MANAGEMENT CONTROL SYSTEM 2003

1(A) What are the objectives of Transfer prices? Under which conditions a
Transfer pricing mechanism is likely to induce Goal congruence?

ANS: Todays organizational thinking is oriented towards decentralization. One

of the principal challenges in operating a decentralized system is to
device a satisfactory method off accounting for the transfer of goods and
services from one profit center to another in companies that have a
significant number of these transactions.

OBJECTIVES OF TRANSFER PRICING:

If two or more profit centers are jointly responsible for product

development, manufacturing and marketing, each should share in the revenue
generated when the product is finally sold. The transfer price is the mechanism
for distributing this revenue. The transfer price should be designed so that it
accomplishes the following objectives:

It should provide each business unit with the relevant information it

needs to determine the optimum trade-off between company costs and
revenues.

It should induce goal congruent decisions that is, the system should be
designed so that decisions that improve business unit profits will also
improve company profits.

It should help measure the economic performance of the individual

business units

The system should be simple to understand and easy to administer.

A market price- based transfer price will induce goal congruence if all of the
following condition exists. Rarely, if ever, will all these conditions exist in
practice. The list, therefore, does not set forth criteria that must be met to have
a transfer price. Rather,, it suggests a way of looking at the situation to see
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what changes should be made to improve the operation of the transfer price
mechanism.

COMPETENT PEOPLE:

Ideally, managers should be interested in the long-run as well as the short-run

performances of their responsibility centers. Staff people involved in negotiation
and arbitration of transfer prices also must be competent.

GOOD ATMOSPHERE

Managers must regard profitability, as measured in their income statements,

as an important goal and a significant consideration in the judgment of their
performance. They should perceive that the transfer prices are just.

A MARKET PRICE

The ideal transfer price is based on a well-established, normal market price for
the identical product being transferred- that is, a market price reflecting the
same conditions (quantity, delivery time, and quality) as the product to which
the transfer price applies. The market price may be adjusted downward to
reflect savings accruing to the selling unit from dealing inside the company.
E.g. there would be no bad debt expense, and advertising and selling costs
would be smaller when products are transferred from one business unit to
another within the company. Although less that ideal, a market price for a
similar, but not identical, product is better than no market price at all.

FREEDOM TO SOURCE

Alternatives for sourcing should exist, and managers should be permitted to

choose the alternative that is in their own best interests. The buying manager
should be free to buy from the outside, and the selling manager should be free
to sell outside. In these circumstances, the transfer price policy simply gives
the manager of each profit center the right to deal with either insiders or
outsiders at his or her discretion. The market thus establishes the transfer
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price. The decision as to whether to deal inside or outside also is made by the
marketplace. If buyers cannot get a satisfactory price from the inside source,
they are free to buy from the outside.

This method is optimum if the selling profit center can sell all of its products to
either insiders or outsiders and if the buying center can obtain all of its
requirements from either outsiders or insiders. The market price represents the
opportunity costs to the seller of selling the product inside. This is so because
if the product were not sold inside, it would be sold outside. From a company
point of view, therefore, the relevant cost of the product is the market price
because that is the amount of cash that has been forgone by selling inside; the
transfer price represents the opportunity cost to the company.

FULL INFORMATION:

Managers must know about the available alternatives and the relevant costs
and revenues of each.

NEGOTIATION:

There must be a smoothly working mechanism for negotiating contract

between business units.

If all of these conditions are present, a transfer price system based on market
price would induce goal congruent decisions, with no need for central
administration.
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(B) Explain advantages and disadvantages of two step pricing and profit
sharing methods.

ANS: Transfer pricing can create a significant problem in integrated

companies. The profit center that finally sells to the outside customer may not
even be aware if the amount of upstream fixed costs and profit included in its
internal purchase price.

