring Assets Employed• Capital Charge: rate for capital charge should he higher than corporation’s rate for debt financing but below company’s estimated cost of capital some companies use lower rate for working capital than fixed assets• Surveys of practice: most companies include fixed assets at net book value in their investment base this method gives misleading signals, but allowances can be given for errors

EVA v/s ROIEVA v/s ROI• There are three benefits of using ROI measure: anything affecting financial statements is reflected in this ratio it is simple to calculate, easy to understand and meaningful in an absolute sense it is a common denominator applied to any organisational

unit for profitability ROI data are available for competitors and can be used for comparison; dollar amounts of EVA does not provide such a basis for comparisonEVA v/s ROIEVA v/s ROI• There are four reasons to prefer EVA over ROI: all business units have same profit objective for comparable investments with EVA, ROI provides different incentives for investments across business units decisions increasing a center’s ROI may decrease its overall profits, while investments that produce profit in excess of cost of capital will increase EVA and will be attractive to manager different interest rates may be used for different types of assetsEVA v/s ROIEVA v/s ROI it has a strong positive correlation with changes in a company’s market value, in contrast to ROI shareholder value creation is critical for firm asit reduces risk of takeoverit creates currency for aggressiveness in mergers and acquisitionsIt reduces cost of capital; allowing faster growth in future through investment• Following actions can increase EVA: increase ROI through BPR and productivity gains, without increasing asset baseEVA v/s ROIEVA v/s ROI divestment of assets, products and/or businesses whose ROI is less than cost of capital aggressive new investments in assets, products and/or businesses whose ROI exceeds COC increase in sales, profit margins, or capital efficiency or decrease in cost of capital %• EVA solves problem of differing profit objectives for same asset in different business units and for same profit objective for different assets in same unit; managers may be reluctant to invest in social goals if they perceive lossesUse of EVA in Planning & ControlUse of EVA in Planning & Control• Strategic Direction:• Acquisitions: e.g. AT & T used in $ 12.6 billion purchase of McCaw Cellular• Operational Improvements: quality initiatives, product introductions, supplier arrangements etc.• Product Line Discontinuation: e.g. Coca-cola• Working Capital Focus: e.g. packaging material inventories and amount tied in finished goods• Cost of Capital Focus:• Incentive Compensation: e.g. annual bonusesAdditional Considerations Additional Considerations • EVA does not solve problem of accounting for fixed assets,

unless annuity depreciation is used• EVA can be increased for gross book value by taking decisions contrary to interests of company• EVA does not solve problem created by differing profit potentials• Some assets may be undervalued, when they are capitalised and others, when they are expensed• Some companies have decided to exclude fixed assets from investment baseAdditional ConsiderationsAdditional Considerations• Such companies make an interest charge for controllable assets (working capital) only and they control fixed assets by separate devices• Investments in fixed assets are controlled by capital budgeting process before the fact and by post completion audits to determine whether anticipated cash flows in fact materialised• ROI suffers from conceptual flaws while evaluating performance, but it is difficult to determine extent of dysfunctional conduct, which is faced by business unit managersEvaluating Entity’s Economic PerformanceEvaluating Entity’s Economic Performance• Economic reports indicate whether current strategies of business unit are satisfactory and if not, what should be done – expansion, sell etc.• Economic reports are a basis for getting value of company called breakup value• The report indicates relative attractiveness of business units and may suggest that management is misallocating its scarce time• A gap between current profitability and breakup value indicates changes that need to be madeEvaluating Entity’s Economic PerformanceEvaluating Entity’s Economic Performance• Difference between economic reports & management reports is that former focus on future profitability rather than current or past profits• management reports are prepared monthly or quarterly, whereas economic reports are prepared at irregular intervals, usually once for several years• Conceptually, value of a business unit is present value of its future earnings stream i.e. cash flows• Such cash flows are rough estimates and they provide a different way of looking at business units from that shown in performance reports

Strategic PlanningStrategic PlanningNature of Strategic PlanningNature of Strategic Planning• Strategic Planning is process of deciding on the programs that organisation will undertake and on approximate resources that will be allocated to each program over next several years• Relation to Strategic Planning:

after management arrives at goals of the organisation in strategy formulation, strategic planning process then takes goals and strategies as given and develops programs to carry out strategies and achieve goals efficiently and effectivelyNature of Strategic PlanningNature of Strategic Planning studies made during planning process may indicate desirability of changing goals or strategies, while formulation usually includes a preliminary consideration of programs that will be adopted as a means of achieving these goals strategic planning is systematic, having annual process with prescribed procedures & timetables; while strategy formulation is unsystematic in a formal strategic planning process, an important first step often has to be to write descriptions of organisation’s goals and strategiesNature of Strategic PlanningNature of Strategic Planning• Evolution of Strategic Planning: a few companies started formal strategic planning systems in late 1950s, but early efforts were failures required data was much detailed than was appropriate, staff people rather than line people did most of the work participants spent more time filling in forms than thinking deeply about alternatives currently, many organisations appreciate advantages of making a plan for next 3 to 5 yearsNature of Strategic PlanningNature of Strategic Planning• Benefits of Strategic Planning: framework for developing annual budget:It facilitates optimal resource allocation decisions in support of key strategic options management development tool:Formal system forces managers to take time to think on important long-term issues means of aligning managers with corporate strategies:Debates, discussions and negotiations during planning process Nature of Strategic PlanningNature of Strategic Planning• Limitations of Strategic Planning: planning can end up becoming a “form filling” bureaucratic exercise, devoid of strategic thinking organisation may create a large strategic planning department and delegate preparation of strategic plan to that staff department it is time consuming and expensive• A formal strategic plan should have features like: top management is convinced that strategic planning is importantNature of Strategic PlanningNature of Strategic Planning organisation is relatively large and complex considerable uncertainty about future exists, but

organisation has flexibility to adjust to changed circumstances in summary, formal strategic planning process is not needed in small, relatively stable organisations• Program structure and content: in most industrial organisations, programs are product families, plus R & D, general and administrative expenses, not in existing productsNature of Strategic PlanningNature of Strategic Planning in service organisations, programs correspond to types of services rendered by the entity typical strategic plan covers a period of five future years rupee amounts for each plan show approximate magnitude of its revenues, expenses and capital expenditures if strategic plan is structured by business units, the “Charter”, specifying boundaries within which business unit is expected to operate, is also statedNature of Strategic PlanningNature of Strategic Planning• Organisational Relationships: in some organisations, controller organisation prepares strategic plan, as they may be skilled primarily in detailed analytical techniques required in fine-tuning annual budget & analysing variances between actual & budgeted amounts in other organisations, separate planning staff may support in analytical skills and broader outlook that may not exist in controller set up headquarter staff members should facilitate, not intervene in strategic planning processNature of Strategic PlanningNature of Strategic Planning Top management style:some Chief Executives prefer to make decisions without benefit of a formal planning apparatusIn some companies, Chief Executive want some overall plan for business, but by temperament has an aversion to paperworkIn other companies, senior management prefers extensive analysis and documentation of plans and formal part of system is relatively elaborateDesigners must correctly diagnose style of senior management and fit the system accordingly Analysing Proposed New ProgramsAnalysing Proposed New Programs• Proposals for programs are essentially either reactive or proactive• Ideas for new programs can originate anywhere in the organisation i.e. CEO, planning staff etc.• Planners should view adoption of program not as a single all-or-nothing decision but rather as a series of decisions, each one a relatively small step in testing and developing proposed program• Planners should have full implementation and its consequent significant investment only if tests indicate about proposal’s good chance of success

Analysing Proposed New ProgramsAnalysing Proposed New Programs• Capital Investment Analysis: there are atleast four reasons for not using PV in analysing all proposals:proposal is obviously very attractiveestimates involved are so uncertain that PV calculations cannot draw reliable conclusionsrationale for the approach is something other than increased profitabilitythere is no feasible alternative to adoption either NPV or IRR is found for analysis

Analysing Proposed New ProgramsAnalysing Proposed New Programs• Rules: companies usually publish rules and procedures for approval of capital expenditure proposals of various magnitudes rules also contain certain guidelines for preparing proposals and general criteria for approving proposals• Avoiding manipulation: sponsors who know that their project with negative NPV is not likely to be approved may have a gut feeling that project should be selectedAnalysing Proposed New ProgramsAnalysing Proposed New Programs in some cases, sponsors may make optimistic estimates of sales revenues or reduce allowances for contingencies in some of cost elements analyst may place reliance on sponsors having an excellent track record• Models: there are specialised techniques like risk analysis, sensitivity analysis, simulation, scenario planning, game theory, option pricing models etc. planning staff should know such methods and use them in situations when required

Analysing Proposed New ProgramsAnalysing Proposed New Programs• Organisation for Analysis: decision to proceed with proposal may require a succession of development and testing hurdles to be crossed before full implementation expert systems use computer software in analysis of proposed programs software for expert systems permits each participant to vote on an explicitly rank, each of criteria used to judge the project computer then tabulates results and uncovers misunderstandings and raises queries to be solvedAnalysing Ongoing ProgramsAnalysing Ongoing Programs• Value Chain Analysis: from strategic planning perspective, concept highlights three

potentially useful areas:Linkages with suppliersLinkages with customersProcess linkages within value chain of the firm

