Concept of control

• Ensuring that implementation is done as per plans.

Steps :
1. Set standards
2. Communicate standards
3. Compare standards with actual performance
4. Report deviations
5. Take corrective actions.

1
 Control Process in General
• Four basic elements –
– Detector (actual measurement)
– Assessor (comparison with standard)
– Effector (alteration of behavior, if required)
– Communication network (transmission of
information)

2
 Elements of control process
Co
n mm
atio Control device u
Ne nica
unic k two tion
mm twor (Assessor : compares
o
C Ne rk
With standards)

Detector Effector
(Provides information (Feedback for altering
About actual) Behaviour)

Entity being controlled

3
 Concept of MCS
• Management Control :
“Mgt control is the process by which managers assure that the resources
obtained are used efficiently and effectively in the accomplishment of
organizational goals” : Anthony

Efficiency : doing the things right ie. Relationship between input and output
I/P efficiency O/P

Effectiveness : doing the right things ie. Relationship between output and
objectives
O/P effectiveness OBJECTIVES

System is a prescribed way or a systematic way of carrying out a set of

activities which are usually repetitive in nature

4
 MCS
• “MCS is a total system i.e. it covers all aspects of the
firms’ operations to assure that all parts of the
operations are in balance with each other”: Anthony

• “MCS refers to a framework or a set up by which the

managers can ensure control over the actions of the
actions of his subordinates as well as control over
entire operations in the organization.” : Saravanavel

5
 Characteristics of MCS
• Systematic method
• Result oriented
• Covers all operations
• Based on the concept of Responsibility Centres
• Covers both efficiency and effectiveness
• Control of managerial performance
• Regular process
• Ensures goal congruence

6
Designing MCS for an organization
• Pre – requisites
1. Control requires plans
2. Clear org structure
3. Active top mgt involvement
4. Participation and motivation of employees
5. Proper MIS
6. Proper accounting system ( responsibility
accounting)

7
 ……………..Designing
• Steps
1. Classifying org into responsibility centres(RC)
2. Fixing responsibility of each RC
3. Deciding key variables for performance assessment
4. Developing MIS
5. Finding deviations and relating it to individual responsibility
6. Performance reporting to top mgt
7. Short term remedial actions and long term measures for
controlling deviation

8
 Formal MCS
Mission, Rules Other
Goals & Information
strategies

Reward (feedback)

Yes

Responsibility
Report Was
Strategic Budgeting Actual v/s Performance
Center
Planning performance Plan Satisfactory?
No

Corrective
Revise Revise Measurement
action
Feedback 9
Communication
General relationship between
Planning and control
Activity Nature of end Product

Strategy formulation Goals, Strategies, Policies

Management Control Implementation of Strategies

Effective and efficient

Operational Control Performance of individual tasks

10
 3 levels of controls
Point Strategy formulation Management control Task control
(long term planning (ensuring managerial (ensuring specific tasks
based on environmental performance in are performed
analysis) accordance to efficiently)
0bjectives )

1. Nature of end product Goals, strategies & Implementation of Efficient and effective
policies strategies performance of individual
tasks
2. Degree of Unstructured and Somewhat systematic Most systematic
systematization unprogrammed and regular

3. Time frame focus Focuses on long-run Focuses on medium-term Focuses on short-run

activities

4. Inputs Rough estimations of Internal and Historical Uses current accurate

future/external and comprehensive data related to specific
task only
5. Techniques SWOT, ETOP, Porters 5 Budgeting , comparative Variance analysis
force, BCG matrix, SAP analysis

6. Importance of planning Planning more important Planning & control Control more important
& control equally important
11
 SUB-SYSTEMS OF CONTROL
PROCESS : Formal
Formal Infrastructure Formal Mgt style
and culture
•Organization structure
•Autocratic / democratic
•Patterns of autonomy
•Formal values and beliefs

Formal control
Process
Formal co-ordination /
Formal reward system co-operation
•Committees
•Formal promotion policy •Formal meetings/conference
•Monetary incentives •Formal conflict resolution
techniques

