UNIT 1.

INTRODUCTION

Contents

1.0 Aims & Objective

1.1 Introduction
1.2 Basic Concepts
1.3 Management
1.4 Control
1.5 System
1.6 Management Control
1.7 Management Control Activities
1.8 Behavioral Considerations
1.9 Strategy Formulation
1.10 Task Control
1.11 Distinction Between Strategy Formulation and Management Control
1.12 Distinction Between Strategy Formulation and Task Control
1.13 Relation to Management Accounting
1.14 Internal Auditing

1.0 AIMS AND OBJECTIVES

When you have studied this unit you should be able to do the following:
 Define the words management, control and systems
 Explain what management control systems mean
 Differentiate between management control, strategy formulation and task control
 Identify the scope of management control
 Explain the activities of the management control
 Understand the relationship of MANAGEMENT CONTROLS to the subjects like
Management Accounting and Auditing

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1.1 INTRODUCTION

The meaning of three words

Management:
Management is an art of getting things done through others.
Management is what managers do.
Managements are the leaders of the organization, each supervises people in his own
organization unit and is a subordinate of the manager to whom he reports.

Control: it is a set of devices to ensure that the set goals are achieved. Any control process
has at least four elements
 A detector
 Assessor
 An effector
 And a communications network

System:
A system is a prescribed way of carrying out an activity or set of activities. Usually the
activities are repeated.

It is characterized by recurring, coordinated series of steps that are included to accomplish a

specified purpose.

However, management actions are not systematic.

If all the systems provided the correct action for all situations, there would be no need for
human managers and are needed only in the event of system failure.

Management control: Management control process is the process that managers use to
assure that the members of the organization implement their strategies. It is the process by
which managers influence other members of an organization to implement the organizations
strategies
Difference between simple control process and management Control process
Though, elements of the control process are the same in both the simple and Management.
Control process, there are, however, significant differences between the two, which are
described below.

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 Control process
simple management
1. Standards are present are a result of conscious planning
process. It
Involves both planning and control
activities.
2. Control automatic Management control. It’s not automatic.
3. People it involves only one person it requires coordinator among many
Individuals.
4. In an assessor the desired action is by no it is like a black box, the exact nature of
an
function means clearest operation cannot be observed.
5. Control in an self regulated to obey the assure the general instructions given by
the
organization supervisor.

Scope of Management control

Management control is one of several types of planning and control activities that occur in an
organization. There are two other types of planning & control activities in an organization,
namely strategy formulation & task control.
control.

Management control fits between Strategy Formulation and Task Control in several respects.
Distinction between management control and strategy formulation and task control

Strategy Formulation Management control Task Control

1. systematic in between more systematic
2. Long run focus “ short run focus
3.rough app. Of nature “ current accurate date
4. More planning & less control equal planning &control less planning & More
control
5. End product:
product:
Goals implementation efficient and effective
Policies of strategies performance of individual
Strategies tasks

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The Management control activities:
It involves the variety of activity, which include,
1. Planning what the organization should do
2. Co-coordinating the activities of several parts of an organization
3. Communicating the information
4. EVAluating the information
5. Deciding what action should be taken
6. Influencing people to change their behavior.

1. Management control should anticipate what conditions are going to be in future.

2. The purpose of management control is to ensure that strategies are carried out so that
the organization’s objectives are attained.
3. Management control process, even systematic, is by no means mechanical.
Management control process involves among individuals.

Managers have personal goals, and the central control problem is to indicate them to act so
that when they seek their personal goals, they help to attain the organization’s goals. This is
called goal congruence,
congruence, which means that the goals of the individual member of an
organization should be, as far as feasible, consistent with the goals of the organization itself.

Tools for implementing strategies

Management control systems aid management in moving an organization toward its strategic
objectives. Thus, Management control focuses primarily on strategy execution.

Imp. Mechanism
Management control
strategies OS HRM performance
Culture

1. Management controls are only one of the tools managers use in implementing desired
strategies. These strategies get implemented through,

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  OS specifies the roles, reporting relationships, and responsibilities that mere dm
items in organization
 HRM deals with selection, training development, EVAluation promotion and firing
of employees.
 Culture refers to the organization’s set of common beliefs, attitudes and norms that
explicitly or implicitly guide managerial actions.

Management control systems encompass both financial and non-financial performance

measures.

Financial objectives maximization of Net income

Non-financial objectives Product qualities, market share, consumer satisfaction,
Strategy Formulation, actions, employee morale.

Management controls are to help in the execution of chosen strategies. It can also provide the
basis for development of new strategies as and when the environment changes.

Strategy Formulation
It is the process of deciding on the goals of the organization and the strategies for attaining
these goals.

The strategies differ from one organization to another organization. Strategies are big plan;
important plans which state direction in which senior Management. Wants the organization to
be heading in a general way.

The Strategy Formulation process involves reexamining some of these strategies, perhaps
changing them or perhaps adopting new strategies.

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 Strategy Formulation Management control
Is the process of deciding on new strategies? Process of deciding how to implement
strategies.
Unsystematic
Systematic
Involves few people i.e. part of organization.
Involves all the people in an organization I.e.,
whole organizations.

Task Control:
Control: is the process of approving that that specified tasks are carried out effectively
and efficiently.
-Is transaction oriented?

Task Control Management control

1. Scientific. 1. Can never be scientific.
2. Focus is on specific tasks. 2. Focus is on organizational units.
3. No judgment is required. 3. Judgment is always required.

Relationship to management accounting.

Accounting

Financial accounting management accounting

-Deals with financial reports prepared for shareholder financial cost accounting.
accounting.
Inv. analysis and other outside parties. Measures full covering product
processes, services, and other cost
objects.
External users -aid in production, pricing and
measuring product profitability.
- Used for inv. valuation and for
the analysis of certain long diff.
accounting. Run decision what
course would be under alterative
courses of action?

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 -Management
control/responsibilities
accounting.

Management control with internal auditing.

Management control is an activity that is carried out primarily by managers. Internal auditing
is a staff activity intended to ensure that information is reported accurately and in accordance
with prescribed rules, that fraud and misappropriation of assets is kept to minimum and to
suggest ways of improving the organization efficiency and effectiveness.

However, Internal auditing can be considered as the part and parcel of management control.

Key points
Management is an art of getting things done through others.

Control is a set of devices to ensure that the set goals are achieved. Any control process has
at least four elements A detector, Assessor, An effectors And a communications network

A system is a prescribed way of carrying out an activity or set of activities. Usually the
activities are repeated. However, management actions are not systematic.

If all the systems provided the correct action for all situations, there would be no need for
human managers and are needed only in the event of system failure.

Management control process is the process that managers use to assure that the members of
the organization implement their strategies.

It is the process by which managers influence other members of an organization to implement

the organizations strategies

Though, elements of the control process are the same in both the simple and Management.
Control process, there are, however, significant differences between the two,

Management control is one of several types of planning and control activities that occur in an
organization. There are two other types of planning & control activities in an organization,
namely strategy formulation & task control.
control.
Management control fits between Strategy Formulation and Task Control in several respects.

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The Management control activities include,
Planning what the organization should do
Co-coordinating the activities of several parts of an organization
Communicating the information
EVAluating the information
Deciding what action should be taken
Influencing people to change their behavior.

The purpose of management control is to ensure that strategies are carried out so that the
organization’s objectives are attained.

Management control process, even systematic, is by no means mechanical. Management

control process involves among individuals.

Managers have personal goals, and the central control problem is to indicate them to act so
that when they seek their personal goals, they help to attain the organization’s goals. This is
called goal congruence,
congruence, which means that the goals of the individual member of an
organization should be, as far as feasible, consistent with the goals of the organization itself.

Management control systems aid management in moving an organization toward its strategic
objectives. Thus, Management control focuses primarily on strategy execution.

Management controls are only one of the tools managers use in implementing desired
strategies. These strategies get implemented through,
 OS specifies the roles, reporting relationships, and responsibilities that mere dm
items in organization
 HRM deals with selection, training development, EVAluation promotion and firing
of employees.
 Culture refers to the organization’s set of common beliefs, attitudes and norms that
explicitly or implicitly guide managerial actions.
Management control systems encompass both financial and non-financial performance
measures.

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Management controls are to help in the execution of chosen strategies. It can also provide the
basis for development of new strategies as and when the environment changes. Strategy
Formulation is the process of deciding on the goals of the organization and the strategies for
attaining these goals.

The strategies differ from one organization to another organization

Strategies are big plan; important plans which state direction in which senior Management.
The Strategy Formulation process involves reexamining some of these strategies, perhaps
changing them or perhaps adopting new strategies.

Task Control: is the process of approving that that specified tasks are carried out effectively
and efficiently.

Internal auditing can be considered as the part and parcel of management control.

Check Your Progress Exercise

1.Define
 Management control
 Management control system

2. What are the management control activities?

3. List the tools for implementing strategies?
4. Differentiate task control and strategy formulation from management control?
5. Explain the relationship between management accounting and management control
system?
6. Explain the relationship between internal auditing and management control system?

SUMMARY

ANSWER TO CHECK YOUR PROGRESS EXERCISE

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UNIT 2. UNDERSTANDING STRATEGIES

Contents
2.0 Aims and Objectives
2.1 Introduction
2.2 Goals
2.2.1 Financial Goals
2.2.2 Profitability
2.2.3 Maximizing Shareholder Value
2.2.4 Risk
2.2.5 Other Goals
2.3 The Concept of Strategy
2.4 Corporate Level Strategy
2.4.1 Single Industry
2.4.2 Unrelated Industries
2.4.3 Related Industry
2.5 Business Unit Level Strategy
2.5.1 BCG Matrix
2.5.2 GE 3x3 Planning Model
2.5.3 Least Cost
2.5.4 Competitive Advantage
2.5.5 Differentiation
2.5.6 Value Chain Analysis

2.0 AIMS AND OBJECTIVES

When you have finished this unit you should be able to do the following:

 To discuss about the goals of an organization

 To discuss about the strategies of an organization at corporate level and business unit
level
 To discuss the implications of the above in the design of control systems

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2.1 INTRODUCTION

Management control systems are tools to implement strategies. Strategies differ between
organizations, and controls should be tailored to the requirements of specific strategies.
Different strategies require different task proprieties, different key success factors, and
different skills, perspectives, and behaviors. Thus, a continuing concern in the design of
control systems should be whether the behavior induced by the system is the one called for by
the strategy.

Strategies are plans to achieve organization goals. Therefore, in this chapter we first describe
some typical goals in organizations. Then we discuss strategies at two levels in an
organization: the corporate level and the business unit level. Strategies provide the broad
context within which one can evaluate the optimality of the elements of the management
control systems. In this chapter, we discuss how to vary the form and structure of control
systems in accordance with variations in corporate and business unit strategies.

2.2 GOALS

Although we often refer to the goals of a corporation, a corporation as such does not have
goals. The corporation is an artificial being with no mind or decision-making ability of its
own. the goals are arrived at by the chief executive officer (CEO) of the corporation, with the
advice of other members of senior management; usually they a ratified by the board of
directors. In many well-known corporations, the goals originally set by the founder persist for
generations. In the formal management control system of a business, profitability is by no
means the only goal, however, we describe other goals in a following section.

2.2.2 Profitability
In the broadest and conceptually soundest sense, profitability is expressed by an equation that
is the product two ratios:

Revenues – expenses revenues

-------------------------- * ----------------- = return on investment
Revenues investment

An example is:

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 $10,000 - $9,500 $10,000
-------------------- * ---------- = 12.5%
$10,000 $4,000

The first ratio in this equation is the profit margin percentage:

($10,000 - $9,500)/$10,000 = 5%

The second ratio is the investment turnover:

$ 10,000/$4,000 = 2.5 times

The product of these two ratios is the return on investment: 5%x 2.5 times = 12.5%. It can be
found directly by dividing profit (i.e., revenues minus expenses) by investment; but this does
not draw attention to the two principal components: profit margin an investment turnover.

In the most basic form of this equation, “investment” is the shareholders’ investment, which
consists of proceeds from issuance of stock, plus retained earnings.. However, for many
purposes, the source of financing is not relEVAnt; “investment” then is the total of debt
capital and equity capital.

“Profitability” refers to profits in the long run, rather than in the current year or the current
quarter; many current expenditures for advertising, research and development, and other items
reduce current profits but increase long-run profits.

2.2.3 Maximizing Shareholder Value

In the 1980s and 1990s the term shareholder value appeared frequently in the business
literature; it was said that the appropriate goal of a for-profit corporation is to maximize
shareholder value. Although the meaning of this term isn’t always clear form the context, we
presume it refers to the market price of the corporation’s stock. we believe that achieving
satisfactory profit better states a corporation’s goal than maximizing shareholder value for
three principal reasons.

First, “maximizing” implies that there is a way of finding the maximum amount that a
company can earn. This is not the case. In deciding between two courses of action,
management believes (with some qualifications) that the selected course will add more to
profitability than the rejected courses. Management rarely discovers, however, all the
alternatives possible and the effect on profitability of each. Profit maximization requires that

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marginal costs and a demand curve be calculated, and managers would spend every working
hour (and many sleepless nights), thinking about endless alternatives for increasing profit
ability: life is generally considered too short to warrant such an effort.

Second, although optimizing shareholder value may be one goal, it is by no means the only
goal in most organizations. Certainly a business that does not earn a profit at least equal to its
cost of capital is not doing its job. Without achieving this goal, a business cannot discharge
any other responsibilities. But economic performance is not the sole responsibility of a
business. Most managers want to behave ethically, and most feel an obligation to other
stakeholders in the organization.

Third, shareholder value is usually equated to the market value of the company’s stock; but
market value is not an accurate measure of what the shareholders’ investment is actually
worth, except at the moment at which the shares are traded. Today’s stock price results from
the judgment of the average investor; but the average investor tends to think primarily about
the company’s prospects in the short run, whereas shareholders should want management to
make decisions that benefit the corporation in the long run, even at the expense of short-run
profitability. Moreover, the average investor is not privy to much of the information that
management has concerning the company’s long-run prospects.

By rejecting the maximization concept, we do not mean to question the validity of certain
obvious principles. A course of action that decreases expenses without affecting another
element, such as market share, is sound. So is a course of action that increases expenses with
a greater than proportional increase in revenues, such as increased advertising expense in
some cases. So is a course of action that increases profit without an increase in shareholder
investment, or one that increases profit with a less than proportional increase in shareholder
investment, such as an investment in a cost-saving machine. These principles assume, in all
cases, that the course of action is ethical and consistent with the corporation’s other goals.

2.2.4 Risk
An organization’s pursuit of profitability is affected by management’s willingness to take
risks. The degree of risk taking varies with the personalities of individual managers.
Nevertheless, there is an upper limit; some organizations explicitly state that management’s

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primary responsibility is to preserve the company’s assets and that the goal of profitability is
secondary. The calamitous bankruptcy of hundreds of savings and loan associations in the
1980s is traceable, in large part, to managers who made what appeared to be highly profitable
loans without giving adequate recognition to the risk ness of those loans.

2.2.5 Other Goals

In a survey by posner and Schmidt of 900 American executives, the executives ranked their
goals in order of importance: organizational effectiveness ranked first, then high productivity,
good organizational leadership, high morale, good organizational reputation, high
organizational efficiency, profit maximization, organizational growth, organizational stability,
value to local community, and service to the public. Clearly, profit, here as profit
maximization, is only one of a large number of goals. The same survey asked executives to
rank the importance of various stakeholders to the corporation: customers were ranked first,
followed by “myself” subordinates, employees as a whole, bosses, co-workers and colleagues,
managers, technical and white-collar employees, founders of the company, craftsmen and
skilled workers,
workers, public stockholders, and elected public officials and government bureaucrats.
Again, the fact that public stockholders were ranked 11 th out of 12 stakeholders indicates that
corporations do not operate solely, or even primarily, for the benefit of their shareholders.

Other studies show that most managements will not condone unethical behavior; they forbid
the payment of bribes, even though this would increase profitability; and they support
participation in community activities and contributions to educational and charitable
organizations, even though these activities increase expenses and, therefore, in the short run,
reduce profits.

2.3 THE CONCEPT OF STRATEGY

Although definitions differ, there is general agreement that a strategy describes the general
direction in which an organization plans to move to attain its goals. Every well-managed
organization has one or more strategies, although they may not be stated explicitly. In the
previous section we described the typical goals of an organization. The rest of this chapter
will deal with generic types of strategies that can help an organization achieve its goals.

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Strategies can be found at two levels:
(1) Strategies for a whole organization; and
(2) Strategies of business units within the organization.
About 85 percent of fortune 500 industrial firms in the united states have more than one
business unit and consequently formulate strategies at both levels.

EXHIBIT 2-1
Strategy formulation

Environmental Internal
Analysis Analysis

Competitor Technology know-how

Customer Manufacturing know-how
Supplier Marketing know-how
Regulatory Distribution know-how
Social/Political Logistics know-how

Opportunities Strengths and

And threats Weaknesses
Identify Opportunities Identify core competencies

Fit internal competencies

With external opportunities

Firm’s strategies

Although strategic choices are different at different hierarchical levels, there is a clear need
for consistency in strategies across business unit and corporate levels. Exhibit 2-2 summarizes
the strategy concerns at the two organizational levels and the generic strategic options. The
remainder of this chapter will elaborate on the ideas summarized in exhibit 2-2. Given the
system orientation of this book, we will not attempt an exhaustive analysis of the appropriate
content of strategies. We rather provide enough appreciation for the strategy formulation
process so the reader is able to identify the strategies at various organizational levels at part of
an evaluation of the firm’s management control system.

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2.4 CORPORATE LEVEL STRATEGY

Corporate strategy is about being in the right mix of business. Thus, corporate strategy is
concerned more with the question of where to compete than with how to compete in a
particular industry; the latter is a business unit strategy. At the corporate level, the issues are:

(1) The definition of business in which the firm will participate; and
(2) The deployment of resources among those businesses. Corporate-wide strategic
analysis results in decision involving businesses to add, businesses to retain, business
to emphasize, businesses to de-emphasize, and businesses to divest.

In terms of their corporate level strategy, companies can be classified into one of three
categories. a single industry firm operates in one line of business.

EXHIBIT 2-2 two levels of strategy

strategy key strategic generic strategic primary organizational

level issues options levels involved

corporate level are we in the right mix single industry. corporate office.
of industries? related diversification.
what industries or unrelated diversification.
sub industries should
we be in?
business what should be the build. corporate office and
unit level mission of the business hold. business unit general
unit? harvest. manager.
divest.
how should the business low cost. business unit
unit competes to realize differentiation. general manager.

2.4.1 Single Industry Firms

One axis in exhibits 2-3 extent of diversification-relates to the number of industries in which
the company operates. At one extreme, the company may be totally committee to on industry.
Firms that pursue a single industry strategy include Maytag (major household appliances),
Wrigley (chewing gum), Perdue farms (poultry), and Nucor (steel). A single industry firm
uses its core competencies to pursue growth within that industry.

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EXHIBIT 2-3
Corporate-level strategies: graphical representation of generic corporate strategies

High single industry

·(Management controldonald’s. wrigley)

Degree related diversification

Of · (procter & gamble,
Relatedness dow-corning, corning glass)

·
Unrelated diversification
(textron, itt)

Low high
Extent of diversification

Example: Nucor achieved growth of 17% annually over a 27-year period (1970-1997) by
focusing exclusively on the steel industry. Nucor used its three core competencies
(manufacturing process know-how, technology adoption and implementation know-how, and
plant construction know-how) in achieving these results.

2.4.2 Unrelated Diversified Firms

At the other extreme, there are firms, such as Textron, that operate in a number of different
industries.

The other axis in exhibit 2-3 degree of relatedness- refers to the nature of linkages across the
multiple business units. Here we refer to operating synergies across businesses based on
common core competencies and on sharing of common resources. In the case of Textron,
except for financial transactions, its business units have little in common. There are few
operating synergies across business units within Textron. Textron headquarters functions like
a holding company, lending money to business units that are expected to generate high
financial returns. We refer to such firms as unrelated diversified firms or conglomerates.
conglomerates.
Conglomerates grow primarily through acquisitions. Other examples of unrelated diversified
firms are Litton and ltv.

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2.4.3 Related Diversified Firms
Another group consists of firms that operate in a number of industries and their businesses are
connected to each other through operating synergies. we refer to these firms as related
diversified firms.
firms.

Operating synergies consist of two types of linkages across business units:

(1) Ability to share common resources; and
(2) Ability to share common core competencies. One way related diversified firms create
operating synergies is by having two or more business units share resources such as a
common sales force, common manufacturing facilities, and a common procurement
function. Such sharing of resources helps the firm reap benefits of economies of scale
and economies of scope.

Example. Most of Procter & gamble’s individual products share a common sales force and a
common logistics; most of its products are distributed through supermarkets.

Another key characteristic of related diversified firms is that they possess core competencies
that benefit many of their business units. They grow by leveraging core competencies
developed in one business when they diversify into other businesses.

Example. Dow corning diversified into several products and markets that use its core
competencies in silicon chemistry. Texas instruments used its competence in electronic
technology to diversify into several industrial consumer products. corning glass has a
diversified set of businesses (cookware, optical wave-guides. TV bulbs, and capacitors) but
most of its products derive from the company’s core competence in specialty glass
technology. other examples of related diversified firms include Procter & gamble, nec, canon,
Philip Morris, du punt, Emerson electric, and America telephone & telegraph.

Related diversified firms typically grow internally through research and development.
The role of the corporate office in a related diversified firm is twofold:

(1) Similar to conglomerate, the chief executive of a related diversified firm must make
resource allocation decisions across business units;

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 (2) But, unlike a conglomerate, the chief executive of a related diversified firm must also
identify, nurture, deepen, and leverage corporate wide core competencies that benefit
multiple business units.

Core competence and corporate diversification

Despite the dismal track record of companies pursuing diversification, many have pursued
this strategy since the 1960s. Porter writers:

Research has shown that, on average, related diversified firms perform the best, single
industry firms perform next best, and unrelated diversified firms do not perform well over the
long term. This is because corporate headquarters, in a related diversified firm, has the ability
to transform core competencies from one business unit to another. C.K. Prahalad and Gary
hamel in their Harvard business review article, “the core competence of the corporation,”
(may-june 1990) make compelling case for corporate diversification based on a company’s
core competencies. A core competency is what a firm excels at and what adds significant
value for customers. Competency-based growth and diversification, therefore, have
significant potential for success.

The business units of a related diversified firm might be worse off if they were split up into
separate companies since a related diversified firm can exploit operating synergies across its
business units. For instance, if the business units of Honda (motorcycles, automobiles, lawn
mowers, task Control.) were split up as separate companies, they would then lose the benefit
of Honda’s expertise in small engine technology.

Unrelated diversified firms, on the other hand, do not possess operating synergies. Most of the
failed corporate diversification attempts in the past were of this type. Nevertheless, some
unrelated diversified firms (example: general electric) are highly profitable. Since we
continue to see examples of unrelated diversified firms, we discuss this type of corporate
strategy.

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EXHIBIT 2-4
Corporate-level strategies: summary of three generic strategies

Type of corporate strategy Single industry firm Related diversified firm Unrelated diversified firm

Pictorial representation of
strategy

Identifying features Competes in only sharing of core totally autonomous

One industry competencies business in very
across business different markets

Examples Management control procter & gmble itt

Donald’s corporation emerson electric textron
Perdue farms
corning glass ltv
Iowa beef
Wrigley
johnson & johnson litton
Crown, cork & seal philip morris rockwell
Maytag dow-corning general electric
Texas air du pont
Ford motor general foods
Nucor gilette
texas instruments
at & t

Business Unit Strategies

Competitions between diversified firms do not take place at the corporate level. Rather, a
business unit in one firm (Procter & gamble’s pampers unit) competes with a business unit in
another firm (Kimberly Clark’s haggis unit). The corporate office of a diversified firm does
not produce profit by itself; revenues are generated and costs are incurred in the business
units. Business unit strategies deal with how to create and maintain competitive advantage in
each of the industries in which a company has chosen to participate. The strategy of a
business unit depends on two interrelated aspects:

(1) Its mission (“what are its overall objectives?”) and

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 (2) Its competitive advantage (“how should the business unit compete in its industry to
accomplish its mission”).

Business Unit Mission

In a diversified firm one of the important tasks of senior management is resource deployment,
i.e., make decisions regarding the use of the cash generated from some business units to
finance growth in other business units. Several planning models have been dev eloped to help
corporate level managers of diversified firms to effectively allocate resources. These models
suggest that a firm has business units in several categories, identified by their mission; the
appropriate strategies for each category differ. Together, the several units make up a portfolio,
the components of which differ as to their risk/reward characteristics just as the components
of an investment portfolio differ. Both the corporate office and the business unit general
manager are involved in identifying the missions of individual business units.

Of the many planning models, two of the most widely used are Boston consulting group’s
two-by-two growth-share matrix (exhibit 2-5) and general electric company/Management
control Kinsey & company’s three-by-three industry attractiveness business strength matrix
(exhibit 2-6). While these models differ in the methodologies they use to develop the most
appropriate missions for the various business units, they have the same set of missions from
which to choose: build, hold, harvest, and divest.

Build. This mission implies an objective of increased market share, even at the expense of
short-term earnings and cash flow (examples: Monsanto’s bio-technology, corning glass’s
optical wave guides, black and Decker’s handheld electric tools).

Hold. This strategic mission is geared to the protection of the business unit’s market share and
competitive position (example: IBM’s mainframe computers).

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EXHIBIT 2-5 business unit mission: the BCG model

Cash source
High low
High high
“Star,” “question mark”
Hold build

Market cash
Growth “cash cow” “dog” use
Rate harvest divest

Low low
High high

Relative market share

Harvest. This mission has the objective of maximizing short-term earnings and cash flow,
even at the expense of market share (examples: American brand’s tobacco products, general
electric’s and Sylvania’s light bulbs).

Divest. This mission indicates a decision to withdraw from the business either through a
process of slow liquidation or outright sale.

While the planning models can aid in the formulation of missions, they are not cookbooks. A
business unit’s position on a planning grid should not be the sole basis for deciding its
mission.

In the Boston consulting group (BCG) model, every business unit is placed in one of four
categories- question mark, star, cash cow, and dog-that represent the four cells of a 2x2
matrix, which measures industry growth rate on one axis and relative market share on the
other (exhibit 2-5). BCG views industry growth rate as an indicator of relative industry
attractiveness and relative market share as an indicator of the relative competitive position of
a business unit within a given industry.

BCG singles out market share as the primary strategy variable because of the importance it
places on he notion of experience curve. According to BCG, cost per unit decreases
predictably with the number of units produced over time (cumulative experience). Since the

22
market share leader will have the greatest accumulated production experience, such a firm
should have the lowest costs and highest profits in the industry. The association between
market share and profitability has also been empirically supported by the profit impact of
market strategy (PIMS) date base.

EXHIBIT 2-6 business unit mission: the general electric planning model
A
The portfolio matrix

High Winners Winners Question

Marks

Average Winners Average Losers

Businesses

Profit Losers Losers

Low Producers

Strong average weak

Business strength
B
Recommended business strategies

High Invest/grow Invest/grow Dominate/

Strongly Selectively Delay/
(Build) (Build) Divest

Average
Invest/grow Earn/ Harvest/
Selectively Protect Divest
(Build) (Hold)
Low
Earn/ Harvest/ Harvest/
Protect Divest Divest
(Hold)

Strong average weak

Business strength

Although the experience curve is a powerful analytical tool, it has limitations:

1.the concept applies to undifferentiated products where the primary basis of competition is
on price. For these products, becoming the low cost player is critical. However, market share
low cost are not the only ways to succeed. There are low market share firms (such as

23
Mercedes Benz in automobiles) that earn high profits by emphasizing product uniqueness
rather than low cost.

2. In certain situations improvements in process technology may have a greater impact on the
reduction of per-unit cost than cumulative volume per second.
Example. Certain companies in the U.S. steel industry have greatly reduced their per-
unit (ton) cost of producing steel and recouped a large portion of worldwide market
share by vast investments in technological improvements, not by producing more tons
of steel (on a cumulative basis) than their competitors.

3. An aggressive pursuit of reducing cost via accumulated production of standardized

items can lead to loss of flexibility in the marketplace.

Example. The classic example of this problem is when, during the 1920s, Henry ford
standardize the car (“i will give you any color provided it is black”) and aggressively reduced
costs. Ford lost its leadership in the auto industry when general motors sold the consumers on
product variety (“a car for every purse and every purpose”), so much so that in 1927 ford
discontinued the model t and suffered a 12-month shutdown for retooling.

4. Commitment to the experience curve concept can be a severe disadvantage if new

technologies emerge in the industry. Example. Timex’s low cost position in the wask Control
industry, build over several years, was erased overnight when Texas instruments entered the
market with digital was ask Controllers.

5. Experience is not the only cost driver. Other drivers that affect cost behavior are: scale,
scope, technology, and complexity. a firm needs to consider carefully the relevant cost drivers
at work to achieve the low cost position.

