Management Control System ASSIGNMENT NO. 1

Submitted by :Deepak R GoradMMS : C-9

(Marketing)

submitted to:Prof. Jyoti Singhal

MMS : SEM-IV

Q.1 How is RI (EVA) analysis carried out? Explain advantages and disadvantages.

Ans. The EVA method is based on the past performance of the corporate enterprise. The underlying economic principle in this method is to determine whether the firm is earning a

higher rate of return on the entire invested funds than the cost of such funds (measured in terms of weighted average cost of capital, WACC). If the answer is positive, the firm‟s management is adding to the shareholders value by earning extra for them. On the contrary, if the WACC is

higher than the corporate earning rate, the firm‟s operations have eroded the existing wealth of its equity shareholders. In operational terms, the method attempts to measure economic value

added (or destroyed) for equity shareholders, by the firm‟s operations, in a given year.

Since WACC takes care of the financial costs of all sources of providers of invested

funds in a corporate enterprise, it is imperative that operating profits after taxes (and not net profits after taxes) should be considered to measure EVA. The accounting profits after taxes, as reported by the income statement, need adjustments for interest costs. The profit should be the

net operating profit after taxes and the cost of funds will be the product of the total capital supplied (including retained earnings) and WACC

EVA= [Net operating profits after taxes – [Total Capital * WACC]

Example; Following is the condensed income statement of a firm for the current year;

Particulars Amt (in lakhs) Sales Revenue 500

Less: Operating costs 300 Less: Interest costs 12 Earnings before taxes 188

Less: Taxes (0.40) 75.2 Earnings after taxes 112.8

The firm‟s existing capital consists of Rs 150 lakhs Equity funds, having 15% cost and of Rs 100 lakh 12% debt. Determine the economic value added during the year.

Solution

(I) Determination of Net Operating Profit After Taxes

Particulars Amt (in lakhs)

Sales revenue 500 Less: Operating Costs 300

Operating profit (EBIT) 200 Less: Taxes (0.40) 80

Net operating profit after taxes (NOPAT) 120

(II) Determination of WACC

Particulars Amt (in lakhs)

Equity (150 lakh * 15%) 22.5 12% Debt (100 lakh * 7.2%) 7.2 Total Cost 29.7

WACC (29.7 lakh/ 250 lakh) 11.88% Cost of debt= 12% (1 – 0.4 tax rate) = 7.2%

(III) Determination of EVA

EVA = NOPAT – (Total capital * WACC)

Rs 120 lakh – (Rs 250 lakh * 11.88%) Rs 120 lakh – Rs 29.7 lakh = Rs 90.3 lakh

During the current year, the firm has added an economic value of Rs.90.3 lakh to the

existing wealth of equity shareholders. Essentially, the EVA approach is a modified accounting approach to determine profits earned after meeting all financial costs of all the providers of capital. Its major advantage is that this approach reflects the true profit position of the firm.

RI (EVA) has the following advantages:

(i) It avoids suboptimal decisions as investments are not rejected merely because they lower the divisional manager‟s ROI.

(ii) It maximizes the growth of the company and increases shareholders‟ wealth by accepting opportunities which earn a rate of return in excess of the cost of capital.

(iii) The cost of capital charge on divisional investments ensures that divisional managers

are aware of the opportunity cost of funds. (iv) Charging each division with the company‟s cost of capital ensures that decisions

taken by different divisions are compatible with the interests of the organization as a whole.

RI (EVA) has the following weaknesses:

(i) Like ROI it is difficult to have satisfactory definitions of „divisional profits‟ and

„divisional investment‟. (ii) It may be difficult to calculate an accurate cost of capital. Also, decision has to be

taken whether to use the company‟s cost of capital or a specific divisional cost of capital. The former enhances divisional goal congruency and the latter reflects each division‟s level of risk.

(iii) Identifying controllable and uncontrollable factors at the divisional level may be difficult.

