Management Control System

Author: Manohar Prasad

3. BEHAVIOR IN ORGANIZATION Learning outcomes

1. GOALS & CONGRUENCE2. INFORMAL FACTORS THAT INFLUENCE GOAL

CONGRUENCE3. FORMAL CONTROL SYSTEMS4. TYPES OF ORGANIZATIONS5. FUNCTIONS OF THE CONTROLLER

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Organization Structure

• How tasks are divided, resources are deployed, and departments are coordinated– Set of formal tasks

– Formal reporting relationships

– Effective coordination of employees across departments

TYPES OF ORGANIZATIONS

• FUNCTIONAL ORGANIZATIONS• BUSINESS UNIT ORGANIZATIONS• MATRIX ORGANIZATIONS

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Five Approaches to Structural Design

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Five Approaches to Structural Design

daft ch10 insert1.CLP

FUNCTIONS OF THE COTROLLER

1. DESIGNING & OPERATING MCS2. FINANCIAL STATEMENTS & REPORTS3. TAX RETURNS4. PREPARATION AND ANALYSIS OF

PERFORMANCE REPORTS

FUNCTIONS OF THE CONTROLLER(contd.)

5. BUDGET PROPOSALS WITH ANALYSIS & JUSTIFICATION

6. INTERNAL AUDITS FOR PREVENING FRAUD/THEFT

7. DEVELOPING PEOPLE IN CONTROL FUNCTION

8. BUSINESS UNIT CONTROLLER & CORPORATE CONTROLLER

4. RESPONSIBILITY CENTERSLearning outcomes

1. TYPES OF RESPOSIBILITY CENTERS2. COST/EXPENSE CENTERS3. REVENUE/PROFIT CENTERS4. INVESTMENT CENTERS5. MEASURES USED TO EVALUATE THEIR

PERFORMANCES6. ROI, ROA, MVA

THE CONTROLLER

BUSINESS UNIT CONTROLLER CORPORATE CONTROLLER RELATIOSHIP BETWEEN BOTH DOTTED LINE SOLID LINE

RESPONSIBILITY CENTRES

1. RESPONSIBILITY CENTRES• MANAGER RESPONSIBLE

FOR ACTIVITIES• UNIT WITHIN COMPANY

RESPONSIBILITY CENTRES

2. NATURE OF RESPONSIBILITY CENTRES

• OBJECTIVES• INPUTS/WORK/OUTPUT• RELATIONSHIP BETWEEN

INPUT & OUTPUT

RESPONSIBILITY CENTRES

3. MEASURING INPUTS & OUTPUTS• PHYSICAL MEASUREMENT LIKE HRS,

KGS• TRANSLATED INTO MONETARY TERMS• COST –MONETARY MEASURE OF

RESOURCES USED BY RESPONSIBILITY CENTRE

RESPONSIBILITY CENTRES

4. EFFICIENCY & EFFECTIVENESS• RATIO OF OUTPUT TO INPUT• RATIO OF OUTPUT TO ITS OBJECTIVES• EVERY RESPONSIBILITY CENTRE OUGHT TO

BE BOTH EFFICIENT AND EFFECTIVE• A RESONSIBILITY CENTRE IS EFFICIENT IF IT

DOES THINGS RIGHT, AND IT IS EFFECTIVE IF IT DOES THE RIGHT THINGS

TYPES OF RESPONSIBILITY CENTRES

1. COST/EXPENSE CENRES2. TYPES a) ENGINEERED EXPENSE CENTRESb) DISCRETIONARY EXPENSE CENTRES

TYPES OF RESPONSIBILITY CENTRES

2. REVENUE CENTRES• OUTPUT IS MEASURED IN MONETARY TERMS• NO FORMAL ATTEMPT TO RELATE TO INPUT

Responsibility Accounting forProfit Centres

Based on detailed information about both controllable revenues and controllable costs