BCG used the following logic to make strategic prescriptions for each of the four cells in
exhibit 2-5. Business units that fall in the question mark quadrant are typically assigned the
mission: “build” market share. The logic behind this recommendation is related to the
beneficial effects of the experience curve. BCG argued that, by building market share early in
the growth phase of an industry, the business unit would enjoy a low-cost position. These
units are major users of cash, since cash outlays are needed in the areas of product

24
development, market development, and capacity expansion. These expenditures are aimed at
establishing market leadership in the short term, which will depress short-term profits.
However, the increased market share is intended to result in long-term profitability. Some
businesses in the question mark quadrant might also be divested if their cash needs to build
competitive position are extremely high.

Example. In the early 70s, RCA decided to divest its computer division because of the
enormous cash outflows that would have been required to build market share in such a
capital-intensive and highly competitive industry.

Business units that fall in the star quadrant are typically assigned the mission: “hold” market
share. These units already have a high market share in their industry, and the objective is to
invest cash to maintain that position. These units generate significant amounts of cash
(because of their market leadership), but they also need significant cash outlays to maintain
their competitive strength in growing market. On balance, therefore, these units are self-
sufficient and do not require cash from other parts of the organization.

Business units that fall in the cash cow quadrant are the primary sources of cash for the firm.
Since these units have high relative market share, they probably have the lowest unit costs and
consequently the highest profits. on the other hand, since these units operate in low-growth or
declining industries, they do not need to reinvest all the cash generated. Therefore, on a net
basis, these units generate significant amounts of positive cash flows. Such units are typically
assigned the mission: “harvest” for short-term profits and cash flows.

Businesses in the dog quadrant have a weak competitive position in unattractive industries.
They should be divested unless there is a good possibility of turning them around.

The corporate office should identify cash cows with positive cash flows and redeploys these
resources to build market share in question marks.

The general electric company/MC Kinsey & company grid (exhibit 2-6) is similar to the BCG
grid in helping corporations assign missions across business units. However, its methodology
differs from the BCG approach in the following respects:

25
1. BCG uses industry growth rate as a proxy for industry attractiveness. In the general electric
grid, industry attractiveness is based on weighted judgments about such factors as market size,
market growth, entry barriers, technological obsolescence, and the like.

2. BCG uses relative market share as a proxy for the business unit’s current competitive
position. The general electric grid, on the other hand, uses multiple factors such as market
share, distribution strengths, and engineering strengths to assess the competitive position of
the business unit.

Control system designers need to know what the mission of a particular business unit is, but
not necessarily why the firm has chosen that particular mission. Since this book focuses on
designing control systems for ongoing businesses, it deals with the implementation of the
build, hold, and harvest but not divest-missions. these missions constitute a continuum, with
“pure build” at one end and “pure harvest” at the other end. a business unit could be anywhere
on this continuum, depending upon the trade-off it is supposed to make between building
market share and maximizing short-term profits.

EXHIBIT 2-7 industry structure analysis: porter’s five forces model

New
Entrants

Industry
Suppliers Competitors Customers

Substitutes

2.5 BUSINESS UNIT COMPETITIVE ADVANTAGE

Every business unit should develop a competitive advantage in order to accomplish its
mission. Three interrelated questions have to be considered in developing the business unit’s
competitive structure of the industry in which the business unit operates? Second, how should
the business unit exploit the industry’s competitive structure: third, what will be the basis of
the business unit’s competitive advantage? Michael porter has described two-analytical

26
approaches-industry analysis and value chain analysis-as aids in developing a superior and
sustainable competitive advantage. each is described below.

Industry analysis. Research has highlighted the important role industry conditions play in the
performance of individual firms. Studies have shown that average industry profitability is, by
far, the most significant predictor of firm performance. According to porter, the structure of
an industry should be analyzed in terms of the collective strength of five competitive forces
(see exhibit 2-7)

1. The intensity of rivalry among existing competitors. Factors affecting direct rivalry
are industry growth, product differentiability, number and diversity of competitors,
level of fixed costs, intermittent overcapacity, and exit barriers.
2. The bargaining power of customers.
customers. Factors affecting buyer power are: number of
buyers, buyer’s switching costs, buyer’s ability to integrate backward, impact of the
business unit’s product on buyer’s product quality/performance, and significance of
the business unit’s volume to buyers.
3. The bargaining power of suppliers.
suppliers. Factors affecting supplier power are number of
suppliers, supplier’s ability to integrate forward, presence of substitute inputs, and
importance of the business unit’s volume to suppliers.
4. Threat from substitutes. Factors affecting substitute threat are relative
price/performance of substitutes, buyer’s switching costs, and buyer’s propensity to
substitute.
5. The threat of new entry. Factors affecting entry barriers are capital requirements,
access to distribution channels, economies of scale, product differentiation,
technological complexity of product or process, expected retaliation from excising
firms, and government policy.

We make three observations with regard to the industry analysis:

1. The more powerful the five forces are, the less profitable industry is likely to be. in
industries where average profitability is high (such as soft drinks and pharmaceuticals),
the five forces are weak (e.g., in the soft drink industry, entry barriers are high). in

27
 industries where the average profitability is low (such as steel and coal), the five forces
are strong (e.g., in the steel industry, threat from substitutes is high).
2. Depending upon the relative strength of the five forces, the key strategic issues facing
the business unit will differ from one industry to another.
3. Understanding the nature of each force helps the firm to formulate effective strategies.
Supplier selection (a strategic issue) is aided by the analysis of the relative power of
several supplier groups; the business unit should link with the supplier group for which it
has the best competitive advantage. Similarly, analyzing the relative bargaining power of
several buyer groups will facilitate selection of target customer segments.

Generic Competitive Advantage.

Advantage. The five-force analysis is the starting point for developing a
competitive advantage since it helps to identify the opportunities and threats in the external
environment. with this understanding, porter claims that the business unit has two generic
ways of responding to the opportunities in the external environment and developing a
sustainable competitive advantage: low cost and differentiation.

Low cost. Cost leadership can be achieved through such approaches as economies of scale in
production, experience curve effects, tight cost control, and cost minimization (in such areas
as research and development, service, sales force, or advertising). some firms following this
strategy include: Charles Schwab in discount brokerage, wall-mart in discount retailing, Texas
instruments in consume electronics, Emerson electric in electric motors, Hyundai in
automobiles, dell in computers, black and Decker in machine tools, Nucor in steel, Lincoln
electric in arc welding equipment, and bic in pens.

EXHIBIT 2-8 basis for competitive advantage

Superior
Cost-Cum- Differentiation
Differentiation Advantage
relative Advantage
Differentiation
Position Low Cost Stuck-in-
Advantage The-middle
Inferior
Inferior superior
Relative cost position

28
Differentiation. The primary focus of this strategy is to differentiate the product offering of
the business unit, creating something that is perceived by customers as being unique.
Approaches to product differentiation include brand loyalty (coca-cola and Pepsi cola in soft
drinks), superior customer service (Nordstrom in retailing), dealer network (caterpillar
tractors in construction equipment), product design and product features (Hewlett-Packard in
electronics), and technology (Motorola in communications). other examples of firms
following a differentiation strategy include: Mercedes in automobiles, Stouffer’s in frozen
foods, neiman-marcus in retailing, mont blanc in pens, and Rolex in wristwatches.

Value Chain Analysis. As noted in the previous section and as depicted in exhibit 2-8,
business units can develop competitive advantage based on low cost, differentiation, or both.
The most attractive competitive position is to achieve cost-cum-differentiation.

Both intuitively and theoretically, competitive advantage in the marketplace ultimately

derives from providing better customer value for an equivalent cost or equivalent customer
value for a lower cost. Competitive advantage cannot be meaningfully examined at the level
of the business unit as whole. The value chain disaggregates the firm into its distinct strategic
activities. The value chain is the complete set of activities involved in a product, beginning
with extraction of raw material and ending with post delivery support to customers. Exhibit 2-
9 depicts such a chain. A company chooses those activities that it will carry out with its own
resources and that it will obtain from outside parties.

Value chain analysis seeks to determine where in the company’s operations from design to
distribution customer value can be enhanced or costs lowered.

EXHIBIT 2-9
Typical value chain for a business
Product Manu- marketing service/
Development facturing and sales logistics

Support activities: finance, human resources,

Information technology

For each value added activity, the key questions are:

a) Can we reduce costs in this activity, holding value (revenues) constant?
b) Can we increase value (revenue) in this activity, holding costs constant?

29
 c) Can we reduce assets in this activity, holding costs and revenue constant?
d) Most importantly, can we do (a), (b), and (c) simultaneously?

By systematically analyzing costs, revenues, and assets in each activity, the business units can
achieve cost-cum differentiation advantage.

The value chain framework is a method for breaking down the chain from basic raw materials
to end-use customers- into specific activities in order to understand the behavior of costs and
the sources of differentiation. Few if any firms carry out the entire value chain of a product
with their own resources. In fact, firms within the same industry vary in the proportion of
activities that they carry out with their own resources.

The value chain helps the firm to understand the entire value delivery system, not just the
portion of the value chain in which it participates. Suppliers and customers, and supplier’s
suppliers, an customers’ customers have profit margins that are important to identify in
understanding a firm’s cost differentiation positioning, since the end-use customers ultimately
pay for all the profit margins along the entire value chain. Suppliers not only produce and
deliver inputs used in a firm’s value activities, but they significantly influence the firm’s
cost/differentiation position.

Similarly, customers’ actions can have significant impact on the firm’s cost/differentiation
advantage. Example. When printing press manufacturers built a new press of “3 meters”
width, the profitability of paper mills was affected because paper machine widths must match
some multiple of printing press width. Mill profit is affected by customer actions even though
the paper mill is two stages upstream from the printer, who is a customer of the press
manufacturer!

SUMMARY

Every organization has one or more goals. Profitability is an important goal, but a firm should
also adopt goals vies-a- vis employees, suppliers, customers, and community.

Diversified firms undertake strategy formulation at two levels-corporate and business units.
At the corporate level, the key strategic questions is: what set of business should the firm be
in? The “generic” options for corporate level strategic questions are:

30
 (1) A single industry firm.
(2) A related diversified firm,
(3) An unrelated diversified firm.

A key concept in corporate level strategy is the notion of core competence. A core
competency is an intellectual asset in which a firm excels.

At the business unit level, the key strategic questions are:

(1) What should be the business unit’s mission? (The “generic” business unit
missions are build, hold, and harvest.) And
(2) How should the business unit compete to accomplish its mission? (The
“generic” competitive advantages are low cost and differentiation.)

Three tools can help in developing business unit strategies: portfolio materials, industry
structure analysis, and value chain analysis. Portfolio matrices especially position a business
unit on a grid where one axis is “market attractiveness” and the other axis is “market share.”
such matrices are useful in deciding on the business unit mission.

Industry structure analysis is a tool to systematically assess the opportunities and threats in
the external marketplace. This is accomplished by analyzing the collective strength of five
competitive forces-existing competitors, buyers, suppliers, substitutes, and new entrants.

The value chain for a business is the linked set of value-creating activities to produce a
product, from basic raw material sources for component suppliers to the ultimate end-use
product delivered into the final consumer’s hands. Each business unit must be understood in
the context of the overall chain of value creating activities of which it is only a part. Value
chain analysis is a useful tool in developing competitive advantage based on low cost, or
differentiation, or preferably, cost-cum-differentiation.

Control system designers need to be cognizant of the organization’s strategies since systems
have to support strategies

Check Your Progress Exercise

Discuss about the financial goals of the organization

31
Discuss about the other goals of an organization
Explain about the concept of strategy.
Explain in detail about the BCG matrix
Explain in detail about the GE 3x3 matrix
Write a short notes on
Value chain analysis
Low cost
Competitive advantage
Differentiation

ANSWER TO CHECK YOUR PROGRESS EXERCISE

32
UNIT 3. BEHAVIOR IN ORGANIZATIONS

Contents
3.0 Aims and Objectives
3.1 Introduction
3.2 Goal Congruence
3.3 Informal Factors that Influence Goal Congruence
3.4 External Factors
3.5 Internal Factors
3.6 The Formal Control System
3.7 Formal Control Process
3.8 Types of Organizations
3.9 Functions of the controller

3.0 AIMS AND OBJECTIVES

 To explain the concept of goal congruence

 To describe the external factors that affect goal congruence process
 To describe the internal factors that affect goal congruence process
 To discuss the types of organizations to implement strategies.
 To know about the different structures of organization.
 To describe the functions of controller

3.1 INTRODUCTION

MCS influence human behaviour. The system should influence behaviors in a goal
congruence manner. The concept of goal congruence is explained here. Goal congruence is
affected both by informal processes and also by formal systems. Internal factors External
factors

Control is attained by two factors

1. Rules broadly defined
2. A systematic way of planning and controlling.

33
Organizations structures and their types

The function of the controller on the management control process. Different types of
organization structures can be used to implement strategies. a discussion of the types of
organization structure is essential, since the design of management control systems should fit
the organization structure used. Finally, we describe the function of the controller in the
management control process.

3.2 GOAL CONGRUENCE

Senior management wants the organization to attain the organization’s goals. However, the
members of the organization have their own personal goals, and these are not entirely
consistent with the goals of the organization. The actions of individual members of the
organization are directed toward achieving their personal goals. The central purpose of a
management control system, therefore, is to assure, so far as is feasible, what is called “goal
congruence.” goal congruence in a process means that actions it leads people to take in
accordance with their perceived self-interest are also in the best interest of the organization.

Perfect congruence between individual goals and organizational goals does not exist. One
obvious reason is that individual goals and organizational goals do not exist. One obvious
reason is that individual participants usually want as much compensation as they can get;
whereas, from the organization’s viewpoint, there is an upper limit to salaries beyond which
profits would be adversely and unnecessarily affected. as a minimum, however, the
management control system should not encourage individuals to act against the best interests
of the organization. for example, if the system signal s that the emphasis should be only on
reducing costs, and if a manager responds by reducing costs at the expense of adequate
quality or by reducing costs in other parts of the organization, then the manager has been
motivated, but in the wrong direction.

Two questions are important in evaluating any management control practice:

1. What actions does it motivate people to take for their self-interest?
2. Are these actions in the best interest of the organization?

34
3.3 INFORMAL FACTORS THAT INFLUENCE GOAL CONGRUENCE

Both formal systems and informal processes influence human behavior in organizations and,
therefore, affect the degree to which goal congruence can be achieved. This book is primarily
concerned with formal control systems. Nevertheless, the designers of formal systems should
consider the informal processes in their design choices because formal mechanisms should be
consistent with informal processes in order to effectively implement organization strategies.
The system of strategic plans, budgets, and report is a formal control system. Before
discussing the formal system, we shall describe informal forces. Work ethic, management
style, and culture are examples of informal organization processes, some of which are external
to the organization, but most of which are internal.

3.4 EXTERNAL FACTORS

External factors are norms of desirable behavior that exist in the society of which the
organization is a part. They are often referred to as the work ethic. They are manifest in
employees’ loyalty to the organization, their diligence, their spirit, and their pride in doing a
good job (as contrasted with merely putting in time). Some of these attitudes are local; they
are specific to the city or region in which the organization does its work. In encouraging
companies to locate in their city or state, chambers of commerce or other promotional
organizations often claim that their locality has a loyal, diligent work force. Others are
industry specific: the railroad industry has norms that differ from those in the airline industry.
Still others are national; some countries have a reputation for excellent work ethics.
Currently, for example, Japan, South Korea, Hong Kong, and other East Asian countries have
an excellent reputation on this dimension.

3.5 INTERNAL FACTORS

Culture. The most important internal factor is the organizations’ culture, or climate.
Organization culture refers to the set of common beliefs, attitudes, norms, relationships, and
assumptions that are explicitly or implicitly accepted and evidenced throughout the
organization. The term climate is used to designate the quality of the internal environment that
conditions the quality of cooperation, the development of individuals, the extent of members’
dedication or commitment to organizational purpose, and the efficiency with which that

35
purpose is translated into results, Climate is the atmosphere in which individuals help, judge,
reward, constrain, and find out about each other. It influences morale – the attitude of the
individual toward his or her work and his or her environment.

Cultural norms are extremely important, they explain why either of two organizations may
have an excellent formal management control system, but why one has much better actual
control than the other. An organizations’ culture is rarely stated in writing,. And attempts to
do so almost always result in platitudes.

Management Style. The internal factor that probably has the strongest impact on management
control is management style – in particular, the attitude of a manager’s superior toward
control. Usually the attitude of subordinates reflects in a general way their perception of the
attitude of their superiors, modified, of course, by each subordinate’s own attitude. The
attitude ultimately stems from the attitude of the chief executive officer. This is another way
of saying “an institution is the lengthened shadow of a man.”

Managers come in all shapes and sizes. Some are charismatic and outgoing others are less
ebullient. Some spend much time looking and talking to people (called “management by
walking around”); others rely more heavily on written reports. We know ,of no way to
generalize about the “ideal” manager.

The Informal Organization. The lines on an organization chart depict the formal organization
– that is, the formal authority and responsibility relationships of the specified mangers. The
organization chart may show, for example, that the production manager of Division Reports to
the general manager. Actually the production manger communicates with several other people
in the organization other mangers, support units, and staff people at headquarters – and simply
friends and acquaintances. In extreme situations, the production manager may pay inadequate,
attentions to messages received from the general manger. This tends to happen when the
production manger is evaluated more on production efficiency than on overall performance.
The relationships that constitute the informal organization are important in understanding the
realities of the management control process.

Perception and Communication. In working toward the goals of the organization, operating
mangers must know what these goals are and what actions they are supposed to take in order
to achieve them. They receive information about what they are supposed to do through

36
various channels. In part, it is conveyed by conversations and other informal means. This
information often is not a clear message about what senior management wants done. An
organization is complicated, and the actions that should be taken by one part of it to
accomplish the overall goals cannot be stated with absolute clarity, even under the best of
circumstances.

Moreover, the message received through various information channels may conflict with one
another, or managers may interpret them in different ways.

Cooperation and Conflict. The lines connecting the boxes on an organization chart imply that
the way organizational goals are attained is that senior management makes a decision and
communicates that decision down through the organizational hierarchy to mangers at lower
levels of the organization, who then implement it. This implication ignores the personal goals
of individuals, and it is not the way an organization actually functions.

3.6 THE FORMAL CONTROL SYSTEM

The informal factors discussed above have a great influence on the effectiveness of
management control in an organization. The other influence is, Of course, the formal
systems. These systems can be classified into two types: (1) the management control system,
which is our main emphasis in this book and, therefore, not discussed further at this point; and
(2) rules, which are describe d briefly below.

Rules
We use the word rules as shorthand for all types of formal instructions and controls, they
include standing instructions, practices, job descriptions, standard operating procedures,
manuals, and codes of ethics. Unlike the directives or guidance implicit in budget amounts,
which change from month to month, these rules are in force indefinitely – that is, they exist
until they are modified. Typically, rules are changed infrequently. They relate to matters that
range from the most trivial (e.g., capital expenditures of over $5 million must be approved by
the board of directors).

Some rules are guides – that is, organization members are permitted, and indeed expected, to
depart from them, either under specified circumstances or if in the person’s judgment a
departure is in the best interests of the organization.

37
Some rules should never be broken. A rule that prohibits payment of bribes and a rule that an
airline pilot should never take off without permission from the air traffic controller are
examples; Some rules are prohibitions against unethical, illegal, or other undesirable actions.

Physical Controls. Security guards, locked storeroom, vaults, computer passwords, television
surveillance, and other physical controls are part o the control structure. Most of them are
associated with task control, rather than with management control.

Manuals. Much judgment is required in deciding which should be written and put in a
manual; which should be guidelines, rather than fixed rules, what discretion should be
allowed; and a variety of other matters. The literature constraints only obvious guidance on
these matters. Bureaucratic organizations have more detailed manuals than other
organizations; large organizations have more than small ones; centralized organizations have
more than decentralized ones; and organizations with geographically dispersed units
performing similar functions (such as fast food restaurant chains) have more manuals and
rules than single-site organizations.

System Safeguards. Various safeguards are built into the information processing system to
ensure that the information flowing through the system is accurate and to prevent (or at least
minimize) fraud and defalcation. They include cross-checks of totals with details,, required
signatures and other evidence that a transaction has been authorized, separation of duties,
frequent counts of cash and other portable assets, and a number of other rules that are
described in texts on auditing. They also include checks of the system that are made by
internal and external auditors.

38
 Part I. The Management Control Environment

Goals and Other

Strategies Rules informatio
(Chapter 2) Reward(Feedback)

Responsibility Was performance Yes

Strategic Budgeting center Report satisfactory
planning (Chapter 9) performance Actual (Chapters 11 &
(Chapters 5, 12)
(Chapter 8) 10,& 11) versus plan No

Revise Revise Corrective Measuremen

Feed Back
Action t
Exhibit 3-1 the formal control process Communicat

Formal Control Process

Exhibit 3-1 is a sketch of the formal management control process. Its foundation is the
organization’s goals, and strategies for attaining these goals. A strategic plan is prepared in
order to implement these strategies; all available information is used in making this plan. The
strategic plan is converted to an annual budget that focuses on the planned revenues and
expenses for individual responsibility centers. Responsibility centers also are guided by a
large number of rules and other information. They operate, and the result of their operation
are measured and reported. Actual results are compared with the plant, ,to answer the question
“was performance satisfactory?” If it was satisfactory, there is feedback to the responsibility
center in the form of praise or other reward. If performance was not satisfactory, there is
feedback leading to corrective action in the responsibility center and possible revision on the
plan. (Like most such diagrams, this sketch is valid only as a generalization. As we shall show
in later chapters, the process in practice is less straightforward than this sketch indicates.)

Types of Organization
The firm’s strategy has an important influence on its organization structure. The type of
organization structure, in turn, has an influence on the design of management control systems.
Although organization some in all sizes and shapes, their structures can be grouped into three
general categories: (1) a functional structure, in which each manger is responsible for a
specified function, such as production or marketing; (2) a business unit structure, in which
each business unit manager is responsible for most of the activities of a business unit, which is
a semi-independent part of the company; and (3) a matrix structure, in which functional units
have dual responsibilities.

39
Functional Organizations
The rationale for the functional form of organization is the same as that developed by
Frederick Taylor and others for specialization of labor in large scale production. It involves
the notion of a manager who brings specialized knowledge to bear on decisions related top the
functions. This contrasts with the general purpose manager, who cannot possibly have as
much knowledge about a given function as a specialist in that function. A skilled marketing
manger should make better marketing decisions and a skilled production manger should made
better production decisions than the decisions made by a manger who is responsible form both
marketing and production. Moreover, the skilled specialist should be able to supervise
workers in the same function better than the generalist; similarly, skilled higher-level mangers
should be able to provide better supervision of lower-level managers in the same or similar
function. Thus, an important advantage of a functional structure is efficiency.

There are five disadvantages of a functional structure

First, in a functional organization, there is no unambiguous way of determining the

effectiveness of the separate functional managers because each function contributes jointly to
the final output of the organization.

A second disadvantage of the functional organization is that there is no good way of planning
the work if the separate functions at lower levels in the organization.
Third, if the organization consists of managers in one functions who report to higher-level
mangers of the same functions, who, in turn, report to still higher level mangers of that
function, then a dispute between managers of different functions can be resolved only at the
very top of the organization, even th0ug it originates at a low level.

Fourth, functional structures are inadequate when the firm diversifies its products and
markets.

Finally, functional organizations tend to create “silos” across function, thereby preventing
cross-functions coordination in areas such as new product development. This problem can be
mitigated by supplementing this organization with lateral cross-functional processes such as
cross-functional job rotation and team-based rewards.

A. Functional Organization

hief

40
 cturing ing Manager

Plant 1 Plant 2 Plant 3

Region A Region B Reg
B. Business Unit Organization

hief

Manager Business Manager Business Manager Business

Unit X Unit Y Unit Z
Staff Staff Staff

Plant Marketing Plant Marketing Plant Marketing

Manager Manager Manager Manager Manager Manager

C. Matrix Organization

hief

41
 Manager Manager

Manager

Manager
Manager
Business Units
The business unit form of organization is designed to solve problems inherent in the
functional structure. A business unit, also called a division, is responsible for all the functions
involved in producing and marketing a specified product line. Business unit mangers act
almost as if their units were separate companies. They are responsible for planning and
coordinating the work of the separate functions, and they resolve dispute that arise between
these functions., they ensure that they plans of the marketing department are consistent with
production capabilities, their performance is measured by the profitability of the business unit,
and this is a satisfactory measure because profit incorporates the activities of both ,marketing
and production

Business unit mangers do not have complete authority. Headquarters reserves the right to
make certain decisions. At a minimum, headquarters is responsible for obtaining funds for the
company as a whole, and it allocates funds to business units according to its judgment on
where the available funds can be put to the best use. Headquarters also approves the business
unit budgets, judges the performance of business unit managers, sets their compensation, ,and
if the situation warrants, removes them. Headquarters established the “charter’ of each
business unit – that is, the product lines it is permitted to make and sell or the geographical
territory in which it can operate, or both, and occasionally, the customers to which it may sell.
An advantage of the business unit form of organization is that it provides a training ground in
general management. The business unit manger should have the entrepreneurial spirit that
characterizes the CEO of an independent company.

Another advantage is that because the business unit is closer to the market for its products
than the headquarters organization, its manager may make sounder decisions than
headquarters can make, and it can react to new threats or opportunities more quickly.

42
Offsetting these advantages is the possibility that each business unit staff may duplicate some
work that in a functional organization is done at headquarters. The business unit manager is
presumably a generalist, but his or her subordinates are functional specialists, and they must
deal with many of the same problems that specialists in other business units and at
headquarters address. The layers of business unit staff may be more expensive than the value
gained by divisionalization. Moreover, skilled specialists in certain functions are in short
supply, and business units may be unable to attract qualified persons. These problems could
be mitigated by supplementing business unit organization with certain centralized functional
expertise.

Another disadvantage of the business unit form is that the dispute between functional
specialists in a functional organization may be replaced by disputes between business units
inn a business unit organization. These may involve one business unit infringing on the
charter of another unit. There may also be disputes between business unit staffs and
headquarters staff.

Although the possibility of holding several mangers responsible for pieces of the company’s
overall profit performance is attractive, the above noted disadvantages may outweigh the
benefits of business unit structure.

Implications for Systems Design

If ease of control were the only criterion, companies would be organized into business units
when ever it was feasible to do so because in a business unit organization, ,each unit manager
is held responsible fro the profitability of the unit’s product line, and he or she presumably
plans, coordinates, and controls the elements that affect its profitability. Control is not the
only criterion, however. A functional organization may be more efficient because larger
functional units provide the benefits of economies of scale. A business unit organization
requires a somewhat broader type of manger than the specialist who manages a function;
competent general mangers may be difficult to find.

Because of the apparently clear-cut nature of the assignment of profit responsibility in a

business unit organization, designers of management control systems sometimes recommend
such an organization without giving appropriate weight to the other considerations involved in

43
organization design. Nevertheless, the systems designer must fit the system to the
organization, not the other way around. In other words, although the control implications of
various organization structures should be discussed with senior management, once
management has decided that a given structure is best, all things considered, then the system
designer must take that structure as given.

Nevertheless, the systems designer should not insist that the rotation policy be abandoned
simply because to do so would make performance measurement easier.

3.9 FUNCTIONS OF THE CONTROLLER

We shall refer to the person who is responsible for designing and operating the management
control system as the controller. Actually, in many organization, the title of this person is
chief financial officer.

The controller usually performs the following functions:

 Designs and operates information and control system.
 Prepares financial statements and financial reports (including tax returns) to
shareholders and other external parties.
 Prepares and analyzes performance reports and assists mangers by interpreting these
reports, by analyzing program and budget, proposals, and b consolidating the plans of
various segments into an overall annual budget.
 Supervises internal audit and accounting control procedures to ensure the validity of
information, establishes adequate safeguards against theft and defalcation, and
performs operations audits.
 Develops personnel in the controller organization and participates in the education of
management personnel in matters relating to the controller functions.
Relation to Line Organization
The controllership function is a staff function. Although the controller usually is responsible
fro the design and operation of systems in which control information is collected and reported,
the sue of this information in actual control is the responsibility of line management. The
controller also may b e responsible for developing and analyzing control measurements and
for making recommendations for action to management.

44
The controller does not make or enforce management decisions, however. The responsibility
for control runs from the chief executive officer down through the line organization, which
uses information provided by the controller.

The controller does make some decisions, In general, these are decisions that implement
policies decided on by line management. For example, a member of the controller
organization often decides on the propriety of expenses listed on a travel voucher, line
managers usually prefer not to get involved in discussions of whether the traveler spent too
much on meals or whether the airplane trip should have been made in economy class rather
than first class.

The controller plays an important role in the preparation of strategic plans and budgets. Also,
the controller organization typically analyzes performance reports, assures that they are
accurate, and calls the line manager’s attention to items that may indicate the need for actins.
In these activities, the controller acts almost like a line manager. The difference is that the
controller’s decisions can be overruled by the line manager to whom the subordinate manger
is responsible.
Exhibit 3-3. Alternative controller relationships
Part I. The Management Control Environment

Corporate Corporate
Controller Controller

Business Unit Business Unit

Manager Manager

The Business Unit Controller

Business Unit
Controller
Business unit controllers inevitably have a divided loyalty. On the one hand they owe some
Business Unit
Controller
allegiance to the corporate controller, who is presumably responsible for the overall operation
of the control system. On the other hand, they owe allegiance to their business unit mangers
since controllers are responsible for furnishing staff assistance to them. Two possible types
of relationship are diagrammed in Exhibit 3-3.