Many experts regard EVA as a concept superior to ROI and yet in certain cases,

EVA does not solve all the problems of measuring profitability in an investment

center. In particular, it does not solve the problem of accounting for fixed assets

discussed above unless annuity depreciation is also used, and this is rarely done in

practice. If gross book value is used, a business unit can increase its EVA by taking

actions contrary to the interests of the company, as shown in TABLE If net book value

is used, EVA will increase simply due to the passage of time. Furthermore, EVA will

be temporarily depressed by new investments because of the high net book value in

the early years. EVA does solve the problem created by differing profit potentials. All

business units, regardless of profitability, will be motivated to increase investments if

the rate of return from a potential investment exceeds the required rate prescribed by

the measurement system.

Moreover, some assets may be undervalued when they are capitalized, and others

when they are expensed. Although the purchase cost of fixed assets is ordinarily

capitalized, a substantial amount of investment in start-up costs, new product

development, dealer organization, and so forth may be written off as expenses, and,

therefore, not appear in the investment base. This situation applies especially in

marketing units. In these units the investment amount may be limited to inventories,

receivables, and office furniture and equipment. When a group of units with varying

degrees of marketing responsibility are ranked, the unit with the relatively larger

marketing operations will tend to have the highest EVA.

For example, if inventories are too high, unnecessary capital is tied up, and the risk of

obsolescence is increased; whereas, if inventories are too low, production interruptions

or lost customer business can result from the stockouts. To focus attention on these

important controllable items, some companies, such as Quaker Oats, 17 include a

capital charge for the items as an element of cost in the business unit income

statement. This acts both to motivate business unit management properly and also to

measure the real cost of resources committed to these items.

Investments in fixed assets are controlled by the capital budgeting process before the

fact and by post completion audits to determine whether the anticipated cash flows, in

fact, materialized. This is far from being completely satisfactory because actual

savings or revenues from a fixed asset acquisition may not be identifiable. For

example, if a new machine produces a variety of products, the cost accounting system

usually will not identify the savings attributable to each product.

The argument for evaluating profits and capital investments separately is that this

often is consistent with what senior management wants the business unit manager to

accomplish; namely, to obtain the maximum long-run cash flow from the capital

investments the business unit manager controls and to add capital investments only

when they will provide a net return in excess of the company's cost of funding that

investment. Investment decisions, then, are controlled at the point where these

decisions are made. Consequently, the capital investment analysis procedure is of

primary importance in investment control. Once the investment has been made, it is

largely a sunk cost and should not influence future decisions. Nevertheless,

management wants to know when capital investment decisions have been made

incorrectly, not only because some action may be appropriate with respect to the

person responsible for the mistakes but also because safeguards to prevent a

recurrence may be appropriate.

Q.2(a) Explain how different types of expenses centers operates with the help of

sketches?

Answer:

Expense centers are responsibility centers whose inputs are measured in monetary terms whose output are not. There are two general types of expenses centers: - engineered and discretionary. These labels relates to two types of cost. Engineered costs are those for which the

„right‟ or „proper‟ amount can be estimated with reliability. For example, factory‟s costs for direct labour, direct material, components supplier and utilities. Discretionary costs are those for which

no such engineered estimate is feasible. In discretionary expenses centers, the cost incurred depends on management‟s judgment as to the appropriate amount under the circumstances.

1. Engineered expenses centers:- it have following characteristics:-

2. The profit input can be measured in monetary terms.

3. Their output can be measured in physical terms.

4. The optimum dollars amount of input required to produce one output can be

determined.

Diagram:-

Manufacture function

(Dollar) (Physical)

Engineered expense centers are usually found in manufacturing operation, warehouse

distribution and similar units within the marketing organization may also be engineered expenses centers as certain responsibility centers within administrative and support departments for

instance, account receivable, account payable and pay roll sections in controller department. Such unit performs repetitive task for which standard cost can be developed. These centers are usually located within departments that are discretionary expenses centers.