To handle this problem is to establish a transfer price that includes two

charges. First, for each unit sold, a charge is made that is equal to that
standard variable cost of production.Second,a periodic (usually monthly)
change is made that is equal to the fixed costs associated with the facilities
reserved for the buying unit.
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2. Write short notes:

a. Strategy formulation and task control

Strategy formulation is the process of deciding on the goals of the organization

and the strategies for attaining these goals. Goals are timeless, they exist until
they are changed, and they are changed only rarely. For many businesses,
earning a satisfactory return on investment is an important goal for others
attaining a large market share is equally important. Non-profit organizations
also have goals; they seek to provide the maximum services possible with
available funding.

Strategies are big plans, important plans. They state in a general way the
direction in which senior management wants the organization to move. The
need for formulating strategies usually arises in response to a perceived threat
(a shift in consumer taste, new government regulations) or opportunity
(technological innovations).strategies to address a threat or opportunity can
arise from anywhere in an organization and at any time. Complete
responsibility for strategy formulation should never be assigned to a particular
person or organizational unit. Virtually anyone might come up with a bright
idea, which, after analysis and discussion, can form the basis for a new
strategy.

Strategy formulation is essentially unsystematic. Threats, opportunities, and

new ideas do not occur at regular intervals, thus, strategic decisions may be
made at any time. Furthermore, the analysis of a proposed strategy varies with
the nature of the strategy. Strategy analysis involves much judgment, and the
numbers used in the process are usually rough estimates.

Analysis of a proposed strategy usually involves relatively few people- the

sponsor of the idea, headquarters staff, and senior management.
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TASK CONTROL:

Task control is the process of ensuring that specified tasks are carried out
effectively and efficiently.

It is transaction oriented-that is, it involves the performance of individual tasks

according to rules established in the management control process. Task control
often consists of seeing that these rules are followed, a function that in some
cases does not even require the presence of human beings. Many task control
activities are scientific; that is, the optimal decision or the appropriate action of
bringing an out-of-control condition back to the desired state is predictable
within acceptable limits. For instance, the rules for economic order quantity
determine the amount and timing of purchase orders. Task control is the focus
of many management science and operations research techniques.

Most of the information in an organization is task control information. Many of

an organizations central activities- including procurement, scheduling, order
entry, logistics, quality control and cash management are task control
systems. Some of them, though mechanical, can be extremely complicated.

Certain activities that were once performed by managers are now automated
and have thus become task control activities. This shift from management
control to task control frees some of the managers time for other management
activities.
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Which factors need to be borne in mind by the management in controlling

activities of Research and Development?

ANS: The control of research and development centers presents its own
characteristic difficulties, in particular, difficulty in relating results to inputs
and lack of goal congruence.

Difficulty in Relating Results to Inputs:

The results of research and development activities are difficult to measure

quantitatively. In contrast to administrative activities, R&D usually has a least
a semi tangible output in the form of patents, new products or new processes;
but the relationship of output to input is difficult to appraise on an annual
basis because the completed Product of an R & D group may involve several
years of efforts. Thus, inputs as stated in an annual budget may be unrelated
to outputs.

Lack of Goal Congruence:

The goal congruence problem in R & D centers is similar to that in

administrative centers. The research manager typically wants to build the best
research organization money can buy, even though that may be more
expensive than the company can afford. A further problem is that research
people often do not have sufficient knowledge of ( or interest in) the business to
determine the optimum direction of the research efforts.

In some companies, basic research is included as a lump sum in the research

program and its budget. In others, no specific allowance is made for basic
research as such, but there is an understanding that scientists and engineers
can devote part of their time to exploring in whatever direction they find most
interesting, subject only to the informal agreement of their supervisor.

There is no scientific way of determining the optimum size of R & D budget.

Many companies simply use a percentage of average revenues as a base. The
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specific percentage applied is determined in part by a comparison with

competitors R & D expenditures and in part by the companys own spending
history. Depending on circumstances, other factors may also come into play.

If a company has decided on a long-range R & D program and has

implemented this program with a system of project approval, the preparation of
the annual R & D budget is a fairly simple matter, involving mainly the
Calendarization of the expected expenses for the budget period.

At regular intervals, usually monthly or quarterly, most companies compare

actual expenses with budgeted expenses for all responsibility centers and
ongoing projects.