45
In some companies the business unit controller reports to the business unit manager, and has
what is called a dotted line relationship with the corporate controller, Here, the business unit
general manager is the controller’s immediate boss. This means that the business unit
general manger has the ultimate authority in decisions relating to hiring, training, transferring,
compensation, promotion, and firing of business unit controllers. However, the business unit
general manger usually takes the inputs of the corporate controller before making these
decisions.

In other companies’ business unit controllers report directly to the corporate controller – that
is, the corporate controller is their boss, and indicated by a solid line on the organization chart.

There are problems with each of these relationships. If the business unit controller works
primarily for the business unit manger, there is the possibility that he or she will not reveal
“fat” in the proposed budget or provide completely objective reports on performance. On the
other hand, if the business unit controller works primarily for the corporate controller. The
business unit manger may treat him or her as a “spy from the front office” rather than as a
trusted aide.

QUESTIONS

1.explain the concept of goal congruence?

2.explain the informal factors that influence goal congruence process?
3.explain the influence of formal control system in goal congruence process?
4.explain about the various types of organizations in brief?
5.explain the functions of the controller in detail?
6. Write about the role of business unit controller?

UNIT 4. RESPONSIBILITY CENTERS

Contents
4.0 Aims and Objectives
4.1 Introduction
4.2 Revenue Centers
4.3 Expense Centers

46
 4.4 Responsibility Center
4.5 Nature of Responsibility Centers
4.6 Relation Between Inputs and Outputs
4.7 Measuring Inputs and Outputs
4.8 Efficiency and Effectiveness
4.9 The role of Profits
4.10 Types of Responsibility Centers
4.11 Revenue Centers
4.12 Expense Centers: Engineered and Discretionary
4.13 General Control Characteristics
4.14 Profit Centers
4.15 Investment Centers
4.16 Administrative and Support Centers
4.17 Research and Development Centers
4.18 Marketing Centers

4.1 AIMS AND OBJECTIVES

 To describe the nature of responsibility centers

 To discuss about revenue centers and expense centers
 To discuss the concepts of efficiency and effectiveness
 To discuss about the general control characteristics
 To learn about administrative, research and development and marketing centers

Questions
1. Define responsibility center and list the types of responsibility centers
2. Explain the general control characteristics?
3. Write about the expense centers in detail?
4. List the control problems in administrative and support centers?
5. List the control problem in R&D centers?

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4.2 REVENUE AND EXPENSE CENTERS

Management control focuses on the behavior of managers in responsibility centers. We

describe the nature of responsibility centers in general and the criteria of efficiency and
effectiveness that are relevant in measuring the performance of responsibility center
managers. We then discuss revenue centers and expense centers, which are two types of
responsibility centers. There are two general types of expense centers: engineered expense
centers and discretionary expense centers. Discretionary expense centers can be classified
further as administrative and support centers, research and development (R&D) centers, and
marketing centers.

4.4 RESPONSIBILITY CENTERS

A responsibility center is an organization unit that is headed by a manager who is responsible

for its activities.
activities. In a sense, a company is a collection of responsibility centers, each of which
is represented by a box on the organization chart. These responsibility centers form a
hierarchy. At the lowest level in the organization are responsibility centers of sections, work
shifts, or other small organization unit. At a higher level are departments or business units that
consist of several of these smaller units plus staff and management people; these large units
are also responsibility centers. And from the standpoint of senior management and the board
of directors, the whole company is a responsibility center, although the term is usually used to
refer to units within the company.

4.5 NATURE OF RESPONSIBILITY CENTERS

A responsibility center exists to accomplish one or more purpose; 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 centers are to help
implement these strategies. Because the organization is the sum of its responsibility centers, if
the strategies are sound, and if each responsibility center meets its objectives, the whole
organization should achieve its goals.

Exhibit 4-1 shows the essence of any responsibility center. A responsibility center uses inputs,
which are physical quantities of material, hours of various types of labor, and a variety of

48
services. It works with these resources, and it usually requires working capital (e.g.,
inventory, receivables), equipment, and other assets to do this work. As a result of this work,
the responsibility center produces outputs, which are classified either as goods, if they are
tangible, or as services, if they are intangible. Every responsibility center has outputs- that is,
it does something. In a production plant, the outputs are goods. In staff units, such as human
resources, transportation, engineering, accounting, and administration, the outputs are
services. For many responsibility centers, especially staff units, outputs are difficult to
measure; never the less, they exist.

The products (i.e., goods and services) produced by a responsibility center may be furnished
either to another responsibility center or to the outside marketplace. In the first case, the
products are inputs to the other responsibility center; in the latter case, they are outputs of the
whole organization. Revenues are the amounts earned from providing these outputs.

4.6 RELATION BETWEEN INPUTS AND OUTPUTS

Management is responsible for obtaining the optimum relationship between inputs and
outputs. In some situations, the relationship is causal and direct. In a production department,
for example, the inputs of raw material resources become a physical part of the finished goods
output. Control focuses on producing the outputs at the time needed, in the desired quantities,
according to the correct specifications and quality standard, and with minimum inputs.

In many situations, however, inputs are not directly related to outputs. Advertising expense is
an input that is expected to increase sales revenue; but revenue is affected by many factors
other than advertising, so the relationship between an additional amount of advertising and the
resulting revenue rarely is known. Management’s decision on the amount to spend for
advertising is based on judgments. For research and development, the relationship between
inputs and outputs is even more ambiguous; the value of today’s R&D effort may not be
known for several years, and the optimum amount that a given company should spend for
R&D is indeterminable.

4.7 MEASURING INPUTS AND OUTPUTS

49
The amounts of labor, material, and services used in a responsibility center are physical
quantities: hours of labor, quarts of oil, reams of paper, and kilowatt-hours of electricity. In a
management control system these amounts are translated into monetary terms. Money
provides a common denominator hat permits the amount of individual resources to be
combined. The monetary amount is ordinarily obtained by multiplying the physical quantity
by a price per unit of quantity (e.g., hours of labor times a rate per hour). The resulting
amount is called “cost”. Thus, the inputs of a responsibility center are ordinarily expressed as
costs. Cost is a monetary measure of the amount of resources used by a responsibility center.

Note that inputs are resources used by the responsibility center. The patients in a hospital or
the students in a school are not inputs. Rather, inputs are the resources that are used in
accomplishing the objectives of treating the patients or educating the students.

Although the cost of most inputs can be measured, outputs are much more difficult to
measure. In a profit-oriented organization, revenue is an important measure of output of the
whole organization, but such a measure is rarely a complete expression of outputs; it does not
encompass everything that the organization does. For example, this year’s revenue does not
measure the value of R&D work, employee training, or advertising and sales promotion
carried out this year; these inputs produce outputs that will benefit future years. In many
responsibility centers, outputs cannot be measured satisfactorily. How can one measure the
value of the work done by a public relations department, a quality control department, or a
legal staff? In many nonprofit organizations, no good quantitative measure of output exists. A
college easily can measure the number of students graduated, but it cannot measure how much
education each of them acquired. Many organizations do not attempt to measure the output of
such responsibility centers. Others use an approximation, or surrogate, of the output of some
of them, recognizing its limitations.

4.8 EFFICIENCY AND EFFECTIVENESS

The concepts stated above can be used to explain the meaning of efficiency and effectiveness,
which are the two criteria for judging the performance of a responsibility center. The terms
are almost always used in a comparative, rather than in an absolute sense. That is, we
ordinarily do not say that responsibility center a is 80 percent efficient; rather we say that it is

50
more (or less) efficient than its competitor, more (or less) efficient currently than it was in the
past, more (or less) efficient compared to its budget, or more (or less) efficient than
responsibility center b.

 Efficiency is the ratio of outputs to inputs, or the amount of output per unit of input.
 Effectiveness is the relationship between a responsibility center’s outputs and its
objectives.
 An organization unit should be both efficient and effective; it is not a cost of choosing
one or the other.
 In summary, a responsibility center is efficient if it does things right, and it is effective
if it does the right things.

4.10 TYPES OF RESPONSIBILITY CENTERS

There are four types of responsibility centers, classified according to the nature of the
monetary inputs or outputs, or both, that are measured: revenue centers, expense centers,
profit centers, and investment centers. Their characteristics are shown in exhibit 4-2. In
revenue centers, 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.

The planning and control systems for responsibility centers differ depending on whether they
are revenue centers, expense centers, profit centers, or investment centers. We discuss the
appropriate planning and control techniques for revenue centers and expense centers in the
remainder of this chapter. Profit centers are discussed in chapter 5 and investment centers in
chapter 7.

4.11 REVENUE CENTERS

In a revenue center, outputs are measured in monetary terms, but no formal attempt is made
to relate inputs (i.e., expenses or costs) to outputs. (If expenses were matched with revenues,
the unit would be a profit center.) Revenue centers, therefore, are marketing organizations that

51
do not have profit responsibility. Actual sales or orders booked are measured against budgets
or quotas.

Each revenue center is also an expense center in that the revenue center manager is held
accountable for the expenses incurred directly within the unit. The primary measurement,
however, is revenue. Revenue centers are not charged for the cost of the goods that they
market. Consequently, they are not profit centers.

The manager of a revenue center does not have knowledge that is needed to make the
cost/revenue trade-off required for optimum marketing decisions. Therefore, responsibility for
this type of decision cannot be delegated to a revenue center manager. For instance, revenue
centers typically do not have authority to set selling prices.
In this book, we do not discuss revenue centers as such. We shall discuss the
management of revenue as part of our discussion of profit centers.

4.12 EXPENSE CENTERS: ENGINEERED AND DISCRETIONARY

Expense centers are responsibility centers for which inputs, or expenses are measured in
monetary terms, but for which outputs are not measured in monetary terms. There are two
general types: engineered expense centers and discretionary expense centers. They correspond
to two types of costs. Engineered costs are elements of cost for which the “right” or “proper”
amount of costs that should be incurred can be estimated with a reasonable degree of
reliability. Costs incurred in a factory for direct labor, direct material, components, supplies,
and utilities are examples. Discretionary costs (also called managed costs) are those for which
no such engineered estimate is feasible; the amount of costs incurred depends on
management’s judgment about the amount that is approximate under the circumstances.
Expense centers in which all, or most, costs are engineered costs are engineered expense
centers; expense centers in which most costs are discretionary are discretionary expense
centers.
Many expense centers are also cost centers, as this term is used in cost accounting. The
distinction is that an expense center is a responsibility center that is; it has a manager, whereas
some cost centers do not have identifiable managers. For example, in a factory, there is
usually an “occupancy” cost center, which collects the costs associated with the building, such

52
as heat, air conditioning, light, insurance, and building maintenance. No one manager is
responsible for these costs, so this cost center is not an expense center. Similarly, each of the
printing presses in a print shop may be cost centers, but only the whole department is an
expense center.

Engineered expense centers

Engineered expense centers have the following characteristics:

1. Their inputs can be measured in monetary terms.

2. Their outputs can be measured in physical terms.
3. The optimal dollar amount of input required to produce one unit of output can be
established.

Engineered expense centers usually are found in manufacturing operations. Warehousing,

distribution, trucking, and similar units in the marketing organization also may be engineered
expense centers, and so may certain responsibility centers within administrative and support
departments. Examples are accounts receivable, accounts payable, and payroll sections in the
controller department; personnel records and the criteria in the human resources department;
shareholder records in the corporate secretary department; and the company motor pool. Such
units perform repetitive tasks for which standard costs can be developed. (Note that these
sections are in departments that are discretionary expense centers.)

In an engineered expense center, the output multiplied by the standard cost of each unit
produced represents what the finished product should have cost.

Discretionary expense centers

The output of discretionary expense centers cannot be measured in monetary terms. They
include administrative and support units (e.g., accounting, legal, industrial relations, public
relations, human resources), research and development organizations, and most marketing
activities.
The term discretionary does not mean that management’s judgments are capricious of
haphazard. Management has decided on certain policies that should govern the operation of
the company: whether to match, exceed, or spend less than the marketing efforts of its
competitors; the level of service that the company provides to its customers; the appropriate

53
amount of spending for R&D, financial planning, public relations; and many other activities.
One company may have a small headquarters staff; another company of similar size and in the
same industry may have a staff that is 10 times as large. The managements of both companies
may be convinced that they made the correct decision on staff size, but there is no objective
way of judging which decision was actually better (or whether they were equally good, and
the differences reflect other differences about the way the companies operated). Managers are
hired and paid to make such decisions.

Management’s view about the proper level of discretionary costs is subject to change.
Dramatic changes may occur when a new management takes over.

4.13 GENERAL CONTROL CHARACTERISTICS

Budget preparation. The decisions that management makes about a discretionary expense
budget are different from the decisions that it makes about the budget for an engineered
expense center. For the latter, management decides whether the proposed operating budget
represents the cost of performing task efficiently for the coming period. Management is not so
much concerned with the magnitude of the task because this is largely determined by the
actions of other responsibility centers, such as the marketing department’s ability to generate
sales. In formulating the budget for a discretionary expense center, however management’s
principal task is to decide on the magnitude of the job that should be done.

These tasks can be divided generally into two types – continuing and special. Continuing
tasks are those that continue from year to year- for example, financial statement preparation
by the controller’s office. Special tasks are “one-shot” projects-for example, developing and
installing a profit-budgeting system in a newly acquired division.

The technique management by objectives is often used in preparing the budget for a
discretionary expense center. Management by objectives is a formal process in which a
budgeted proposes to accomplish specific tasks and states a means for measuring whether
these tasks have been accomplished.

There are two different approaches to planning for the discretionary expense centers-
incremental budgeting and zero-base review.

54
Incremental budgeting. Here, the current level of expenses in discretionary expense center is
taken as a starting point. This amount is adjusted for inflation, for anticipated changes the
workload of continuing tasks, for special tasks, and, if the data are readily available, for the
cost of comparable work in similar units.

There are two drawbacks to incremental budgeting. First, because managers of these centers
typically want to provide more services, they tend to request additional resources in the
budgeting process; and, if they make a sufficiently strong case, these requests will be granted.
This tendency is expressed in Parkinson’s second law: overhead costs tend to increase, period.
There is ample evidence that not all of this upward creep in costs is necessary. This problem
is especially compounded by the fact that the current level of expenditure in the discretionary
expense center is taken for granted and is not reexamined during the budget preparation
process. Second, when a company faces a crisis or when a new management takes over,
overhead costs are sometimes drastically reduced without any adverse consequences.

Despite these limitations, most budgeting in discretionary expense centers is incremental.

Time does not permit the more through analysis described in the next section.

Zero-base review. An alternative approach is to make a through analysis of each

discretionary expense center on a schedule that will cover all of them over a period of five
years or so. The analysis provides a new base. There is a likelihood that expenses will creep
up gradually over the next five years, and this is tolerated. At the end of five years, another
new base is established.

Such an analysis is often called a zero-base review.

review. In contrast with incremental budgeting,
which takes the current level of spending as the starting point; this more intensive review
attempts to build up, de novo,
novo, the resources that actually are needed by the activity. Basic
questions are raised:
(1) Should the function be performed at all? Does it add value from the standpoint of end-
use customers?
(2) What should the quality level be? Are we doing too much?
(3) Should the function be performed in this way?
(4) How much should it cost?

55
As a part of this approach, it is desirable to compare costs and, if feasible, the output measures
of the expense center with information from other sources. Comparisons may be made with
averages of similar units within the company, with data published by trade associations and
other outside organizations, and even with information obtained by visits to a company in
which performance is believed to be outstanding. The latter source, called benchmarking, is of
course available only if a leading company is willing to cooperate. Despite the natural
reluctance to disclose trade secrets to a competitor, such cooperation does exist.

These comparisons may identify activities that appear to be too expensive and, thus, lead to a
more thorough examination of them. Such comparisons can be useful, even though there are
problems in achieving comparability, finding a “correct” relationship between the cost and
output in a discretionary cost situation, and danger in taking an outside average as a standard.
All the same, they often lead to the following interesting question: if other organizations get
the job done for $x, why can’t we?

Zero-base reviews suffer from several potential problems. A zero-base review is time-
consuming, and it is also likely to be a traumatic experience for the managers whose
operations are being reviewed. This is one reason why such reviews are scheduled once every
four or five years, rather than annually. The review establishes a new base for the budget, and
the annual budget review attempts to keep costs reasonably in line with this base for the
intervening period until the next review is made.

Zero-base review is difficult. Managers will not only do their best to justify their current level
of spending but they may also do their best to thwart the entire effort. They consider the
annual budget review as a necessary evil, but the zero-base review as something to be put off
indefinitely in favor of “more pressing business.” if all else fails, they sometimes create
enough doubts that the findings are inconclusive, and the status quo prEVAils.
In the later 1980s and early 1990s, several well-known companies conducted zero-base
reviews, usually as a reaction to a downturn in profitability associated with the country’s
recession. These efforts were often called downsizing, or, euphemistically, rightsizing or
restructuring, or process reengineering.

56
Examples. Aetna, a large insurance company, began a restructuring program in 1990. It
reorganized three divisions into 15 profit centers, reduced its workforce by more than 10
percent, and incurred $156 million of restructuring charges.

In 1993 sears, roebuck & co. closed 113 retail stores, and eliminated 16,000 full time and
34,000 part-time jobs, nearly 15 percent of its merchandising employees.

In 1992 general motors shrank its headquarters office from 13,500 employees to 2,300.
In 1996, sunbeam’s chairman and chief executive Albert j.dunlap downsized the workforce of
the company by half to 6,000 and rationalized manufacturing. The expected annual savings of
these reengineering efforts were put at $220 million.

Another tool that is useful in zero-base review is activity-based management, a tool more
fully discussed in unit 8.

Cost variability. In discretionary expense centers, costs tend to vary with volume from one
year to the next, but they tend not to vary with short-run fluctuations in volume within a given
year. By contrast, costs in engineered expense centers are expected to vary with short-run
changes in volume. The reason for the difference is that, in preparing budgets for
discretionary expense centers, management tends to approve a change in budget size that
corresponds to changes in budgeted sales volume-that is, additional personnel are budgeted
when volume is expected to increase, and layoffs or attrition are planned when volume is
expected to decrease. in part this reflects that fact that volume changes do have an impact
throughout the company, even though their actual impact cannot be measured; in part, this
results from a management judgment that the company can afford to spend more in
prosperous times. Since personnel and personnel-related costs are by far the largest expense
item in most discretionary expense centers, the annual budgets for these centers tend to be a
constant percentage of budgeted sales volume.
Based on the approved budget, managers of discretionary expense centers hire additional
personnel or plan attrition. Having done so, it is uneconomical for them to adjust the work
force for short-run needs is expensive, and temporary layoffs hurt morale, thus, although costs
of discretionary expense centers are sometimes classified as fixed; they are in fact fixed only
within a year; they tend to change with changes in volume from one year to the next.

57
Types of financial control.
control. The financial control exercised in a discretionary expense center
is quite different from that in an engineered expense center. The letter attempts to minimize
operating costs by setting a standard and reporting actual costs against this standard. The main
purpose of a discretionary expense budget, on the other hand, is to allow the manager to
control costs by participating in the planning. Primarily deciding what tasks should be
undertaken, and what level of effort is appropriate for each controls costs. Thus, in a
discretionary expense center, financial control is primarily exercised at the planning state
before the amounts are incurred.

Measurement of performance. The primary job of the manager of a discretionary expense

center is to accomplish the desired output. Spending an amount that is “on budget” is
satisfactory . Spending more than this amount is cause for concern, and spending less than the
budgeted amount may indicate that the planned work is not being done. The financial
performance report is not a means for EVAluating the efficiency of the manager. This is in
contrast with the report in an engineered expense center, which helps higher management to
EVAluate the manager’s efficiency. If these two types of responsibility centers are not
carefully distinguished, management may treat the performance report for a discretionary
expense center as if it were an indication of efficiency. If this is done, the people responsible
for spending may be motivated to spend less than budgeted, and the lower spending will result
in less output. In any event, there is little point in trying to increase efficiency by such indirect
methods as rewarding executives who spend less than budget.

Control over spending can be exercised by requiring that the manager’s approval be obtained
before the budget is overrun. Sometimes, a certain percentage of overrun (say, 5 percent) is
permitted without additional approval. If the budget really sets forth the best estimate of
actual costs, there is a 50 percent probability that it will be overrun, and this is the reason that
some latitude is often permitted.

The preceding paragraphs relate to financial control. Total control over discretionary expense
center is achieved primarily by the use of non-financial performance measures. For instance,
the quality of service provided by many discretionary expense centers can be judged based on
the opinion of its users.

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4.16 ADMINISTRATIVE AND SUPPORT CENTERS

Administrative centers, which are one type of discretionary expense center, include senior
corporate management, business unit management, and managers who are responsible for
their staff units. Support centers are units that provide services to other responsibility centers.

Control problems
The control of administrative expense is especially difficult because of
(1) The near impossibility of measuring output, and
(2) The frequent lack of congruence between the goals of the staff department and the
goals of the company.

Difficulty in measuring output. Some staff activities, such as payroll accounting, are so
reutilized that they are engineered expense centers. For others, however, the principal output
is advice and service; there are no valid means of measuring the value, or even the amount, of
this output. It output cannot be measured; it is not possible to set cost standards and measure
financial performance against these standards. A budget variance, therefore, cannot be
interpreted as representing either efficient or inefficient performance. For instance, if the
finance staff were given an allowance to “develop an accounts receivable system,” a
comparison of actual cost to budget cost would not tell management how effectively the job
had been done. The job of development and installation might have been poor, regardless of
the amount spent.

Lack of goal congruence. Managers of most administrative staff offices want to have an
excellent department. Superficially it may appear that an excellent department is best for the
company. Actually, a great deal depends on how one defines excellence. For example:

 Line managers want the controller to be able to answer immediately a question

involving accounting data. The cost of a system to do this, however, might far exceed
the benefits it provides.
 A perfect legal staff will never permit the slightest flaw in any contract they approve.
The staff required for complete assurance can be very large, however. The potential
loss from minor flaws may be much less than the cost of ensuring perfection.

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Thus, although a staff office may want to develop the “ideal” system, program, or function,
the ideal may be too costly when compared to the additional profits generates. At worst, there
can be a tendency to “empire build” or to “safeguard one’s position,” without regard to its
value to the company.

The severity of these two problems-the difficulty of measuring output and the lack of goal
congruence- is directly related to the size and prosperity of the company. In small and
medium-sized business, senior management is in close personal contract with staff units and
can determine from personal observation what they are doing and whether a unit is worth its
cost. Also, in a business with low earnings, discretionary expenses are of the kept under tight
control. In a large business, senior management cannot possibly know about, much less
EVAluate, all the staff activities; also in a profitable company, there is a temptation to
approve staff requests for constantly increasing budgets.

The severity of these two problems is also related directly to the organizational level of the
staff activity. For example, at the plant level, the administrative staff tends to be controlled
carefully by the plant manager who has personal knowledge of what is happening. At the
business unit level, the staff has more discretion in the tasks that it performs than at the plant
level; at the corporate level, there is even more discretion. In general, the type of staff activity
that is performed at the plant and business unit level is closely related to organizational
objectives. Discretionary expense centers at the corporate level are the most difficult to judge
in relation to objectives.

Support centers often charge other responsibility centers for the services that they provide.
For example, the management information services department may charge others for
computer services. These responsibility centers are profit centers, as discussed in unit 5.
Budget Preparation
The proposed budget for an administrative or support center usually consists of a list of
expense items, with the proposed budget being compared with the current year’s actual. In
some companies, the presentation is more elaborate consisting of some or all of the following
components:

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  A section covering the basic costs of the center. This includes the costs of “being in
business” plus the costs of all activities that must be undertaken and for which no
general management decisions are required.
 A section covering the discretionary activities of the center. This includes a
description of the objectives and the estimated costs of each such activity. The purpose
of this section is to provide information to allow management to make cost-effective
decisions.
 A section fully explaining all proposed increases in budget other than those related to
inflation.

Clearly, these sections are worthwhile only if the budget is large and management wishes to
decide on the extent of the activities of the center. In other situations, the amount of detail
depends on the importance of the expenses and the desires of management. The presentation
should be aimed in providing the information needed for an intelligent decision, given the
level and the center’s activities.

4.17 RESEARCH AND DEVELOPMENT CENTERS

Control problems
The control of R&D centers, which are also discretionary expense centers, difficult for the
following reasons.

1. Results are difficult to measure quantitatively. As contrasted with initiative activities, R&D
usually has at least a semi tangible output in patents, new products, or new processes.
Nevertheless, the relationship of the outputs to inputs is difficult to measure and appraise. A
complete “product” R&D group may require several years of efforts; consequently, inputs
stated in an annual budget may be unrelated to outputs. Even if an output can be identified, a
reliable estimate of its value often cannot be made. Even if the value of the output can be
calculated, it is usually not possible for management to EVAluate the efficiency of the R&D
effort because of its technical nature. A brilliant effort may come up against an insuperable
obstacle, whereas a mediocre effort may, by luck, result in a bonanza.

2. 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 that money can

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buy, even though this is more expensive than the company can afford. A further problem is
that research people often may not have sufficient knowledge of (or interest in) the business to
determine the optimum direction of the research efforts.

3. Research and development can seldom be controlled effectively on an annual basis. A

research project may take years to reach fruition, and the organization must be built up slowly
over a long time period. The principal cost is for the work force. Obtaining highly skilled
scientific talent is often difficult, and short-term fluctuations in the work force are inefficient.
It is not reasonable, therefore, to reduce R&D costs in years when profits are low and increase
them in years when profits are high. R&D should be looked at as a long-term investment, not
as an activity that varies with short-run corporate profitability.

4.17 RESEARCH AND DEVELOPMENT PROGRAM

There is no scientific way of determining the optimum size of the R&D budget. In many
companies, the amount is specified as a percentage of average revenues: average rather than
annual revenue for a specific year, is used because the size of the R&D organization should
not fluctuate with short-term swings in revenue. The percentage is arrived at partly by
comparison with what competitors are spending (the amounts must be disclosed in published
annual reports), partly by what the company is accustomed to spending, and partly by other
factors. For example, senior management may authorize a large and rapid increase in the
budget if it thinks there has been a significant breakthrough.

The R&D program consists of a number of projects plus, in some companies, a blanket
allowance for unplanned work, as mentioned earlier. Senior management, often by a research
committee consisting of the chief executive officer, the research director, and the production
and marketing managers, reviews this program annually; the latter are included because they
will use the output of successful Formulation research projects. This committee makes broad
decisions about the magnitude of projects: new projects, projects in which work is to be
expanded, projects in which work is to be cut back, and projects that are to be discontinued.
These decisions, of course, are highly subjective; they are made within the ceiling established
by the overall policy on total research spending. Thus, the research program is determined not

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by adding the total amount of approved projects, but, rather, by dividing the “research pie”
into what seems to be the most worthwhile slices.

Annual budgets
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. The annual budget is the calendarization of the expected expenses for the budget
period. If the annual budget is in line with the strategic plan and the approved projects (as it
should be), the budget approval is routine, and its main function is to assist in cash and
personnel planning. Preparation of the budget gives management an opportunity for another
look at the R&D program. Management can ask, “in view of what we now know, is this the
best way to use our resources next year?” also, the annual budget ensures that actual costs will
not exceed budget without management’s knowledge. Management should approve
significant variances from budget before they are incurred.

Measurement of performance
Each month or each quarter, actual expenses are compared to budgeted expenses for all
responsibility centers and also for projects. These are summarized progressively for managers
at higher levels. The purpose of these reports is to assist the managers of responsibility centers
to plan their expenses and to assure their superiors that expenses are within approved plans.

In many companies, two types of financial reports are provided to management. The first type
compares the latest forecast of total cost with the approved amount for each active project.
This report is prepared periodically and given to the executive or group of executives that
controls research spending. Its main purpose is to help determine whether changes should be
made in approved projects. The second type is a report of actual expenses in each
responsibility center compared with the budget amounts. Its main purpose is to help research
executives in expense planning and to make sure expense commitments are being met.
Neither report of financial information tells management about the effectiveness of the
research effort. Progress reports are the formal source for this information. Management
makes judgments about effectiveness, partly on the basis of these progress reports but
primarily on the basis of face-to-face discussions.

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The management control of projects is discussed in more detail in chapter 18.

4.18 MARKETING CENTERS

In many companies, the activities that are grouped under the heading of marketing consist of
two quite different types, and the control that is appropriate for one type is different from the
control that is appropriate for the other. One set of activities relates to filling orders, and they
are called order-filling or logistics activities. Order –filling activities take place after an order
has been received, and order-getting activities take place before an order has been received.