Analysing Ongoing ProgramsAnalysing Ongoing Programs Process linkages with Value Chain of the Firm: individual activities within a firm are not independent but rather are interdependent efficiency of design portion of value chain can be improved by reducing number of separate parts and increasing their ease of manufacture efficiency of inward portion i.e. preceding production, can be improved by reducing number of vendors, by Just-in-time deliveries, by having computer system placing automatic orders etc.Analysing Ongoing ProgramsAnalysing Ongoing Programs efficiency of production portion can be improved by increased automation, by rearranging machines into cells and by better production control systems efficiency of outward portion (i.e. from factory door to customer) can be improved by having customers place orders electronically, by changing locations of warehouses etc. Such efficiency-oriented initiatives involve trade-offs e.g. direct computer orders may speed up delivery but order filling costs may increaseAnalysing Ongoing ProgramsAnalysing Ongoing Programs• Activity-Based Costing: sixty years ago, most companies allocated overhead costs to products by means of plantwide overhead rate based on direct labour hours today, an increasing number of companies collect costs for material-related costs e.g. storage, seperately from other manufacturing costs, collected from individual departments in these cost centers, direct labour costs may be combined with other costs, giving conversion costAnalysing Ongoing ProgramsAnalysing Ongoing Programs with conversion costs, new system assigns R & D, general and administrative and marketing costs to products basis of allocation or cost driver, for each of cost centers reflect cause of cost incurrence ABC concept is not particularly subtle or counter intuitive, but in line with common sense advocates of ABC maintain that a meaningful assessment of full cost today must involve assigning overhead in proportion to activities that generate it in long runAnalysing Ongoing ProgramsAnalysing Ongoing Programs• Use of ABC information: it may show that complex products with many separate parts

have higher design and production costs than simple products many engineering change orders have higher unit costs than other products information on magnitude of such differences may lead to changes in policies relating to full line v/s focused product line, product pricing, make or buy decisions, adding/deleting products Strategic Planning ProcessStrategic Planning Process• This process involves the following steps: Reviewing and updating the strategic plan:first step is to review and update the strategic plan agreed to last yearActual experience for first few months of current year is already reflected in accounting reports and these are extrapolated for current best estimate of the year as a whole Deciding on assumptions and guidelines: updated strategic plan incorporates broad assumptions as growth in GDP, labour rates etc.Strategic Planning ProcessStrategic Planning Process updated strategic plan contains implications on revenues, expenses and cash flows of existing operating facilities and changes in facilities like opening new plants, expanding or closing plants it also shows amount of new capital likely from retained earnings and new financing objectives are stated seperately for each product line and are expressed as sales revenue, as a profit percentage/return on capital employed principal guidelines are assumptions about wage and salary increases, selling prices etc.Strategic Planning ProcessStrategic Planning Process Management meetings:Many companies hold an annual meeting of corporate and business unit managers, often called “summit conference”, to discuss proposed objectives and guidelines First Iteration of Strategic Plan:Business units and other operating units prepare their “first cut” of strategic plan, including different operating plans from those included in current plan such as change in marketing tactics; these are supported by reasons Strategic Planning ProcessStrategic Planning ProcessCompleted Strategic Plan consists of income statements; inventory, accounts receivable and other key balance sheet items; quantitative information on sales and production; expenditures for plant & other capital acquisitions; any unusual cash flows; number of employees and a narrative explanation and justification Analysis (of first iteration):when headquarters receive business unit plans, they aggregate them into overall corporate strategic plan

Strategic Planning ProcessStrategic Planning Processheadquarter people examine business unit plans for consistency alsoheadquarters staff and their counterparts in business units resolve some of these questions by discussion and report others to corporate management, where, they are basis for discussions between corporate and business unit managersin many cases, sum of business unit plans reveals a planning gapfrom planning numbers, headquarters can develop planned cash requirements for whole organisationStrategic Planning ProcessStrategic Planning ProcessPlanning gap can be closed by:finding opportunities for improvements in plansmake acquisitionsreview the corporate objectives Second Iteration of Strategic Plan:Revision of plans of only certain business units may be required, limited to change in assumptions and guidelines that affect all business unitsSome companies do not require a formal revision from business units, changes are negotiated and results are taken into the plan at headquarters

Strategic Planning ProcessStrategic Planning Process Final Review and Approval:A meeting of senior corporate officials usually discusses the revised plan at lengthPlan may also be presented at a meeting of the Board of DirectorsChief Executive Officer gives final approvalApproval has to come prior to beginning of the Budget preparation process because the strategic plan is an important input to that process

BUDGET PREPARATIONBUDGET PREPARATIONNature of A BudgetNature of A Budget• An operating budget states revenues and expenses planned for one year• Characteristics of an Operating Budget: it estimates profit potential of business unit it is stated in monetary terms it generally covers a period of one year it is a management commitment budget proposal is reviewed and approved once approved, it can be changed only under specified conditions Nature of A BudgetNature of A Budget periodically, actual financial performance is compared to

budget and variances are analysed and explained• Process of preparing a budget has to be separate from strategic planning and forecasting• Relation to Strategic Planning: a budget is, in a sense, a one-year slice of the organisation’s strategic plan budget is structured by responsibility centers, while strategic plan is structured by product lines or other programsNature of A BudgetNature of A Budget strategic plan precedes budgeting and provides framework within which annual budget is prepared• Contrast with Forecasting: forecast may or may not be stated money wise it can be for any time period forecaster does not accept responsibility for meeting forecasted results it is not usually approved by higher authority variances from forecast are not analysed formally or periodically

Nature of A BudgetNature of A Budget forecast is updated as soon as new information indicates that there is a change in conditions an example is one made by treasurer’s office to help in cash planning financial forecast is exclusively a planning tool while, budget is both planning and control tool if a budgetee can change a so-called budget each quarter without formal approval, such a document is essentially a forecast forecast cannot be used for evaluation and controlNature of A BudgetNature of A Budget• Use of a Budget: fine-tuning strategic plan budget preparation provides an opportunity to make decisions to improve performance before a commitment is made to a specific way of operating during a year Coordination inconsistencies in plans of various departments can be identified and resolved assigning responsibilityIt indicates responsibilities and authoritiesNature of A BudgetNature of A Budget basis for performance evaluationAt top level, budget summary assigns responsibility to individual profit centersWithin profit centers, budget assigns responsibility to functional areas e.g. marketingWithin functional areas, budget assigns responsibility to individual responsibility centersBudget represents a commitment by budgetee to his or her superior; this commitment can change if assumptions on which it is

based, change Nature of A BudgetNature of A Budget• Operating Budget: it is prepared for organisation as a whole and for each business unit and classified by responsibility centers contents include revenues, production cost & cost of sales, marketing expense, logistic expense general and administrative, research & development, income taxes and net income expenses may be flexible, discretionary or committed it is divided into months & quarters from yearNature of A BudgetNature of A Budget• Operating Budget Categories: revenue budgetsIt is usually based on forecasts of some condition for which sales manager cannot be responsibleDegree of uncertainty differs among companies and within same company, degree of uncertainty is different at different times budgeted production cost and cost of salesProduction managers make plans for obtaining quantities of material & labour and may prepare procurement budgets for long lead-time itemsNature of A BudgetNature of A BudgetBudgeted cost developed by production managers may not be for same quantities of products as shown in sales budget; difference represents additions or subtractions from finished goods inventoryCost of sales in summary budget is standard cost of products budgeted to be soldBudgeted cost of sales in wholesale and retail establishments is not necessarily cost of goods that will be purchased in budget yearProduction managers develop production scheduleNature of A BudgetNature of A Budget marketing expensesAdvertising must be prepared months in advance of its release and contracts with media also are placed months in advanceLogistic expenses are usually reported seperately from order getting expenses e.g. order entry, warehousing and order picking etc. general and administrative expensesOverall, they are discretionary expenses, although some components are engineered expensesThey are at headquarter and business unit levelNature of A BudgetNature of A Budget research and development expenses:In one approach used, total amount is focus, which may be current level of spending adjusted for inflation or may be a larger amountAlternative approach is aggregating planned spending on each approved project, plus an allowance for work likely to be undertaken income taxes

Some companies do not take income taxes into account as these policies are determined at corporate headquartersOther BudgetsOther Budgets• Capital Budget: it states approved capital projects, plus a lump sum amount for small projects during budget, approved projects are assembled into an overall package and examined in total• Budgeted Balance Sheet: operating managers who can influence level of inventories, accounts receivable or accounts payable are held responsible for level of items it shows balance sheet implications of decisions in operating and capital budgetOther BudgetsOther Budgets• Budgeted Cash Flow Statement: it shows cash needs being met by retained earnings and from borrowing and other sources• Management by Objectives (MBO): there are certain specific objectives implicit in the budget like open new sales offices, introduce a new product line etc. process of attaining objectives is MBO, where objectives of each responsibility center are set in quantitative terms, and, as in case with budgeted amounts, are accepted by responsible managerBudget Preparation ProcessBudget Preparation Process• Organisation: Budget department:It reports to corporate controller and administers information flow of budgetary control system Budget committee:It consists of members of senior management like CEO, Chief Operating Officer and Chief Financial OfficerIt reviews and either approves or adjusts each of the budgetsBudget Preparation ProcessBudget Preparation Process• Issuance of Guidelines: first step in budget preparation process is to develop guidelines that govern preparation of budget for dissemination to all managers all responsibility centers must follow some of these guidelines like assumed inflation in general and inflation for specific items such as wages, corporate policies on promotions, compensation at each wage and salary level etc. budget staff develops guidelines and in some cases, lower-level managers may discuss them Budget Preparation ProcessBudget Preparation Process• Initial Budget Proposal: Changes from current level of performance can be classified as: all changes in external forces and changes in internal policies and practices

