Management Control System

ASSIGNMENT NO. 1

Submitted by :
Deepak R Gorad
MMS : 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 firms 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 firms 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 firms 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 firms 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 managers 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 companys 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 companys cost of capital or a specific divisional cost of
capital. The former enhances divisional goal congruency and the latter reflects each
divisions 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, factorys 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 managements 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 quarters 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
centers 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 stores
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 centers 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 centers 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 managers
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 centers 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. One 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.