Logistics activities
Logistics activities are those involved in moving goods from the company to its customers
and collecting the amounts due from customers. They include transportation to distribution
centers, warehousing, shipping and delivery, billing and the related credit functions are
fundamentally similar to expense centers in manufacturing plants. Many are engineered
expense centers that can be controlled through standard costs and budgets that are adjusted to
reflect the costs at different levels of volume.

Marketing activities
Marketing activities are those carried on to obtain orders? They include test marketing;
establishing, training, and supervising the sales force; advertising; and sales promotion. These
activities have important characteristics that affect the management control problem.

The output of a marketing organization can be measured; however, it is difficult to EVAluate

the effectiveness of the marketing effort because the environment in which it operates cannot
be controlled. Economic conditions or competitive actions, over which the marketing
department has no control, may be different from that expected when sales budgets were
established.

Meeting the budgetary commitment for selling expense is normally a minor part of the
EVAluation of marketing performance. If a marketing group sells twice as much as its quota,
it is unlikely that management will worry if it exceeded its budgeted cost by 10 percent. The
impact of sales volume on profits tends to overshadow cost performance. The sales target, not
the expense target, is the critical factor in EVAluation.

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The control techniques that are applicable to logistics activities are generally not applicable to
order-getting activities. Failure to appreciate this fact can lead to incorrect decisions. For
example, a reasonably good correlation is often found between volume of sales and the level
of sales promotion and advertising expense. This may be taken to mean that sales and the
level of sales promotion and advertising expense. This may be taken to mean that sales
expenses are variable with sales volume. Such a conclusion is fallacious. Budgets that are
flexible with changes in sales volume cannot be used to control selling expenses that are
incurred before the time of sale. Advertising or sales promotion expense budgets should not
be adjusted with short-run changes in sales volume. As indicated above, many companies
budget marketing expenses as a percentage of budgeted sales, but they do so not because sales
volume causes marketing expense, but rather on the theory that the higher the sales volumes,
the more the company can afford to spend on advertising.

In summary, a marketing organization has three types of activities and, consequently, three of
activity measures. First, there is the amount of revenue that the activity generates. Comparing
actual revenue with budgeted revenue and comparing physical quantities sold with budgeted
units usually measure this. Second, there is the order-filling or logistics activity. Many of
these costs are engineered expenses. Third, there are order-getting costs. Order-getting costs
are discretionary; no one knows what the optimum amounts are. Consequently, the
measurement of efficiency and effectiveness for these costs is highly subjective.

4.19 SUMMARY

A responsibility center is an organization unit that is headed by a responsible manager. In this

chapter, we have described revenue centers and expense centers. Their performance is judged
by the criteria of efficiency and effectiveness. In revenue centers, revenues are measured and
controlled separately from expenses.

There are two broad types of expense centers: engineered and discretionary. In engineered
expense centers, the “right” amount of costs that should be incurred for a given level of output
can be estimated. In discretionary expense centers, on the other hand, budgets describe the
amounts that can be spent; these are not known to be the optimum amounts, so financial
controls do not measure efficiency or effectiveness.

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The principal types of discretionary expense centers are administrative and support centers,
R&D centers, and marketing centers. Control is most difficult in R&D units, next most
difficult in true marketing units (as contrasted with logistic units), and less difficult, but
nevertheless more difficult than manufacturing, in administrative and support units.

Check Your Progress Exercise

1. Define responsibility center and list the types of responsibility centers
2. Explain the general control characteristics?
3. Write about the expense centers in detail?
4. List the control problems in administrative and support centers?
5. List the control problem in R&D centers?

4.20 ANSWER TO CHECK YOUR PROGRESS EXERCISE

UNIT 5. PROFIT CENTERS

Contents
5.0 Aims and Objectives

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 5.1 Introduction

5.0 AIMS AND OBJECTIVES

 To explain the concept of profit center

 To discuss the considerations involved in creation of profit centers
 To discuss the alternative ways of measuring the profitability of a profit center

CHAPTER CONTENTS
When the financial performance is measured in terms of profit, which is the difference
between the revenue and expenses, the responsibility center is called a profit center.
General considerations
Conditions for Delegating profit Responsibility
PrEVAlence of Profit Centers
Advantages of profit Centers
Difficulties with profit center

Business Units as Profit Centers

Constraints on Business Unit Authority

Constraints from Other Business Units.
Constraints from Corporate Management.

Other Profit Centers

Functional Units
Marketing Manufacturing
Service and Support Units
Other Organizations

Measuring Profitability
Types of Profitability Measures
 Contribution Margin
 Direct Profit
 Controllable Profit

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  Income before Taxes
 Net Income
Bases of comparison.
Revenues
Management Considerations

PROFIT CENTERS
When financial performance in a responsibility center is measured in terms of profit, which is
the difference between the revenues and expenses, the responsibility center is called a profit
center.
center. Profit as a measure of performance is especially useful since it enables senior
management to use one comprehensive measure instead of several measures that often point
to different directions.

Some generalizations to keep in mind about organizations are:

 All companies are organized functionally at some level.

 The difference between a functional organization and a business unit organization is a
continuum. Between the extremes of the entirely functional structure and the entirely
business unit structure are all types of combinations of functional and business unite
structure.
 Complete authority for generating profits is never delegated to a segment of the
business. The degree of delegation differs among business.

CONDITIONS FOR DELEGATING PROFIT RESPONSIBILITY

Many management decisions involve proposals to increase expenses in the expectation of a
grater increase in sales revenue; such decisions are said to involve expense/revenue trade-offs.
Additional advertising expense is an example. Another example is increased quality control
expense, which can result in more satisfied customers, and hence, increased revenue. Before
such a trade-off decision can be delegated safely to a lower-level manager, two conditions
should exist.

1. The manager should have the relEVAnt information to make expense/revenue trade-
offs.

68
 2. There should be some way to measure how effectively the manger is making these
trade-offs.
A major consideration in identifying profit centers is to determine the lowest point in an
organization where these two conditions prEVAil. All responsibility centers fit on a
continuum ranging between those that clearly should not. Management must decide whether
the advantages of gibing profit responsibility offset the disadvantages. As with all
management control system design choices, there is no clear line of demarcation.

Advantages of profit centers

Establishing organization units as profit centers has the following advantages:

 The speed of operating decisions may be increased because many decisions do not
have to be referred to corporate headquarters.
 The quality of many decisions may be improver because the managers can make them
closest to the point of decision.
 Headquarters management may be relieved of day-to-day decisions and can, therefore,
concentrate on broader issues.
 Profit consciousness may be enhanced. Managers who are responsible for profits will
be looking constantly for ways to improve them. For example, a manager who is
responsible only for marketing activities will be motivated to make sales promotion
expenditures that maximize sales, whereas a manager who is responsible for profits
will be motivated to make sales promotion expenditures that maximize profits.
 Measurement of performance is broadened.
broadened. Profitability is a more comprehensive
measure of performance than the measurement of either revenues or expenses
separately. it measures the effects of management actions on both revenues and
expenses.

 Managers, subject to fewer corporate restraints, should be freer to use their

imagination and initiative.
 a profit center provides an excellent training ground for general management. because
a profit center is similar to an independent company, its manager is trained in

69
 managing all the functional areas. The profit center also provides an excellent means
of EVAluating the manager’s potential for higher management jobs.
 If a company has a strategy of diversification, the profit center structure facilitated use
of different specialists and experts in different types of businesses. For example,
people who are best trained in managing a certain type of business can be assigned to
work exclusively in that business if it is a separate business unit.
 Profit centers provide top management with information on the profitability of the
components of the company.
 Profit centers are subject to pressures to improve their competitive performances.
performances.

Difficulties with Profit Centers

However, the creation of a profit center may cause difficulties:

 To the extent that decisions are decentralized, top management may lose some control.
control.
Relying on control reports is not as effective as personal knowledge of an operation.
With profit centers, top management must change its approach to control. Instead of
personal direction, senior management must rely, to a considerable extent, on
management control reports.
 Competent general managers may not exist in a functional organization because there
may not have been sufficient opportunities for them to develop general management
competence.
 Organization units that were once cooperating as functional units may now compete
with one another disadvantageously.
disadvantageously. An increase in one manager’s profits may
decrease those of another. This decrease in cooperation may manifest itself in a
manager’s unwillingness to refer sales leads to another business unit, even though that
unit is better qualified to follow up on the lead, in production decisions that have
undesirable cost consequences on other units, or in the hoarding of personnel or
equipment that, from the overall company standpoint, would be better off used in
another unit.
 Friction can increase. There may be arguments over the appropriate transfer price, the
assignment of common costs, and the credit for revenues that were generated jointly
by the efforts of two or more business units.

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  There may be too much emphasis on short-run profitability at the expense of long-run
profitability. In the desire to report high current profits, the profit center manager may
skimp on R&D, training programs, or maintenance. This tendency is especially
prEVAlent when the turnover of profit center managers is relatively high. In these
circumstances, managers may have good reason to believe that their actions may not
affect profitability until after they have moved to other jobs.
 There is no completely satisfactory system for ensuring that each profit center, by
optimizing its own profits, will optimize company profits.
profits.
 If headquarters management is more capable or has better information than the
average profit center manager, the quality of some of the decisions may be reduced.
 Divisionalization may cause additional costs because it may require additional
management, staff personnel, and record keeping, and may lead to redundant tasks at
each profit centers.

Measuring profitability

There are two types of profitability measurements in a profit center, just as there are for the
organization as a whole. There is, first, a measure of management performance,
performance, in which the
focus is on how well the manager is doing. This measure is used for planning, coordinating,
and controlling the day-to-day activities of the profit center and as a device for providing the
proper motivation to the manager. Second, there is a measure of economic performance,
performance, in
which the focus is on how well the profit center is doing as an economic entity. The messages
given by these two measures may be quite different. For example, the management
performance report of a branch store may show that the profit center manager is doing an
excellent job, under the circumstances; but 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.
Profit center income statement

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Revenue…………………………………………
Cost of sales…………………………………….
Variable expenses………………………………
Contribution margin…………………………..
Fixed expenses incurred in the profit center…
Direct profit…………………………………...
Controllable corporate charges…………………
Controllable profit……………………………..
Other corporate allocations…………………….
Income before taxes…………………………...
Taxes……………………………………………
Net income……………………………………...

The necessary information for both purposes usually cannot be obtained from a single
underlying set of data. Since the management report is used frequently, but the economic
report is prepared only on hose occasions when economic decisions must be made,
considerations relating to management performance measurement have first priority in
systems design- that is, the system is designed to measure management performance
routinely, and economic information is derived from these reports and from other sources.

Types of profitability measures

In order to EVAluate the economic performance of a profit center, one must use net income
after allocating all costs, including a fair share of the corporate overhead, to the profit center.
However, in EVAluating the performance of the profit center manager, and of five different
measures of profitability can be used:
(1) Contribution margin,
(2) ) Direct profit,
(3) Controllable profit,
(4) Income before income taxes,
(5) Net income.

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1. Contribution Margin. The principal argument for measuring the profit center
manager’s performance on the basis of contribution margin is that fixed expenses are not
controllable by the manager, and that the manager, therefore, should focus attention on
maximizing the spread between revenue and variable expenses. the problem with this
argument is that some fixed expenses are entirely controllable and that almost all fixed
expenses are partially controllable. as discussed in chapter 4, many items of expenses are
discretionary; they can be changed at the discretion of 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, can not be changed in the
short-run, the profit center manager should control the efficiency and productivity of the
employees.
2. Direct Profit. This measure shows the amount that the profit center
contributes to the general overhead and profit of the corporation. It incorporates all
expenses incurred in or directly traced to the profit centers, regardless of whether these
items are entirely controllable by the profit center manager. Expenses incurred at
headquarters are not allocated to profit centers, however. a weakness of this measure is
that it does not recognize the motivational benefit of charging headquarters costs.
3. Controllable Profit. Headquarters expenses can be divided into two
categories: controllable and noncnotrollable. The former includes headquarters expenses
that are controllable, at least to a degree, by the business unit manager (e.q., management
information service). Consequently, if these costs are included in the measurement
system, the profit center manager will influence the profit. Controllable profits, however,
cannot be compared directly with published data, or with trade association data that report
the profits of other companies in the industry, because it excludes no controllable
headquarters expenses.
4. Income Before Taxes. In this measure, all corporate overheads are allocated
to profit centers. The basis of allocation reflects the relative amount of expense that is
incurred for each profit center.

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There are two arguments against such allocations. First, the costs incurred by corporate staff
departments, such as finance, accounting, and human resource management, are not
controllable by profit center managers. Therefore, they should not be held accountable for
what they do not control. Second, it may be difficult to find acceptable methods of allocating
the corporate staff services that would properly reflect the relative amount of corporate costs
caused by each profit center.

There are, however, arguments for allocating corporate overhead to profit centers in their
performance reports:

 Corporate service units have a tendency to empire

build, to increase their power base, and to make their units as excellent as possible without
regard for their value to the company. If such costs are allocated to profit centers, the
possibility that the profit center managers will raise questions about the amount of
corporate overhead is greater; this helps to keep the head office spending in check. For
instance, companies have been known to sell a corporate aircraft because of complaints
from profit center managers about its costs.

 Profit centers’ performance will be more realistic

and comparable to competitors because competitors pay for similar services.

 The profit center manager is given the message that

the profit center has not earned a profit unless it recovers all costs, including a share of
allocated corporate overhead. Thus, profit center managers will be motivated to make
optimum long-term marketing decisions (pricing, product mix, and so on) because they
must keep in mind that they must keep in mind that they must recover their share of the
corporate overhead. this is desirable; since the company will not otherwise be viable in the
long run.

If corporate overheads are allocated to profit centered, budgeted costs, not actual costs, should
be allocated. the profit center’s performance report then will show an identical amount in the
“budget” and “actual” columns for such corporate overhead. This ensures that profit center
managers will not complain either about the arbitrariness of allocations or the lack of control

74
over allocated costs since, in their performance reports, no variances would be shown for
allocated overheads. The variances would appear in the reports of the responsibility center
that incurred the costs.

5. Net income. Here, companies measure performance of domestic profit centers at the
bottom line, the amount of net income after income tax. There are two principal
arguments against using this measure: (1) in many situations, the income after tax is a
constant percentage of the pretax income, so there is no advantage in incorporating
income taxes; and (2) many decisions that have an impact on income taxes re made
headquarters, and it is believed that profit center managers should not be judged by the
consequences of these decisions.

In some companies, however, the effective income tax rate does vary among profit centers.
For example, foreign subsidiaries or business units with foreign operations may have different
effective income tax rates. In other situations, profit centers may influence income taxes by
their decisions on acquiring or disposing of equipment, installment credit policies, and other
ways in which taxable income differs from income as measured by generally accepted
accounting principles. In these situations, it may be desirable to allocate income tax expenses,
not only to measure the economic profitability of the profit center but also to motivate the
manager to minimize taxes.

Summary

A profit center is an organization unit in which both revenues and expenses are measured in
monetary terms. Setting up profit centers pushes decision making to lower levels where
relEVAnt information in making expense/revenue tradeoffs exists. This can speed up
decision-making, improve the quality of decisions, focus attention on profitability, provide a
broader measure of management performance, and other advantages.

Profit centers’ autonomy may be constrained by other business units, and also there may be
constraints imposed by corporate management. These constraints need to be recognized in
operation organization units as profit centers.

75
Under appropriate circumstances, even the production or marketing functions can be
constituted as profit centers. However, considerable judgment is involved in designation a
functional unit, such as production or marketing, as a profit center.

Measuring profit in a profit center also involves judgments regarding how revenues and
expenses should be measured. In terms of revenues, choice of a revenue recognition method is
important. In terms of expenses, measurement can range from variable costs incurred in the
profit center to fully allocated corporate overhead, including income taxes. Judgments
regarding the measurement of revenues and costs should be guided not just by technical
accounting considerations, but also more importantly by behavioral and motivational
considerations. The key is to include those expenses and revenues in profit center managers’
reports that the managers can influence,
influence, even if they cannot totally control them.

Check Your Progress Exercise

1. List the conditions for delegating responsibility.
2. What are the general considerations for creation of profit centers?
3. Write about the advantages of profit centers.
4. What are the difficulties with the profit centers?
5. Explain how do you measure the profitability of profit center.
6. What are the various types of profitability measures?

ANSWER TO CHECK YOUR PROGRESS EXERCISE

76
UNIT 6. TRANSFER PRICING

Contents
6.0 Aims and Objectives
6.1 Introduction
6.2 Methods of Transfer Pricing
6.3 Market Price
6.4 Negotiation
6.5 Cost Based Transfer Prices
6.6 Two Step Pricing
6.7 Profit Sharing
6.8 Pricing Corporate Services
6.9 Control Over Amount of Service
6.10 Optional Use of Services
6.11 Simplicity of the Price Mechanism
6.12 Administration of Transfer Prices
6.13 Negotiation
6.14 Arbitration and Conflict Resolution
6.15 Product Classification
6.16 Summary
6.17 Answer to Check Your Progress Exercise

6.0 AIMS AND OBJECTIVES

 To devise a satisfactory method of accounting for the transfer of goods and services
from one profit center to another
 To discuss about various approaches to arriving at transfer prices for transactions
between profit centers
 The system of negotiation and arbitration.
 To discuss about pricing of services that corporate staff units furnish to profit centers.

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6.1 INTRODUCTION

Today’s organizational thinking is oriented toward decentralization. one of the principal

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

In this chapter we discuss various approaches to arriving at transfer prices for transaction
between profit centers and the system of negotiation and arbitration that is essential when
Tran sfer prices are used. We also discuss the pricing of services that corporate staff units
furnish to profit centers.

Objectives of Transfer Prices

if two or more profit centers are jointly responsible for product development, manufacturing,
and marketing, each should share in the revenue that is generated when the product is finally
sold. the transfer price is not primarily an accounting tool; rather, it is a behavioral tool that
motivates managers to make the right decisions. in particular, the transfer price should be
designed so that it accomplishes the following objectives:

 It should provide each segment with the relEVAnt information required to determine
the optimum trade-off between company costs and revenues.
 It should induce goal congruent decisions-that is, the system should be so designed
that decisions that improve business unit profit will also improve company profits.
 It should help measure the economic performance of the individual profit centers.
 The system should be simple to understand and easy to administer.

Designing transfer pricing systems is a key management control topic for most corporations;
the govindafajan survey found that 79 percent of companies transfer products between profit
centers.

Transfer pricing methods

Some writers use the term “transfer price” to refer to the amount used in accounting for any
transfer of goods and services between responsibility centers. We use a somewhat narrower

78
definition and limit the term transfer price to the value placed on a transfer or goods or
services in transactions in which at least one of the two parties involve is a profit center. Such
a price normally includes a profit element, because an independent company would not
normally transfer goods or services to another independent company at cost or less. We,
therefore, exclude the mechanics for the allocation of costs in a cost accounting system; such
costs do not include a profit element. The term price,
price, as used here, has the same meaning as it
has when it is used in connection with transactions between independent companies.

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

The ideal situation to improve the operation of the transfer price mechanism. A transfer
price will induce goal congruence if all the conditions listed below exist. Rarely, if ever, will
all these conditions exist in practice. The list, therefore, does not ser for the criteria that must
be met to have a transfer price. Rather, it suggests a way of looking at a situation to see what
changes should be made to improve the operation of the transfer price mechanism.

1. 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.

2. Good atmosphere.
atmosphere. Managers must regard profitability as measured in their income
statement as an important goal and as a significant consideration in the judgment of their
performance. they should perceive that the transfer prices are just.

6. 3 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 the like) 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. For example, there would be no bad debt expense and smaller advertising
and selling costs when products are transferred from one business unit to another within the

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company. Although less than ideal, a market price for a similar, but not identical, product is
better than no market price at all.

1. Freedom to source.
source. Alternatives should exist, and managers should be permitted to choose
the alternative that is in their own best interest. The buying manager should be free to buy
from the outside, and the selling manger should be free to sell outside. In these circumstances,
the transfer price policy is simply to give the manager of each profit center the right to deal
with either insider of outsiders, at his or her discretion. The market thus establishes the
transfer price. The decision of 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.

If the selling profit center can sell all of its products, either to insiders or to outsiders, and as
long as the buying center can obtain all of its requirements from either outsiders or insiders,
this method is optimum. The market price represents the opportunity cost 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.

2. Full flow of information. Managers must know about the available alternative and the
relEVAnt costs and revenues of each.

6.4 NEGOTIATION

There must be a smoothly working mechanism for negotiating “contracts” between business
units.

If all of the above conditions are present, a transfer price system based on market prices
would fulfill all of the objectives stated above, with no need for central administration. in the
next subsection, we consider situations where one or more of these conditions are not present.

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6.5 COST-BASED TRANSFER PRICES

If competitive prices are not available, transfer prices may be set up on the basis of cost plus a
profit, even though such transfer prices may be complex to calculate and the results less
satisfactory than a market-based price. Two decisions must be made in a cost-based transfer
price system:
(1) How to define cost?
(2) How to calculate the profit markup?

The Cost Basis. The usual basis is standard cost. Actual costs should not be used because
production inefficiencies will then be passed on to the buying profit center. If standard costs
are used, there is a need to provide an incentive to set tight standards and to set tight standards
and to improve standards.

Some companies have tried using “efficient producer” costs, but someone has to decide what
this cost are, which is difficult.

Under both cost-plus pricing and market-based pricing, companies typically eliminate
advertising, financing, or other expenses that the seller does not incur on internal transactions.
(This is similar to the practice when two outside companies are arriving at a price. the buyer
ordinarily will not pay for cost components that do not pay for cost components that do not
apply to the contract.)

The Profit Markup. In calculating the profit markup, there also are two decisions:
(1) On what is the profit markup to be based?
(2) What is the level of profit allowed?

The simplest and most widely used base is a percentage of costs.

costs. if this base is used, however,
no account is taken of capital required. A conceptually better base is a percentage of
investment, but there may be a major practical problem in calculating the investment
applicable to a given product. if the historical cost of the fixed assets is used, new facilities
designed to reduce prices could actually increase costs because old assets are undervalued.

The second problem with the profit allowance is the amount of the profit. Senior
management’s perception of the financial performance of a profit center will be affected by

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the profit it shows. Consequently, to the extent possible, the profit allowance should be the
best approximation of the rate of return that would be earned if the business were an
independent company, selling to outside customers. The conceptual solution is to base the
profit allowance on the investment required to meet the volume needed by the buying profit
centers. The investment would be calculated at a “standard” level, with fixed assets and
inventories at current replacement costs. This solution is complicated and, therefore, rarely
used in practice.

Upstream Fixed Costs and Profits

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 of the amount of upstream
fixed costs and profit included in its internal purchase price. Even if the final profit center
were aware of these costs and profit, it might be reluctant to reduce its own profit to optimize
company profit. Methods that companies use to mitigate this problem are described below.

Agreement Among Business Units.

Units. A company could establish a formal mechanism
whereby representatives from the buying and selling units meet periodically to decide on
outside selling prices and on the sharing of profits for products having significant amounts of
upstream fixed costs and profit center; otherwise, the value of these negotiations may not be
worth the effort.

6.6 TWO-STEP PRICING

Another way to handle this problem is to establish a transfer price that includes two charges.
First, a charge is made for each unit sold that is equal to the standard variable cost of
production. Second, a periodic (usually monthly) charge is made that is equal to the fixed
costs associated with the facilities reserved for the buying unit. One or both of these
components should include a profit margin.

Following are some points to consider about the two-step pricing method.

· The monthly charge for fixed costs and profit should be negotiated periodically and would
depend on the capacity reserved for the buying unit.

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· Some questions may be raised about the accuracy of the cost and investment allocation. in
some situations, there is no great difficulty in assigning costs and assets to individual
products. In any event, approximate accuracy is adequate. the principal problem usually is not
the allocation technique; rather, it is the decision about how much capacity is to be reserved
for the various products. Moreover, if capacity is reserved for a group of products sold to the
same business unit, there is no need to allocate fixed costs and investments to individual
products in the group.

· Under this pricing system, the manufacturing unit’s profit performance is not affected by
the sales volume of the final unit, which solves the problem that arises when other business
units’ marketing efforts affect the profit performance of a purely manufacturing unit.

· There could be a conflict be a conflict between the interests of the manufacturing unit and
the interests of the company. if capacity is limited, the manufacturing unit could increase its
profit by using the capacity to produce parts for outside sale, if it is advantageous to do so.
(Stipulating that the marketing unit has first claim on the capacity it has contracted for
mitigates this weakness.)

· This method is similar to the “take or pay” pricing that is frequently used in public utilities,
pipelines, coal mining companies, and other long-term contracts.

6.7 PROFIT SHARING

If the two-step pricing system just described is not feasible, a profit sharing system might be
used to ensure congruence of business unit interest with company interest. This system
operates somewhat as follows.

1. The product is transferred to the marketing unit at standard variable cost.

2. After the product is sold, the business units share the contribution earned, which is the
selling price minus the variable manufacturing and marketing costs.

This method of pricing may be appropriate if the demand for the manufactured product is not
steady enough to warrant the permanent assignment of facilities, as in the two-step method. In
general, this method accomplishes the purpose of making the marketing unit’s interest
congruent with the company’s.

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There are several practical problems in implementing such a profit sharing system.
 First, there can be arguments over the way contribution is divided between the
two profit centers. Senior management might have to intervene to settle these disputes,
which is costly, time consuming, and works against a basic reason for decentralization,
namely, autonomy of business unit managers.
 Second, arbitrarily dividing up the profits between units does not give valid
information on the profitability of each segment of the organization.
 Third, since the contribution is not allocated until after the sale has been made,
the manufacturing unit’s contribution depends on the marketing unit’s ability to sell and
on the actual selling price. Manufacturing units may perceive this situation to be unfair.

Two sets of prices.

In this method, the manufacturing unit’s revenue is credited at the outside sales price, and the
buying unit is charged the total standard costs. The difference is charged to a headquarters
account and eliminated when the business unit statements are consolidated. This transfer
pricing method is sometimes used when there are frequent conflicts between the buying and
selling units that cannot be resolved by one of the other methods. Both the buying and selling
units benefit under this method.

There are several disadvantages to the system of having two sets of transfer prices, however.
The sum of the business unit profits is greater than overall company profits. Senior
management must be aware of this situation in approving budgets for the business units and in
subsequent EVAluation of performance against these budgets. Also, this system creates an
illusive feeling that business units are making money, while in fact; the overall company
might be losing after taking account of the debits to headquarters. Further, this system might
motivate business units to concentrate more on internal transfers (where they are assured of a
good markup) at the expense of outside sales. Finally, there is additional bookkeeping
involved in first debiting the headquarters account every time transfers made and then
eliminating this account when business unit statements are consolidated.

The fact that the conflicts between the business units would be lessened under this system
could be viewed as a weakness. Sometimes, it is better for headquarters to be aware of the

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conflicts arising out of transfer prices because such conflicts may signal problems in either the
organizational structure or in other management systems.

Under the two-sets-of –prices method, these conflicts are smoothed over, thereby not alerting
senior management to these problems.

6.12 ADMINISTRATION OF TRANSFER PRICES

We have so far discussed how to formulate a sound transfer pricing policy. In this section, we
discuss how the selected policy should be implemented; specifically, the degree of negotiation
allowed in setting the transfer prices, methods of resolving transfer pricing conflicts, and
classification of products according to the appropriate method.

6.13 NEGOTIATION

In most companies, business units negotiate transfer prices with each other that is, transfer
prices are not set by a central staff group. Perhaps the most important reason for this is the
belief that one of the primary functions of line management is to establish selling prices and
to arrive at satisfactory purchase prices. If control of pricing is left to the headquarters staff,
line management’s ability to affect profitability is reduced. Also, many transfer prices require
a degree of subjective judgment. Consequently, a negotiated transfer price often is the result
of compromises made by both buyer and seller. if headquarters establishes transfer prices,
business unit managers can argue that their low profits are due to the arbitrariness of the
transfer prices. Another reason for having the business units negotiate their prices is that they
usually have the best information on markets and costs, and, consequently, are best able to
arrive at reasonable prices.

6.14 ARBITRATION AND CONFLICT RESOLUTION

No matter how specific the pricing rules are, there may be instances in which business units
will not be able to agree on a price. For this reason, some procedure should be in place for
arbitration transfer price disputes. There can be widely different degrees of formality in
transfer price arbitration.

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At one extreme, the responsibility for arbitrating disputes is assigned to a single executive- for
example; the financial vice president or the executive vice president- who talks to business
unit managers involved and then announces the price orally.

The other extreme is to set up a committee. Usually such committee will have three
responsibilities:
1. To settle transfer price disputes
2. To review sourcing changes and
3. To change the transfer price rule when appropriate

The degree of formality employed depends on the extent and type of potential transfer price
disputes. in any case, transfer price arbitration should be the responsibility of a high-level
headquarters executive or group, since arbitration decisions can have an important effect on
business unit profits.

Arbitration can be conducted in a number of ways. With a formal system, both parties submit
a written case to the arbitrator. The arbitrator reviews both positions and decides on the price.
In establishing a price, the assistance of other staff offices may be obtained. For example, the
purchasing department might review the validity of a proposed competitive price quotation, or
the industrial engineering department might review the appropriateness of a disputed standard
labor cost. As indicated above, in less formal systems, the presentations may be largely oral.