12
 SUB-SYSTEMS OF CONTROL
PROCESS : Informal
• Informal control is :

1. Ad- hoc ( as and when required)

2. Based on intuition, experience,
rationalization
3. No specific procedure.

13
 SUB-SYSTEMS OF CONTROL
PROCESS : Informal
Informal Infrastructure Informal Mgt style
and culture
•Informal Organization
Structure (groups) •Customs / traditions
•Networks •Prevailing individual styles
Informal
control
Process Informal co-ordination /
Informal reward system co-operation
•Informal gatherings / outings
•Appreciation •Informal communication
•Recognition / Status •Informal conflict resolution
techniques

14
 Cybernetic Paradigm of control
Process
• Cybernetics is the theory of communication and
control
• Elements :
1. Sensors – collection of data formally/informal
2. Perception – Interpretation of data
3. Factual premises – belief about performance
4. Value premises – what is desired to be achieved
5. Behavioural repetoire - alternatives

15
Management Control Systems –
Cybernetic Paradigm & control
Environment Decision maker Goals

Value
premises
Factual
sensor Perception premises
Comparator
feedback

Behavior choice

Effector Behavioral
16 Repertoire
 Cybernetic Paradigm & Control Process
Elements of a control process

1. Set goals and performance measures

2. Measure achievement
3. Compare achievement with goals
4. Compute variances
5. Report variances
6. Determine cause(s) of variances
7. Take action to eliminate variances
8. Follow-up to ensure goals are met
17
 Attributes of good control system
(MCS)
1. A positive view of the control process
2. Objectives should be expressed in measurable terms
3. Objectives should have focus and should not be too many in numbers
4. Controls should seek balance among various aspects
5. No dual assignment of responsibility
6. True control is achieved by comparing projected performance against the
standard
7. Early warning predictors should be tracked
8. Use of sampling
9. Establish acceptable range of variation
10. Control by exception
11. Confirm severity of a problem; cause of the problem should be identified;
results of the corrective action should be monitored
12. Developing a discerning view of control

18
Understanding strategies – Concept
of strategy
• Strategy describes the general direction in
which an organization plans to move to attain
its goals
• Strategy formulation – Environmental analysis
pointing out opportunities and threats,
simultaneous internal analysis revealing
strengths and weaknesses, matching core
competencies with external opportunities and
deciding a strategy

19
 Understanding strategies –
Corporate and unit-level strategies
• Corporate strategy is concerned more with where to compete
than how to compete; the latter is a matter of unit level
strategy
• Classification into 3 types for corporate level
– Single industry
– Related diversification
– Unrelated diversification
• Research has shown that, on average, related diversified
firms perform the best, single industry perform next best, and
unrelated diversified firms do not perform well over the long
run. This is because Corporate HQ, in the related diversified
firm, has the ability to transfer core competencies from one
business unit to another.

20
 Understanding strategies –
Corporate level strategies-
summary of 3 generic strategies
Type Single industry Related diversified Unrelated diversified

Pictorial representation

Features Competes in only one Sharing core Totally autonomous

industry competencies across businesses in different
businesses markets

Examples Wrigley, Ford Motor P & G, Gillete General Electric

21
 Understanding strategies –
Unit-level strategies
• Business unit strategies depend on two interrelated aspects
1) its mission & 2)its competitive advantage
• There are a couple of famous models to fix the BU mission
• One is the BCG Model and the other one is the GE Planning
Model
• These models basically try to match the industry and the unit
in terms of opportunities/threats and strengths/weaknesses
• Control system designers need to know what is the BU
mission but not necessarily why the BU has chosen that
mission

22
 Understanding strategies –
Business unit mission – BCG Model
High Low
High High

“Star” “Question mark”

Hold Build
Market growth
rate

“Cash cow” “Dog”

Harvest Divest

Low Low
High Low
Relative Market share
23
 Understanding strategies –
Business unit mission – GE Model
The Portfolio matrix &
Recommended Business Strategies

High Winners Winners ? Marks

Invest Invest Dominate/
Strongly Selectively Delay/Divest
Industry Winners Avg bus Losers
Attractiveness Invest Earn/ Harvest/
Average Selectively Protect Divest