Changes In External Forces:Changes in general level of economic activityExpected changes in prices of purchased material and servicesExpected changes in labour ratesExpected changes in cost of discretionary activityBudget Preparation ProcessBudget Preparation ProcessChanges in selling prices Changes in internal policies and practices:Changes in production costsChanges in discretionary costs based on anticipated changes in workloadChanges in market share and product mix• NegotiationMany budgetees tend to budget lower revenues & higher expenses than their best estimatesDifference between the above two is called Slack

Budget Preparation ProcessBudget Preparation Process• Review and Approval: proposed budgets go through successive levels in the organisation and top management looks for consistency in its various parts final approval is recommended by budget committee to CEO CEO also submits approved budget to Board of Directors for ratification in December• Budget Revisions: they must be justified on basis of significantly changed conditions from conditions at approval

Budget Preparation ProcessBudget Preparation Process there are two general types of revisions:Procedures that provide for a systematic updatingProcedures allowing revisions under special circumstances an important consideration is that managers should not be allowed to adhere to plans that subsequent events prove to be sub optimum• Contingency Budgets: it provides a way of quickly adjusting to changed conditions if situation arises e.g. sales volume increase or decrease

Behavioral AspectsBehavioral Aspects• Participation in budgetary process: an effective budget blends two approaches of “top down” or “bottom up” budgetees prepare first draft of budget for their area of responsibility, but they do so within guidelines established at higher levels

research has shown that budget participation has positive effects on managerial motivation as:there is likely to be greater acceptance of budget goals if they are perceived being under manager’s control, rather than being imposed externallyBehavioral AspectsBehavioral Aspectsparticipative budgeting results in effective information exchanges participative budgeting is especially useful for centers operating in dynamic and uncertain environments• Degree of Budget Target Difficulty: Merchant and Manzoni, in a field study of unit managers, concluded that business unit budget achievability in practice is usually considerably higher than 50 percent bonus payments give satisfactory performanceBehavioral AspectsBehavioral Aspects several reasons are there for senior management approving achievable budgets for business units:If budgeted target is too difficult, managers may take short-term actions against long-term interests of the companySuch targets reduce motivation for managers to engage in data manipulationIf business unit profit budgets are achievable, senior managers can divulge a profit target to security analysts, shareholders and other external constituencies with reasonably correct estimatesBehavioral AspectsBehavioral AspectsA profit budget, difficult to attain, usually implies an overly optimistic sales targetWhen business unit managers are able to meet & exceed their targets, there is a “winning” atmosphere and positive attitude within company one limitation is that business unit managers will not put forth satisfactory effort, once budget is met• Senior management involvement: some managers will submit easily attainable budgets or budgets with excessive allowancesBehavioral AspectsBehavioral Aspects there should be top management feedback on budget results to motivate the budgetee• Budget Department: it must analyse budgets in detail and it must be certain that budgets are prepared properly and that information is accurate to perform their function effectively, members of budget department must have a reputation for impartiality and fairness department must walk a fine line between helping line manager and ensuring integrityQuantitative TechniquesQuantitative Techniques• Simulation: with computer simulation, senior management can inquire about effects of different types of changes and receive almost

instantaneous answers some of available software packages are specific to certain industries and others are general purpose• Probability estimates: each number in a budget is a point estimate i.e. it is the single “most likely” amountQuantitative TechniquesQuantitative Techniques after a budget has been tentatively approved, computer model substitutes a probability distribution for each major point estimate then, probability distribution of expected profits is calculated and used for planning some authors have proposed that budgets be prepared initially using probability distributions instead of point estimates subsequent variance analysis, according to these authors, would be based on such probability distributions

ANALYSING FINANCIAL PERFORMANCEANALYSING FINANCIAL PERFORMANCEREPORTSREPORTSCalculating VariancesCalculating Variances• Competent operating managers nevertheless adopt a ‘Kaizen’ mentality, they do not assume optimal performance as per budget• A more thorough analysis identifies causes of variances between actual and budgeted revenues and expenses and the organisation unit responsible• Total business performance is divided into revenue variances and expense variances• Revenue variances are divided into volume and price variances for each responsibility centerCalculating VariancesCalculating Variances• Expense variances are divided into other expenses and manufacturing expenses• Profit budget has considered certain estimates on state of industry and about company’s market share, its selling prices and its cost structure• Variance analysis incorporates following ideas: identify key casual factors affecting profits break down overall profit variances by these key casual factors focus on profit impact of variation in each casual factorCalculating VariancesCalculating Variances try to calculate the specific, separable impact of each casual factor by varying only that factor while holding all other factors constant add complexity sequentially, one layer at a time, beginning at a very basic level stop the process when added complexity at a newly created

level is not justified by added useful insights into casual factors underlying the overall profit variance• Revenue Variances: selling price varianceCalculating VariancesCalculating Variances mix and volume variance: it is found as: (actual volume – budget volume) * budgeted unit contribution mix variance for each product:mix variance =(total actual sales volume * budget proportion) – (actual sales volume * budgeted unit contribution) volume variance for each product:Volume variance =(total actual sales volume * budgeted percentage) – (budgeted sales * budgeted unit contribution)

Calculating VariancesCalculating Variances market penetration and industry volume:principle is that business unit managers are responsible for market share but they are not responsible for industry volume because it is largely influenced by state of the economymarket share variance = (actual sales – industry volume) * budgeted market penetration * budgeted unit contributionIndustry volume variance = (actual industry volume – budgeted industry volume) * market penetration budgeted * budgeted unit contributionVariations In PracticeVariations In Practice• Time period of comparison: a comparison of annual budget with current expectation of actual performance for the whole year shows how closely business unit manager expects to meet annual profit target senior management needs a realistic estimate of profit for whole year both as it may suggest need to change dividend policy, get additional cash, change spending levels etc. performance reporting should be for the year to date and year as a wholeVariations In PracticeVariations In Practice• Focus on Gross Margin: task of the marketing manager is to obtain a budgeted gross margin- i.e. constant spread between cost and selling prices, such a policy in important in period of inflation unit gross margin is difference between selling prices and manufacturing costs standard, rather than actual manufacturing cost is used so that manufacturing inefficiencies do not affect the performance of marketing organisationVariations In PracticeVariations In Practice• Evaluation Standards: predetermined standards or budgets

historical standards:Such standards have two serious weaknesses:conditions may have changed between two periods and hence, comparison is invalidatedprior period’s performance may not be accepted external standards:Some companies identify best companies in the industry and use them as basis for comparisonVariations In PracticeVariations In Practicedata for individual companies are available in annual and quarterly reports and in form 10KMany institutes provide information about member companies e.g. Financial Executives• Limitations on standards: even standard cost may not be an accurate estimate of costs under circumstances for either or both of the reasons below:Standard was not set properly andAlthough it was set properly, conditions have changed to make it obsolete

Variations In PracticeVariations In Practice• Full Cost Systems: both variable and fixed overhead costs are included in inventory at standard cost per unit if inventory levels change and if actual volume of production is different from budgeted, part of production volume variance is taken in inventory important point is that production variances should be associated with production volume• Amount of detail: revenue variances are analysed at various levels- total, volume, mix, price etc.Variations In PracticeVariations In Practice at each of levels, variances are analysed by individual products it is possible and in some cases, worthwhile, to develop additional sales and marketing variances by sales territories, by individual salesperson etc. additional detail for manufacturing costs can be developed by calculating variances for lower-level responsibility centers and by identifying variances with specific input factors like wages how much information is worthwhile, depends on requirement of individual managersVariations In PracticeVariations In Practice• Engineered and Discretionary costs: a favourable variance in engineered costs is an indication of good performance, i.e. lower the cost, the better, based on satisfactory quality and on-time delivery performance of a discretionary expense center is satisfactory

if actual expenses are equal to budgeted amount as some elements in discretionary center are engineered (e.g. bookkeeping in controller set up) a favourable variance is taken as favourable Limitations of Variance AnalysisLimitations of Variance Analysis• it does not tell where variance occurred or what is being done about it• it is difficult to decide significance of variance• as the performance reports become highly aggregated, offsetting variances might mislead the reader• also, as variances become more highly aggregated, managers become more dependent on accompanying explanations and forecasts• reports only show current happening; future effects of actions taken by manager are missingLimitations of Variance AnalysisLimitations of Variance Analysis• Management Action monthly profit report should contain no major surprises one of the most important benefits of formal reporting is that it provides desirable pressure on subordinate managers to take corrective actions in their own initiative usually there is a discussion between business unit manager and his superior for discussion on variances profit reports should lead to action