It is important that relatively few disputes be submitted to arbitration. If a large number of

disputes are arbitrated, this indicates that the rules are not specific enough, the rules are
difficult to apply, or the business unit organization is illogical. in short, this is a symptom that
something is wrong. Not only is arbitration time consuming to both line managers and head
quarters executives, but also arbitrated prices often satisfy neither the buyer nor the seller. In
some companies, an onus is involved in submitting a price dispute to arbitration such that
very few are ever submitted. if, as a consequence, legitimate griEVAnces do not surface, the
results are undesirable. Preventing disputes from being submitted to arbitration will tend to
hide the fact that there are problems with the transfer price system.

Irrespective of the degree of formality of the arbitration, the type of conflict resolution process
that is used will also influence the effectiveness of a transfer pricing system. Lawrence and

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lurch pointed out four ways to resolve conflicts: forcing, smoothing, bargaining, and problem
solving. The conflict resolution mechanisms range from conflict avoidance through forcing
and smoothing to conflict resolution through bargaining and problem solving.

Summary

The delegation of significant amounts of authority is dependent upon the ability to delegate
responsibility for profits. Profit responsibility cannot be safely delegated unless two
conditions exist:

1. The delegate has all of the relEVAnt information to make optimum profit decisions.
2. The delegatee’s performance is measured on how well he or she has made
cost/revenue trade-offs.

Where segments of a company share responsibility for products development, manufacturing,

and marketing, a transfer price system is required if these segments are to be delegated profit
responsibility. This transfer price system must result in the two conditions described above. in
complex organizations it can be a difficult problem to devise a transfer price system that
assures the necessary knowledge and motivation for optimum decision-making.

Two decisions are involved in designing a transfer pricing system. First is the sourcing
decision: should the company produce the product inside the company or purchase it from an
outside vendor? Second is the transfer price decision: at which price should the product be
transferred between profit centers?

Ideally, the transfer price should approximate the normal outside market price, with
adjustment for costs not incurred in intracompany transfers. Even under conditions where
sourcing decisions are constrained, the market price is the best transfer price.

If competitive prices are not available, transfer prices may be set on the basis of cost plus a
profit, even though such transfer prices may be complex to calculate and the results less
satisfactory than a market-based price. Cost-based transfer can be made at standard cost plus
profit margin, or by the use of a two-step pricing system.

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The method of negotiation transfer prices should be in place, and there should be an
arbitration mechanism for setting transfer price disputes, but these arrangements should not be
so complication that an undue amount of management time is devoted to transfer pricing.

There are probably few instances in complex organizations where a completely satisfactory
transfer price system exists. As with many management control design choices, it is necessary
to choose the best of perhaps several less than perfect courses of action. the important thing is
to be aware of the areas of imperfections and to be sure that administrative procedures are
employed to avoid sub optimum decisions.

Check Your Progress Exercise

Explain the concept of transfer price in brief?
List the methods of transfer pricing available.
Explain how the transfer prices will be administered
How do you price the corporate services?
Write a short notes on
 Two step pricing
 Negotiated pricing
 Two sets of prices

ANSWER TO CHECK YOUR PROGRESS EXERCISE

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UNIT 7. MEASURING AND CONTROLLING ASSETS EMPLOYED

Contents
7.0 Aims and Objectives
7.1 Introduction
Measuring and controlling assets employed
Structure of the analysis
Measuring assets employed
Cash
Receivables
Inventories
Working capital
Property plant and equipment
Acquisition
Gross book value
Disposition of assets
Annuity depreciation
Other valuation methods
Leased Assets
Idle assets
Intangible assets
Non-Concurrent liabilities
The capital charge
EVA vs. ROI
Alternative approaches to EVAluating managers
EVAluating the economic performance of the entity

7.0 AIMS AND OBJECTIVES

 To discuss each of the principal types of assets that may be employed in an investment
center.
 To discuss about the two methods of relating profit to the investment1.return on
investment 2. Economic value added.

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  To describe the advantages and qualifications relating to the use of each in
performance measurement.
 To discuss problem of measuring the economic value of an investment center.

7.1 INTRODUCTION

In some business units, the focus is on profit as measure by the difference between revenues
and expenses, as described in chapter 5. In other business units, this profit is compared with
the assets employed in earning it. We refer to the latte group of responsibility centers as
investment centers and discuss in this chapter the measurement problems involved in such
responsibility centers. In the real world, companies do not use the term investment center but
rather use the term profit center to refer to both their responsibility centers discussed in
chapter 5 and also those in this chapter. We agree that an investment center is a special type of
profit center,
center, rather than a separate, parallel category. Our reason for treating investment
centers separately is primarily pedagogical; that is, there are so many problems involved in
measuring the assets employed in a profit center that the topic warrants a separate chapter.

In this chapter we first discuss each of the principal types of assets that may be employed in
an investment center. The sum of these assets is termed the investment base. We then discuss
the two methods of relating profit to the investment base:
(1) The percentage return on investment (ROI)
(2) Residual income or economic value added (EVA)

We describe the advantages and qualifications relating to the use of each in performance
measurement. Finally, we discuss the somewhat different problem of measuring the economic
value of an investment center.

Economic value added (EVA) is a dollar amount, rather than a ratio. It is found by subtracting
a capital charge from the net operating profit. This capital charge is found by multiplying the
amount of assets employed by a rate, which in 10 percent.

EVA is conceptually superior to ROI; and therefore, we shall generally use EVA in our
examples. Nevertheless, it is clear from the surveys that ROI is more widely used in business
than EVA.

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7.4 MEASURING ASSETS EMPLOYED

In deciding on the investment base to be used for Evaluating managers of investment centers,
headquarters asks two questions:

(1) What practices will induce business unit managers to use their assets most efficiently
and to acquire the proper amount and kind of new assets? Presumably, when their
profits are related to assets employed, business unit managers will try to improve their
performances as measured in this way, and senior management wants the actions that
they take toward this end to be actions that are in the best interest of the whole
corporation.
(2) What practices best measure the performance of the unit as an economic entity?

1. Cash
2. Receivable
3. Inventories
4. Working capital in general
5. Property, plant and equipment
i. Acquisition of new equipment
ii. Gross book value
iii. Annuity depreciation
6. Other valuation methods
7. Leased assets
8. Idle assets
9. Intangible assets
10. Non current liabilities

The Capital Charge

Corporate headquarters sets the rate used to calculate the capital charge. It should be higher
than the corporation’s rate for debt financing because the funds involved are a mixture of debt
and higher-cost equity. Usually, the rate is set somewhat below the company’s estimated cost
of capital (assuming that a company can calculate its cost of capital) so that the economic
value added of an average business unit will be above zero.

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Although conceptually a good argument can be made for using different rates for business
units with different risk characteristics, in practice this is rarely done; that is, the same rate is
used for all units.

Some companies use a lower rate for working capital than for fixed assets. This may represent
a judgment that working capital is less risky than fixed assets because the funds are
committed for a shorter time period. in other cases the lower rate is a way of compensating for
the fact that the company included inventory and receivables in the investment base at their
gross amount (i.e., without a deduction for accounts payable); the lower rate is an implicit
recognition of the fact that funds obtained from accounts payable have zero interest cost.

7.7 EVA VERSUS ROI

Most companies employing investment centers evaluate business units on the basis of ROI
rather than EVA. There are three apparent benefits of an ROI measure. First, it is a
comprehensive measure in that anything that affects financial statements is reflected in this
ratio. Second, ROI is easy to calculate, easy to understand, and meaningful in an absolute
sense. For example, an ROI of less than 5 percent is considered low on an absolute scale, and
an ROI of over 25 percent is considered high. Finally, it is a common denominator that may b
applied to any organizational unit responsible for profitability, no matter what its size or in
what business it practices. the performance of different units may be compared directly to
each other. Also, ROI data is available for competitors that can be used as a basis for
comparison. The dollar amount of EVA does not provide such a basis for comparison.
Nevertheless, the EVA approach has some inherent advantages over ROI.

There are three compelling reasons to use EVA over ROI. First, with EVA all business units
have the same profit objective for comparable investments. The ROI approach, on the other
hand, provides different incentives for investments across business units. For example, a
business unit that currently is achieving a ROI of 30 percent would be most reluctant to
expand unless it is able to earn a ROI of 30 percent or more on additional assets; a lesser
return would decrease its overall ROI below its current 30 percent level. Thus, this business
unit might forgo investment opportunities whose ROI is above the cost of capital but below
30 percent.

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Second, decisions that increase a center’s ROI may decrease its overall profits. For instance,
in an investment center whose current ROI is 30 percent, the manager can increase its overall
ROI by disposing of an asset whose ROI is 25 percent? However, if the cost of capital tied up
in the investment center is less than 25 percent, the absolute dollar profit after deducting
capital costs will decrease for the center.

The use of EVA as a measure deals with both of the above noted problems of ROI. The
problems relate to asset investments whose ROI falls between the cost of capital and the
center’s current ROI. If an investment center’s performance is measured by EVA, investments
which produce a profit in excess of the cost of capital will increase EVA and therefore by
economically attractive to the manager.

A third advantage of EVA is that different interest rates may be used for different types of
assets. For example, a relatively low rate may be used for inventories while a higher rate may
be used for investments in fixed assets. Furthermore, different rates may be used for different
types of fixed assets to take into account different degrees of risk. In short, the measurement
system can be made consistent with the decision rules that affect the acquisition of the assets.
I follow that the same type of asset may be required to earn the same return throughout the
company, regardless of the profitability of the particular business unit. Thus, business unit
managers should act consistently in decisions involving investments in new assets.

7.8 ALTERNATIVE APPROACHES TO EVALUATING MANAGERS

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, 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.

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Moreover, some assets any be undervalue 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 an 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.

In view of all these problems, some companies have decided to exclude fixed assets from the
investment base. These companies make an interest charge for controllable assets only, and
they control fixed assets by separate devices. Controllable assets are, essentially, receivables
and inventory. Business unit management can make day-to-day decisions that affect the level
of these assets. If these decisions are wrong, serious consequences can occur-quickly. 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 stock outs. To focus attention on these important
controllable items, some companies, such as Quaker oats, include a capital charge for the
items as an element of cost in the business unit income statement. This act both to motivate
business unit management properly and also to measure the real cost of resources committed
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 tat 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

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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.

Management control systems designers disagree about whether it is better to use a single
measure, EVA, to control profits and capital investments, or whether it is better to Evaluate
profit performance and capital investment performance separately. Most seem to feel that it is
important to have a single overall measurement of financial performance. For example, if the
actual profit was better than the budgeted profit but the capital investment performance was
worse, how does management judge overall financial performance? EVA weighs the impact
of the poorer investment performance against the improved profit performance and provides a
single measure.

7.9 EVALUATING THE ECONOMIC PERFORMANCE OF THE ENTITY

The discussion to this point has focused on measuring the performance of business unit
managers. As pointed out in chapter 5, reports are also made on economic performance of
business units. The two types of reports are quite different. Management reports are prepared
monthly or quarterly, whereas economic performance reports are prepared at irregular
intervals, usually once every several years. For reasons stated earlier, management reports
tend to use historical information on actual cost incurred, whereas economic reports use quite
different information. in this section we discuss the purpose and nature of the economic
information.

Economic reports are a diagnostic instrument; they indicate whether the current strategies of
the business unit are satisfactory, or whether a decision should be made to do something about
the business unit-expand it, shrink it, change its direction, or sell it. The economic analysis of
an individual business unit may reveal that current plans for new products, new plant and

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equipment, or other new strategies, when considered as a whole, will not produce a
satisfactory future profit, even though each separate decision seemed sound at the time it was
made.

Economic reports are also made as a basis for arriving at the value of the company as a whole.
Such a value is called the breakup value-that is, the estimated amount that shareholders would
receive if individual business units were sold separately. (Consulting firms often use the term
shareholders value.)
value.) The breakup value is useful to an outside organization that is considering
making a takeover bid for the company, and of course, it is equally useful to company
management in appraising the attractiveness of the several business units, and it may suggest
that senior management is misallocation its scarce time-that is, spending an undue amount of
time on business units that are unlikely to contribute much to the company’s total
profitability. if there is a gap between current profitability and shareholders value, there is an
indication that changes may need to be made. (Alternatively, current profitability may be
depressed by costs that will enhance future profitability, such as new product development
and advertising, as mentioned in an earlier section.)

The most important difference between the two types reports is that economic reports focus
on predicting future profitability, rather than what profitability is or has been. The book value
of assets and depreciation based on the historical cost of these assets is used in the
performance reports of managers, despite their known limitations. This information is
irrelevant in reports that estimate the future; in these reports, the emphasis is on replacement
costs.

Conceptually, the value of a business unit is the present value of its future earnings stream.
This is calculated by estimating cash flows for each rate. The analysis covers 5, or perhaps 10,
future years. Assets on hand at the end of the period covered are assumed to have a certain
value, the terminal value,
value, which is discounted and added to the value of the annual cash
flows. Although these estimates are necessarily rough, they provide a quite different way of
looking at the business units fro that conveyed in the performance reports.

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7.10 SUMMARY

Investment centers are encumbered by all of the measurement issues involved in defining
expenses and revenues, which were discussed in chapter 4,5, and 6. Investment centers raise
additional issues regarding how the assets employed should be measured-issues such as which
assets to include, how to value fixed assets and current assets, which depreciation method to
use for fixed assets, which corporate assets to allocate, which liabilities to subtract, and so on.

An important goal of a business organization is to optimize return on shareholder equity (i.e.,

the net present value of future cash flows). it is not practical to use such a measure to Evaluate
the performance of business unit manages on a monthly or quarterly basis. Accounting rate of
return is the best surrogate measure of business unit manager’s performance. Economic value
added is conceptually superior to return on investment in evaluating business unit managers.

While setting the annual profit objectives, in addition to the usual income statement items,
there should be an explicit interest charge against the projected balance of controllable
working capital items, principally receivables and inventories. There is considerable debate
about the right approach to management control over fixed assets. Reporting on the economic
performance of an investment center is quite different from reporting on the performance of
the manager in charge of that center.

Check Your Progress Exercise

1. Define ROI
2. Define EVA
3. Compare and contrast ROI and EVA

7.11 ANSWER TO CHECK YOUR PROGRESS EXERCISE

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UNIT 8. STRATEGIC PLANNING

Contents
8.0 Aims and Objectives
8.1 Introduction
8.2 Nature of Strategic Planning
8.3 Relation Ton Strategic Formulation
8.4 Evolution of Strategic Planning
8.5 Benefits and Limitations of Strategic Planning
8.5.1 Framework for Developing the Budget
8.5.2 Management Development Tool
8.5.3 Forces Management to Think Long Term
8.5.4 Alignment With Corporate Strategies
8.5.5 Framework for Short Run Actions
8.6 Limitations of Strategic Planning
8.6.1 Form Filling Bureaucratic Exercise
8.6.2 It is Line Management Function Often Delegated Staff Management
8.6.3 Time Consuming and Expensive
8.7 Program Structure and Content
8.8 Organizational Relationships
8.9 Top Management Style
8.10 Analyzing Proposed New Programs
8.10.1 Capital Investment Analysis
8.10.2 Rules
8.10.3 Avoiding Manipulation
8.10.4 Models
8.10.5 Organization for Analysis
8.11 Analyzing Ongoing Programs
8.12 Value Chain Analysis
8.12.1 Linkage With Suppliers
8.12.2 Linkage With Customers

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 8.12.3 Process Linkages
8.13 Activity Based Costing
8.14 The Strategic Planning Process
8.14.1 Review and Update the Strategic Plan From Last Year
8.14.2 Deciding on Assumptions and Guidelines
8.14.3 First Iteration of the New Strategic Plan
8.14.4 Analysis
8.14.5 Second Iteration of the New Strategic Plan
8.14.6 Review and Approval
8.15 Summary
8.16 Answer to Check Your Progress Exercise

8.0 AIMS AND OBJECTIVES

 To describe the nature of strategic planning

 To discuss the techniques for analyzing the proposed new programs and
ongoing programs
 To explain the steps involved in the strategic planning process.

8.1 INTRODUCTION

The chapters in part ii discuss steps in the management control process in the sequence in
which they occur in practice: chapter 8 describes strategic planning; chapter 9, budget
preparation; chapter 10, analyzing financial performance reports; chapter 11, development of
the balance scored incorporating financial and non financial measures; and chapter 12
discusses management compensation as it relates to the management control process.

The first section of chapter 8 describes the nature of strategic planning. The second part
discusses techniques for analyzing and deciding on proposed new programs. The final part
describes the several steps in the strategic planning process.

NATURE OF STRATEGIC PLANNING

The formal statement of plans is here called strategic plan, and the process of preparing and
revising this statement is called strategic planning; it is also called long-range planning, or

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programming. Strategic planning is the process of deciding on the programs that, the
organization will undertake and the approximate amount of resources that will be allocated
to each program over the next several years.

Relation to Strategy Formulation

The distinction is that strategy formulation is the process of deciding on new strategies,
whereas strategic planning is the process of deciding how to implement strategies. The
document that describes how strategies are to be implemented is here called a strategic plan.

In the strategy formulation process, management decides on the goals of the organization and
the main strategies for achieving these goals. The strategic planning process takes these goals
and strategies as given and seeks to develop programs that will implement the strategies
efficiently and effectively. The decision by an industrial goods manufacturer to diversify into
consumer goods is a strategic decision. Having made this basic decision, a number of
implementation issues have to be resolved: whether to diversify through acquisition or by
building a new organization, what product lines to emphasize, whether to make or to buy,
what marketing channels to use, and so on.

Strategic planning is systematic; there is an annual strategic planning process, with prescribed
procedures and timetables. strategy formulation is unsystematic. Strategies are reexamined in
response to a perceived opportunity or threat. a possible strategic initiative may surface at any
time and by anyone in the organization. if initially judged to be worth pursuing, it is analyzed
immediately, without waiting to be fitted into a prescribed timetable.

Benefits and limitations of strategic planning

A formal strategic planning process can yield several potential benefits for the organization:
(1) A framework to develop the annual budget
(2) A management development tool
(3) A mechanism to force managers to think long term
(4) Help in aligning managers toward the long term direction of the company and
(5) Help in thinking explicitly about the short-run actions required to implement the long-
term strategies.

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Limitations.
There are several potential limitations of formal strategic planning.
First, there is a danger that strategic planning could end up becoming a “form-filling,”
bureaucratic exercise, devoid of strategic thinking.

A second potential problem could develop if an organization creates a large strategic

planning department and delegates the preparation of the strategic plan to that staff
department.

Finally, strategic planning is time consuming and expensive. the most significant expense is
the time devoted to it by senior management and managers at other levels in the organization.
a formal process is not worthwhile in some organizations; the formal planning process in
these organizations starts with the preparation of the annual budget, and the decisions that
govern the budget are made informally.

1. Its top management is convinced that strategic planning is important. Otherwise,

strategic planning is likely to be a staff exercise that has little impact on actual
decision-making.
2. It is relatively large and complex. in small, simple organizations, an informal
understanding of the organization’s future directions is adequate for making decisions
about resource allocations, which is a principal purpose of preparing a strategic plan.
3. Considerable uncertainty about the future exists, but the organization has the
flexibility to adjust to change circumstances. in a relatively stable organization, a
strategic plan is unnecessary; the future is sufficiently like the past, so the strategic
plan would be only an exercise in extrapolation. (if a stable organization foresees the
need for a change in direction, such as a decline in its markets or drastic changes in the
cost of materials, it prepares a contingency plan showing the actions to be taken to
meet these new conditions.) If the future is so uncertain that reasonably reliable
estimates cannot be made, preparation of a formal strategic plan is a waste of time.

In summary, a formal strategic planning process is not needed in small, relatively stable
organizations, and it is not worthwhile in organizations that cannot make reliable estimates

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about the future or in organizations whose senior management prefers not to manage in this
fashion.

Analyzing proposed new programs

Ideas for new programs can originate anywhere in the organization: with the chief executive,
with a headquarters planning staff, or in various parts of the operating organization. For
example, in 3m corporations, the idea for “post-it” notepads originated down in the
organization, not at the initiative of the CEO. Some units are a more likely source than others,
for fairly obvious reasons. the R&D organization is expected to generate ideas for new
products or processes, the marketing organization for marketing innovations, and the
production engineering organization for new equipment and manufacturing methods.

Proposals for programs are essentially either reactive or proactive-that is, they arise either as
the reaction to a perceived threat such as rumors of the introduction of a new product by a
competitor, or they represent an initiative designed to capitalize on a newly perceived
opportunity.
Because a company’s success depends in part on its ability to find and implement new
programs, and because ideas for these can come from a wide variety of sources, it is important
that the atmosphere be such that these ideas come to light and that they receive appropriate
management attention. a highly structured, formal system may create the wrong atmosphere
for this purpose, and therefore it is important that the system be flexible enough and receptive
enough so that good new ideas do not get killed off before they come to the attention of the
proper decision maker.

It is also important that, wherever possible, the adoption of a new program be viewed not as a
single all-or- nothing decision but, rather, as a series of decisions, each one involving a
relatively small step in testing and developing the proposed program. Full implementation and
its consequent significant investment should be decided upon if, but only if, the tests indicate
that the proposal has a good chance of success. Most new programs are not like the edsel
automobile, which involved the commitment of several hundred million dollars in a single
decision: rather, they involve many successive decisions: agreement that the initial idea for a
product is worth pursuing, then examining its technical feasibility in a laboratory, then

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examining production problems and cost characteristics in a pilot, plant, then testing
consumer acceptance in test markets, and only then making a major commitment to full
production and marketing. the system must provide for these successive steps, and for a
thorough Evaluation of the result of each step as a basis for making the decision on the next
step.

CAPITAL INVESTMENT ANALYSIS

Most proposals require significant amounts of new capital. Techniques for analyzing capital
investment proposals attempt either to find;

(a) The net present value of the project-that is, the excess of the present value of the
estimated cash inflows over the amount of investment required; or
(b) The internal rate of return implicit in the relationship between inflows and outflows.
An important point is that these techniques, in fact, are used in only about half the
situations in which, conceptually, they are applicable. There are at least four reasons
for not using present value techniques in analyzing all proposals.

1. The proposal may be so obviously attractive that a calculation of its net present
value is unnecessary. A newly developed machine that reduces costs so substantially
that it will pay for itself in a year is an example.
2. The estimates involved in the proposal are so uncertain that making present
value calculations is believed to be not worth the effort-one can’t draw a reliable
conclusion from unreliable data. This situation is common when the results are heavily
dependent on estimates of sales volume of new products for which no good market data
exist. (In these situations, the “payback period” criterion is used frequently.)
3. The rationale for the proposal is something other than increased profit ability.
The present value approach assumes that the “objective function” is to increase profits
in some sense, but many proposed investments are justified on the grounds that they
improve employee morale, improve the company’s image, or are needed for safety
reasons.
4. There is no feasible alternative to adoption of the proposal. An investment that
is required to comply with environmental legislation is an example.

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The management control system should provide an orderly way of reaching a decision on
proposals that cannot be analyzed by quantitative techniques. in particular, the fact that these
non-quantifiable proposals exist means that systems that attempt to rank projects in order of
profitability are unlikely to be practical; many projects do not fit into a mechanical ranking
scheme.

We describe briefly some considerations that are useful in implementing capital expenditure
Evaluation systems.

Rules.
Rules. Companies usually publish rules and procedures for the submission of capital
expenditure proposals. These rules specify the approval requirements for proposals of various
magnitudes that is, proposed expenditures to relatively small amounts may be approved by the
plant manager, subject to a total specified amount in one year, and larger proposals go
successively to business unit managers, to the chief executive officer, and, in the case of very
important proposals, to the board of directors.

The rules also contain guidelines for preparing proposals and the general criteria for
approving proposals. For example, small cost-saving proposals may require a maximum
payback period of two (sometimes three) years. For larger proposals, there is usually a
minimum required earnings rate, to be used either in net present value or internal rate of
return analysis. The required earnings rate may be the same for all proposals, or there may be
different rates for projects with different risk characteristics; also, proposals for additional
working capital may use a lower rate than proposals for fixed assets.

Avoiding manipulation.
manipulation. Sponsors know that a project with a negative net present value is not
likely to be approved. They, nevertheless, may have a “gut feeling” that the project should be
undertaken. In some cases, a proposal may be made attractive by adjusting the original
estimates so that the project does meet the numerical criteria-perhaps by making more
optimistic estimates of sales revenues, perhaps by reducing allowances for contingencies in
some of the cost elements. One of the most difficult tasks of the project sponsors can provide
a safeguard; more reliance is placed on numbers from a sponsor who has an excellent track
record of past performance. In any event, although all proposals that come up for approval are
likely to satisfy the formal criteria, not all of them are truly attractive.

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Models. In addition to the basic capital budgeting model, there are specialized techniques.
Such as risk analysis, sensitivity analysis, game theory, option-pricing models, contingent
claims analysis, and decision tree analysis. Some of them have been oversold, but others are
of practical value. The planning staff should be acquainted with them and require their use in
situations in which the necessary data are available.

Organization for analysis

A team may be formed to Evaluate extremely large and important proposals, and the process
may require a year or more. Even for smaller proposals, there is usually considerable
discussion between the person who is sponsoring the proposal and the headquarters staff. As
many as a dozen functional and line executives may be required to sign off on an important
proposal before it is submitted to the chief executive officer. The CEO for further analysis
may return the proposals several times before the final decision is made to go ahead with or
reject the project. And, as noted earlier, the decision to proceed may require that a succession
of development and testing hurdles be crossed prior to full implementation.

Recent work in the rapidly developing field of expert systems has found ways of using
computer software in the analysis of proposed programs. Software has been developed that
permits each participant in the group that is considering a proposal to vote on, and to
explicitly rank, each of the criteria used to judge the project. The computer tabulates the
results, uncovers inconsistencies or misunderstandings, and raises questions about them. A
succession of such votes can lead to a conclusion that expresses the consensus of the group.

There are no set timetables for analyzing investment proposals. Analysis is started as soon
after receipt of the proposal as people are available. Approved projects are collected during
the year for inclusion in the capital budget. There is a deadline in the sense that the capital
budget for next year has a deadline (usually just prior to the beginning of the budget year). If a
proposal doesn’t make that deadline, its formal approval may wait until the following year,
unless there are unusual circumstances. The capital budget contains the authorized capital
expenditures for the budget year, and, if additional amounts are approved, cash plans must be
revised; there may be problems in financing the additional amount.

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Analyzing ongoing programs

In addition to developing new programs, many companies have systematic ways of analyzing
ongoing programs. Several analytical techniques can aid in this process. This section
describes the following analytical tools: value chain analysis and activity-based costing.

Value chain analysis

As pointed out in chapter 2, the value chain for any firm in any business is the linked set of
value-creating activities to produce a product from basic raw material sources for component
suppliers to the ultimate end-use product delivered into the final consumer’s hands. Each firm
must be understood in the context of the overall chain of value-creating activities of which it
is only a part.

From the strategic planning perspective, the value chain concept highlights three potential
areas:
1. Linkages with suppliers.
2. Linkages with customers.
3. Process linkage within the value chain of the firm.

Linkages with suppliers.

suppliers. As indicated in exhibit 8-3, the linkage with suppliers should be
managed so that both the firm and its supplier can benefit. Such opportunities can be
dramatically important in lowering costs, increasing value, or both.

Example. When bulk chocolate began to be delivered in liquid from in tank cars instead of
ten-pound molded bars, an industrial chocolate firm (i.e., the supplier) eliminated the cost of
molding and packing bars, and a confectionery producer (i.e., the firm) saved the cost of
unpacking and melting.

EXHIBIT 8-3 profit improvement opportunities through linkages with suppliers

Suppliers’
suppliers Suppliers Firm

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Linkages with customers. As indicated in exhibit 8-4, customer linkages can be just as
important as supplier linkages. There are many examples where the linkage between a firm
and its customer becomes mutually beneficial.

Example. Some container producers (i.e., the firms) have constructed manufacturing facilities
next to beer breweries (i.e., the customers) and deliver the containers through overhead
conveyors directly onto the customers’ assembly line. this results in significant cost
reductions for both the container producers and their customers by expediting the transport of
empty containers, which are bulky and heavy.

Process linkages within the value chain of the firm. Value chain analysis explicitly
recognizes the fact that the individual value activities within a firm are not independent but
rather are interdependent (exhibit 8-5).

Example. At MC Donald’s, the timing of promotional campaigns (one value activity),

significantly influences capacity utilization in production (another value activity). These
linked activities must be coordinated if the full effect of the promotion is to be realized.

EXHIBIT 8-4 profit improvement opportunities through linkages with customers.

Firm Customer Customers’

customer

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EXHIBIT 8-5 profit improvement opportunities through linkages within value chain.

Stages in added value

Amount of
Value added
R&D raw manufacturing marketing distribution service
Materials

A company might want to analyze the process linkages within the value chain, seeking to
improve their efficiency. The overall objective is to move materials from vendors, through
production, and to customer at the lowest cost and in the shortest time.

Reducing the number of separated parts, and increasing their ease of manufacture might
increase efficiency of the design portion of the value chain.