Manager controls operating revenues earned, such as sales,

Manager controls all variable costs (and expenses) incurred by the centre because they vary with sales

Profit Centre

Shows budgeted budgeted and actualactual controllable revenues and costs

Prepared using the cost-volume-profit income statement format:– Deduct controllable fixed costs from the contribution

margin– Controllable marginControllable margin - excess of contribution

margin over controllable fixed costs – best measure of manager’s performance in controlling revenues and costs

– Do not not report non-controllable fixed costs

Advantages of Profit Centre

Speed of operating decisions Quality of decisions Unit level day to day decisions Corporate can concentrate on long term planning Freedom for unit managers, less dependence on head

office Excellent training ground Profit consciousness among units Ready made infn on profitability of compny’s independent

units Competitive performance

Measuring Profitability

Contribution margin Direct profit Controllable profit Income before taxes Net income Revenues

Investment Center

An investment center is a subunit that is responsible for generating revenue, controlling costs, and investing in assets.

An investment center is charged with earning income consistent with the amount of assets invested in the segment.

Most divisions of a company can be treated as either profit centers or investment centers.

6. Transfer Pricing Learning outcomes

1. Objectives and need of Transfer pricing2. Methods of Transfer Pricing3. Cost Based4. Market price based5. Negotiated price6. Administration of TRANSFER PRICES

Need For Transfer Pricing

Liberalization and Growth of multinationals More decentralization. Considerable autonomy Encourage them to perform well. Business units are supposed to work under

the same organization Performance of business units.

OBJECTIVES OF TRANSFER PRICES

1. Proper distribution of revenue between profit centers. 2. Resulting profit has to be shared between the profit

centers. 3. Providing relevant information to the profit centers4. Inducing goal-congruent decisions,

-improve the profits of business units and also improve the profits of the company

4. Measure the economic performance of profit centers 5. Minimizing tax liability

Goal Congruence

Some of the prerequisites for achieving goal congruency are

1.Competent people 2.Good organizational atmosphere 3.Details of market prices 4.Freedom to source 5.Availability of information 6.Scope for negotiation

Transfer Price Defined

The price that is used to value internal transfers of goods and services within the same company is

known as the transfer price.

Transfer Pricing

The fundamental principle is that the transfer price should be similar to the price that would be charged if the product were sold to outside customers or purchased from outside vendors.

Transfer Pricing

• Not used for external pricing • Used to set prices for transfers within a

company’s departments, divisions, or segments

Transfer prices do not affect revenues and costs of

the company as a whole Transfer prices do affect revenues and costs of the

divisions involved.

Pricing for Internal Providers of

Goods and Services

Transfer pricing enables a business to assess both the internal and external profitability of its products or services

Methods of calculating transfer price

The three methods of calculating transfer price that are used commonly are: 1.Cost-based pricing method 2.Negotiated pricing method 3.Market-Based Pricing Method

Cost Based Pricing

• How to define cost?– Actual cost– Standard cost– Percentage of cost– Percentage of investment

Market Based Pricing

1. Market Price Information2. Freedom to source3. Full Information4. Negotiation5. Constraints

Negotiated Transfer PriceMay be based on an agreement to use a cost plus

a profit percentageWill be between the negotiation floor and the

negotiation ceilingNegotiation floor: the selling division’s variable

costNegotiation ceiling-the market price

This approach allows for cost recovery while still allowing the selling division to return a profit

Administration of TRANSFER PRICES

Implementing transfer pricing involves Long negotiations between heads of various unitsClassification of products, Arbitration conflict resolution in case conflicts arise.  

Transfer Pricing in Multinational Settings

• Extremely difficult to set– Tax systems– Customs duties– Freight and insurance costs– Import/export regulations– Foreign exchange controls– Internal and external objectives of transfer differ

• May use different transfer prices for different countries; make certain of legality.

7.Measuring & Controlling Assets

Prof.S.G.Patwardhan

Measuring & Controlling Assets

Why long term investment is a strategic issue?