PERFORMANCE MEASUREMENTPERFORMANCE MEASUREMENTPerformance Measurement SystemsPerformance Measurement Systems• Goal of such systems is to implement strategy• A performance measurement system is simply a mechanism that improves the likelihood that organisation will implement its strategy properly• Limitations of Financial Control Systems: it may encourage short-term actions not in the company’s long term interests business unit managers may not undertake useful long-term actions, in order to obtain short term profits, e.g. investments promising long-term benefits may not be undertakenPerformance Measurement SystemsPerformance Measurement Systems using short-term profits as sole objective can distort communication between a business unit manager and senior management tight financial control may motivate managers to manipulate data• Companies have used financial & non-financial measures in the past• Non-financial measures have been used at lower levels in the organisation for task control and financial measures at higher organisational levels for management control

Performance Measurement SystemsPerformance Measurement Systems• General Considerations: this system has a series of measures to provide information about operation of many different processes e.g. equity of company, inventory level of finished goods etc. all these measures have implicit interactions & changes in one reflect changes in another• Balanced Scorecard Approach: business units must be assigned goals and then measured from the following four perspectives:Performance Measurement SystemsPerformance Measurement SystemsFinancial e.g. profit margin, cash flowCustomer e.g. market share, customer satisfactionInternal business e.g. employee skillsInnovation and learning e.g. new product research in creating balanced scorecard, executives must choose a mix of measurements that:accurately reflect critical factors for the companyshow relationships among individual measuresprovide a broad-based view of current status of the companyPerformance Measurement SystemsPerformance Measurement Systems• Additional Considerations: outcome and driver measures:Outcome – lagging indicators – indicate results of a strategy e.g. revenue from new productDriver – leading indicators – progress of key areas in implementing a strategy e.g. R & D costby focusing management attention on key aspects of business, drivers affect behaviour in the firm financial and nonfinancial measures:sophisticated systems have developed to measure financial performancePerformance Measurement SystemsPerformance Measurement Systemseven though nonfinancial measures are seen as important, many organisations have failed to incorporate them into their executive-level performance reviews internal and external measures:Companies must strike a balance between external measures like customer loyalty and internal measures like manufacturing efficiency measurements drive change:Organisation achieves goal congruence by linking overall financial objectives with lower-level areas Performance Measurement SystemsPerformance Measurement Systemsas various measures are explicitly tied to an organisation’s strategies, they should be strategy-specific in scorecard and therefore organisation specificscorecard measures are linked from top to bottom and tied to specific targets throughout entire organisation

scorecard emphasizes idea of cause-and-effect relationships among measuresscorecard measure relationships should be understood in a better way for firm’s successPerformance Measurement SystemsPerformance Measurement Systems• Key Success Factors: Customer-focused key variables:BookingsBack ordersMarket shareKey account ordersCustomer satisfactionCustomer retentionCustomer loyaltyPerformance Measurement SystemsPerformance Measurement Systems• Key Variables related to Internal business processes: capacity utilisation on-time delivery inventory turnover quality cycle time: it is equal to = processing time+storage time+movement time + inspection timeProgress can be measured by observing ratio of process time to cycle time

Performance Measurement SystemsPerformance Measurement Systems• Implementing a Measurement System: define strategyprocess of defining a scorecard begins by defining organisation’s strategy define measures of strategy integrate measures into management system review measures and results frequentlyensure successful implementation of strategyshow management’ seriousness about measureskeep measures aligned to ever-changing strategiesPerformance Measurement SystemsPerformance Measurement Systemsensure that measurements are improved• Difficulties in implementing system: poor correlation between nonfinancial measures and results fixation on financial results measures are not updated measurement overload difficulty in establishing trade-offsscorecards need to assign explicit weights across measures to establish such trade-offs Performance Measurement SystemsPerformance Measurement Systems• Measurement practices:

type of measures:financial, operating and customer satisfaction measures are mainly included in regular reviews quality of measures:measures of employee performance and change & innovation have generally been poorly defined and of poor quality relationship of measures to compensationMost of companies, according to survey, used innovation & change measures for compensation

Interactive ControlInteractive Control• Its main objective is to facilitate creation of a learning organisation• In industries that are subject to very rapid environmental changes, management control information can also provide basis for thinking about new strategies; this is interactive control• there is a fundamental difference between critical success factors and strategic uncertainties• Interactive controls alert management to uncertainties, either troubles like complaints or opportunities like a new marketInteractive ControlInteractive Control• It has the following characteristics: subset of management control information that has an effect on strategic uncertainties facing business becomes the focal point senior executives take information seriously managers at all levels in organisation focus attention on information produced by system superiors, subordinates and peers meet face-to-face to interpret and discuss implications of the information for future strategic initiativesInteractive ControlInteractive Control face-to-face meetings take the form of debate and challenge of underlying data, assumptions and appropriate actions• Firms should monitor following technological discontinuities: internet an e-commerce growth have potential implications for many firmsemergence of ubiquitous point-and-click interfaces based on open standardsincreasing power of computing and communication technologiesInteractive ControlInteractive Controlgrowth in mobile communications for both voice telephony and internet accessdevelopment and deployment of speech recognition and machine-based language translation technologies convergence technologies will have effects such as blending of hardware and software, integration of chemical and digital technologies etc. miniaturization can provide opportunities for firms in consumer electronics and appliances

shifts from physical goods to services

Interactive ControlInteractive Control• Following discontinuities have potential to create new opportunity due to globalisation: liberalisation, deregulation and privatisation have potential to create huge new customer segments in emerging markets like India & China new competitors from emerging markets may become global players in the future• interactive control information usually, but not exclusively, tends to be nonfinancial• interactive controls are an integral part of the management control systemInteractive ControlInteractive Control• Subsystem should satisfy following conditions before being used as an interactive system: data contained in the subsystem should be unambiguous & simple to understand & interpret the subsystem must contain data on strategic uncertainties data in subsystem should help the firm to develop new strategiesMittal Steel wants to expand its customer reach across the world, necessary data has to be collected

MANAGEMENT COMPENSATIONMANAGEMENT COMPENSATIONResearch Findings on Organisational IncentivesResearch Findings on Organisational Incentives• Reward incentives are inducements to satisfy their needs that individuals cannot obtain without joining the organisation• Research on incentives points out following: individuals tend to be more strongly motivated by potential of earning rewards than by fear of punishment a personal reward is relative or situational individuals are highly motivated, on receiving reports or feedback about their performanceResearch Findings on Organisational IncentivesResearch Findings on Organisational Incentives incentives become less effective as period between an action and its feedback increases motivation is weakest when person believes that incentive is either attainable/easily attainable if senior management signals about importance of management control system, operating managers will also regard it as important incentive provided by a budget or other statement of objective is strongest when managers work with their superiors to arrive at amountsCharacteristics of Incentive PlansCharacteristics of Incentive Plans• A manager’s total compensation package consists of three

components: salary, benefits and incentive compensation• incentive compensation is related to the management control function• most corporate bylaws and securities regulation require such incentive plans and revisions of existing plans to be approved by shareholders• Incentive compensation plans are divided into short-term and long-term plans, bonus can be earned by a manager under both the plansCharacteristics of Incentive PlansCharacteristics of Incentive Plans• Short Term Incentive Plans: total amount of bonus that can be paid to a qualified group of employees in a given year is called ‘bonus pool’ simplest method for bonus pool is to make bonus equal to a set percentage of profits many companies may not like above method as bonus will be paid even in low profit periods and additional investments are not reflected one method is to base bonus on % of EPS after a predetermined level of EPS has been obtainedCharacteristics of Incentive PlansCharacteristics of Incentive Plans this above method does not take into account increases in investments from reinvested earnings another method of relating profits to capital employed is to define capital as shareholder equity plus long term liabilities in above method, bonus is equal to percent of profit before taxes and interest on long-term debt, minus a capital charge on total of shareholder equity plus long-term debt this method is used as managerial performance should be based on corporate net assets profitably Characteristics of Incentive PlansCharacteristics of Incentive Plans in another option, capital can be equal to shareholder equity in this option, difficulty is that a loss year reduces shareholder equity and increases bonus to be paid in profitable years a few companies base the bonus on increase in profitability over preceding year some companies base bonuses on their profits relative to that of their industry in above case, obtaining comparable data may be difficultCharacteristics of Incentive PlansCharacteristics of Incentive Plans• Carryovers: instead of total amount in bonus pool, plan may provide for carryover annually of part of amount this method is more flexible, since Board of Directors can exercise their judgement also, it can reduce magnitude of swings that occur when bonus payment is strictly on formula disadvantage in this method is that bonuses relate less

directly to current performance generally, payments are not automatically determined by a formulaCharacteristics of Incentive PlansCharacteristics of Incentive Plans• Deferred Compensation: payments to recipients may be spread out over a number of years in this method annually merit is that managers can estimate their cash income with reasonable accuracy deferred payments smooth cash receipts a retiring manager will continue to receive cash for a number of years this time frame encourages to think long term disadvantage is that deferred amount is not available to executive in the year earnedCharacteristics of Incentive PlansCharacteristics of Incentive Plans• Long Term Incentive Plans: growth in the value of company’s common stock reflects company’s long run performance, is basic premise of such plans Stock Options:It is the right to buy a number of shares of stock at, or after, a given date in the future, at a price agreed upon at the time option is granted (usually current market price or 95% of current price)major benefit is that managers’ energies are directed towards performance of the company