Example. Japanese VCR producers were able to reduce prices from $1,300 in 1977 to $295 in
1984 by emphasizing the impact of an early step in the chain (product design) on a later step
(production) by drastically reducing the number of parts in VCRs.

A firm should also work toward improving the efficiency of every activity within the chain
through a better understanding of the drivers that regulate costs and value for each activity.

Efficiency of the inward portion (i.e., the portion that precedes production) might be
improved by reducing the number of vendors; by having a computer system place orders
automatically; by limiting deliveries to “just-in-time” amounts (which reduces inventories);
and by holding vendors responsible for quality, which reduces or eliminates inspection costs.

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Efficiency of the production portion might be improved by increased automation, perhaps by
using robots; by rearranging machines into “cells,” each of which performs a series of related
production steps; and by better production control system.

Efficiency of the outward portion (i.e., the portion from the factory door to receipt by the
(customer) might be improved by having customers place orders electronically (which is now
common in hospital supply companies and in certain types of retailing); by changing the
locations of warehouses; by changing channels of distribution and placing more or less
emphasis on distributors and wholesalers; by improving and placing more or less emphasis on
distributors and wholesalers; by improving the efficiency of warehouse operations; and by
changing the mix between company-operated trucks and transportation furnished by outside
agencies.

Example. Procter & gamble places order-entry computers in wall-mart stores. This eliminates
errors that used to occur when wall-mart buyers transmitted orders to p&g order-entry clerks,
reduces the cost of the operation in both firms, and reduces the time between initiation of an
order and shipment of the goods. Levi strauss has a similar system with its own retail stores.

These efficiency-oriented initiatives usually involve trade-offs. For example, direct orders
from customer computers may speed delivery and reduce paperwork but lead to an increase in
order-filling costs because of the smaller quantities ordered. Thus, it is important that all
related parts of the value chain be analyzed together; otherwise, improvements in one link
may be offset by additional costs in another.

Activity-based costing

Increased computerization and automation in factories have led to important changes in

systems for collecting and using cost information. Fifty year ago, most companies allocated
overhead costs to products by means of a plant wide overhead rate by based on direct labor
hours or dollars. Today, an increasing number of companies collect costs for material-related
costs (e.g., transportation, storage) separately from other manufacturing costs; and they collect
manufacturing costs for individual departments, individual machines, or individual “cells,”
which consist of groups of machines that perform a series of related operations on a product.
In these cost centers, direct labor costs are combined with other cost elements, giving

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conversation cost-that is, the labor and factory overhead cost of converting raw materials and
parts into finished products. In addition to conversion costs, the newer systems also assign
R&D, general and administrative, and marketing costs to products. The newer systems also
use multiple allocation bases. In these newer systems, the word activity is often used instead
of cost center, and cost driver instead of basis of allocation; and the cost system is called an
activity-based cost system (ABC). The basis of allocation, or cost driver, for each of the
cost centers reflects the cause of cost incurrence-that is, the element that explains why the
amount of cost incurred in the cost center, or activity, varies. For example, in procurement,
the cost driver may be the number of orders placed; for internal transportation, the number of
parts moved; for products design, the number of different parts in the product; and for
production control, the number of setups. Note that “cause” here refers to the factor causing
the costs in the individual cost center, in contrast with the traditional system, in which the
cause of cost is taken to be the volume of products as a whole.

Examples. General motors used ABC analysis to formulate a component make-or-buy

strategy. in a single plant, its ABC system had over 5,000 activity cost pools and over 100
different cost drivers (i.e., drivers that traced activity cost pools to products.)

Schrader bellows, a division of scovill, inc, used abc analysis to re-Evaluate marketing and
product line strategies. Its abc analysis had 28 activity cost pools and 16 cost drivers. Its
previous system had one cost pool for each of the five production departments and used one
cost driver (viz., direct labor) to allocate the cost pools to products.

Stewart box company (case 1-3 in this book) uses abc analysis to develop price estimates, as
described in exhibit 3 of the case.

Fundamentally, each components of overhead is caused by some activity. In ABC each

product is charged for a share of the overhead based on the proportion of that activity which it
causes. The number of production runs to be scheduled, for example, generates production-
scheduling cost. It thus is allocated based on the number of production runs each product
generates. Products that generate a large number of relatively short production runs will
always bear a less than proportionate share of the scheduling cost under any volume-based
allocation scheme. Scheduling cost is not production volume dependent. It is dependent on

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how many runs must be scheduled, not how many units the firm produces. Production
volume-based allocation methods (labor hours or machine hours) misstates the extent to
which the product with many short runs causes scheduling cost. The basic idea is that
transaction volume (number of production runs) is a better proxy for long-run variable cost
than is out put volume.

The mechanics of ABC contrasted with traditional cost systems are illustrated in exhibit 8-7.
The following example highlights the systematic undercoating of low volume, complex
products and the systematic overcastting of high volume, vanilla products under traditional
costing systems.

Example. “Imagine a production line in a pen factory in which two kinds of pens are being
made, black in high volume and purple in low. Assume that it takes eight hours to program
the machinery to shift production from one kind of pen to the other. The total costs include
supplies, which are the same for both types of pens, the direct labor of the workers on the line,
and factory overhead. The most significant piece of overhead in this instance would be the
cost of reprogramming the machinery wherever there’s a switch from black to purple or
purple to black.

If the company produces 10 times as many black pens as purple pens, 10 times the cost of
reprogramming will be allocated to the black as to the purple under any production volume-
based allocation scheme. Obviously this understates the cost of producing the low-volume
product. The ABC approach comes much closer than traditional costing to showing managers
what causes the expenses of manufacture. Once pen manufacturing is broken down into its
activities, managers can recognize that the activity of changing pens triggers the cost of
retooling. The abc accountant then calculates an average cost of setting up the machinery and
charges it against each batch of pens that requires retooling regardless of the six of the run.
Thus, a product carries the cost for only the overhead it actually consumes.”

The ABC concept is not particularly subtle or counterintuitive. in fact, it is very much in line
with common sense. But, in earlier days, factories tended to produce fewer different products,
cost was labor dominated (high labor cost relative to overhead), and products tended to differ
less in the amount of support services they consumed. Thus, the activity basis for overhead

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allocation was not likely to produce product cost results much different from a simple
volume-driven basis tied to labor cost.

Today, labor cost in many companies is not only dramatically less important; it is also viewed
less and less as a cost to be varies when production volume varies. Indirect cost is now the
dominant part of cost in many companies. in the prototypical “flexible factory”, raw material
is the only production volume-dependent cost and the only cost directly relatable to individual
products. Advocates of ABC maintain that a meaningful assessment of full cost today must
involve assigning overhead in proportion to the activities that generate it in the long run.

The Strategic Planning Process

In a company that operates on a calendar-year basis, the strategic planning process starts in
the spring and is completed in the fall, just prior to the preparation of the annual budget. The
process involves the following steps:

1. Reviewing and updating 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. Review and approval.

Summary

A strategic plan shows the financial and other implications, over the nest several years, of
implementing the company’s strategies.

In the period since the current strategic plan was prepared, the organization has made capital
investment decisions. The process of approving proposed capital investments does not follow
a set timetable; the decisions are made as soon as the need for them is identified. The
implications of these decisions are incorporated in the strategic plan. Assumptions and
guidelines about external forces, such as inflation, internal policies, and product pricing, are
also incorporated.

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Based on this information, the business units and support units prepare proposed strategic
plans, and these are discussed in depth with senior management. if the resulting plan does not
indicate that profitability will be adequate, there is a planning gap, which is dealt with by a
second iteration of the strategic plan.

Several analytical techniques, such as value chain analysis and activity based costing, can aid
in the strategic planning process.

Check Your Progress Exercise

Define strategic planning

Explain the nature of strategic planning
Distinguish strategy formulation and strategic planning
List the advantages and disadvantages of strategic planning
Explain how do the proposed new programs are analyzed
Explain how the ongoing programs are analyzed
Explain the strategic planning process.
Write a short notes on
Capital investment analysis
Value chain analysis
Activity based costing

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UNIT 9. BUDGET PREPARATION

Contents
Nature of the budget
Other budgets
The budget preparation process
Behavioral aspects
Quantitative techniques

Objectives:
 To describe the process of budget preparation
 To describe the purpose of the budget
 To distinguish a budget from strategic plan or forecast
 To describe the types of budgets
 To explain the steps in preparing an operating budget
 To discuss the behavioral implications of the budget preparation process.

Budget: - a quantitative device that explains the total operation carried out by the firm during
one year.

Operating budget:
budget: - states the revenue & expenses planned for one year.

Characteristics/features of budget:
1. It estimates the profit potential of the enterprise
2. It always express in monetary terms
3. The period is usually one year
4. The budget is a management commitment to accept the responsibility accomplishing
the stated objectives
5. The budget normally approved by top management
6. The budget may be changed according to circumstances
7. The budget will compared with actual performance and variances or analyzed and
explained

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The difference between the strategic planning and budgeting
1. Both involve planning
2. The types of planning activities
3. Budget is for one year and strategic to 3-5 year
4. Strategic planning proceeds budgeting and budgeting is done on the basis of strategic
plan
5. Product lines and programs structure strategic plan, whereas budgeting structured by
responsibility centers.

Differences between forecasting and budgeting

1. Budget is a management plan whereas forecast simply prediction about the future.
2. Budget always states in monetary terms whereas the forecast may be stated monetary
and non-monetary terms.
3. Budget is for a period of 1 year but forecast for any period.
4. Budget is a commitment but forecasting is not.
5. Higher authorities approve budget but forecast does not.
6. Forecast for not analysis but budget is for analysis, explanation & comparison.
7. Forecasting is a planning activities but budgeting is planning and controlling activities.

Purpose of budgets

1. To fine-tune the strategic plan

2. To coordinate the activities of several parts of the organization
3. To assign the responsibility to managers
4. To authorize the amounts they are permitted to spent
5. To inform the managers about the expect performance
6. To obtain a commitment from a managers for Evaluating their actual performance

Types of budget

1. Operating budgets
2. Capital budgets
3. Budgeted balance sheet

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 4. Budgeted cast flow statement
5. Management by objective (MBO)

Operating budget

Characteristics of operating budgets

1. It is prepared for the organization as a whole & for each business unit
2. It is classified by responsibility centers
3. Prepared for one year divided into quarter, month task Control.,
4. It reconcile to strategic plan

Contents of operating budget

1. Revenue budget
2. Production cost budget /cost of sales budget
3. Marketing expense budget
4. Logistics expense budget
5. General and administrative budget
6. Research & development budget
7. Taxes budget
8. Net income budget

These expenses can be flexible or discretionary in their nature

1. Sales/revenue budget/ service budget

2. Capital budget: it is the budgeting especially for capital expenditure specially long
term expenditure. it is prepared quarterly, monthly task Control., this capital budgets
helps the preparation of cash flow statements.
3. Budgeted balance sheet: incorporation of operating budget as well as capital budget
4. Budgeted cash flow statement
Cash receipt- cash payment = surplus /deficit
Cash flow statement
Opening balance
Plus: Receipts

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Total cash available
Less Payment
closing balance
It includes both revenue and capital items.

5. Management by objectives [MBO]: all the organizations objectives should be

communicated to all organization. Members in state terms as monetary and non-monetary
terms.

Budget preparation process

1. Budget dep’t
2. Set p a budge committee
3. Issue guidelines
4. Issue of initial budget proposal
5. Negotiation
6. Approval
7. Revision
8. Budget dep’t
In a big organization, one dep’t (separate) for budget preparation
Certain functions will be,

Functions of budget dep’t

1) It publishes the procedures & forms for the preparation of budget.
2) It coordinates & publishes the assumptions about the economy for the
preparation of budget
3) It provides help & assistance in preparation of budget.
4) It analyzes the proposed budget & makes recommendations
5) It administers the process of making and revising the budget
6) It analyzes the reported performance against budget, interprets the results &
prepares summary report to senior manager

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1. Budget committee
In many organizations, the budget preparation is done by, CEO with the budget committee
The budget committee consists
1) CEO
2) CFO
3) Chief operating officials
4) Members of senior Management
5) Board of directors

Functions of the budget committee

1. It reviews and either approves or adjusts each of the budgets submitted
by all the departments or units of the organization.
2. It approves measure budget revisions made during the year.

Issuing of guide lines

These guidelines are the basis on which budgets are prepared
These are implicit in the strategic plan
(They don’t issue separate guidelines)
Some guidelines are general for all responsibility centers while some guidelines are
specific to some responsibility centers.
These guidelines developed by budget staff and approved by senior Management. &
distributed through out the organization

4. Issue of initial budget proposal

It is prepared with the existing resources & modified in accordance with the guidelines
issued
The changes in current budget may be classified as:-
a) Changes in external forces
b) Changes in internal policies & practices
a) Changes in external forces:-
General level of economic activity changes in prices
Changes in wage rates, changes in costs of discretionary activities

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 b) Changes in internal policies & practices
Changes in production cost
Changes in discretionary cost
Changes in market share & product mix
5. Negotiation
It is heart of the process in which the budgeted discusses the budget process with his
superiors; in this process both the budge tee & superior will negotiate and finalize the budget
through negotiation.

6. Approval
All the budgets have to be analyzed & approved by either by the budget committee or by the
person responsible just before the beginning of the New Year.

7. Budget Revision
There are tow types of revisions
a) General revision
b) Revision under special circumstances (special revision)
The behavioral aspects
1. Participation in the budget process
2. Degree of budget target difficulty
3. Involvement of senior Management
4. The budget dep’t

1. Participation in the budget process

There are 3 approaches to prepare the budget
Top-down bottom-up combined

1.prepared by top Management lower Management lower Management

2. Approved “ “ top Management top Management
3. Reviewed “ “ lower Management top Management
The budgets will be too high easily achievable the target will neither be too
(Too difficult target) (Too easy target, too low) easy or too stiff most
advisable

Degree of budget target

The degree of budget target should be
–Neither low nor high
-Neither optimistic not pessimistic

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Involvement of senior Management
In order to make an effective budget, the involvement of senior Management should be more
senior. Management should participate in review and approval & budget preparation such
approval should not be like a rubber stamps.

Check Your Progress Exercise

1. Define budget, and explain the nature of a budget.

2. Explain the relationship of budget with strategic planning.
3. Compare and contrast budgeting with forecasting.
4. List the uses of budget.
5. Mention the contents of an operating budget.
6. Explain the budget preparation process.
7. Explain the behavioral aspects of the operating budget.
8. Explain the use of mathematical techniques I the budget
preparation process.

Write a short notes on

1. The capital budget
2. MBO
3. Budget committee
4. Simulation

ANSWER TO CHECK YOUR PROGRESS EXERCISE

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UNIT 10. ANALYZING FINANCIAL PERFORMANCE REPORT

Unit contents

Calculating variances:
Revenue variances
Selling price variance
Mix and volume variance
Other revenue variances
Expense variances
Variations in practice
Time period of the comparison
Focus on gross margin
Evolution standards:
Predetermined standards
Historical standards
External standards

Limitations of variance analysis

Behavioral considerations in performance Evaluation
Tight control vs. loose control
Behavioral effects of tight and loose controls
Factors affecting the choice of tight vs. loose controls
 Amount of discretion
 Degree of influence
 Relative uncertainty
 Time span
9.0 Objectives
 To describe the variances between actual and budgeted data
 To describe how the senior management to Evaluate business unit managers uses
reports of the variances

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  To explain how non-financial performance measures can be incorporated into the
management control process.

Calculation of different variances

Evaluation of business units’ performance by variance reports
Calculating the variances
i. Variance analysis identifies the causes of the variances & the organization units
responsible
ii. Variances are hierarchical
The variances are divided in to
a) Revenue variance
b) Expense variance

a) Revenue variance further classified

i. Volume variances
ii. Price variances
b) Expenses variances
i. Manufacturing exp. variances
ii. Other exp. variances
Total variance

Non-manufacturing manufacturing cost selling

Cost

Administrative material f.org volume price Marketing labor r&d

v.overhead market selling price

Mix variance
(Actual mix-standard mix) in to the budget unit contribution

Market share variance = (actual sales-industry volume) x (budgeted unit contribution)

Budget market contribution
Summary performance report

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1. Actual profit
Budget profit
Variance (+/-)
Analysis of variances
1. Revenue variances explained in terms of
Price
Mix
Value
2.net revenue variance, the segregations of the
3. Variable -cost variance
Material
Labor
V.oh
Net. V.c.v
4. Fixed cost variances
Selling expenses.
Administrative expenses. exp.
Net fixed cost

Time period
A time period may be a quarter, a month or a year.
Special events may also cause preparation of reports.
(Not because of volumes or prices)

Focus of gross margins

The gross margin= selling price-manufacturing cost and this gross margin. Variance has to be
analyzed by
1. Material price variance
2. Wage rate variance
3. Selling price variance
4. Selling volume variance

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Evaluation standards
There are three types of Evaluation standards.
1. Pre-determined standards
2. Historical standards
3. External standards

Limitations of variance analysis

A. It doesn’t tell about why the variance occurred & what is being done about it
B. It is difficult to decide what variance is significant & what variance is
negligible
C. The aggregation of variances may mislead the reader.
D. Variance analysis tells only about past actions. it doesn’t tell about the future
E. It reports only about the accounting items & don’t take into account the long-
term effects.

Controllable variances – had we taken an action?

Non-controllable variances

Tight versus Loose Controls. A manager's style affects the degree of tight versus loose
control in any situation. The manager of a routine production responsibility center can be
controlled either relatively tightly or relatively loosely, and the actual control reflects the style
of the manager's superior. Thus, the degree of tightness or looseness often is not revealed by
the content of the forms or aspects of the formal control documents, rules, or procedures. It
depends on how these formal devices are used.

The degree of looseness tends to increase at successively higher levels in the organization
hierarchy: higher-level managers typically tend to pay less attention to details and more to
overall results (the bottom line, rather than on the details of how the results are obtained) than
lower-level managers.

Check Your Progress Exercise

Write a short notes on

Revenue variances

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 Selling price variance
Expense variances
Predetermined standards
Historical standards
External standards

Explain Limitations of variance analysis

Discuss the Behavioral considerations in performance Evaluation
Compare and contrast Tight control vs. loose control
Explain the Behavioral effects of tight and loose controls in detail
What are the Factors affecting the choice of tight vs. loose controls?

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UNIT 11. PERFORMANCE MEASUREMENT

Contents
 Information Used in Control Systems
o Informal Information
o Task Control Information
o Budget Reports and
o Non-Financial Information
 Performance Measurement Systems in General
 The Balanced Scorecard
 Financial and Non-Financial Measures
 Internal and External Measures
 Implementation of Balanced Scorecard Approach
 Define Strategy
 Define Measures of Strategy
 Integrate Measures in to the Management System
 Review Measures and Results Frequently
 Limitations of the Balanced Score Card Approach
 Interactive Control

Objectives
 To describe the nature of the several types of information managers receive
o Informal information
o Task control information
o Budget reports and
o Non-financial information

 To discuss about the performance measurement systems

 To list the objectives of the performance measurement systems
 To explain about interactive control.

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PERFORMANCE MEASUREMENT

In last Chapter, we described a report that measures actual financial performance compared
with budgeted financial performance. This is one type of performance measurement. But
financial performance, although important, is only one aspect of what an organization’s
performance was. In this chapter we describe other aspects.

In the first part of the chapter we describe the nature of the several types of information
managers receive: informal information, task control information, budget reports, and
nonfinancial information. In the second part we discuss performance measurement systems,
especially the balanced scorecard, which blend financial information systems is to aid in
strategy implementation. In the final part we discuss interactive control- the use of a subset of
management control information in developing new strategies.

INFORMATION USED IN CONTROL

Heir function is to ensure that the work get done efficiently and effectively. Managers literally
do not “Control costs.” What managers do- or at least attempt to do- is to influence the actions
of the people who are responsible for incurring the costs.

To carry on activities, managers need information. In the following paragraphs we describe

the nature of the several types of information that are useful in the control process.
Information is used here in the broad sense of anything that reduces the user’s uncertainty.

Informal Information
Much of the information that mangers use is informal- that is, the manger receives it through
observation, face-to-face conversation, telephone conversations, memoranda, and meetings, as
contrasted with information obtained from form formal reports. Recently the tern
management by walking around has come to signify the importance of this information.
Because it is information, this information is difficult to describe and categorize. We shall say
simply that most mangers find informal information more important than any formal report.

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Task Control Information
Most of the formal information that flows through an organization in its day- to day
operations is task control information. A production control system provides information that
schedules the flow of material, labor, and other resources, so that the correct products in the
correct quantities emerge at the end of the process. Systems also control procurement, payroll,
storage, and other activities. Management control information is primarily a summary of this
task control information.

Budget Reports
The approved budget is the principal financial device for controlling the activities of
responsibility centers, and a report that compares actual revenues and expenses with budget
amounts is the principal financial report.

Budget Signals. Operating mangers should understand which budget amounts are expected
amounts, which are ceilings, and which are floors. Some items are ceilings (e.g. entertainment
expense, dues and subscriptions, advertising); they signal the manager to spend no more than
the budget amount without obtaining specific approval. Other are flowers(e.g. training); they
signal the manger to spend at least the budget amount. Still others are general guides in the
sense that spending is expected to be approximately, but not exactly, the amount stated.

No financial Information
Certain nonfincial information are key indicators of how well the chosen strategy is being
implemented. These are referred to in several :key variables, strategic factors, key success
factors, critical success factors, pulse points or key performance indicators.
indicators. In the next
section we describe how such nonfinacial information can be blended together with financial
information in designing a performance measurement system.

Performance Measurement Systems (PMS)

Performances Measurement Systems (PMS) have the goal of strategy implementation. In
setting up a PMS, senior management selects a series of measures that best represent the
company’s strategy. These measures can be seen as current and future critical success factors.
It these factors are improved, then the company has implemented its strategy. The success of

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the strategy depends on the strategy itself. A PMS is simply a mechanism for improving the
like hood of the organization successfully implementing a strategy.
An example of a performance measurement system is the balanced score card approach. After
some initial discussion of PMS in general, the discussion of the balanced scorecard will be
divided into four parts.
 The balanced scorecard defined
 Balanced scorecard implementation
 Common failings with balanced scorecard
 Current measurement practices

Performance Measurement Systems in General

A PMS, like a dashboard, has a series of measures that provide information about the
operation of many different processes.

The Balanced Scorecard

The balanced scorecard is an example of a performance system. It fosters a balance between
otherwise disparate strategic measures in an effort to achieve goal congruence, thus
encouraging employees to act in the best interest of the organization. Augmenting the goal-
congruence function, the balanced scorecard is a tool for focusing the organization, improving
communication, setting organizational objectives, and providing feedback on strategy.

Every measure on a balanced scorecard addresses an aspect of a company’s strategy. In

creating the balanced scorecard, executives must choose as set of measurements that 1)
accurately reflect the critical factors that will determine the success of the company’s strategy:
2) show the relationships among the individual measures in cause-effect manner, indicating
how nonflnancial measures affect long- term financial results: and 3) provide a broad- based
view of the current status of the company.

The balanced scorecard endeavors to create a blend of strategic measures: outcome and driver
measures, financial and nonfinancial measures, and internal and external measures.

Outcome and Driver Measures.

Measures. Outcome measurements indicate the result of a strategy
(e.g. increased revenue or improved quality). The amount by which revenue increased is the

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result of the successful implementation of the organization’s strategy. These measures are
typically “lagging indicators,” they tell management what has happened. By contrast, driver
measures are “leading indicators,” showing the progress of key areas in implementing a
strategy. An example of a driver is cycle time. Outcome caesuras can only indicate the final
result. Driver measures can be taken at a more granular level and indicate incremental
changes the will ultimately affect the outcome.

By focusing management attention on key aspects of the business, drier measures affect
behavior in the organization. If an element of the strategy is to improve time- to- market,
focusing on cycle time allows management to closely track how well this goal is being
achieved. This additional focus on cycle time in turn encourages employees to improve this
particular measure.

Outcome and drive measures are inextricably linked. If the outcome measures indicate that
there is a problem, yet the driver measures indicate that the strategy is being implemented
well, there is a high chance that the strategy needs to be changed.

Financial and Non-ficancial Measures.

Measures. Organization have developed very sophisticated
systems to measure financial performance. Unfortunately as many U.S. companies discovered
during the 1980s, industries were being driven by changes in nonfinancial areas, such as
quality and customer satisfaction, that eventually impacted the company’s financial
performance.

Internal and External Measures. Companies must strike a balance between external
measures, such as customers satisfaction, and measured of internal business processes, such as
manufacturing yields. The reason for this is that companies often sacrifice internal
development for external results or ignore external results, under the mistaken belief measures
were sufficient.

Measurements Drive Change.

Change. The most important aspect of the balanced scorecard is its
ability to measure outcomes and drivers in such as way as to cause the organization to act in
accordance with its strategies. The organization achieves goal congruence by linking the
overall financial and strategic objectives with lower level objectives that can be observed and

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affected at the different levels of the organization. With these measures every employee can
understand how their actions impact the company’s strategies.
Because these measures are explicitly tied to an organization’s strategies the measures in the
balanced scorecard must be strategy- specific and, there fore, organization- specific. While
there is a generic balanced scorecard frame work there is no such thing as a generic scorecard.

The balanced scorecard measures are linked from the top to the bottom and tied to specific
targets throughout the entire organization. Objectives can provide and additional level of
clarification to a strategy so that the organization knows both what they need to do and how
much of it needs to get done.

Finally, the balanced scorecard emphasizes the idea of cause and effect relationships between
measures. By explicitly presenting the cause and effect relationship, an organization will
understand how nonfinancial measures, such as product quality, drive financial measures,
such as revenue.

It is critical that the scorecard not simply be a “laundry list” of measures. Rather, the
individual measures and the four perspectives in the scorecard must be linked together
explicitly in cause- effect way, as a tool to translate strategy into action.

The better understood these relationships, the more readily each individual in the organization
will be able to directly and clearly contribute to the success of the organization’s strategies.

Implementing a Balanced Scorecard

We can summarize the implementation of a balanced scorecard in four general steps:
1. Define strategy.
2. Define measures of strategy.
3. Integrate measures into the management system.
4. Review measures and results frequently.

Each of these steps is iterative, requiring the participation of senior executives and employees
throughout the organization. Though the controller may be given the duty to overseeing its
development, it is task for the entire management team.

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Define Strategy:
Strategy: The balanced scorecard builds a link between strategy and operational
action. As a result in necessary to being the process of defining a balanced scorecard by
defining the organization’s strategy. At this phase it is important that the organization’s goals
are explicit and that targets have been developed.

Define Measures of Strategy:

Strategy: The next step is to develop measures in support of the
articulated strategy. It is imperative that the organization focuses on a few critical measures at
this point, otherwise management will be overloaded with measure. Also, it is important that
the individual measures be linked with each other in a cause- effect manner.

Integrate Measures into the Management System:

System: The balanced scorecard must be
integrated with the organization’s formal and informal structures, its culture, and its human
resource practices. While the balanced scorecard gives some means for balancing measures,
the measures can still become unbalanced by other systems in the organization, such as
compensation polices that compensate managers strictly based on financial performance.

Review Measures and Results Frequently.

Frequently. Once the balance scorecard is up and running, it
must be consistently reviewed by senior management. The organization should be looking for
the following.
 How do the outcome measures say the organization is doing?
 How do the driver measure say the organization is doing?
 How as the organization’s strategy changed since the last review?
 How have the scorecard measured changed?

The most important aspects of these reviews are as follows:

 They tell management whether the strategy is being implemented correctly
and how successfully the strategy is working.
 They show that management is serious about the importance of thsese
measures.
 They maintain alignment of measure to ever changing strategies.
 They improve measurement

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These review sessions will complete the four steps and provide the impetus to start the cycle
again.

PITFALLS OF THE BALANCED SCORECARD

The following problems, unless suitably dealt with, could limit the usefulness of the balanced
scorecard approach:
 Poor correlation between nonfluancial measures and results.
 Fixation on financial results.
 No mechanism for improvement.
 Measures are not updated.
 Measurement overload.
 Difficulty in establishing trade-offs.

INTERACTIVE CONTROL
The primary role of management control is to help in the execution of strategies. Under this
view (Exhibit 11-4), the chosen strategy defines the critical success factors which become the
focal point for the design and operation of control systems. The end result is the successful
implementation of the chosen strategy. In industries which are subject to very rapid
environmental changes, management control information can also provide the basis for
thinking about new strategies. This is illustrated in Exhibit 11-5. Simons refers to this as
interactive control. In a rapidly changing and dynamic environment, creating a learning
organization is fundamental to corporate survival. By a learning organization, we refer to the
capacity of the employees of an organization to learn to cope with changes in the environment
on an on- going basis. An effective learning organization is one where employees at all levels
of the organization continuously scan the environment, identify potential problems and
opportunities, exchange environmental information candidly and openly, and conduct
experiments of alternate business models in order to successfully adapt to the emerging
environment. The main objective of interactive control is to facilitate the creation of learning
organization.