In engineered expenses centers output are multiplied by standard cost of each unit

produce measured what the finished products should have cost. Managers of engineered expenses center may be responsible for activities such as training and employee development that are not related to current production. The term engineered expense center refers to responsibility centers

in which engineered cost predominate, but it does not imply that valid engineered estimates can be made for each and every cost items.

Discretionary expenses centers:-

Discretionary expenses centers include administrative and supports units, research and developments operation and most marketing activities. The output of these centers can not be

measured in monetary terms.

Diagram:-

Work

Optimal relationship

can be established

Output Input

Optimal relationship

cannot be established

R&D function

(Dollar) (Physical)

The term discretionary does not imply that managements judgment to optimum cost is capricious rather it reflects managements decision regarding certain policies, whether to match the marketing effort of competitors; the level of service the company should provide to its customer

and appropriate amount to spend for R&D, public relations and other activities.

One company may have a similar small head quarter‟s staff, while another company of similar size and same industry may have staff 10 times as large. The senior manager of each company may each to be convinced that their respective decision on staff size are correct but their

is no objective to judge which is right; both decision may be equally good under the circumstances with the differences in the two companies.

In discretionary centers, the differences between budget and actual expenses are not a measure of efficiency. Rather it is simply the differences between the budgeted input and actual

does not incorporate the value of output if actual expenses do not exceed the budget amount, the manager has “ lived within the budget”, but since by definition the budget does not to predict the

optimum amount of spending living within the budget does not necessarily indicate efficient performance.

Q.3 Explain with illustrations the different ways in which the profit objective of a profit

centre can be stated and controlled.What role do corporate overhead allocations play in this

process?

Ans. The different ways in which the profit objective of a profit centre can be stated and controlled can be explained with the help of, types of profitability measurements used in

evaluating a profit center.

First, there is the measure of management performance, which focuses on how well the manager is doing. This measure is used for planning, coordinating, and controlling the profit

center‟s day-to-day activities and as a device for providing the proper motivation for its manager.

Second, there is the measure of economic performance, which focuses on how well the

profit center is doing as an economic entity. The messages conveyed by these two measures may be quite different from each other.

Work

Output Input

For eg: The management performance report for a branch store may show that the store‟s manager is doing an excellent job under the circumstances, while the economic performance

report may indicate that because of economic and competitive conditions in its area the store is a losing proposition and should be closed.

Types of Profitability Measures

A profit center‟s economic performance is always measured by net income (i.e., the

income remaining after all costs, including a fair share of the corporate overhead, have been allocated to the profit center). The performance of the profit center manager, however, may be

evaluated by five different measures of profitability :

1. Contribution margin,

2. direct profit, 3. controllable profit,

4. income before income taxes, or 5. net income.

1) Contribution Margin

Contribution margin reflects the spread between revenue and variable

expenses. The principal argument in favour of using it to measure the performance of profit center managers is that since fixed expenses are beyond their control, managers should focus their attention on maximizing contribution. The problem with this argument is that its premises are

inaccurate, in fact, almost all fixed expenses are at least partially controllable by the manager, and some are entirely controllable. Many expense items are discretionary; that is, they can be changed at the discretion of the profit center manager. Presumably, senior management wants the profit

center to keep these discretionary expenses in line with amounts agreed on in the budget formulation process. A focus on the contribution margin tends to direct attention away from this

responsibility. Further, even if an expense, such as administrative salaries, cannot be changed in the short run, the profit center manager is still responsible for controlling employees‟ efficiency and productivity.

2) Direct Profit

This measure reflects a profit center‟s contribution to the general overhead and profit of the corporation. It incorporated all expenses either incurred by or directly traceable to the profit center, regardless of whether or not these items are within the profit center manager‟s

control. Expenses incurred at headquarters, however, are not included in this calculation.

A weakness of the direct profit measure is that it does not recognize the motivational benefit of charging headquarters costs.