Characteristics of Incentive PlansCharacteristics of Incentive Plansoutright purchase of stock under the plan gives managers equity that they can retain, even if they leave the company and a gain that they obtain, whenever they decide to sell the stockhowever, many stock options are for restricted stock Phantom Shares:manager is awarded a number of shares for bookkeeping purposes onlythis award may be in cash, shares of stock or boththis plan has no transaction costsCharacteristics of Incentive PlansCharacteristics of Incentive Plansat end of a specified period, executive is entitled to receive an award equal to appreciation in market value of stock since date of awardrisk of decrease in market price and interest costs associated with holding shares is not in this plan Stock Appreciation Rights:It is a right to receive cash payments based on increase in stock’s value from time of award until a future datethis & previous plan, involves uncertainty in both directions about the ultimate amount paidCharacteristics of Incentive PlansCharacteristics of Incentive Plans Performance Shares and Units:

A performance share plan awards a specified no. of shares based on specific long-term goals metadvantage of this plan is that award is based on performance that executive can partially control like EPS, but limitation is that bonus is based on accounting measureA performance unit plan pays cash bonus based on specific long term targets metit is especially useful in companies with little or no publicly traded stockIncentives for Corporate OfficersIncentives for Corporate Officers• CEO’s compensation is usually discussed by Board of Directors compensation committee based on his recommendations for subordinates compensation• Are CEOs paid too much ? – a hot debate• Several proposals have been made to ensure that BODs act in interest of shareholders: prevent directors from selling their stock for duration of their term to encourage them to ask “tough” questions of CEOs without fear of adversely affecting short-term stock prices Incentives for Corporate OfficersIncentives for Corporate Officers set mandatory limits on tenure of directors to avoid their becoming too entrenched with management hold an annual performance review of directors avoid having CEO of corporation as chairman of the board• Following arguments are given to support expensing stock options in year for top managers: about 75% of CEO and top management compensation represents stock options under current rules, stock options are felt as free Incentives for Corporate OfficersIncentives for Corporate Officers treating stock options as an expense would result in a more accurate earnings picture this would prevent top managers from playing accounting games to pump up short-run stock prices in order to cash their options finally, there are double standards at present since companies are allowed to expense difference between issue and exercise price of options for income tax purposes but it is not required for financial reporting options dilute shares and have real costs

Incentives for Corporate OfficersIncentives for Corporate Officers• Following arguments are advanced against expensing stock options: stock options do not involve cash outlay valuing stock options is far from easy it will dampen earnings and reduce stock price, so fewer options will be issued cash-trapped start-ups, especially in Silicon Valley, use

options to attract human talent, this could damage innovative spirit in this sector they are disclosed in foot-notes to the balance sheetIncentives for Business Unit ManagersIncentives for Business Unit Managers• Types of incentives: financial rewards:Salary increase, bonuses, benefits & perquisites psychological and social rewards:Promotion possibilities, increased responsibility, increased autonomy, better geographical region and recognition size of bonus relative to salary:One school of thought states that we recruit good people, pay them well and then expect good performance – fixed pay performanceIncentives for Business Unit ManagersIncentives for Business Unit ManagersAnother school states that we recruit good people expect them to perform well and pay them well if performance is actually good – performance based pay cut off levels:upper cutoff and lower cutoff levels will be specified, but both will have side effectsmanagers may be motivated to decrease profits in one year to create high bonus for following yearthis issue can be solved by carrying excess or deficiency into the following yearIncentives for Business Unit ManagersIncentives for Business Unit Managers• Bonus basis: bonus could be based solely on total corporate profits or on business unit profits or on both in a single industry firm whose business units are highly interdependent, manager’s bonus is tied primarily to corporate performance in a conglomerate, it is desirable to reward managers primarily based on business unit performance to solve free rider problems for related diversified firms, mix of unit performance and company profits can be used Incentives for Business Unit ManagersIncentives for Business Unit Managers• Performance Criteria: financial criteria:for a profit center, criteria like contribution margin, direct business unit profit, net income etc.are usedfor an investment center, definition of profit, definition of investment and choice between ROI and EVA has to be done adjustments for uncontrollable factors:One adjustment removes expenses resulting from decisions made by executives above unit level

Incentives for Business Unit ManagersIncentives for Business Unit Managers

Another adjustment eliminates effects of losses caused by “acts of nature” and accidents not caused by manager’s negligence benefits and shortcomings of short-term financial targets:it induces managers to search for different ways to perform existing operations and initiate new activities to meet financial targetsIt could encourage short-term actions not in long-term interests of the company e.g. equipment undermaintenance Incentives for Business Unit ManagersIncentives for Business Unit Managersmanagers might not undertake promising long term investments that hurt short-term financial resultsmanagers may be motivated to manipulate data to meet current period targets mechanisms to overcome short-term bias:advantage is that supplementing financial measures with additional incentive mechanisms may overcome short-term orientation of annual financial goals, for e.g. multi-year performance can be base for manager’s bonus

Incentives for Business Unit ManagersIncentives for Business Unit Managersthere are certain weaknesses in this mechanism:Firstly, managers have difficulty seeing connection between their efforts and rewards in a multilayer award schemeSecondly, if a manager retires or is transferred during multilayer period, implementing such a plan becomes too much complexThirdly, it is more likely that factors beyond manager’s control will influence achievement of long-range targetsIncentives for Business Unit ManagersIncentives for Business Unit Managersanother method is to develop a scorecard having one or more nonfinancial criteria like sales growth, market share, product quality etc., which will affect long-run profitsanother mechanism to correct short-term bias is to base part of business unit manager’s bonus on long-term incentive plans, such as stock options, phantom shares etc. benchmarks for comparison:Typical practice is to evaluate a business unit manager against the profit budgetIncentives for Business Unit ManagersIncentives for Business Unit Managers• Bonus Determination Approach: a bonus award can be determined by using a formula like % of business unit’s operating profit or by purely subjective assessment by superior or by some combination of the two only objective formula use has some merits:reward system can be specified with precisionthere is little uncertainty on performance standardsuperiors cannot show any bias demerit is that less attention will be given to the dimensions difficult to quantify like R & D

Incentives for Business Unit ManagersIncentives for Business Unit Managers numerical indicators of unit’s performance are less valid measures of manager’s performance in the following cases:unit manager inherits problems of predecessorunit is highly interdependent with other units and hence, its performance is influenced by decisions and actions of outside individualsstrategy requires much greater attention to long-term concerns as in cases of units aggressively building market share Agency TheoryAgency Theory• This theory explains how contracts & incentives can be written to motivate individuals to achieve goal congruence• Concepts: in a corporation, shareholders are principals and CEO is their agent at a lower level, CEO is principal and business unit managers are agents incentive contracts can reduce divergent preferences or objectives between principal and agentsAgency TheoryAgency Theory• Divergent Objectives of Principals and Agents: this theory assumes that all individuals act in their own self-interest agents are assumed to receive satisfaction from financial compensation and perquisites an agent’s preference for leisure over work is called work aversion, deliberately withholding work is called shrinking principals are assumed to be interested only in financial returns that accrue from their investment in the firmAgency TheoryAgency Theory agents are assumed to be risk averse, while owners are risk neutral• Nonobservability of Agents’ Actions: as principal has inadequate information about agent’s performance, he can never be certain how agent’s effort contributed to actual results; this situation is termed as information asymmetry agent may know more about task than principal this additional information is private information shareholders are not able to monitor activities of CEOAgency TheoryAgency Theory moral hazard is a situation, where an agent being controlled is motivated to misrepresent private information by nature of control system• Control Mechanisms: there are two major ways of dealing with problem of divergent objectives and asymmetry: Monitoring:principal can design control systems to monitor agent’s actions,

limiting actions that increase agent’s welfare at expense of principal’s interestAgency TheoryAgency Theoryagency theory attempts to explain that monitoring is more effective if agent’s task is well defined and information or “signal” used is accurate Incentive Contracting:principal should define performance measure to further interest of the agent; this ability to achieve is termed as goal congruencea compensation scheme not incorporating an incentive contract poses problem like CEO not motivated when paid a straight salary as compared to salary plus bonusAgency TheoryAgency Theoryprincipals face challenge of identifying signals that are correlated with both agent effort and firm valuenone of incentive arrangements can ensure complete goal congruence due to difference in risk preferences between two parties, asymmetry of information and costs of monitoring CEO compensation and Stock Ownership PlansA company paying bonus in form of stock options to CEO shows example of agency cost like risk preference differences inherent in compensationAgency TheoryAgency Theoryagent may not take on high risk/high return projects found desirable by the principalanother problem with stock ownership bonus is lack of direct casual relationship between agent’s effort and change in stock pricein spite of these two problems, stock ownership contract is preferred to a non-incentive contract Unit managers & accounting-based incentives:it is difficult to isolate contributions made by individual business units to changes in the firm’s stock price Agency TheoryAgency Theoryif bonus is based strictly on net income, however, agent’s compensation will decreasewhile a contract based on business unit net income may have lower agency costs than straight salary, these costs do not go down to zero• A Critique: this theory has been invented in 1960s, but has had no discernible influence on management control process real-world payoffs have not been seen where managers have benefitted by using this theoryAgency TheoryAgency Theory managers in nonprofit and Governmental organisations, who cannot receive incentive compensation, inherently lack motivation for goal congruence, according to this theory some people believe that models are no more than

statements of obvious facts expressed in mathematical symbols other people say that elements in model can’t be quantified and model oversimplifies real world relationship between superiors and subordinates theory ignores other factors affecting above relationship