Profit producers Losers Losers

Earn/ Harvest/ Harvest/
Low
Protect Divest Divest
Strong Average Weak
Business strength 24
Understanding strategies – Gaining
competitive advantage
• 3 interrelated questions should be considered –
– What is the industry structure?
– How should the BU exploit it?
– What will be the basis of the BU’s competitive advantage?
• Michael Porter has suggested 2 analytical
approaches to develop & sustain competitive
advantage –
Industry analysis & Value chain analysis

25
Understanding strategies – Industry
structure analysis –
Porters 5 forces model
Threat of
New
Entrants

Suppliers Intensity of Customers

Bargaining Industry Bargaining
Power Competition power

Threat
From
Substitutes

26
Understanding strategies – Industry
structure analysis –
Porters 5 forces model
• 3 observations with regard to industry analysis
– More powerful the 5 forces less profitable an industry is
likely to be; conversely in high profitable industries these 5
forces are not strong
– Depending on relative strength of the 5 forces the strategic
issues would emerge and would differ from industry to
industry
– Understanding the nature of each force helps the firm to
formulate effective strategies

27
 Understanding strategies –
Gaining competitive advantage – Porters model

• The 5 force analysis is starting point to

develop competitive advantage as it helps
understanding external environment
• Response from the firm can be on two fronts –
low cost & differentiation
• A firm should strive to achieve cost leadership
and/or product differentiation to gain
competitive advantage
28
 Understanding strategies –
Gaining competitive advantage – Porters model

Superior

Cost-cum-
Differentiation
Differentiation
advantage
Relative advantage
Differentiation
position

Low cost Stuck-in-

Advantage The-middle

Inferior
Superior Inferior
Relative Cost Position
29
 Understanding strategies –
Gaining competitive advantage –
Value chain analysis
• Value chain disaggregates the firm into its
distinct strategic activities
• It is a complete set of activities involved in a
product beginning with extraction of raw
material and ending with after sales service
• The VC framework is a method of breaking
down the chain into specific activities in order
to understand behavior of costs and sources
of differentiation.
30
Understanding strategies –
Gaining competitive advantage –
Value chain analysis

Product Marketing Services/

Manufacturing
Development And Sales Logistics

Support Activities : - Finance, Human Resources, IT

31
 Understanding strategies –
Gaining competitive advantage –
Value chain analysis
• For each value added activity, key questions are –
1. Can we reduce costs in this activity, holding value (revenues)?
2. Can we increase value (revenues) in this activity holding costs
constant?
3. Can we reduce assets in this activity holding costs and value
(revenues) constant?
4. Most importantly can we do 1, 2 & 3 simultaneously?
• By systematically analyzing costs, revenues and assets
in each activity, BU can achieve cost-cum-differentiation
advantage.

32
 Goal Congruence

• Central purpose of a MCS is to ensure a high level of

goal congruence
• In a goal congruent process actions people are led to
take in accordance with their perceived self-interest are
also in the best interest of the organization
• In evaluating any management control practice, 2 most
important questions are –
• What actions does it motivate people to take in their own self-
interest?
• Are these actions in the best interest of the organization?

33
 Goal Congruence-
Influencing factors
• INFORMAL FACTORS
• External
• Work ethic – overall attitude of the working community
• Internal
• Organization culture
• Management style
• Informal organization
• Perception and Communication
• FORMAL CONTROL SYSTEM
• MCS
• Rules – Physical controls, Manuals, System safeguards etc

34
 Goal congruence-
Formal MCS
Goals & Rules Other
strategies Information

Reward (feedback)

Yes

Responsibility
Report Was
Strategic Budgeting Actual v/s Performance
Center
Planning performance Plan Satisfactory?
No

Corrective
Revise Revise Measurement
action
Feedback 35
Communication
 Types of organizations –
A. Functional organization
CEO

Staff

Manufacturing Marketing
Manager Manager

Staff Staff

Manager Manager Manager Manager Manager Manager

Plant 1 Plant 2 Plant 3 Region A Region B Region C

36
 Types of organizations –
B. Business unit organization
CEO

Staff

Manager Manager Manager

BU X BU Y BU Z

Staff Staff Staff

Plant Marketing Plant Marketing Plant Marketing

Manager Manager Manager Manager Manager Manager

37
Types of organizations –
C. Matrix organization
Chief Executive Officer

Staff

Function A Project X
Manager Manager

Project Y
Function B
Manager
Manager

Function C Project Z
Manager 38Manager
Organization Structure & implications
for system design
• Designers might be tempted to recommend the
BU structure because of the apparently clear-cut
profit responsibility. However they should not
forget other considerations.
• The system designer must always fit the system
to the organization rather than the other way
around