Why long term investments is a control issue?

Characteristics of long-term assets Long-term assets (Building, Plant, Machinery,

Information Technology) Long-term assets - an organization is committed for a

long period of time. The lack of investment could cause opportunity

losses or the investment could cause excess capacity.

The investment amount is usually large.

Why relate profits to investments?

• Profits are generated ONLY if you have investments.• Therefore, earning a satisfactory return on the

investments employed is necessary.• To compare two units, A and B, without considering

the investment made in each is meaningless.

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Responsibility Accounting

Types of Responsibility Centers1. Cost center: only responsible for costs2. Revenue center: only responsible for revenues3. Profit center: responsible for both revenues and

costs4. Investment center: responsible for revenues,

costs, and investments

Measuring the Performance of Investment Centres

• Return on Investment (ROI)

• Residual Income (RI)

• Economic Value Added (EVA)

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Accounting-Based Performance Measures

Accounting-Based Performance Measures

1. Choose Performance Measures that align with top management’s financial goals

2. Choose the time horizon of each Performance Measure

3. Choose a definition of the components in each Performance Measure

4. Choose a measurement alternative for each Performance Measure

5. Choose a target level of performance

6. Choose the timing of feedback

EffectivenessDegree to which a goal,

objective, or target is met.

Determined by process design

Effectiveness vs Efficiency Effectiveness vs Efficiency

EfficiencyDegree to which inputs are used in

relation to a given level of outputs.Determined by process design and

how the process operatesPerformance may be effective, efficient,

both, or neither.

Effectiveness vs Efficiency Effectiveness vs Efficiency

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Return on Investment (ROI)Return on Investment (ROI)

ROI is an accounting measure of income divided

by an accounting measure of investment

IncomeInvestmentROI =

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ROIROI

• ROI may be decomposed into its two components as follows:

• ROI = Return on Sales X Investment Turnover

• This is known as the DuPont Method of Profitability Analysis

Income Income RevenuesInvestment Revenues InvestmentX=

A. The Components of ROIROI has a distinct advantage over income as a measure

of performance since it considers both income (the numerator) and investment (the denominator).

ROI = Income

Invested capital

ROI = Income

Salesx

Sales

Invested capital

Profit Margin Investment Turnover

The breakdown of the formula shows that managers can increase return by more profit and/or generating more sales for each investment dollar.

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Measuring the Performance of Investment Centers

Margin: portion of sales

available for interest, taxes

and profit

Operating income

Sales

Turnover: how productively

assets are being used to generate

sales

Sales

Average operating assets

D. Residual Income (RI) as an Alternative to ROI

Residual Income = NOPAT – Required Profit

= NOPAT – Cost of Capital x Investment

= NOPAT – Cost of Capital x (Total Assets – Noninterest Bearing Current Liabilities)

Residual Income (RI) overcomes the underinvestment problem ofROI since any investment earning more than the cost of capital will

increase residual income.

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Residual incomethe difference between operating income and the minimum Rs. return required on a company’s operating assets

Measuring the Performance of Investment Centers

Residual Operating Minimum rate of return= -Income Income Operating assets

Components of RI

Decomposition of the RI formula:

RI = Operating income- (Minimum rate of return x Operating assets)

= Operating income – Minimum return on Assets

Economic Value Added

Economic value added (EVA) is after-tax operating profit minus the total annual cost of capital.

EVA = After-tax operating income - (Weighted average cost of capital x total capital employed)

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Economic value added (EVA)after-tax operating profit minus the total annual cost of capital.

Measuring the Performance of Investment Centers

After-tax Weighted average cost of capitalEVA = operating - Total capital employedincome

Total capital employed = capital assets plus other expenditures meant to have a

long-term payoff

MVA

Market Value Added (MVA)–Difference between the market

value of a corporation and capital contributed by shareholders and lenders.

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