CONTROLS FOR DIFFERENTIATED STRATEGIESCONTROLS FOR DIFFERENTIATED STRATEGIESCorporate StrategyCorporate Strategy• Logic for linking controls to strategy is based on following line of thinking: different organisations generally operate in different strategic contexts different strategies require different task priorities, key success factors, skills, perspectives and behaviour for effective execution control systems influence behaviour of people thus, a continuing concern in design of control systems should be whether the behaviour induced by system is consistent with strategyCorporate StrategyCorporate Strategy• Implications for Organisation Structure: at single industry end, company tends to be functionally organised at unrelated diversified end, many senior managers tend to be experts in finance as firm moves from single industry to diversified end, autonomy of unit manager increases for two reasons:* senior managers of unrelated diversified firms may not have knowledge & expertise to make strategic & operating decisions for business unitsCorporate StrategyCorporate Strategy* there is very little interdependence across units in a conglomerate size of a conglomerate’s corporate staff as that to same-sized single industry firm, tends to be low also, a conglomerate may not have single, cohesive, strong corporate culture• Implications for Management Control: different corporate strategies imply following differences for designing of control systems: due to more diversification, corporate managers may not be experienced in activities of units

Corporate StrategyCorporate Strategy* single industry and related diversified firms possess corporatewide core competencies on which strategies of most of business units are based Strategic Planning:

due to lower level of interdependencies, conglomerates tend to use vertical planning system for related diversified and single industry firms, planning systems tend to be horizontal & vertical Horizontal dimension might come into process in different ways like: a group executive might be responsible to plan

Corporate StrategyCorporate Strategy* strategic plans of individual units could have an interdependence section, where general manager identifies focal linkages with other units and how they will be exploitedcorporate office could require joint strategic plans for interdependent business unitsstrategic plans of individual units could be circulated to managers of similar units to critique and reviewAbove methods are not mutually exclusive, some of them could be proposed fruitfully at same timeCorporate StrategyCorporate Strategy Budgeting:Chief Executives of single industry firms may be able to control operations of subordinates through informal and personally oriented mechanisms like frequent personal interactionsIn a conglomerate, it is nearly impossible for Chief Executive to rely on informal interpersonal interactions as a control toolFor a conglomerate, business unit managers have more influence in developing budgets and greater emphasis is on meeting budgeted targets Corporate StrategyCorporate Strategy Transfer Pricing:For a conglomerate, policy is to give sourcing flexibility to business units and use arm’s length market pricesFor a single industry or related diversified firm, synergies may be important rather than freedom to make sourcing decisions Incentive Compensation:Use of formulas by conglomerates to determine bonuses, while subjective factors are used in case of single industry and related diversified firmsCorporate StrategyCorporate StrategyProfitability measures are used to determine incentives for unrelated diversified firms in terms of profit of particular business unit’s managerSingle industry and related diversified firms base bonus of business unit manager on both – unit’s performance and performance of larger organisational unit such as product groupBonus of general managers should be based on overall corporate performance so that greater inter-unit cooperation is encouraged, thereby enhancing exploitation of interdependenciesBusiness Unit StrategyBusiness Unit Strategy

It depends on two interrelated aspects:Mission Competitive advantage Mission: mission for existing business units could be either build, hold or harvest to implement strategy effectively, there should be congruence between mission chosen and type of controls usedBusiness Unit StrategyBusiness Unit Strategy control-mission “fit” is developed with the following line of reasoning: mission of business unit influences uncertainties faced by general managers and short term v/s long-term trade-offs management control systems can be varied systematically to help motivate the manager to cope effectively with uncertainty

Business Unit StrategyBusiness Unit Strategy Mission and uncertainty: build strategies are undertaken in growth stage of product lifecycle, whereas harvest strategies are undertaken in decline stage of lifecycle build strategy has a business unit in greater conflict with its competitors than a harvest one on both input and output side, build managers tend to experience greater dependencies on external individuals and organisations

Business Unit StrategyBusiness Unit Strategy since build units are often in new and evolving industries, their managers are likely to have less experience in their industries Mission and time span: share building strategy includes:Price cuttingMajor R & D expendituresMajor market development expenditures harvest strategy concentrates on maximising short-term profits

Business Unit StrategyBusiness Unit Strategy Strategic Planning: strategic planning process is more critical and important for build as compared to harvest units in screening capital investment and allocating resources, system may be more quantitative and financial for harvest units for build units, non-financial data may be more important, as low discount rates can be set to forward more investment ideas to corporate officeBusiness Unit StrategyBusiness Unit Strategy Budgeting:

budgets are relied on less in build units than in harvest units

Following additional differences are found in budget process between build & harvest units:

Budget revisions are likely to be more frequent for build units than harvest units

Build unit managers may have greater input and influence in budget formulation

Business Unit StrategyBusiness Unit Strategy Incentive compensation system: what should size of incentive bonus payments be relative to

general manager’s base salary ? what measures of performance i.e. profit, EVA sales

volume, market share etc. should be used to decide general manager’s bonus – what should be weights ?

how much reliance should be on subjective judgements in deciding bonus amounts ?

how frequently should incentive be awarded ? Business Unit StrategyBusiness Unit Strategy Incentive compensation system (continued): with respect to first question, many firms use the principle that riskier the strategy, greater the proportion of general manager’s compensation in bonus compared to salary for second question, when rewards are tied to certain performance criteria, behavior is influenced by desire to optimise performance based on those criteriaBusiness Unit StrategyBusiness Unit Strategy for third question, manager’s bonus might be a strict formula-based plan or superior’s subjective judgement or combination of both approaches for third question, build managers are evaluated more subjectively than harvest ones for the final question, payments of bonuses less frequently encourages managers to take a long term perspective and hence build managers receive bonus less frequently than harvest ones

Business Unit StrategyBusiness Unit Strategy Competitive Advantage: choosing a differentiation approach, than a low cost

approach, increases uncertainty in a business unit’s task environment for 3 reasons:

Product innovation is more critical for differentiation business units

Differentiation business units tend to have a broader set of products to create uniqueness

Products of differentiated units succeed if customers perceive its advantages over competitors

Top Management StyleTop Management Style Management control function is influenced by the style of senior management Differences in management styles: style is influenced by manager’s background and personality some rely heavily on reports, some prefer conversations and informal contacts some are analytical, some use trial & error some are process-oriented, some are result-orientedTop Management StyleTop Management Style Implications for management control: style affects management control process- how CEO prefers to use information, conduct performance review meetings etc. personal versus impersonal contacts:Some managers are number-orientedSome managers are people-orientedManagers attitudes towards formal reports affect amount of detail they want, frequency of these reports etc.Top Management StyleTop Management Style tight versus loose controls:Manager of a routine production centre can be controlled relatively tightly or loosely and actual control reflects style of manager’s superiorDegree of looseness tends to increase at higher levels successively in the organisation hierarchy; however it may not happen if CEO has a different styleDegree of tightness or looseness is a factor of how such formal devices are used

SERVICESERVICEORGANISATIONSORGANISATIONSService Organisations in GeneralService Organisations in General Characteristics: Absence of Inventory buffer:• Services cannot be stored• Costs of many organisations are essentially fixed in short run• A key variable is extent to which capacity is matched with demand Difficulty in controlling quality: Labour intensive:• increases costs by adding expensive equipmentService Organisations in GeneralService Organisations in General Multi-unit organisations:• some of units are owned, some are franchised• e.g. fast food chains, auto rental companies, educational services etc. Historical development:• their use of product cost and other management accounting

data is fairly recent- mostly since World War II• nowadays management control systems are rapidly developing in servicesProfessional Service OrganisationsProfessional Service Organisations Special characteristics: Goals:• in many organisations, goal is to increase size• Also goals are to increase efficiency, accountability etc. Professionals:• they are labour intensive and labour is of special type• they tend to do best job, ignoring financial implications