39
 Functions of the Controller

• Design and operate information and control systems

• Preparing financial statements and reports
• Preparing and analyzing performance reports
• Compiling the annual operating plan (budget)
• Supervising internal audit and accounting control
procedures
• Developing subordinates

40
 Nature of Controllers role

• Relation to line organization

• Controllership is a staff function
• Controller designs system, its use is done by line
managers
• Decisions made by controllers are primarily those that
implement policies decided by line management
• Controllers play important role in preparation of
strategic plans and budgets.
• They are also called to scrutinize reports prepared by
line managers

41
 Nature of Controllers role

Business
Business
Unit Mgr
Unit Mgr

BUC BUC
42
CC – Corporate Controller BUC – Business unit controller
 Responsibility Centers - Basic

• Responsibility Centers (RC) constitute the

structure of a control system and the assignment
of responsibility to organizational units must
reflect the organizations strategy.
• RC is an organization unit that is headed by a
manager who is responsible for its activities
• RC exists to accomplish some purpose that are
called as its objectives

43
Responsibility Centers – Core operation
• RC receives inputs. Using capital and assets it converts
this input in an output, that can be either tangible (goods)
or intangible (services)

Inputs Outputs
Work
Resources used Goods or services
Measured by “cost”

• Management is responsible for ensuring the optimum

relationship between inputs and outputs

44
Responsibility Centers – Measuring inputs
and outputs
• Cost is a monetary measure of the amount of
resources used by a RC
• It is much easier to measure the cost of input
than to calculate the value of outputs. For
example, a college can easily measure how
many students have passed but it is difficult to
measure how much education each of them
acquired

45
Responsibility Centers – Measuring inputs
and outputs – Efficiency and Effectiveness
• Efficiency and effectiveness are the 2 performance
measurement criteria for RC
• Efficiency is a ratio of input to output (doing things right)
• Effectiveness is determined by the relationship between
a RC’s output and its objectives (doing right things)
• These 2 e’s are not mutually exclusive; each RC has to
be efficient and effective as well
• Profit as a measure of performance measures both
efficiency and effectiveness because profit is the major
objective (effectiveness) and it is also the difference
between output and input (efficiency)

46
Responsibility Centers - Types
Optimal relationship
Can be established

Inputs Outputs
Work
(monetary value) (physical)

Example – Manufacturing Function

Above is the relationship between input and output in case of

An ENGINEERED EXPENSE CENTER

Characteristics : - 1. Input can be measured in monetary terms

2. Output can be measured in physical terms
3. Optimum relationship between amount of input
for one unit of output can be established
47
Responsibility Centers - Types
Optimal relationship
cant be established

Inputs Outputs
Work
(monetary value) (physical)

Example – R & D Function

Above is the relationship between input and output in case of

An DISCRETIONARY EXPENSE CENTER

48
Responsibility Centers - Types
Inputs not related to
outputs

Inputs Outputs
Work
(monetary value (monetary value)
only for costs
directly incurred)

Example – Marketing Function

Above is the relationship between input and output in case of

a REVENUE CENTER

49
Responsibility Centers - Types
Inputs are related to
outputs

Inputs Outputs
Work
(monetary value) (monetary value)

Example – BU

Above is the relationship between input and output in case of

a PROFIT CENTER

50
Responsibility Centers - Types
Profits are related to
capital employed

Inputs Outputs
Capital
(monetary value) employed (monetary value)

Example – BU

Above is the relationship between input and output in case of

an INVESTMENT CENTER

51
Responsibility centers – difference between
engineered & discretionary expense center
Point Engineered EC Discretionary EC

Nature of expenditure Engineered costs are those for Discretionary costs are those for
which standards can be easily which standards cant be easily
established established
I/p - o/p relationship Optimal relationship can be Optimal relationship cant be
established established