While critical success factors are important in the design of control systems to implement the
chosen strategy, strategic uncertainties guide the use of a subset of management control

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information interactively in developing new strategies. Strategic uncertainties refer to
fundamental environmental shifts (changes in customer preferences, technologies,
competitors, lifestyles, substitute products etc.) that could potentially disrupt the rules by
which an organization is playing today. Interactive control alerts management of strategic
uncertainties – either troubles (e.g. loss of market share; customer complaints) or
opportunities (e.g. opening a new market because certain governmental regulations changing
environment by thinking about new strategies.

Interactive control has the following characteristics.

1. A subset of the management control information that has a bearing on the strategic
uncertainties facing the business becomes the focal point.
2. Senior executives take such information seriously.
3. Managers at all levels of the organization focus attention on the information produced
by the system.
4. Superiors, subordinates, and peers meet face to face to interpret and discuss the
implications f the information for future strategic initiatives.
5. The face- to- face meetings take the form of debate and challenge of the underlying
data, assumptions, and appropriate actions.

Interactive controls are not a separate system: they are an integral part of the management
control system. Some management control information helps mangers think about new
strategies; interactive control information usually, but not exclusively, tends to be
nonfinancial. Since strategic uncertainties differ from business to business, senior executives
in different companies might choose different parts of their management control system to use
interactively.

Check Your Progress Exercise

1. Write in detail about various types of Information used in control systems
2. Explain about the Performance measurement systems in general
3. Write a short notes on
4. The balanced scorecard
5. Financial and non-financial measures
6. Internal and external measures

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7. Interactive control
8. Explain the process of Implementation of balanced scorecard approach
9. List down the Limitations of the balanced score card approach
UNIT 12. MANAGEMENT COMPENSATION

Chapter contents

Research findings on organizational incentives

Characteristics of incentive compensation plans
Short-term incentive plans
The total bonus pool
Carryovers
Deferred compensation

Long-term incentive plans

Stock options
Phantom shares
Stock appreciation rights
Performance shares
Performance units
Incentives of corporate officers

Incentives for business unit managers

Size of bonus relative to salary
Cut off levels
Bonus basis
Performance criteria
Financial criteria
Adjustments for uncontrollable factors
Benefits and shortcomings of short-term financial targets
Mechanisms to over come short-term bias
Benchmarks for comparison
Bonus determination approach

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Agency theory:
It explores how contracts and incentives can be written to motivate individuals to achieve goal
congruence.
Concepts
Divergent objectives of principals and agents
Non-operability of agent’s actions
Control mechanisms
Monitoring
Incentive contracting
CEO compensation and stock ownership plans
Business unit managers and accounting based incentives
A critique

Unit objectives:
To discuss the design of incentive compensation plans for general managers
To discuss some research findings on organizational incentives
To describe the nature of compensation plans i.e., short term Incentive and long term
incentive plans
To describe how the compensation of individual’s managers is decided both at the corporate
and business unit level.
To describe the agency theory, which is an approach for deciding on the best type of incentive
compensation, plans.

MANAGEMENT COMPENSATION
We then describe the nature of compensation plans, which we classify into two types; short-
term incentive plans and long-term incentive plans. These plans must be approved by the
shareholders. Next, we describe how the compensation of individual mangers is decided, first
at the corporate level and then at the business unit level. These decisions typically are made
by the board of directors, based on recommendations of the chief executive officer. Finally,
we describe agency theory, which is an approach for deciding on the best type of incentive
compensation plan.

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CHARACTERISTICS OF INCENTIVE COMPENSATION PLANS
A manager’s total compensation packages consist of three components: (1) salary; (2) benefits
(principally pension and health benefits, but also prerequisites of various types), and (3)
incentive compensation. The compensation of managers in large companies tends to be higher
than compensation in smaller companies and compensation in one company tends to be
competitive with that of other companies in the industry, but few other generalizations can be
made about the level of management compensation.

Incentive compensation plans can be divided into (1) short-term incentive plans, which are
based on performance in the current year, and (2) long-term incentive plans, which relate
compensation to the longer-term accomplishments. Long-term plans usually are related to the
price of the company’s common stock. A manager may earn a bonus under both plans. The
bonus in a short-term plans usually is paid in cash,. And the bonus in a long-term plan is
usually an option to buy the company’s common stock.

Short –term Incentive Plans

The Total Bonus Pool. In a short-term incentive plan, shareholders vote in the formula to be
used in arriving at the total amount of bonus that can be paid to a qualified group of
employees in a given year, which is called the “bonus pool.” This formula usually is related
to the overall company profitability in the current year (in a few companies, the current
quarter.) In deciding on the size of this pool, the overriding issue is to make the total
compensation paid to executives competitive.

Several methods of establishing the bonus pool are described below.

The simplest method is to make the bonus equal to a ser percentage of the profits. -------------
million represents an average profitable year, and if a $1 million bonus fund is required to
make the executive compensation package competitive, the bonus formula then could be set
up to pay 2 percent of net income in bonuses.

One method is to base the bonus on a percentage of earnings per share after a predetermined
level of earning s per share has been attained.

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This method, however, does not take into account increases in investment from reinvested
earnings. The objection can be overcome by increasing the minimum earnings per share each
year by a percentage of the annual increase in retained earnings.

Another method of relating profits to capital employed is to define capital as shareholder

equity plus long-term liabilities. The bonus is equal to a percent of the profits before taxes and
interest on long-term debt minus a capital charge on the total of shareholder equity plus long-
term debt. Companies using this method reason that managerial performance should be based
on employing corporate net assets profitably, and since the proportion of long-term debt to
total capital is determined by financial policy. Rather than by operating mangers, this
proportion should not influence the judgment about operating performance.

Another method is to define capital as equal to shareholder equity. A difficulty with both this
and the preceding method is that a loss year reduces shareholder equity and, thereby,
increases the amount of bonus to be paid in profitable years. This might tempt management to
take a “big bath” in a year with otherwise low profits so as to make earning future bonuses
easier.

Another method bases bonuses on company profitability relative to industry profitability.

Obtaining comparable industry data may be difficult, however, because few companies have
the same product mix or employ identical accounting systems. This method also could result
in a high bonus in a mediocre year, because one or more of the industry competitors had a
poor year.

In calculating both the profit and the capital components of these formulas adjustments may
be made in the reported amount of net income and in the reported amount of net income and
in the reported amount of shareholder equity. Certain types of extraordinary gains and losses,
and gains and losses from discontinued operations may be excluded. Goodwill resulting from
acquisition of other companies may be excluded even though it is included in the published
financial statements.

Carryovers. Instead of paying the total amount in the bonus pool, the plan may provide for
an annual carryover of a part of the amount determined by the bonus formula each year a
committee of the board of directors decides how much to add to the carryover, or how much

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of the accumulated carryover to use if the bonuses would otherwise be too low. This method
has two advantages: (1) it offers more flexibility, since payment is not determined
automatically by a formula,. And the board of directors can exercise its judgments; (2) it can
reduce the magnitude of the swings that occur when the bonus payment is based strictly on
the formula amount calculated each year. Thus, in an exceptionally good year, , the
committee decide to pay out only a portion of the bonus. Conversely, in a relatively poor
year, the committee may decide to pay out more than the amount justified by current year
performance by drawing from the carryover bonus amount. The disadvantage of this method
is that the bonus relates less directly to current performance.

Deferred Compensation. Although the amount of the bonus is calculated annually, payments
to recipients may be spread out over a period of years, usually five. Under this system,
executive receive only one-fifth of their bonus in the year in which it was earned. The
remaining four-fifth are paid out equally over the nest four years. Thus, after the manager has
been working under the plan for five years, the bonus consists of cone-fifth of the bonus for
the current year plus one fifth of each of the bonuses for the preceding four years. In some
companies, the differed period is three years. This deferred payment method offers a number
of advantages.
 Managers can estimate, with reasonable accuracy, their cash income for the coming
year.
 Deferred payments smooth the manager’s receipt of cash, because the effects of
cyclical wings in profits are averaged in the cash payments.
 A manger who retires will continue to receive payments for a number of years; this not
only augments retirement income but also usually provides a tax advantage, because
income tax rates after retirement may be lower than rates during working life.
 The deferred time frame encourages longer term thinking with regard to decision-
making.

Deferree bonus plans have the disadvantage opf not making the deferred amount available to
the excecutive in te year earned. (The deffered amount may earn interest for the manger and
offset this disadvantage). Because bonus paymentsd in a year are not related to performance
in that year, they may have a lesser impact as an incentive.

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When bonus payments are deferred, the deferred amount may or may not vest. In some
instances, a manger will not receive the defecrred bonus if he or she leaves the company
before it is paid (excluding disability, death, or being laid off). This arrangement is called a
golden handcuff, because the manager who leaves voluntarily sacrifice s the deferred amount
and, therefore, is less willing to leave.

Long term Incentive Plans

A basic premise of many long-term incentive plans is that growth is the value of the
company’s common stock reflects the company’s long-run performance. There are several
types of such plans. The popularity of specific types of plans changes with, among other
factors, changes in the income tax law, changes in accounting treatments, and the state of the
stock market. Consequently, different plans are popular at different times.

Stock Options.
Options. A stock option is a right to buy a number of shares of stock at or after a given
date in the future (the exercise date), at a price agreed upon at the time the option is granted
(usually, the current market price or 95 percent of the current market price). The major
motivation benefit of stock option plans is that they direct mangers' energies toward the long-
term, as well as the short-term performance of the company. The motivational impact of such
plans is dampened to the extent that factors beyond the control of mangers affect stock prices.

Phantom Shares.
Shares. A phantom stock plan awards mangers a number of share for bookkeeping
purposes only. At the end of a specified period (say, fie years) the executive is entitled to
receive an award equal to the appreciation in the market value of the stock since the date of
award. This award may be in cash, in shares of stock, or in both. Unlike a stock option, a
phantom stock plan has no transaction costs. Some stock option plans require that the manger
hold the stock for a certain period after it was purchased, and this involves a risk of a decrease
in the market price and the interest costs associated with holding the stock. This risk and cost
are not involved in phantom stock plan.

Stock Appreciation Rights.

Rights. A stock appreciation right is a right to receive cash payments
based on the increase in the value of stock from the time of the award until a specified future
date. Both phantom shares and stock appreciation rights are a form of deferred cash bonus, in

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which the amount of bonus is a function of the market price of the company's stock. Both
these plans have the advantages of a stock option plan. As contrasted with a cash bonus paid
currently, they involve uncertainty, in both directions, about ultimate amount paid.

Performance Shares. A Performance share plan awards a specified number of shares of

stock to a manger when specific long- term goals have been met. Usually, the goals are to
achieve a certain percentage growth in earnings per share over a there- to -fie period;
therefore, they are not influenced by the price of the stock. This plan has advantages over
either the stock option or the phantom stock plan in that the award is base on performance that
can be controlled, at least partially, by the executive. Also, the award is not dependent on an
increase in stock prices, although the increase in earning is likely to result in an increase in
stock prices, although the increase in earnings is likely to result in an increase in stock prices.
This plan suffers from the limitation of basing the bonus on accounting measures of
performance: actions that corporate executives take to improve earnings per share cold, under
some conditions, not contribute to the economic worth of the firm.

Performance Units.
Units. In a performance unit plan, a cash bonus in paid on the attainment of
specific long-term targets. This plan, thus combines aspects of stock apperception rights and
performance shares. This plan is especially useful in companies with little or no publicly
traded stock. Success of this plan depends upon the careful establishment of the long-term
targets.

Types of Incentives
Some incentives are financial, others are psychological and social. Financial incentives
include salary increases, bonuses, benefits, and perquisites (automobiles, vacation trips, club
memberships, and so on). Psychological and social incentives include promotion possibilities,
increased responsibilities, increased.

Autonomy, a better geographical location, and recognition (trophy, participation in executive

development programs, and the like). In this part of the chapter, we discuss the financial
incentive for business-unit managers recognizing, however, that the motivation of managers is
influenced by both financial and no financial incentive

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Size of Bonus relative to salary
There are two basic philosophies on the issue of the mix between fixed (salary and fringe
benefits) and variable (incentive bonus) portions in the mangers total compensation. One
school states that we recruit good people, pay them well, and then expect good performance.

Another school states that we recruit good people, expect them to perform well, and pay them
well if performance is actually good (Exhibit 12-2). Companies subscribing to this philosophy
practice performance-based pay; they emphasize incentive bonus, not salary.

The fundamental difference between the two philosophies arises from fact that, under fixed
pay, compensation comes first and performance comes later; under performance-based pay,
performance comes first and compensation comes later. The two philosophies have different
motivational implications for mangers.

Cutoff Levels. A bonus plan may be constrain at either end: (1) the level of performance at
which a maximum bonus is reached (upper cutoffs); and (2) the level below which no bonus a
wards will be made (lower cutoffs). Both upper and lower cutoffs may produce undesirable
side effects. When business-unit mangers recognize that either the maximum bones has been
attained or that there will be no bonus at all, the motivational effect of the bonus system may
be contrary to corporate goals. Instead of attempting to optimize profits in the current period,
mangers may be motivated to decrease profitability in one year (by overspending on
discretionary expenses, such as advertising and research and development) to crate an
opportunity for a high nouns in the next year. Although this would affect only the timing of
expenses, such action unusually is undesirable.

One way to mitigate such dysfunctional action is to carry over the excess or deficiency into
the following year-that is, the bonus available for distribution in a given year would be the
amount of bonus earned during that year plus any excess, or minus any deficiency, form the
previous year.

BONUS BASIS
A business-unit manger's incentive bonus could be based solely on total corporate profits or
solely on business-unit profits, or on some mix or the two. The manager's decisions and
actions have a more direct impact on the performance of this or her own unit than that of other

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business units; this would argue for linking incentive bonus to business-unit performance.
However, such an approach could build walls between business units-that is, put significant
barriers against interunit cooperation.

Made for uncontrollable factor. Typically, companies make adjustment for two types f
uncontrollable influences. One type of adjustment removes expenses that are the result of
decisions made by executives above the business unit level.

Benefits and Short Coming of Short-Term Finical Targets. Linking business-unit manger's
bonus to achieving annual financial target (after making allowances for uncontrollable events)
is desirable. It induces managers to search for ways to perform exiting operations indifferent
ways and initiate new activities to meet the financial targets.

However, sole reliance on financial criteria could cause several dysfunctional effects. First
short-term actions that are not in the log-term interests of the company (e.g. under-
maintenance of equipment) may be encouraged. Second, mangers might not undertake
investments that promise benefits in the long-term but hurt short-term financial results. Third,
managers may be motivated to engage in data manipulation to meet current period targets.

Mechanisms to Overcome Short-

Short- Term Bias. If financial criteria are supplanted with
additional incentive mechanisms, this may overcome the short term orientation of annual
financial goals. One possibility is to base part of the manger's bonus on multiyear
performance (i.e., performance over a three fie- year period). Although it has the obvious
advantage of extending the time horizon of mangers, this approach has certain weaknesses.
First, manger have difficulty in seeing the connection between their efforts and rewards in
multiyear award scheme;' this lessens the motivation effect of such awards . Second, a manger
might retire or be transferred during the multiyear period thereby greatly adding to the
complexity in implementing such a plan. Third there is more likelihood that factors beyond
the control of the manger will influence the achievement of long-range targets.

Another method to correct for the inherent inadequacies of financial criteria is to develop a
balanced scorecard including one or more nonfinancial criteria such as sales growth, market
share, customer satisfaction, product quality development, personnel development and public
responsibility. Each of these factors will affect long- run profits.

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Another mechanism to correct for the short- term bias is to base part of the business-unit
manger's bonus on long-term incentive plans, such as stock options, phantom shares, and
performance shares. These plans focus the business unity mangers (a) on company wide
performance and (b) on long-term performance.

AGENCY THEORY
Agency theory explores how contracts and incentives can be written to motivate individuals to
achieve goal congruence. It attempts to describe the major factors that should be considered in
designing incentive contract. An incentive contract, as used in agency theory, is the some as
the incentive compensation arrangements discussed in this chapter. Agency theory attempts to
state these relationships in mathematical models. This introduction describes the general ideas
of agency theory without giving actual models.

CONCEPTS
An agency relationship exists whenever one party (the principal) hires another party (the
agent) to perform some service and, in so doing, delegates decision making authority to the
agent. IN a corporation, shareholders are principals, and the chief executive officer is their
agent. The shareholders hire the CEO and expect that the CEO will act in their interest. At a
lower level, the CEO is the principal, and the business- unit mangers are the agents. The
challenge becomes how to motivate agents so that they will be as productive as they would be
if they were the owners.

One of he key elements of agency theory is that principals and agents have divergent
preferences or objectives. The divergent preferences can be reduced through incentive
contracts.

Divergent Objectives of Principals and Agents. Agency theory assumes that all individuals
act in their own self- interest. Agents are assumed to receive satisfaction not only from
financial compensation but also from the perquisites.

Involved in an agency relationship. The perquisites can take the form of generous amounts of
leisure time, attractive working condition country club memberships, and flexibility in
working hours.

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Another divergence between the preferences of principals and agents is risk preferences.
Agency theory assumes that managers prefer more wealth to less, but that the marginal utility,
or satisfaction, decreases as more wealth is accumulated. Agents typically have much of their
wealth tied up in the fortunes of the firm. This wealth consists both of their financial wealth
and also of their human capital.

On the hand, the shares of stock of the company are held by many owners, who reduce their
risk by diversifying their wealth and becoming owners in many companies. Therefore, owners
are interested in the expected value of their investment and are risk neutral

Managers cannot as easily diversify away this risk, which is why the are risk averse.
Nonoabsorbability of Agent’s actions. The divergence in preferences associated with
compensation and perquisites arises whenever the principal cannot easily monitor the agent’s
actins. Shareholders are not in a position to monitor daily the activates of the CEO to ensure
that he or she is working in their best interest. Likewise, the CEO is not a position to monitor
daily the activates of business-unit managers.

Monitor. The first control mechanism is monitoring. The principle can design control system
that monitor the actions of the agent. The principal design these systems to limit action that
increase the agent’s welfare at the expense of principal’s interest. An example of a monitoring
system is the audited financial statements. Financial reports are general about company
performance, they are audited by third party, and they are then sent to the owners.

Incentive Contracting. The other mechanism that can align the interests of the principal with
those of the agent is incentives. The principal attempts to limit divergent preferences by
establishing appropriate incentive contracts that do this. The more an agent’s reared depends
on a performance measure. The more incentive there is for the agent to improve that measure.
Therefore, the principal should so define the performance measure that it furthers his of her
interest. The ability to accomplish this is referred to as goal congruence, the concept we
discussed in chapter 1. When the contract given to the agent mutates the agent to work in the
principal’s best interest, the contract is considered goal congruent

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CEO Compensation and Stock Ownership plans.
plans. As an example of the agency costs
inherent in incentive compensation, consider a company that pays its CEO a bonus in the
form of stock options. One cost is the risk-preference differences between the owners and
CEO. The agent, already risk averse, in curs additional risks when his or her pay is based on
stock price performance.

Business- Unity Mangers and Accounting-

Accounting- Based Incentives.
Incentives. The relationship between a
business- unit manger's effort and the stock price is more remote than the tie between CEO
effort and stock price. Isolating the contribution made by individual business unites to
increases in the firm's stock price is difficult. Given the remote casual tie between the
manger's effort and stock price, the business-unit manger's bonus might be based on business
nit net income. However, this incentive contract still has agency costs similar to those
discussed in the CEO stock ownership plan.

Check Your Progress Exercise

1. List the characteristics of incentive compensation plans.

2. Explain about the short-term incentives in detail?
3. Explain about the various long-term incentives in detail?
4. Describe the incentives offered to corporate officers in detail?
5. Explain the types of incentives given to business unit managers in detail?
6. List the benefits and shortcomings of short term financial targets?
7. Explain about the agency theory in detail?

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UNIT 13. CONTROLS FOR DIFFERENTIATED STRATEGIES

Contents
 Controls for differentiated strategies
 Corporate strategy
 Implications for management control
 Strategic planning
 Budgeting
 Transfer pricing
 Incentive compensation
 Business unit strategy
 Mission
 Mission and uncertainty
 Mission and time span
 Strategic planning
 Budgeting
 Incentive compensation system
 Competitive advantage
 Additional considerations
 Top management style
 Differences in management styles
 Implications for management control
 Personal vs. impersonal controls
 Tight vs., loose controls

OBJECTIVES
 To discuss the implications of different corporate strategies
 Single industry
 Related diversification
 Unrelated diversification on the design of control systems.
 To discuss the relationship between different business level strategies

147
  Different missions (Build hold harvest) and different competitive advantages low cost
and differentiation.
 To explain about the form and structure of control systems
 To discuss additional consideration involved in tailoring controls of strategies
 To discuss the implications of management style on the design and operation of
control systems

INTRODUCTION

In the first part of the chapter, we discuss implications of different corporate strategies single
industry, related diversification, and unrelated diversification on the design of control
systems. Next, we discuss the relationship between different business-level strategies different
missions (build hold harvest) and different competitive advantages (low cost, differentiation)
—and the form and structure of control systems. We then discuss additional consideration
involved in tailoring controls of strategies. Finally, we discuss the implications of
management style on the design and operation of control systems.

As we noted in Chapter 2 corporate strategy is a continuum with "single industry" strategy at

one end and "unrelated diversification" at the other end. A firm's location on the continuum
depends on the extent and type of its diversification. Different corporate strategies imply
different organization structures and, in turn, different controls. The organization structure
implications of different corporate strategies are given in Exhibit 13-1.

As a firm moves from the single industry end to the unrelated diversified end, the autonomy
of the business unit manager tends to increase for two reasons. First, unlike a single industry
firm, a senior manager of unrelated diversified firms may lack the knowledge and expertise to
make strategic and operating decisions for a group of disparate business units. Second there is
very little interdependence across business units in a conglomerate, whereas there may be a
great deal of interdependence among business units in single.

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 Exhibit 13-1 Different Corporate Strategies: Organizational Structure Implications
Single Related Unrelated
Industry Diversified Diversified
Organizational Structure Functional Business units Holding
Company
Industry familiarity High Low
of corporate management
Functional background RelEVAnt operating Mainly
of corporate management Experience Finance
(mfg. Mktg. R&D)
Decision-making authority More More
Centralized Decentralized
Size of corporate staff High Low
Reliance on High Low
internal promotion
Use of High Low
lateral transfer
Corporate Strong Weak
cultural

Industry and related diversified firms grater interdependence calls for grater top management
intervention.

Given the lower degree of involvement of corporate level management in the operation of
business units, the size of cooperate staff in a conglomerate compared with a single industry
firm of the same size-tends to below. Given the unrelated nature of its varied business units, a
conglomerate—in contrast to a single industry firm—is less likely to benefit from promoting
from within or in lateral transfer of executives from one business unit to another. Also, a
conglomerate may not have the single, cohesive, strong corporate culture that single industry
firm often has.

Implications for Management Control

Any organization—however well aligned its structure is to the chosen strategy—cannot

effectively implement its strategy without a consistent management control system. While

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organization structure defines the reporting relationships and the responsibilities and
authorities of different managers, its effective functioning depends on the design of an
appropriate control system. In this part of the chapter, we discuss the planning and control
requirements of different corporate strategies.

Different corporate strategies imply the following differences in the context in which control
systems need to be designed.
 As firms become more diversified, corporate-level managers may not have significant
knowledge and experience in the activities of the company's various business units. If so,
corporate-level managers for highly diversified firms, cannot expect to control the
different businesses based on intimate knowledge of their activities, and performance
EVAluation tends to be carried out at arm's length.
 Single industry and related diversified firms possess corporate wide core competencies
(wireless technology in case of Motorola) on which the strategies of most of the business
units are based; channels of communication and transfer of competencies across business
sunits, therefore, are critical in such firms. In contrast, in the case of unrelated diversified
firms, there are low levels of interdependence among business units. This implies that, as
firms become more diversified, it may be desirable to change the balance in control
systems from an emphasis on fostering cooperation to an emphasis on encouraging
entrepreneurial spirit.

Specific tendencies in the design of control systems corresponding to variations in corporate

strategies are given in Exhibit 13-2.

The horizontal dimension might be incorporated into the strategic planning process in a
number of different ways. First, a group executive might be given responsibility for
developing a strategic plan for the group as a whole that explicitly identifies synergies across
individual business units within the group. Second, strategic plans of individual business units
could have an interdependence section, in which the general manager of the business unit
identifies the focal linkages with other business units and how those linkages will be
exploited. Third, the corporate office could require joint strategic plans from interdependent
business units. Finally, strategic plant of individual business units could be circulated to
managers of similar business units for critique and review.

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 Exhibit 13-2 Different Corporate Strategies: Management Control Implications
Single Related Unrelated
Industry Diversified Diversified
Strategic Planning Vertical-cum- Vertical
horizontal only
Budgeting: Low High
Relative control of
Business unit manager
Over budget formulation
Importance of attached to Low High
Meeting the budget
Transfer pricing: High Low
Importance of transfer
Pricing
Sourcing flexibility Constrained Arm's-length
Market
Pricing
Incentive compensation: Financial and Primarily
Bonus criteria Non-financial Formula-based
Criteria
Bonus determination Primarily Based primarily
Approach Subjective On business unit
performance
Bonus basis Based both on
Business unit
And corporate
Performance
Budgeting: In a single industry firm, the chief executive officer may have intimate
knowledge of the firm's operations, and corporate and business unit managers tend to have
more frequent contact.

On the other hand, in a conglomerate, it is nearly impossible for the chief executive to rely on
informal interpersonal interactions as a tool of control much of the communication and
control has to be achieved through the formal budgeting system.

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Transfer pricing. Transfers of goods and services between business units are more frequent
in single industry and related diversified firms than between business units in conglomerates.
In a conglomerate, the usual transfer pricing policy is to give sourcing flexibility to business
units and to use arm's-length market prices. However, in a single industry or a related
diversified firm, synergies may be important, and business units may not be given then
freedom to make soureing decisions.

Incentive Compensation.
Compensation. The incentive compensation policy tends to differ across corporate
strategies in the following ways.
Use of formulas
Profitability measures
Business unit strategy:

In this section, we consider intrafirm differences in control systems. Diversified corporations

segment themselves business units. And typically assign different strategist to the individual
business. Many chief executive officers of multibusiness organizations do not adopt a
standardized, uniform approach to controlling their business units rather; they tailor the
approach to the strategy of each business unit.

As we stated in chapter 2, business unit strategy consists of two interrelated aspects: mission
and competitive advantage. We first discuss the control implications of these two dimensions
separately. Considering the two dimensions together poses some specific problems, which
will be discussed in the next section

Mission
The mission for existing business units could be either build, hold or harvest. These missions
constitute a continuum, with "pure build" at one end and "pure harvest" at the other end. For
effective implementation, there should be congruence between the mission chosen and the
types of controls used. We develop the control-mission "fit" using the following line of
reasoning.

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  The mission of the business unit influence the uncertainties that general managers face
and the short-term versus long-term trade-offs that they make.
 Management control systems can be systematically varied top help motivate the
manager to cope effectively with uncertainty and make appropriate short-term versus
long-term trade-offs.
 Thus, different missions often require systematically different management control
systems.

Mission and Time Span. The choice of build versus harvest strategies has implications for
short-term versus long-term profit trade-offs. The share building strategy includes (a) price
cutting, (b) major R&D expenditures (to introduce new products), and (c) major market
development expenditure. These actions are aimed to establishing market leadership, but they
depress short-term profits. Thus, many decisions that the manager of a build unit makes today
may not result in profits until some future period. A harvest strategy, on the other hand,
demands attention to task with a view to maximize short-term profits.

Strategic planning.
planning. While designing a strategic planning process, several design issues need
to be considered. There are not single answers in the se design choices; rather the answers
tend to depend upon the mission being pursued by the business unit (Exhibit 13-3)

Exhibit 13-3 Different Strategic Missions Implications for Strategic Planning Process
Build Hold Harvest
Importance of Relatively Relatively
Strategic planning High Low
Formalization of capital Less formal More formal
Expenditure decisions DCF analysis: DCF analysis:
Longer payback Shorter payback
Capital expenditure More emphasis on More emphasis on
EVAluation criteria Non-financial data Financial data
(Market share, (Cost efficiency;
Efficient use of Straight cash on cash
R&D dollars, etc.) Incremental return)
Discount rates Relatively Relatively
Low High

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Capital investment More subjective More objective
Analysis And qualitative And quantitative
Project approval Relatively Relatively
Limits at High low
the business unit level

Budgeting. Implications for designing budgeting systems to support varied missions are
contained in Exhibit 13-4. The calculation, aspects of variance analysis comparing actual
results with the budget identify variances as either favorable or unfavorable. However, a
favorable variance does not necessarily imply favorable performance; similarly, an
unfavorable variance does not necessarily imply unfavorable performance. The link between a
favorable or unfavorable variance, on the one hand, and favorable or unfavorable
performance, on the other hand, depends upon the strategic context of the business unit under
EVAluation.

A related issues is how much importance should be attached to meeting the budget while
EVAluating the business unit manager's performance.