MANAGEMENT CONTROL PROCESS:

The management control process for ongoing operating activities has the following four
phases:

(I) Programming

(2) Budgeting

(3) Execution

(4) Evaluation.

Control process in case of non-operating activities such as a project consists of the

above phases except the two phases programming and budgeting, are combined into a
single activity, project planning, There are differences in the nature of a project and
that of operating activities. A project generally has a single objective and ongoing
operating activities have multiple objectives. A project comes to an end when the
objective is accomplished. An ongoing operating organisation intends to operate
indefinitely. In some cases, the completion of a project may result into an ongoing
operating organisation although this may involve complex management control
problems.
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The discussion of the four phases of management control - Programming, Budget

Preparation, Execution, Evaluation are as follows:

(1) Programming:

Programming is defined as making programmes by top/senior management in terms

of organizational goals and strategies and deciding the funds and resources needed to
accomplish the programmes. Programmes can be made about developments of new
products, research and development activities, merger, takeover, other activities.

Programming is a long range plan, covering period of approximately 5 future years.

The reason is that if programming is made for a shorter period, the results and
benefits of programming cannot be realised within this period. Some organisations like
public utilities prepare long-range plans for even a period of twenty years. Because of
the relatively long-time plan, only rough estimates are possible for revenues, expenses
and capital expenditure.

The task of programming is done by senior/top management and the managers of

divisions or principal responsibility centers, assisted by their staffs. The managers of
lower responsibility centres generally do not participate in the programming process.
Although the staff of toe divisions making the programming can participate, the
decisions on the different aspects of the plan are made by the line managers.

Programming is time-consuming and expensive. The most significant expense is the

time devoted to it by management, but it also involves a special programming staff and
considerable paperwork. A formal programming process is not worthwhile in some
organisations. It is desirable in organisations that have the following characteristics.

(1) Its top management is convinced that programming is important. Otherwise

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programming is likely to be, or to become, a staff exercise that has little impact on
actual decision-making.

(2) It is relatively large and complex. In small, simple organisations, an informal

understanding of the organisations future directions is adequate for making decisions
about resource allocations, which is a principal purpose of preparing programme.

(3) Considerable uncertainty about the future exists, but the organisation has the
flexibility to adjust to changed circumstances. In a relatively stable organisation, a
programme may be unnecessary; the future is sufficiently like the past so that the
programme would be only an exercise in extrapolation. If the future is so uncertain
that reasonably reliable estimates cannot he made, preparation of a formal programme
is a waste of time.

In summary, a formal programming process is not needed in small, relatively stable

organisations, and it is not worthwhile in organisations that cannot make reliable
estimates about the future or in organisations whose top management does not prefer
to manage in this fashion.

(2) Budgeting:

Budgeting is formal financial plan for each year. A budget, known as short-range
plans, is a technique of expressing revenues, physical targets like production and
sales, profit, assets and liabilities usually for a period of one future year.

Budget has the functions of motivating managers, coordinating activities,

communicating to person within an organisation, providing standards for judging
actual performances and acting as a control tool.

Programming and budgeting differ from each other in following respects:

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(1) Programming involves senior managers: operating managers ordinarily are not
involved. Budgeting involves operating managers as well as senior managers.

(2) Staff personnel have a considerable input to the programming process but
relatively less input to the budgeting process. In a large organization the programming
staff is distinct from the budget staff. The programming staff (perhaps called planning
staff or analysis staff) is skilled in analysing proposed new programmes; the budget
stall is skilled in finding soft spots in proposed budgets.

(3) The programme structure consists of programme and major project; it includes
both capital expenditure and operating items and it covers a period of several years.
The budget is structured
by responsibility center (which may or may not cut across programs) the focus is on
operating revenues and expenses and it typically is for a single year.

(4) Budget preparation is done under greater time pressure and is more hectic than
programming.

(5) A programme is a broad brush sketch of the future. A Budget has more detail, both
because it is a fairly specific guide to operating decisions and also because it will be s
subsequently used to evaluate the performance of individual managers. Also,
management by objectives are incorporated in the budget, but not usually in the
programme.