Application Manufacturing function Service function

Budget preparation Budget represents unit cost of Budget determined by the
performing task efficiently magnitude of the job to be done
Budgetary control Difference between budget and Difference between budget &
actual is a measure of efficiency actual is not a measure of
(since input and output optimum efficiency (since input and output
relationship can be established) optimum relationship cant be
Being “within budget” is important established)
Doing the task is more important
(doesn’t mean that budget is not to
be adhered; emphasis differs)

Financial control During performance More at planning

52 stage
Responsibility centers – difference between
Profit center & revenue center
Point Profit Center Revenue Center

Meaning A responsibility center that is A responsibility center that is

responsible for both revenues and responsible for revenues but not
expenses is profit center. for the expenses is revenue center.

I/p - o/p relationship Optimal relationship is established Optimal relationship cant be

between value of output (revenue) established between value of
and value of input (expense) output (revenue) and value of input
(expense)

Application Business units Marketing offices

Goal Maximizing profit by controlling Maximizing revenue
both revenue and expenses

53
 Responsibility Centers –
General control characteristics of Discretionary EC’s

• Budget preparation – based on the magnitude of the task

to be done
• Tasks divided into 2 – continuing and special
• MBO technique used
• Incremental Budgeting
• ZBB review
• Cost variability – not in short run
• Type of Financial control – planning important
• Measurement of performance – Doing the planned work
is important
54
 Responsibility Centers –
Administrative and Support Centers – control problems & budget preparation

• 2 important reasons for control problems

• Difficulty in measuring output
• Lack of goal congruence
• Budget preparation
• Section covering costs of “being in business”
• Discretionary activities
• Justification for proposed increases in budget

55
 Responsibility Centers –
R&D centers–control problems, budget preparation & performance measurement
• 2 important reasons for control problems
• Difficulty in relating results to output
• Lack of goal congruence

• Budget preparation
• One should understand R & D continuum
• Basic research – applied research – development – production engineering –
testing
• No scientific way of determining R & D budget
• Some companies use % of revenue for R&D budget
• For basic research, budget can be a lump-sum amount
• For testing, number of testing can be a budget base

• Performance measurement
• Monthly/quarterly reports on budgeted and actual expense
• 2 types of financial reports – one reporting total R & D expense, the other
reporting it separately for each RC
• Effectiveness of research is informed though progress reports ( these are not
financial reports)

56
 Responsibility Centers –
Marketing Centers – activities and related controls

• Logistic Activities
• These RCs are similar to expense centers in
manufacturing plants and can be safely called as
engineered expense centers
• Marketing activities – control problems
• Measuring output is easy, evaluating effectiveness is difficult
because of influence of “other” factors on sales
• Marketing expenses are often budgeted at % of sales not
because sales volume cause marketing expenses but
because it gives larger affordability
• “Order-getting costs” are that way discretionary and controls
cannot be easily standardized

57
 Responsibility Centers –
Profit Centers
• 2 conditions for delegating profit responsibility
• Access to relevant information needed for decision
making
• Measurement of effectiveness of the trade-offs made
by managers should be possible

58
 Responsibility Centers –
Profit Centers
• Advantages of profit centers
• Improved quality of decisions
• Quick decisions
• HQ relieved from day-to-day decision making
• Effective use of imagination and initiative
• Training ground for managers
• Enhanced profit consciousness
• Information on profitability of individual units
• They respond well to improvement initiatives since
their output is so readily measurable

59
 Responsibility Centers –
Profit Centers
• Difficulties with profit centers
• Loss of control
• Reduced quality of decisions
• Increased friction amongst units and HQ
• In-house competition may get substituted for
cooperation
• Additional costs
• Non-availability of competent GMs
• Too much emphasis on short-run profitability

60
 Responsibility Centers –
Profit Centers
• Measurement of performance – Management
performance and economic performance
• Measures of economic performance – measures
of profitability
• Contribution margin
• Direct profit
• Controllable profit
• PBT
• PAT