Example: Knight-Ridder, the second-largest newspaper publisher in the United States, measured each of its newspapers based on direct profit. The publisher set specific targets for direct profit at each of its newspapers. For 1996 the Miami Herald had a target of 18 percent and the Philadelphia

Inquirer and the Philadelphia Daily (which were operated as one unit) had a target of 12 percent.

3) Controllable Profit

Headquarters expenses can be divided into two categories: controllable and non-

controllable. The former category includes expenses that are controllable, at least to a degree, by the business unit manager - information technology services, for example: if these costs are

included in the measurement system, profit will be what remains after the deduction of all expenses that may be influenced by the profit center manager. A major disadvantage of this measure is that because it excludes noncontrollable headquarters expenses it cannot be directly

compared with either published data or trade association data reporting the profits of other companies in the industry.

4) Income before Taxes

In this measure, all corporate overhead is allocated to profit centers based on the

relative amount of expense each profit center incurs. There are two arguments against such allocations. First, since the costs incurred by corporate staff departments such as finance,

accounting, and human resource management are not controllable by profit center managers, these managers should be held accountable for them. Second, it may be difficult to allocate corporate staff services in a manner that would properly reflect the amount of costs incurred by each profit

center.

5) Net Income

Here, companies measure the performance of domestic profit centers according to the bottom line, the amount of net income after income tax. There are two principal arguments

against using this measure:

After-tax income is often a constant percentage of the pretax income, in which case there

would be no advantage in incorporating income taxes, and

Since many of the decisions that affect income taxes are made at headquarters, it is not

appropriate to judge profit center managers on the consequences of these decisions.

There are situations, however, in which the effective income tax rated does vary among profit centers. For example, foreign subsidiaries or business units with foreign operations may

have different effective income tax rates. In other cases, profit centers may influence income taxes through their installment credit policies, their decisions on acquiring or disposing of equipment,

and their use of other generally accepted accounting procedures to distinguish gross income from taxable income. In these situations, it may be desirable to allocate income tax expenses to profit centers not only to measure their economic profitability but also to motivate managers to minimize

tax liability.

B) There are three arguments in favor of incorporating a portion of corporate overhead into the profit centers‟ performance reports.

First, corporate service units have a tendency to increase their power base and to enhance

their own excellence without regard to their effect on the company as a whole. Allocating corporate overhead costs to profit centers increases the likelihood that profit center managers will

question these costs, thus serving to keep head office spending in check. (Some companies have actually been known to sell their corporate jets because of complaints from profit center managers

about the cost of these expensive items).

Second, the performance of each profit center will become more realistic and more readily

comparable to the performance of competitors who pay for similar services. Finally, when managers know that their respective centers will not show a profit unless all costs,

including the allocated share of corporate overhead, are recovered, they are motivated to make optimum long-term marketing decisions as to pricing, product mix, and so forth, that will ultimately benefit (and even ensure the viability of) the company as a whole.

If profit centers are to be charged for a portion of corporate overhead, this item should be calculated on the basis of budgeted, rather than actual, costs, in which case the “budget” and “actual” columns in the profit center‟s performance report will not complain about

either the arbitrariness of the allocation or their lack of control over these costs, since their performance reports will show no variance in the overhead allocation. Instead, such

variances would appear in the reports of the responsibility center that actually incurred these costs.

Q.4) Explain responsibilities centres and map the process of evaluation thereof from one stage

to another, with the help of illustrations – cum – experience of the corporate?

It represents a set of activities assigned to a manager or a group of managers. A small collection of machines may be responsibility centre for a production supervisor, a full

department for the department head and the centre organisation for the managing director. The size of a responsibility centre will be determined by the nature of the task, technology,

people and the level in organisation hierarchy. From the point of view of the top mgt, a division, which is a significantly large unit, is a responsibility centre. From the point of view of divisional

mgt, the marketing department of the division is a responsibility centre and from the point of view of the marketing manager, the sales distribution and advertising departments are responsibility centres.