(6) Programming decisions can have consequences of great magnitude. Budgeting

decisions are typically much less significant, because they are made within the context
of the current level of operating activities, except as those activities will be affected by
programme decisions.
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(7) Behavioral considerations are in the programming process. The approved budget is
a bilateral commitment; the programme s not a commitment. Because the budget will
be used to evaluate performance, operating managers tend to be much more
concerned with the numbers in the budget than with the numbers in the programme.

(3) Executing:

After the budget preparation budgeting is used as a tool for coordinating the
actions/individuals and department within the organisatlon. In fact, within the
execution phase, task control is done to ensure that action and performances matched
with the planned or desired results. While performing, the managers goal is to achieve
budgeted targets. However, compliance to budget is not necessary if the plans given in
the budget are found as not the best way of achieving the objectives. Adherence to
budget is not necessarily good, and departure from it is not necessarily bad.

After execution, actual performances and results are compared with the budgeted
plans and the target and variances report are prepared which highlight the variances
between the two and the causes for such
variances. Variance reports should separate controllable items from non-controllable
items, determine the effect of changes in volume on revenues and costs and if
possible, should mention changes in other circumstances affecting the variances.
Variance reports lead to corrective actions subsequently. Variance reports should be
prepared timely and promptly and contain all useful information for helping the
managers take corrective actions.

(4) Evaluation:

Management control process ends with the evaluation phase in which the performance
of managers are evaluated. Since, it is an after-event exercise, the evaluation does not
affect what has happened. However evaluation phase acts like a powerful stimulus as
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employees know that their performances will be subsequently evaluated. Also, on the
basis of performance evaluation, the future budgets and plans are revised.

Expense Centers:

Expense centers are responsibility centers whose inputs are measured in monetary
terms, but whose outputs are not. There are two types of Expense centers: Engineered
and Discretionary.

Engineered Expense centers: have the following characteristics:

(i) Their input can be measured in monetary terms.

(ii) Their output can be measured in physical terms.
(iii) The optimum rupee value of input required to produce one unit of output
can be determined. Engineered expense canters are usually found in
manufacturing operations. They could he engineered expense centers in
marketing like warehousing, distribution, trucking; in administration and
support departments also.

In engineered expense center, output multiplied by the standard cost of each unit
produced measures what the finished product should have costs. The difference
between the theoretical cost and actual cost represent the efficiency of the expense
center. Besides this cost the managers of responsibility center is also responsible for
quality and timely delivery of product and training and development of his employees.

Discretionary Expense centers:

Discretionary expense centers include administrative and support units, research and
development, and most marketing activities. The output of these centers cannot be
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measured in monetary terms. The term discretionary means management exercise its
judgment about what the costs should be taking into account its strategy and
competitive environment.

In a discretionary expense center the difference between budget and actual expense is
not a measure of efficiency. It only means that the manager has lived within its
budget, which may not necessarily indicate efficient performance.

General control consideration:

Budget Preparation:

Management formulates budget for a discretionary expense center by determining the

magnitude of the job that needs to be done. The work done by a discretionary expense
center tails into two categories: Continuing and Special.

Continuing Work is done consistently from year to year such as preparation of

financial statement, by controllers department: Special work is a one slot project. E.g.
Developing and installing a profit budgeting system in newly acquired division. MBO is
used for budget preparation in a discretionary cost center. Where in a budgetee
proposes to do specific jobs and suggest measures to be used in performance
evaluation.

The planning function for discretionary expense center is usually carried out in two
ways:

(a) Incremental budgeting (b) Zero-based budgeting

Incremental Budgeting:
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In this method current level of expenses is taken as a starting point. This amount is
adjusted for inflation, anticipated changes in workload of continuing jobs, special job
and if data are readily available, the cost of comparable jobs in similar units.

It has 2 drawbacks:

Current level of expenditure is accepted and not reexamined during the process of
budget preparation.

Manager of these centers wants to increase the current level of services and thus tend
to request additional resource which if they make sufficiently strong case- are usually
provided. This tendency is called Parkinsons Second Law.