61
 Responsibility Centers –
Investment centers
• Difficulties in measuring assets employed
• Cash- actual cash held at HQ much less than that would have been required as
an independent company
• Receivables – whether to include at SP or COGS?
• Inventories – how to deal with creditors?
• Working Capital in general – treatment of current liabilities – 2 extreme treatments
• Fixed Assets – which value to consider? Problems with depreciation
• Leased assets – preference for leased assets over owned assets so as to reduce
capital charge
• Idle assets – exclusion from computation of assets employed
• Intangible assets – Capitalization of items like R & D and its repercussion on EVA
– if capitalized, very less incentive to cut such expenditure as it would only reduce
a part of if by way of capital charge

62
 Responsibility centers – Performance
measures of an Investment center – ROI v/s EVA
Point RoI EVA
Meaning RoI is the comparison of the EVA is the residual profit after
income generated with the taking into account the capital
assets employed. charge.

Calculation RoI is a ratio. Numerator is EVA is a value. It is found out

income and denominator is by subtracting capital charge
assets employed. from Profit after Tax.

Superiority Conceptually EVA is superior Conceptually EVA is superior

than RoI than RoI
Popularity As per one survey carried by As per one survey carried by
Vijay Govindarajan of Fortune Vijay Govindarajan of Fortune
1000 companies, RoI is more 1000 companies, RoI is more
popular than EVA popular than EVA

Simplicity of calculation RoI is comparatively easy to EVA is a bit difficult to

calculate calculate given the problems
with calculating the capital
charge 63
 Responsibility centers –
Performance measures of an Investment center – RoI

• Advantages of RoI
– It is a comprehensive measure – anything that
affects the financial statements affect the RoI.
– Simple to calculate, easy to understand and
meaningful in an absolute sense
– It is a common denominator that may be applied
to any organizational unit responsible for
profitability regardless of size or type of business

64
 Responsibility centers –
Performance measures of an Investment center – Superiority of EVA over RoI

• 4 points
– EVA offer same profit objective for comparable investments, unlike RoI which may make
a manager reluctant to accept lower RoI (20%) opportunities than the current RoI (30%)
levels despite being more than CoC (10%). RoI creates a bias towards little or no
expansion in high-profit business units while at the same time low-profit units are making
investments at rates of returns well below those rejected by high-profit units .
– Units can increase RoI by actually decreasing its overall profits. This thing will not
happen if EVA is measured.
– Different interest rates can be used for different types of assets. For more riskier assets,
higher rates of costs of capital can be used. With RoI this is not possible.
– EVA as compared to RoI has a stronger positive correlation with changes in a
company’s market value. To induce managers at the BU level to enhance shareholders
value, managers can be told to create and grow EVA.

65
 Strategic Planning Process
1. Reviewing and updating the strategic plan from
last year
2. Deciding on assumptions and guidelines
3. First iteration of the new strategic plan
4. Analysis
5. Second iteration of the new strategic plan
6. Final review and approval

66
 Budgetary control –
Budget preparation process
• Organization
• Budget Department
• Budget Committee
• Issuance of guidelines
• Initial budget proposal
• Negotiation
• Review and approval
• Budget revisions
• Procedures that provide for systematic updation
• Procedures that allow revisions under special circumstances

67
 Budgetary control –
Types of budgets & importance
– Types
• Fixed and flexible budgets
• Functional budgets
• Incremental & Zero Base budgets
• Annual, quarterly, monthly and weekly budgets
• Importance
– It translates the strategic plan into an annual operating plan with
reasonable details
– It provides a basis for translating the strategic decisions into actions
during the forthcoming year
– It provides a good basis for controlling the actuals. Variances can be
analyzed and corrective actions can be taken.
– It relieves the top management from day-to-day intervention and
botheration as it can look only into activities that are outside the budget

68
 Budgetary control –
Zero based budgeting
• In contrast to incremental budgeting, ZBB starts the budget
from the scratch (de novo)
• Managers are required to justify the items with proper
bases
• Thus ZBB is an intensive review of the budgetary
allocations
• Certain basic questions are asked like – should the activity
under review be performed at all? What should the quality
level be?
• It is a good way of doing budgeting and can eliminate a lot
of waste. However it demands some time and energy.