Professional Service OrganisationsProfessional Service Organisations Output and input measurement:• not measured in physical terms such as units, tons or gallons• work done is non-repetitive e.g. research and development projects• some professionals like scientists, engineers and professors are reluctant to keep track of time spending and hence measurements are difficult• some work is repetitive e.g. medical treatmentsProfessional Service OrganisationsProfessional Service Organisations Small size:• organisations are relatively small and operate at a single location e.g. law firms• less need for a sophisticated management control system Marketing:• it is difficult to assign appropriate credit to person responsible for selling to a new customer• it takes form of personal contacts, speeches etc.Professional Service OrganisationsProfessional Service Organisations Management control systems: Pricing:• fees are related to professional time spent on engagement, if keeping track of time is important• in investment banking, fee typically is monetary size of security issue• principal asset is skill of professionals Profit centers and transfer pricing:• support units charge for their servicesProfessional Service OrganisationsProfessional Service Organisations Strategic planning and budgeting:• strategic plan typically consists of a long-range staffing plan rather than a full-blown for all aspects of firm’s operation Control of Operations:• much attention should be given to scheduling time of professionals• inability to set standards for task performance, desirability of work by project teams, behavioural characteristics complicate

control issuesProfessional Service OrganisationsProfessional Service Organisations Performance measurement and appraisal:• recommendations of an investment analyst can be compared to actual market behaviour of securities – subjective judgement• budgeting and control of discretionary expenses are important for a professional firm• in some professions, internal audit procedures are used to control quality• appraisals by a professional’s peer or by subordinates are sometimes part of formal controlFinancial Service OrganisationsFinancial Service Organisations Services Sector: Their importance in overall performance of the economy is considerably greater than what its percentage indicates 30 years ago, commercial banking, investment banking, retail brokerage and insurance existed as distinct and separate industries Firms have used IT revolution to innovate new products and discover new methods of trainingFinancial Service OrganisationsFinancial Service Organisations Need for controls in the sector has become important During 1990s, new forms of financial instruments such as derivatives resulted in millions of dollars of losses from their clients Corporate scandals during 2002 have created a huge push for investment banks to spin off their research departmentsThere are arguments against going for spin offs also like increased research costFinancial Service OrganisationsFinancial Service Organisations Special characteristics: Monetary assets:current value is much more easily measured than value of plant and machineryquality refers to quality of service rendered and to quality of financial instruments other than money Time period for transactions:ultimate financial success or failure of a bond issue, mortgage loan or a life insurance policy may not be known for 30 years or moreFinancial Service OrganisationsFinancial Service Organisationscontrol requires that there be means of continued surveillance of soundness of transaction during its life including periodic auditsat the other extreme, some transactions are completed quicklyFor e.g. firm must have an accurate, prompt system for estimating risks of securities held Risk and rewards:most business decisions involve trade-offs between risk and returnFinancial Service OrganisationsFinancial Service Organisationsin financial service firms, this trade-off is more explicit than in business investments like purchase of machine or introduction of

new product Technology:firms have used IT as a way to offer innovative servicesfor e.g. automated teller machines of banksinsurance and mutual funds have developed electronic marketplacesHealthcare OrganisationsHealthcare Organisations Special characteristics: Difficult social problem:society is gradually coming to grips with the fact that present health care delivery system is unworkable Change in mix of providers:within overall increase in health care cost, significant changes have been done in healthcare delivery and hence in viability of providers

Healthcare OrganisationsHealthcare Organisations Third-party providers:diagnostic related groups and increase in hospital costs per patient, has motivated hospitals to install cost accounting systemsIncreasingly healthcare maintenance organisation reimburse physicians, hospitals and other service providers Professionals:their primary loyalty is profession, rather than the organisationHealthcare OrganisationsHealthcare Organisationsdepartmental managers are typically professional whose management function is only part-time Importance of quality control:There are tissue reviews of surgical procedures, peer review of individual physicians etc. Management control process: because of shift in product mix and because of increase in quantity and cost of new equipment, strategic planning process is important Non-Profit OrganisationsNon-Profit Organisations In many industry groups, there are both non-profit and profit-oriented organisations Special characteristics: Absence of profit measure:income statement is the most useful statement in a non-profit organisation Contributed capital:it receives contributed capital, which few businesses haveplant and endowment are main categories of contributed capitalNon-Profit OrganisationsNon-Profit Organisationsreceipt of a contributed capital asset is not revenueendowment assets must be separate from operating assets Fund accounting:

accounts are separate for several funds, each of which is self-balancingMost organisations have general or operating fund endowment fund with plant fund and variety of other funds like pension fundsNon-Profit OrganisationsNon-Profit Organisations Governance:organisations are governed by Board of Trusteesthey generally exercise less control than directors of a business corporationNeed for a strong governing board is greater here as vigilance may be the only way of detecting signals of difficulty Management control systems: Product pricing:pricing of services at full cost is desirableNon-Profit OrganisationsNon-Profit Organisationspricing for peripheral activities should be market-basedas a general rule, control is facilitated when prices are established prior to performance of services Strategic planning and budget preparation:strategic planning is more important and time-consuming process as allocation of limited resources to worth-while activities is importantexpenses are budgeted to have at least breakeven at estimated amount of revenue

Non-Profit OrganisationsNon-Profit Organisationsmany organisations like colleges, know their revenues approximately before the year starts Operation and evaluation:there is no way of knowing what optimum operating costs are in most organisationsAlthough organisations have had a reputation for operating inefficiencies, this perception has been changing for good reasonse.g. change in hospital costs with reimbursement on basis of diagnostic related groups

MULTINATIONAL ORGANISATIONSMULTINATIONAL ORGANISATIONSCultural DifferencesCultural Differences when an organisation spans nationalities, cultural differences of a profound sort have to do with national and regional character and have an important bearing on management control According to Hofstede, cultures can differ across four dimensions:• power distance• individualism/collectivism• uncertainty avoidance• masculinity/feminity

Cultural DifferencesCultural Differences Another classification by Hall differentiates culture on a spectrum from “low context” e.g. Germany, Britain etc. to “high context” e.g. Japan Korea etc. Inferences: • formal systems used for low context cultures v/s informal controls in high context cultures• decentralisation in decisionmaking is more preferred in low power distances

Transfer PricingTransfer Pricing Taxation: Governmental regulations: Tariffs: net effect of tariffs and taxes should be seen in setting transfer prices Foreign exchange controls:• some countries limit amount of foreign exchange available to import certain commodities Funds accommodation: Joint ventures: prices fixed for win-win situation

Transfer PricingTransfer Pricing Use of transfer pricing methods:• Legal considerations:to minimise taxes, US multinationals transfer assets to low IT countriescompanies transfer intellectual property rights to low tax country like IrelandSection 482 of Internal Revenue Code, provides rules for determining transfer price on sales between members of controlled group

Transfer PricingTransfer Pricing Acceptable intra-company pricing methods, in descending order of priority are as under:• comparable uncontrolled price method:• resale price method:• cost-plus method: Implications of Section 482:• Latitude in transfer prices:in many companies, there is difference between transfer prices for control purposes and legally allowable prices to minimise sum of tax & tariffTransfer PricingTransfer Pricingmanagement can minimise sum of income taxes and tariffs by maintaining transfer prices as far as possible at appropriate end of the range• In the former case, there are two extremes:Some companies permit subsidiaries to deal at arm’s length and let

impact of tax & tariffs fallForeign transfer prices may be controlled fully by corporate headquarters, for purpose of minimising total corporate costs or obtaining optimum mix of currency positionsTransfer PricingTransfer Pricing Solution to above extremes can be to adjust profits for internal evaluation purposes to reflect competitive market prices many companies that price to minimise taxes and tariffs use same prices for profit budget preparation and reporting as are used for accounting and tax purposes If profit budgets & reports reflect uneconomic prices, care must be taken to make certain that subsidiary managers act in best interests of companyTransfer PricingTransfer Pricing• Legal constraints on transfer pricing systems:full cost approach implicit in Section 482 may limit a company’s ability to transfer some products at less than full costscompanies can use one set of transfer prices for taxation and other for control purposes, to safely adjust subsidiary revenues and costs• Minority interests:Top management’s flexibility in distribution of profits between subsidiaries gets restrictedExchange RatesExchange Rates Multinational Enterprises face translation, transaction and economic exposures to changes in exchange rates exchange rates can be nominal like direct quote or indirect quote e.g. 1 $ = Rs. 45 is an indirect quote for India spot exchange rate is nominal rate on a particular day real exchange rate is spot rate after adjusting for inflation differentials between two countriesExchange RatesExchange Rates forward exchange rates are rates known today at which future transactions are done real exchange rates create cost competitiveness changes for a domestic manufacturer against its foreign competitors Different Exchange Rate Exposures:• Translation exposure is income statement & balance sheet exposure on MNEs to changes in nominal rates• Economic exposure is exposure of firm’s cash flows to real exchange rate changesExchange RatesExchange Rates• Transaction exposure is exposure that a firm has in its cross-border transactions where transactions are entered today but payments for settlement are made at some future date Choice of metric in performance evaluation:• in a survey, Choi and Czechowicz found almost all respondents having performance evaluation systems comparing actuals with budget• There are three possibilities of metrics:

initial exchange rate, projected exchange rate or ending exchange rate (setting and tracking budgets)