Zero Based Review:

A thorough review is made of each expense center. This review attempts to ascertain
de novo, i.e. from scratch, the resources actually required to carry out each activity.
This analysis estab1ishes a new base, the annual budget simply tries to keep the cash
in line with this new base.

Certain basic questions raised in this analysis are:

Should the function under review be performed at all? Does it add value from the
stand point of end use customer?

What should the quality level be? Are we doing too much?

Should the function be performed in this way?

How much should it cost?

We try to bench mark our expense with other similar organizations?

Zero base review is time consuming. It is traumatic for the manager whose
performance is being reviewed.
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These days lot of companies resort to restructuring, right sizing, business process re-
engineering to improve the profitability.

Measurement and Controlling Assets employed:

When the profit earned by a business unit is compared with the assets employed in
earning it, the business unit is termed as Investment center. There are two methods of
relating profit to the investment base (I) ROI Return on 1nvestment (2) EVA -
Economic Value Added.

Structure of Analysis: The objectives of the Investment center are:

1) To provide information that is useful in making sound decisions about assets
employed and to motivate managers to make these sound decisions that are in the
best interest of the organization.

2) To measuring the performance of the business unit as economic entity

Focusing on profits, without considering the assets employed to generate those profit
is an adequate basis for control. Except in certain service types of organization in
which the amount of capital is significant.

Unless the amount of assets employed is taken into account, it is difficult for Senior
Management to compare the profit performance of one business unit with that of the
other units or to similar outside companies.
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In general business unit managers have two performance objectives. First they should
generate adequate profits from the resources at their disposal. Second, they should
invest in additional resources only when the investment would produce adequate
return. Conversely, they should disinvest if the existing assets do not earn adequate
return.

Return on investment (ROI is a ratio. The numerator is income, as reported on the

income statement. The denominator is assets employed.

Economic value added is a Rupee amount rather than a ratio. It is found by

subtracting capital charge from the net operating profit. EVA is conceptually superior
to ROI, though ROI is still widely used.

Measuring Assets Employed:

In deciding what- investment base to use to evaluate investment center manager,

headquarter asks two questions:

(i) What practices will motivate the business unit managers to use their assets
most efficiently and to acquire the proper amount, and kind of new assets?
(ii) What practices best measures the performance of the unit as an economic
entity?

Cash:

Most companies control cash centrally because this permits use of a smaller cash
balance it needed to weather the unevenness of its cash inu1ovs and outflows.
Business unit cash balances are only the float between daily receipts and daily
disbursements. For the purpose of comparison with outside company, the units need
to slow higher cash balance. GM reports 4.5% of annual sales as cash.
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Receivables: Business unit managers can influence the level of receivable indirectly,
by their ability to generate sales, and directly by establishing credit terms and
approving individual credit accounts and -credit limits, and by their vigour in
collecting overdue accounts.

Receivables are often included as Sundry Debtors less Provision for bad and doubtful
debt.

Inventories are often recorded at end of period amounts even though intra period
average would conceptually better. Inventories should be valued at standard or
average cost and these costs should be used to measure the cost of sales in Profit and
Loss Account. If work in process inventory is finance, by advance payments from the
customer, this should be subtracted.

Working Capital in General:

Some companies use Gross working capital as investment base. This method is sound
if the business unit manager can not influence accounts payable and other current
liabilities. Other company use Net Working Capital for Investment base. This method
provides a good measure of capital provided by the corporation.

Property, Plant and Equipment:

In financial accounting, fixed asset are initially recorded at their acquisition cost, and
this cost is written of over the assets useful life through depreciation. Most companies
use a similar approach in measuring profitability of the business units asset base.
This causes some serious problems in using the system fur its intended purposes.
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Investment Centre:

An investment centre is responsible for both profits and investments. The investment
centre manager has control over revenues, expenses, and the amounts invested in the
centres assets. He also formulates the credit policy which has a direct influence on
debt collection, and the inventory policy which determines the investment in
inventory. The manager of an investment centre has more authority and responsibility
than the manager of either a cost centre or a profit centre. Besides controlling costs
and revenues, he has investment responsibility too. Investment of asset responsibility
means the authority to buy, sell, and use divisional assets.