69
 Transfer Pricing - basics
• If 2 or more profit centers are jointly responsible for
developing, manufacturing and marketing of a product they
should share the revenue when the product is finally sold.
The transfer price is the mechanism for distributing this
revenue.
• Objective of TP –
• To provide each BU with information to determine optimum
tradeoffs between company costs and revenues
• To induce goal congruent decisions
• To measure economic performance of BU’s
• It should be simple to understand and easy to administer

70
 Transfer Pricing - methods
• Fundamental principle is that the TP should be similar to
the price that would have been if the product was sold in
outside market.
• Methods –

• Cost based
• Marginal Costs plus markup
• Standard cost plus mark up
• Actual cost plus mark up
• Full cost plus mark up

71
 Transfer Pricing - methods

• Market price based

– Equal to market price
– Less than the market price
– More than the market price

• Profit sharing : Profit of company distributed between

the departments

• Negotiated price

72
Transfer Pricing - methods
• Two-step pricing

• Instead of building the fixed cost and profit

element on a unit level as a part of the TP, the
same is charged to the transferee unit on a
periodical basis
• Thus the two-step pricing would mean – the first
step to charge the variable cost as the TP and in
the second step a lump-sum charging of the fixed
cost and the profit.
• This method helps the transferee division to
make appropriate short-term marketing decisions

73
 Transfer Pricing - methods

• Dual Pricing (2 sets of prices)

• Crediting transferor with outside sales price
• But charging the transferee with total standard costs
• Difference to be charged to a HQ account that will get
eliminated at the time of consolidation
• This method is used when there are conflicts between the
transferor and transferee division and any other method is not
working

74
Transfer Pricing - methods
Comparative usage of the TP methods by fortune 1000
Companies as per survey by Vijay Govindarajan

17%
Cost based

Market Price
52%
31% Negotiated
price/other

75
 PERFORMANCE EVALUATION
• Framework for designing performance measurement and
performance evaluation lays emphasis on what is to be
measured and why it should be measured
What counts,
Gets measured

What gets measured ,

What gets rewarded,
Strategy Gets done
Really counts.

What gets done,

Gets rewarded

76
 Multiple criteria for performance
evaluation
• Financial and Non financial variables
• Internal and External measures
• Long term and short term indicators
• Separate controllable and uncontrollable
variables

77
 Performance indicators
• Performance indicators can be:-
1. Results achieved : e.g. sales, profit
2. Efforts taken :- e.g. numbers of tests undertaken,
number of new customers contacted
3. Costs incurred : e.g. cost of production
4. Resources employed : e.g. human resource, capital
resources.

78
 Performance Measurement –
Balanced Score Card
• Developed by Kaplan and Norton

• Provides a mechanism for linking strategy to

action

• Translates strategy into measurable parameters

79
 Performance Measurement –
Balanced Score Card
• Four perspectives to measure performance
• Customer : How do customers see us?
• Internal Business : What most we excel at ?
• Innovation and learning: Can we continue to create
value?
• Financial: How do we look to shareholders?
• For each of this perspective appropriate
performance measures should be developed

80
 Performance Measurement – Balanced
Score Card – Difference between financial and non-financial measures

Point Financial measures Non-financial measures

Meaning These are performance measures These are performance
that are expressed in terms of measures that are not
financial parameters expressed in terms of financial
parameters
Examples Return on Investment, EVA, Profit Customer satisfaction,
Margin etc Employee Morale etc

Degree of accuracy in These measures can be quite It is quite difficult to measure

measurement accurately measured and quantify these measures

Degree of attention Since these measures are easily Since these measures are not
quantifiable and comparable, easily quantifiable and
practically they are widely applied comparable, practically they
are not that widely applied.
However with the advent of
BSC these measures are also
getting importance.
81
 Balanced scorecard

Financial Perspective
Goals Measures

Internal Business
Customer Perspective Vision and Process Perspective
Goals Measures Strategy Goals Measures