A responsibility center exists to accomplish one or more purposes; these purposes are its

objectives. The company as a whole has goals, and senior management has decided on a set of strategies to accomplish these goals. The objectives of responsibility centres are to help implement these strategies. Because the organisation is the sum of its responsibility centers, if

the strategies are sound, and if each responsibility center meets its objectives, the whole organisation should achieve its goal.

Responsibility centre is a sub system which has both inputs and outputs. Its inputs may include physical quantities of materials, manpower and various services, working

capital and fixed assets. It works with these resources.

As a result of this work, the responsibility centre produces output. These can be goods or services which either go to other responsibility centres within the organisation or sold to customers in the outside world.

Management is responsible for obtaining the optimum relationship between inputs and outputs. In some situations the relationship is causal and direct eg. In production department the inputs become a physical part of the finished goods output. In many situations, however, inputs are not

directly related to outputs eg. Advertising expense and R & D expenditure.

Types of responsibility centres

1. revenue centres 2. expense centres

3. profit centres

Work

Inputs

Resources used,

measured by cost

Outputs

Goods or services

Capital

4. investment centres in revenues centres, only outputs are measured in monetary terms; in expense centers, only

inputs are measured; in profit centers, both revenues and expenses are measured‟ and in investment centers, the relationship between profits and investment is measured.

Explain the process of evaluation of Responsibility Center from one stage to another with

the help of illustration-cum-experiences of the corporate .

Process of evaluation of Responsibility Center.

1. The organization is divided into various responsibility centers. Each responsibility centre

is put under the charge of a responsibility manager.

2. The targets or budgets of each responsibility centre are set in consultation with the

manager of responsibility centre, so that he may be able to give full information about his

department. The manager of responsibility centre should know as what is expected of him

- each centre should have a clear set of goals. The responsibility and authority of each

centre should be well defined.

3. Managers are charged with the items and responsibility, over which they can exercise a

significant degree of direct control.

4. Goals defined for each area of responsibility should be attainable with efficient and

effective performance.

5. The actual performance is communicated to the managers concerned. If it falls short of

the standards, the variances are conveyed to the top management. The names of persons

responsible for the variances are also conveyed so that responsibility may be fixed.

The purpose of all these steps is to assign responsibility to different individuals so that their

performance is improved and costs are controlled. The personal factor in Responsibility

Accounting is most important. The management may prepare the best plan or the budget and put

up before its staff, but its success depends upon the initiative and the will of the workers to

execute it

Q.5. How is ROI analysis carried out? Explain advantages and disadvantages?

Return on investment (ROI) is the ratio of profit before tax to the gross investment.

ROI is calculated with the help of the following formula:

ROI = (Pre-Tax Profit/Sales) X (Sales/Net Assets) or (Pre-Tax Profits/Net Assets)

The numerator is profit before tax as reported in the P&L account. The profit should include only the profits arising

out of the normal activities of the division. Unusual items of receipts and expenses should be excluded from the

profit figure. One should also ignore windfalls and income from investments not related to the operations of the

division. Tax is excluded from the numerator because the marginal of the SBU is not responsible for or in control of

the tax paid.

Capital employed can be ascertained from the balance sheet by including fixed and current assets. Assets not

currently put to divisional use should be excluded from the investment base. On e also needs to exclude their relative

earnings if any. The company should also exclude intangible assets like goodwill, deferred revenue expenses,

preliminary expenses, etc.

ROI can be improved by

a) Increasing the profit margin on sales.

b) Increasing the capital turnover

c) Increasing both profit margin and capital turnover.

d) Reducing cost as that adds to the total earnings of the firm.

e) Increasing the profits by expanding present operations or developing new product line, increasing market

share, etc.

f) Diversifying, introducing productivity imporevement measures, expansion, replacement of old equipments

Advantages of ROI

a) ROI relates return to the level of investment and not sales as the rate of return is more realistic.

b) ROI can be decomposed into other variables as shown. These variables have tremendous analytical value.

c) ROI is an effective tool for inter-firm comparison.