Exchange RatesExchange Rates• Favourable cells for setting and tracking budgets include:Initial-initial cell (setting and tracking both)Projected-projected cell (setting and tracking both)Ending-ending cell (setting and tracking both)Initial-ending cell (setting and tracking)Ending-initial cell (setting and tracking) Control System Design issues:• should subsidiary managers be responsible for impact of exchange rate fluctuations on their bottom line ? Exchange RatesExchange Rates• should parent company use home country currency or local currency in performance evaluation ? Further, which type of exchange rate ?• should parent company distinguish between effects of different types of exchange rate exposures while evaluating performance of the subsidiary manager ? If yes, how ?• how should different exchange rate exposures affect evaluation of economic performance of the subsidiary as distinct from manager in charge of subsidiary ?Exchange RatesExchange Rates Translation effects:• managers of subsidiaries, who don’t have cross- border transactions, need not be concerned with strategic & operating decisions such as pricing and sourcing in response to exchange rate changes• subsidiary managers should set and track budgets using same metrics as indicated previously• use of translation gains or losses in evaluating subsidiary manager’s performance could lead to several problems:Exchange RatesExchange Rates• Managers would be made responsible for factors beyond

their control• It does not get rid of translation gain or loss• It will not account for other types of exchange rate

exposures faced by subsidiaries• It will compound performance of the manager and the

subsidiary• When companies report to stockholders, they have to

consolidate accounting numbers of foreign subsidiaries with numbers of parent

Exchange RatesExchange Rates Economic exposure:• it is appropriate for control system to evaluate subsidiary manager on decisions that would enable subsidiary to respond to real exchange rate changes

• setting and tracking budgets using different metrics can be unfair• for subsidiaries having cross-border transactions, real exchange rate changes require important strategic and operating decisions e.g. importer can drop its local currency prices and increase demand & market shareExchange RatesExchange Rates Transaction effects:• basic approach is to use appropriate foreign exchange

hedging strategies• hedging transactions are probably best done at parent

company level rather than subsidiaries as:• Transaction costs are reduced across hedging• Parent company has a better access to wider range of

instruments across a greater range of maturities than a subsidiary

Exchange RatesExchange Rates• There is no reason to presume that a subsidiary manager can forecast exchange rates any better than corporate

treasurer• Performance of subsidiary:

It is important to recognise that economic performance of subsidiary itself should reflect negative or positive consequences of translation transaction and economic exposuresdoes it make continued economic sense for MNE to carry on operations in that country ?

should it take its business elsewhere ?Exchange RatesExchange Rates• Management considerations:subsidiary managers should not be responsible for translation effectstranslation effects are best handled by central coordination of MNEs overall hedging needssubsidiary manager should not be responsible for dependence effects of exchange rates resulting from economic exposureEvaluation of subsidiary for decision to locate or relocate operations should reflect consequences of these exposures

Exchange RatesExchange Rates• Management considerations:In a 1982 survey, inconsistencies have been noted in use of metrics for setting & tracking budgets for possibly following reasons:Most of control systems have developed in 1950s and 1960s, when rates were fixed in natureMany companies may not distinguish between financial

performance of manager & subsidiary

MANAGEMENT CONTROL OF PROJECTSMANAGEMENT CONTROL OF PROJECTSNature of ProjectsNature of Projects A project is a set of activities intended to accomplish a specified end result of sufficient importance to be of interest to management At one extreme, a project may involve one or few persons working for few days or weeks e.g. annual financial audit by a public firm At other extreme, project may involve thousands of people working for several years Extremely complex first-of-a-kind projects have more complicated control problemsContrast with Ongoing OperationsContrast with Ongoing Operations Single objective:• ongoing operations have multiple objectives Organisation structure:• in many cases, project organisation is super-imposed on an ongoing operation and its mgt. control system is superimposed on mgt. control system of that organisation Focus on the project:• primary focus is on cost, with quality & schedule on an exception basisContrast with Ongoing OperationsContrast with Ongoing Operations Need for trade-offs:• scope v/s schedule v/s cost Less reliable standards:• standards for repetitive activities can be developed from past experience or from engineering analysis of optimum time and cost• contingency allowances are also involved Frequent changes in plans:• unforeseen environmental conditions or unexpected facts can lead to changes in plansContrast with Ongoing OperationsContrast with Ongoing Operations Different rhythm:• most projects start small, build up to a peak activity and then taper off as completion nears and only cleanup needs to be done Greater environmental influence:• projects are subject to climatic and other geographical conditions Exceptions:• job-shop like printing company may focus on totality of its activities during a specified period

Control EnvironmentControl Environment Project Structure:• it is a temporary organisation• if project is conducted entirely or partly by an outside contractor, project sponsor should quickly establish satisfactory working arrangements with contractor’s personnel• matrix organisation:employees have two bosses- project manager and manager of functional department e.g. overhauling of a ship, where different craftspeople are neededControl EnvironmentControl Environment• evolution of organisation structure:in planning phase of a construction project, architects, engineers, schedulers and cost analysts predominatein project execution, production managers are involved Contractual relationships:• if project is conducted by an outside contractor, an additional level of project control is created along with the sponsor’s control systemControl EnvironmentControl Environment• Fixed-Price contracts:it appears that contractor assumes all the risks and consequently has responsibility for management controlif sponsor decides to change scope of the project, then change order is issuedParties must agree on cost, scope & schedule of change orderin this contract, sponsor is responsible for auditing the quality and quantity of work to ensure that it is done as specifiedControl EnvironmentControl Environment• Cost-reimbursement contracts:sponsor agrees to pay a reasonable cost plus a profitsuch a contract is appropriate when scope, cost and schedule of project cannot be estimated reliably in advance• Contrasts in Contract Types:for a fixed price contract, competent contractor includes an allowance for contingencies and size of this allowance varies with degree of uncertaintyControl EnvironmentControl Environmentfixed-price contracts are appropriate when scope of project can be closely specified in advance and when uncertainties are lowsponsor may end up paying more under a fixed-price contract than under a cost-reimbursement one and this extra payment is contractor’s rewardin a cost-reimbursement contract, profit component or fee, usually should be a fixed monetary amount, as contractor may manipulate, if it is a percentage of costs

Control EnvironmentControl Environment• Variations:in an incentive contract, completion dates are defined in advance and contractor gets a reward as completion bonus that is set at amount per unit of time saved or cost bonus a fixed price contract may cover contractor’s overhead costs, either as an amount for total project or for each monthif unit costs can be estimated, but quantity is uncertain, contract may be for fixed price per unitControl EnvironmentControl Environment Information Structure:• work packages:smallest element in a project is “work package” & total aggregation of activities is “work breakdown structure”work package should have an unambiguous, identifiable completion point, called milestoneif project has similar work packages, each should be defined in same way for collection & comparison of cost and schedule informationControl EnvironmentControl Environment• indirect cost accounts:cost accounts are established for administrative & support activities, which don’t have defined outputchart of accounts, rules for charging costs to projects and approval authorities & their signing powers are also developed in advancewhich will be lowest level of monetary cost aggregation ? – is to be decidedshould cost commitments be recorded ?

Project PlanningProject Planning Nature of Project plan:• scope part of plan• schedule part of plan• costs in control budget Network analysis:• PERT and CPM• Critical path and Slack:special attention should be for activities on critical path and less on slack activitiesProject PlanningProject Planningin the planning process, attention should be given to reduce critical path timeit may be desirable to reduce critical path time by increasing costs like overtime• Probabilistic PERToptimistic time and pessimistic times are supposed to represent approximately 0.01 and 0.99 on a normal distributionprobabilistic part has a serious problem and is not widely used in

practiceProject PlanningProject Planning Estimating costs:• cost estimates for most projects tend to be less accurate than those for manufactured goods• in estimating future costs, two types of unknown should be seen:first is known unknown which is estimate of the thing going to occurother is unknown unknowns where there is no certainty of occurrence Project PlanningProject Planning Preparing Control Budget:• budget is an important link between planning and control of performance• preparation of control budget should be delayed just prior to the beginning of work for later phases Other Planning activities:• one set of activities involves selection and organisation of personnel• e.g. materials are ordered, permits are obtained etc.Project ExecutionProject Execution is the project going to be finished by scheduled completion date ? is completed work going to meet desired specifications ? is work going to be within estimated cost ? Nature of Reports:• trouble reports – precision v/s speed• progress reports – variances may be identified• financial reports – accurate reports of project costsProject ExecutionProject Execution• cost to complete:in most circumstances, current estimate of total cost should be atleast equal to actual cost incurred to date plus original estimates for the remaining work Informal sources of information:• formal reports should contain no surprises• project manager gathers information by talking to people, unearths problems and solves them before making formal reportsProject ExecutionProject Execution Revisions:• in case of cost overruns, sponsor might decide to accept overrun and proceed as originally planned, decide to cut on scope of project with aim of producing within original cost limitation

OR• decide to replace the project manager• revised plan may become a rubber baseline- i.e. instead of providing a firm benchmark for performance, it may stretch to

cover inefficienciesProject ExecutionProject Execution• a solution to above problem is to compare actual cost with both- original and revised plan Project auditing:• audits may be done depending on the nature of work done in projects • in recent years internal auditors have expanded their function, which is operational auditing• internal auditors call attention to management actions believed to be substandard, in addition to cost incurred

Project EvaluationProject Evaluation Evaluation of Performance:• it covers 2 aspects: evaluation of project management and evaluation of process of managing a project• purpose is to assist in decisions regarding rewards or penalties and discover better ways of conducting future projects respectively• Cost overruns:At best, budget estimates are based on data available at the time it was preparedProject EvaluationProject Evaluation• hindsight:One can usually discover instances in which right decision was madeDiversion of funds or other assets for personal use of project manager may lead to poor mgt.Evaluation of process may indicate that reviews during project were inadequate or timely action was not taken on basis of such reviews Evaluation may also lead to changes in rules and procedures