Learning and Growth

Perspective
Goals Measures

82
 Activity Based Costing (ABC)-
Nature, Benefits
• ABC tries to allocate costs on rational basis instead of ad-hoc basis like
labor hours and machine hours or percentage of labor cost/material cost
• Cost drivers are identified. These are real causes of cost incurrence. For
example in purchasing activity, number of purchase orders is the cost
driver – it causes costs to happen in the purchase department
• The concept is quite useful given the fact that these days OHs are
significant elements of costs and the number of products produced by a
firm have increased. ABC gives more accurate costing of the products as
compared to traditional methods.
• Information provided by ABC can be used in policies relating to: -
– Full-line versus focused product line
– Product pricing
– Make or buy decision
– Product mix decisions
– Elimination of non-value-added activities etc

83
 Activity Based Costing (ABC)-
comparison with traditional costing
Point Traditional Costing ABC
Key concepts Cost Center, basis of Activity, cost driver
allocation
Basis of OH allocation Machine Hour, Labor Based on actual
Hour etc consumption of resource
measured through
different cost drivers

Accuracy in costs Less accurate product More accurate product

costing costing
Simplicity Relatively simple to use Relatively difficult to use

Suitability Lesser number of More number of

products; OH cost products; OH cost
relatively less 84 high
relatively
 MCS in service sector
• Characteristics of service organizations in
general
• Absence of inventory buffer
• Difficulty in controlling quality
• Labor intensive
• Multi-unit organizations
– The above characteristics peculiar to service
sector are the causes of differences in the nature
of MCS that is used in the Manufacturing Sector

85
 MCS in service sector –
Professional service organizations
• Special Characteristics
• Goals
• Professionals
• Output and input measurement
• Small size
• Marketing
• MCS
• Pricing
• Profit Centers and TP
• Strategic planning and budgeting
• Control of operations
• Performance measurement and appraisal

86
 MCS in service sector –
Financial service organizations

• Special Characteristics
• Monetary assets
• Time period for transactions
• Risk and reward
• Technology
• MCS
• General principles of MCS apply but they need to be
adapted to the above mentioned special
characteristics

87
 MCS in service sector –
Health Care Organizations
• Special Characteristics
• Difficult social problem
• Change in mix of providers
• Third-party payers
• Professionals
• Importance of quality control
• MCS
• General principles of MCS apply
• Because of high cost of equipments, strategic planning process is
important
• Annual budget preparation is conventional
• Huge quantity of information are available quickly for controlling of
operating activities
• Financial performance is analyzed by comparison of revenues and
expenses with budgets

88
 MCS in service sector –
Nonprofit Organizations

• Special Characteristics
• Absence of the profit measure
• Contributed Capital
• Fund Accounting
• Governance
• MCS
• Product pricing
• Strategic planning and budget preparation
• Operation and evaluation

89
Auditing as a control tool
• Auditing is a control tool that ensures through checking,
verification of documents and evidence that the plans/policies of
the management are implemented as desired
• Many big organizations have a special internal audit department
that carries internal audit to see to it that the internal controls and
checks as set by the management are being adhered to
• There are different types of audits like financial audit, internal
audit, cost audit, management audit etc. Purpose of these audits
are different.
• An audit system makes the staff more vigilant. Audits like
concurrent audit in banks actually act a continuous control
system. Findings from an audit can help strengthen future
controls.

90
 Auditing as a control tool – Different
types
Point Financial Cost Internal Management
Purpose To verify trueness To check that the To check that the To investigate
and fairness of cost accounting internal checks into specific
financial statements plan is adhered and controls are issues or check
to being observed effectiveness of
corporate
planning

Auditor Qualified CA Qualified ICWA Not necessarily Not necessarily

CA CA
Appointment By shareholders By Government By Board of By Management
& Management Directors

Nature Mandatory as per Ordered by the Usually optional. Optional.

statute. Also known Central Govt.
as statutory audit. Otherwise not
mandatory.
Emphasis Compliance of Efficient use of Propriety/judiciou Effectiveness of
Accounting resources, sness of 91 management
Standards in control over costs decisions, functions
 Management Audit
• Management Audit as the name suggests is the audit of the
management itself, that is, the management auditor judges the
effectiveness of the functions performed by the management.
• The Management Auditor will check the planning, decision
making, controlling and other such functions performed by the
management.
• Management Auditor generally is a senior person with good all-
round knowledge and experience.
• He uses tools like questionnaire to gather audit evidence.
• If used properly Management Audit can be a good control tool to
provide feedback to the management about its own
effectiveness.

92