Incentive Compensation System. In designing an incentive compensation package for

business units managers, the following are some of the questions that need to be resolved:
1. What should be the size of incentive bonus payments relative to general manager's
base salary? Should the incentive bonus payments have upper limits?
2. What measures of performance (e.g., profit, EVA, sales volume, market share, product
development) should be employed as the basis for deciding the general manager's
incentive bonus awards? If multiple performance measures are employed, how should
they be weighted?
3. How much reliance should be placed on subjective judgments in deciding on the
bonus amount?
4. With what frequency (semiannual, biannual, and so on) should incentive awards be
made?

Exhibit 13-4 Different Strategic Missions: Implications for Budgeting

Build Hold Harvest
Role of the budget More a More a

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 Short-term Control tool
Planning tool ("Document
of restraint")
Business unit manager's Relatively Relatively
Influence in preparing High Low
The budget
Revisions to the budget Relatively Relatively
During the year Easy Difficult
Frequency of informal More frequent Less frequent
Reporting and contacts On policy issues: On policy issues;
With superiors Less frequent on More frequent on
Operating issues Operating issues
Frequency of feedback Less often More often
From superiors on
Actual performance
Versus the budget
"Control limit" used on Relatively Relatively
Periodic EVAluation High (i.e., Low (i.e.,
Against the budget More flexible) Less flexible)
Importance attached to Relatively Relatively
Meeting the budget Low High
Output versus Behavior Output
Behavior control Control Control
Decisions on these design variables are influenced by the mission of the business unit
(Exhibit 13-5)

Exhibit 13-5 Different Strategic Missions: Implications for Incentive Compensation

Build Hold Harvest
Percent compensation Relatively Relatively
As bonus High Low
Bonus criteria More emphasis on More emphasis
Non-financial On financial
Criteria Criteria
Bonus determination More More
Approach Subjective Formula-base

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Frequency of Less More
Bonus payment Frequent Frequent
Competitive Advantage
A business unit can choose to compete either as a differentiated player or low-cost player. The
choice of a differentiation approach, rather than a low approach, increases uncertainty in a
business unit's task environment for three reasons.

First, product innovation is more critical for differentiation business unit than for low-cost
business units.

Second, low-cost business units typically tend to have narrow product line to minimize
inventory carry costs as well as to benefit from scale economies.

Third, low-cost business units typically produce no-frill commodity products, and these
products succeed primarily because they have lower prices than competing products.

Additional Considerations
Although differentiating controls within the same firm has a sound logic, control systems
designers need to be cognizant of several problems involved in doing so.

First, a business unit's external environment inevitably changes over time, and a change might
imply the need for a shift in strategy. This raises an interesting issue. Success at any task
requires commitment. The strategy-control "fit" is expected to foster such a commitment to
the current strategy.

Exhibit 13-6 Firs and misfits in control system design

Mission 1 2
Potential Fit
Misfit
Build

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 3 4
Harvest Fit Potential
Misfit

Low cost Differentiation

Competitive advantage

Thus, there is an ongoing dilemma: how to design control systems that can simultaneously
maintain a high degree of commitment as well as a healthy skepticism for current strategies.

Second, we have discussed mission and competitive advantage as separate characteristics.

However, business units have both a mission and a competitive advantage, which, in some
combinations, may result in a conflict regarding the type of controls to be used.

Third, explicitly differentiated controls across business units might create administrative
awkwardness and potential dysfunctional effects, especially for mangers in charge of harvest
units.
Systems designers might consider two possibilities to mitigate this problem. First , as part of
the planning process, they might consider not using such harshly graphic and negative terms
as cash cow, dog, question mark, and star but, instead, use such terms as build, hold, and
harvest. The former are "static terms that do not, in any case, indicated missions as well as
"dynamic" action oriented terms, such as build, hold, and harvest do. Second, to the extent
possible, a harvest manger should be given one or more products with high growth potential.

Finally, strategy is only one variable, albeit an important one, in influencing the choice of
controls. Top management style also has a profound impact on the design and operation of
control systems.

Top management style

The management control function in a n organization is influenced by the style of senior
management.

DIFFERENCES IN MANAGEMENT STYLES

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Managers differ in their styles. Some managers rely heavily on reports and certain formal
documents; others prefer conversations and informal contacts. Some thing in concrete terms;
others think abstractly. Some are analytical; others use heuristics. Some are friendly; others
are aloof. Some are people-oriented; others are task-oriented. Some are friendly; others are
aloof. Some are long-term oriented; others are short-term oriented. Some are "Theory Y"
(they encourage organization participation in decision making). Some place great emphasis on
monetary rewards; others place emphasis on a broader set of rewards.

Management styles are influenced by the manager's (1) background, and (2) personality.
Background includes things like the manager's age, formal education, and the manager's
experience in a given function such as manufacturing, technology, marketing, or finance.
Personality characteristics include such variables as the manager's willingness to take risks
and his/her tolerance for ambiguity.

IMPLICATIONS FOR MANAGEMENT CONTROL

The various dimensions of management style significantly influence the operation of the
control systems. Even if the same set of reports with the same set of data goes with the same
frequency to the CEO, two CEOs would use these reports very differently to manage the
business units if their styles are different.

Style affect the management control process—how the CEO prefers to use the information,
how the ECO conducts performance review meetings, and so on—which, in turn, affects the
actual operation of the control system, even if the formal structure does not change under a
new CEO. In fact, when CEOs change, subordinates typically infer what the new CEO really
wants based on how the new CEO interacts during the management control process (e.g., how
much attention he or she actually gives to performance reports, rather than from speeches or
directives).

Personal versus Impersonal Controls.

Controls. Presence of personal versus impersonal controls in
organizations is an aspect of managerial style. Managers differ on the relative importance that
they attach to formal budgets and reports, contrasted with informal conversations and other
personal contacts. Some managers are "numbers-oriented", they want a large flow of
quantitative information, and they spend much time analyzing this information and deriving

158
tentative conclusions from it. Other managers are "people-oriented"; they look at a few
numbers, but they usually arrive at their conclusions by talking with people, and they judge
the relEVAnce and importance of what they learn partly on their appraisal of the other person.
They spend much time visiting various locations and talking with both management people
and hourly employees to obtain a feel for how well things are going.

Management's attitude toward formal reports affects the amount of detail they desire, the
frequency of these reports, and even such matters as their preference for graphs, rather than
tables of numbers, or for supplementing numerical reports with written comments. Designers
of management control system need to identify these preferences and accommodate them.

Tight versus Loose Controls. A manager's style affects the degree of tight versus loose
control in any situation. The manager of a routine production responsibility center can be
controlled either relatively tightly or relatively loosely, and the actual control reflects the style
of the manager's superior. Thus, the degree of tightness or looseness often is not revealed by
the content of the forms or aspects of the formal control documents, rules, or procedures. It
depends on how these formal devices are used.
The degree of looseness tends to increase at successively higher levels in the organization
hierarchy: higher-level managers typically tend to pay less attention to details and more to
overall results (the bottom line, rather than on the details of how the results are obtained) than
lower-level managers.

The style of the CEO has a profound impact on management control.

Check Your Progress Exercise

Explain about Controls for differentiated strategies in brief?
Write a short notes on
 Corporate strategy
 Implications for management control
 Strategic planning
 Transfer pricing
 Incentive compensation
 Business unit strategy

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  Mission
 Budgeting
 Incentive compensation system
 Competitive advantage
 Top management style
Write about the Differences in management styles in different organizations?
Compare and contrast Personal vs. impersonal controls
Distinguish between Tight vs., loose controls?

UNIT 14. MODERN CONTROL METHODS

Contents
JUST IN TIME(JIT).
TIME(JIT).
Reduce buffer inventory
Decrease set up costs
Decrease procurement costs
Relation with customers
Implications for management control

OBJECTIVES

 To learn about the modern control methods

 The techniques and their advantages of different methods
 Just in time
 Total quality management:

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  Computer integrated manufacturing
 Decision support systems

 The implications of them in the management control

Total quality management:
Consequences of poor quality
TQM approach
Responsibility for quality
Product design
Relation with suppliers
Implications for management control

Computer integrated manufacturing

Computer aided design
Computer aided manufacturing
Numerically controlled machines
Robots
Automated material handling systems
Flexible manufacturing systems:
Implications for management control:
Increase in task control
Better information
More prompt information
Work teams

Decision support systems

These are the systems that aid decision making by providing the answers to a series of
what if questions.
The benefits of decision support systems
Implications for management control

INTRODUCTION

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Beginning in the early 1980s, management literature reported significant new developments
in management control techniques. (Their actual use in leading companies probably began
somewhat earlier.) In part these were consequences of the development of vastly increased
computer power. In part they were a reaction in the United States to the realization that many
companies in Japan, Germany, Sweden, and other countries were manufacturing products
with higher quality and at lower cost than their American counterparts.

Some of these practices and their implications for management control are de scribed in this
chapter.

Just-In Time (JIT)

In certain industries application of what is called the “just-in-time” (JIT) approach has
resulted in significant decreases in set up or procurement costs, and in the recognition that
carrying costs per unit are often understated. These developments result in a decrease in the
optimum lot size. At the extreme the optimum lot is one – that is, there is zero inventory, and
goods are produced or ordered only when they are needed. Hence the name, just-in-time.
just-in-time. This
extreme case is not common, but the term is a catchy way of stating the direction in which lot
size should be headed.
Cycle Time Analysis
A tool in the analysis of inventory requirements is the equation for cycle time.
Cycle time = Processing time + Storage time + Movement time + Inspection time

Only the first element, processing time, adds value to the product. The other three elements
do nothing to make the product more valuable. The analysis, therefore, attempts to identify all
activities that do not directly add value to the product and to eliminate, or reduce the cost of,
these activities. For example, the transportation of in-process work from one workstation to
another does not add value, so an effort is made to rearrange the location of workstations to
minimize transportation costs.

Just-in-Time Techniques
Reduce Buffer Inventory. Buffer inventory exists partly because manufacturing workstations
breakdown and partly because they produce defective products. When these events happen,
production in following workstations ceases unless there is an inventory on which they can

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draw – a buffer inventory. Indeed, it is said that the existence of buffer inventory causes
workstations to be less concerned about producing good products than they should be. The
amount of buffer inventory can be reduced if steps are taken to minimize machine breakdown
and improve product quality. The purpose of just-in-time is to ensure that every workstation
produces and delivers to the next workstation the right items in the right quantity at the right
time; if this purpose were achieved, there would be no need for buffer inventory.

Decrease Set-up Costs. With numerically controlled machine tools, setup involves simply
inserting a new computer program into a machine. Thus, after the computer program has
been created, the cost of setting up for all succeeding lots becomes trivial. The existence of a
computer program to control manufacturing machines decreases the cost of providing
replacement parts for discontinued models of appliances, automobiles, aircraft, and various
other types of machines. For expensive parts with low replacement demand (which are found
on ships, aircraft, heavy construction equipment, and weapons), some manufacturers now
carry no replacement inventory at all.
With smaller sizes, the scrap and rework costs resulting from a defect in a single production
run is minimized. With lower inventory, storage space is decreased, permitting plant space
top be utilized more efficiently or obviating the need for plant expansion.

Decrease Procurement Costs. Traditionally, procurement involved issuing requests for bids
from many vendors, analyzing bids, placing an order with the best (usually, the cheapest)
vendor, and receiving and inspecting the incoming goods. Some companies new reduce the
cost of each of these components by establishing relationships with one to two vendors for
each item. Instead of requesting bids for each order, they place orders with no more than
notification of how many items are needed on a certain date (or, in some cases, on a certain
hour each day). Instead of inspecting the incoming goods, they expect the vendor to inspect
them and assure that all items are of acceptable quality. These orders are often transmitted
electronically between the vendor and the manufacturer.

Relation with Customers. The other side of this coin is the practice of establishing
relationships with customers for automatic ordering. Some manufacturers have systems in
which their salespersons automatically place orders from retailers or other customers on the
basis of preset formulas that determine reorder times and quantities; this reduces the

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customers’ ordering costs and also cements a relationship between the customers and the
manufacturer. Others provide retailers with bar-coded shelf slips for each item; the rote
salesperson uses a hand-held scanner to identify the item and enters an order when the supply
falls below a preset level. Hospital supply houses provide computer programs to hospitals that
permit them to place orders without human intervention,. These systems also provide rapid,
accurate information to managers.

IMPLICATIONS FOR MANAGEMENT CONTROL

With some just-in-time systems, work-in-process inventory becomes so insignificant that it is
disregarded. The only inventories are for raw materials and finished goods; issuances from
raw materials inventory are charged directly to finished goods inventory. In effect, a job-cost
system is transformed into a process- cost system with only one cost center; this results in a
considerable reduction in record keeping. Record keeping is further reduced by the
elimination of the tedious task of calculating “equivalent production”, which is necessary to
find work-in-process inventory amounts when the inventory in a cost center consist of
partially completed products, Products are carried in inventory at standard costs, without
tracing actual costs to individual products or batches of a product.

A just-in-time system focuses management attention on time in addition to the traditional

focus on cost. A reduction in cycle time can lead to a reduction in cost. One of the effective
ways to monitor progress on just-in-time is to compute the following ratio:

Process time
Cycle time
Ideally, the goal for this ratio should be equal to 1. However, this goal cannot be achieved
overnight. The just-in-time systems not a turnkey installation; rather, it is an evolutionary
system that seeks to improve the manufacturing process continually.

TOTAL QUALITY MANAGEMENT

The Japanese have led the way in greater attention to product quality. Efforts that they
initiated and that have been adopted by many American companies are usually described
under the rubric total quality management.

TOTAL QUALITY MANAGEMENT APPROACH

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The total quality management approach is summarized below under three headings:
responsibility for quality, product design, and relations with suppliers.

Responsibility for Quality. The traditional view was that quality problems start on the
factory floor, that workers were primarily responsible for poor quality, and that the best way
to control quality, therefore, was to “inspect quality into the final product.” This required a
large quality cont0rl department. It also set up an adversarial relationship between
manufacturing personnel, whose traditional objective was to maximize output, and the quality
control staff.

The total quality control view is that responsibility for quality should be shared by everyone
in the organization; in fact, most of the quality problems arise before the product even reaches
the factory floor. Edwards Deming, after whom Japan’s Deming Prize for quality is named,
states that the production process can be separated into two parts; (1) the system, which is
under the control of management; and (2) the workers, who are under their own control. He
found that 85 percent of quality problems can be attributed to faulty systems and only 15
percent to the workers.

The system could be faulty for several reasons: designing a product that is difficult to
manufacture, procuring inferior raw materials, providing inadequate equipment maintenance,
permitting poor working conditions, and applying excessive pressure to maximize output.
Since the system is de signed by management, quality is primarily a management
responsibility, he wrote.

Under total quality management, the philosophy is to “build quality into the product”, rather
than “inspect quality of the product.” Errors in design, raw materials procurement, and so on
should be detected at the source. Workers should be held responsible for their own work and
should not pass a defective unit onto the next work station; thus the workers are their own
inspectors. Instead of inspecting product quality at the end of production, the quality control
staff should monitor the production process and enable workers to “make the product right the
first time.”

Product Design. Studies have shown that many quality problems originate with the design of
the product. Some designers pay inadequate attention to the “manufacturability” of the

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product. Others include parts that are unique to the product, whereas parts that are common
to several products would be satisfactory and are available at lower cost; or they design more
separate parts than are necessary, which gives inadequate recognition to the cost involved in
setting up machines for each part. Under total quality control, there has been an effort to have
the designers work closely with production engineers who are familiar with the manufacturing
problems.

Designing for manufacturability is one aspect of design. The other aspect of design is de
signing for marketability – that is, the quality of a product should be what the customer
wants, not more.

Relation with Suppliers. Total quality management involves a change in the traditional
relationship with suppliers, as mentioned in the preceding section. Instead of awarding
contracts to several suppliers, based primarily on which one bid the lowest price, there are
only one or two suppliers for a given item; they are selected on the basis of quality and on-
time , delivery as well as on price, and long-term relationships are established with them.

IMPLICATIONS FOR MANAGEMENT CONTROL

Companies collect non financial information about quality, including the number of defective
units delivered by each supplier, ,number and frequency of late ,deliveries, number of parts
in a product, percentage of common versus unique parts in a product, percentage yields,
first-pass yields (i.e., percentage of unit s furnished without rework) , scrap, rework,
machine breakdowns, number and frequency of times that production and delivery
schedules were not met. Number of employee suggestions , number of customer complaints
level of customer satisfaction (obtained by questionnaire surveys), warranty claims, field
service expenses, number and frequency of product returns, and son on.

There are to major advantages with these non-financial measures: (1) most of them can be
reported almost on a daily basis, (2) corrective actins can be taken almost immediately. Thus,
reporting performance on non-financial measures is essential to provide continuous feedback
to mangers and workers in their pursuit for better quality.

COMPUTER INTEGRATED MANUFACTURING (CIM)

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In petroleum refineries, chemical processing and similar processing plants, materials and
energy enter at the beginning and at various stages of the process, and finished products
emerge at the end, all without any hands-on labor and using computer integrated
manufacturing (CIM). Human beings maintain the equipment, check the quality of the
process, shut it down if it gets out of control, and bring it back into control; that is all.

Recent developments include numerically controlled machine tools, robots, and computers
that integrate the work of other computers. These have resulted in decreases in the amount of
hands-on labor, improvements in quality, reductions in paperwork, eliminations of duplicate
record keeping, the annoying inconsistencies of data among the formerly separate systems,
decreases in inventory, decreases in throughput time, and consequent decreases in productions
costs.

These systems have the common characteristics that they incorporate into a single system,
all, or at least several, of the former separate systems for product design, order processing ,
accounts receivable, payroll, ,accounts payable, inventory control, bills of materials,
capacity planning, product scheduling, and product cost accounting. A computer integrated
manufacturing system has some or all of the following components.

 Computer Aided Design (CAD): use of computers to design new products, replacing
the drafting that was traditionally done by hand, and improving the quality of the design
effort. The completed designs are converted automatically to detailed instructions for
the robots and the computers that control machine tools.
 Computer-Aided Manufacturing (CAM): use of computers to control machine tools
and the flow of materials.
 Numerically Controlled Machines: machine tools that are programmed to perform a
variety of functions (bore, drill, turn, and the like) on parts with different sizes and
shapes.
 Robots (Also called “steel-collar workers”): programmable machines with “arms”
and “legs” (and in a few cases, “eyes”) that perform a variety of repetitive tasks, such as
welding, assembly, and painting.

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  Automated Material Handling Systems: storage and retriEVAl systems that locate
materials, pick them, and move them from storage bins to the factory floor for
processing and to shipping docks for delivery to customers,. Also automated guided
vehicles that move materials automatically from one work station to the next.
 Flexible Manufacturing Systems Computer-Controlled Work Stations. Often the
machines used for producing one product or product line are grouped together in a
single location, or “cell.” They record financial and cost accounting transactions, and
they also incorporate the following types of transactions, which were previously handled
separately.

1. Logistical: order, execute, and confirm material movements.

2. Balancing: match supply of material, labor, and machines with demand.
3. Quality: validate that production is in conformance with specifications.
4. Change: Update-manufacturing information, engineering change orders schedules,
routings, standards, specifications, and bills of material.

IMPLICATIONS FOR MANAGEMENT CONTROL

1. Increase in Task Control
2. Better Information
3. More prompt Information
4. Work Teams

DECISION SUPPORT SYSTEMS

We use the term decision support systems to apply broadly to systems that aid decision-
making by providing the answers to a series of “what-if” questions. In this sense they include
expert systems, natural language systems, artificial intelligence systems, and knowledge-
based systems, although technically there are some differences among these systems.

A decision support system incorporates decision rules that presumably show how an expert in
the area would solve a problem, given a certain set of facts; these are “if-then” rules. The
decision maker answers a series of questions that provide the relEVAnt information. These
questions are asked in plain English – no knowledge of computer programming is required –
which is why they are called “natural language” programs. The computer then suggests a

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course of action. They are called decision support systems, because they help the decision
maker to arrive at a decisions; the decision maker is free to reject the computer’s
recommendation, or to modify it.

When a sound set of rules is established, the quality and ease of decision-making can be
improved, and there are usually significant savings in the time required to make decisions
without reliance on a decision support system.

IMPLICATIONS FOR MANAGEMENT CONTROL

Decision support systems may reduce the need for certain types of managers – that is, they
may convert management control activities into task control activities, They may also permit
managers to spend a larger fractions of their time on other problems.

A decision support system is a double-edged sword in so far as its users are concerned. On the
one hand, it can increase the quality of decisions and reduce (or, in some cases, eliminate) the
time required to make them. On the other hand, they permit many types of decisions to be
made by the computer or by lower-level personnel and, thus, reduce the level of expertise
required and, in some cases, eliminate jobs entirely.

Check Your Progress Exercise

Write short notes on

JUST IN TIME
TOTAL QUALITY MANAGEMENT
COMPUTER INTEGRATED MANUFACTURING
DECISION SUPPORT SYSTEMS

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UNIT 15. SERVICE ORGANIZATIONS

Contents:

Service organizations in general

Characteristics
Absence of inventory buffer
Difficulty in controlling quality
Labor intensive
Multi unit organization
Historical development
Professional organizations
Special characteristics
Goals
Professionals
Output and input measurement
Small size
Marketing
Management control systems
Pricing
Profit centers and transfer pricing

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 Strategic planning and budgeting
Control of operations
Performance measurement and appraisal
Health care organizations
Special characteristics
Difficult social problem
Change in mix of providers
Third party payers
Professionals
Importance of quality control
Management control process
Non-profit organizations
Special characteristics
Absence of the profit measure:
Contributed capital
Fund accounting
Financial accounting
Governance
Management control systems
Product pricing
Strategic planning and budget preparation
Operation and EVAluation
Government organizations:
Special characteristics
Political influences
Public information
Attitude towards clients
Red tape
Financial accounting
Management control systems
Strategic planning and budget preparation

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 Performance measurement
Merchandising organizations

OBJECTIVES

 To Describe The Management Control Process In Service Organizations

 To discuss the characteristics that distinguishes service organizations in general from
manufacturing organizations and
 To discuss the special problems that arises in professional healthcare nonprofit
government and merchandising organizations.

SERVICE ORGANIZATIONS

In Chapter we discuss the characteristics that distinguish service organizations in general from
manufacturing organizations and the special problems that arise in professional, health care,
nonprofit, government and merchandising organizations.

In this we provide insights into management control systems for service organizations.

Characteristics
For several reasons, management control in service industries is somewhat different from the
process in manufacturing companies. Some factors that have an impact on most service
industries are discussed in this section. Others, which are characteristics of certain service
industries, are discussed later. These characteristics also apply to the management control of
legal research and development, and other service departments in companies generally.

1. Absence of Inventory Buffer.

2. Difficulty in Controlling Quality
3. Labor Intensive
4. Multi Unit organizations

Professional organizations:
Research and development organization, law firms, accounting firms, health care
organizations, engineering firms, architectural firms, consulting firms, advertising agencies,

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symphony and other arts organizations, and sports organizations (such as baseball teams) are
examples of organizations whose products are professional services.

Special Characteristics
Goals. There financial goal is to provide adequate compensation to the professionals.

In many organizations, a related goal is to increase their size. In part, this reflects the natural
tendency to associate success with large size. In part, it reflects economies of scale in using
the efforts of a central personnel staff and units responsible for keeping the organization up to
date. Large public accounting firms need to have enough local offices to date. Large public
accounting firms need to have enough local offices to enable them to audit clients who have
facilities located throughout the world.
Professionals. Professional organizations are labor intensive, and the labor is of a special
type. Many professionals prefer to work independently, rather than as part of a team.
Professionals who are also mangers tend to work only part time on management activities;
senior partners in an accounting firm participate actively in audit engagements; senior
partners in law firms have clients.

Output and Input Measurement.

Measurement. The output of a professional organization cannot be
measured in physical terms, such as units, tons, or gallons. We can measure the number of
hours a lawyer spends on case, but this is a measure of input, not output. Output is the
effectiveness of the lawyer’s work, and this is not measured by the number of pages in a brief
or the number of hours in the courtroom.

Small Size. With a few exceptions, such as some law firms and accounting firms, professional
organizations are relatively small and operate at a single location. Senior management in such
organizations can personally observe what is going on and personally motivate employee.
Thus, there is less need for a sophisticated management control system, with profit centers
and formal performance report.

Marketing.
Marketing. Marketing is an essential activity in almost all organizations, however. If it can’t
be conducted openly, it takes the form of personal contacts, speeches, articles, golf, and

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similar activities. These marketing activities are conducted by professionals, usually by
professionals who spend much of their time in production work- that is, working for clients.

Management Control Systems

Pricing. The selling price of work is set in a traditional way in many professional firms. If
the profession is one in which members are accustomed to keeping track of their time, fees
generally are related to professional time spent on the engagement. The hourly billing rate
typically is based on the compensation f the grade of professional (rather than the
compensation of the specific person), plus a loading for overhead costs and profit. In other
professions, such as investment banking, the fee typically is based on the monetary size of the
security issue. In still others, there is a fixed price for the project. Prices vary widely among
professions; they are relatively low for research scientists and relatively high for accountants
and physicians.

Profit Centers and Transfer Pricing.

Pricing. Although this would seem to be a contradiction of
terms, nonprofit organizations make extensive use of profit center. Support units, such as
maintenance, information processing, transportation, telecommunication, printing, and
procurement of material and services, charge consuming units for their services. The
principles for transfer pricing are the same as for other organization.

Strategic Planning and Budgeting. In general, formal strategic planning systems are not as
well developed in professional organizations as in manufacturing companies of similar size.
Part of the explanation is that professional organizations have no great need for such a system
in a professional organization, the principal assets are people; and, although short-run
fluctuations in personnel levels are avoided, changes in the size and composition of the staff
are easier to make and are more easily reversed than changes in the capacity of a physically
consists primarily of a long- range staffing plan, rather than a full- blown plan for all aspects
of the firm’s operation.

The budgeting process in professional organizations is similar to that described budgeting

process chapter in the textbook.

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Control of operations Much attention is or should be given scheduling the time of
professionals. The billed time ratio which is the ratio of hours billed to total professional
hours available, is watched closely. If to use otherwise idle time of for marketing or public
service reasons, some engagements are billed at lower than normal rates, the resulting price
variance warrants close attention.

Performance Measurement and Appraisal.

Appraisal. As noted, at the extremes the performance of
professionals is easy to judge. Appraisal of the large percentage of professionals who are
within either extreme is much more difficult. In some situations objective measures of
performance are available the recommendations of an investment analyst can be compared
with actual market behavior of the securities the accuracy of a surgeon’s diagnosis can
verified by an examination of the tissue that was relived, and skill can be measured by the
success ratio of operation. These measures are, of curse, subject to appropriate qualifications.
In most circumstances, however, the as assessment of performance is matter of human
judgment. Superiors, peers, self, subordinates, or clients may make these judgments.
Most common are judgments made by superiors. Profession organizations increasingly use
formal system to collect performance appraisals as a basis for personnel decisions and for
discussion with the professional. Some systems require numerical ratings of specified
attributes of performance and provide for a weighted average of these ratings. Compensation
may be tied, in part, to these numerical rating. In a matrix organization, performance is judged
both by the person’s project leader and by the head of the functional unit that is his or her
organizational “ home.”

Appraisals by a professional’s peers, or by subordinates, are sometimes part of a formal

control system. In some organization individuals may be from clients are also an important
basis for judging performance, although such expressions may not be forthcoming in many
engagements

Health care organizations

Health care organizations consist of hospitals, clinics and similar physician organizations; and
medical laboratories, among others. Although they have most of the characteristics of non
profit organization, which are discussed in the next section, many of them are profit-oriented
companies.

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Special characteristics
1. Difficult social problem
2. Change in mix of providers within the overall increase in health care cost, significant
changes have occurred in the way in which health care is delivered and, hence, in the
viability of certain types of providers. Many services that traditionally were provided in
hospitals on an inpatient basis are now provide in outpatient clinics or in patient’s homes.
Entrepreneurs have entered the industry to provide these new services there also has been
a shift from small local hospitals to large regional or medical center hospitals. To remain
viable, hospitals must have the flexibility to adapt to these changes, either by vices that are
no longer profitable.
3. Third- Party Payers. The costs are met by Medicaid, absorbed by health care
providers, or paid for by the patient directly. The largest government program is
Medicare, a federal program that provides support for persons age 65 and up and for
younger persons with certain disabilities. The Medicaid program pays for services
provided to low income people; it is financed by the states within general guidelines set by
the federal government.

Professionals. The health care industry employed 3,225,000 professions (physicals, dentists,
registered nurse, and thereabouts), which was more than any other industry except education.
The management control implications of professionals are the same as those discussed in the
preceding section. Their primary loyalty is to the profession, rather than to the organization.
Departmental managers typically are professionals whose management function is only part-
time; the chief of surgery does surgery. Historically, physicians have tended to give relatively
little emphasis to cost control. In particular, there has been and impression that they prescribe
more than the optimum number of tests, partly because of the danger of malpractice suits if
they don’t detect all the patient’s symptoms.

Importance of Quality Control. The health care industry deals with human lives, so the quality
of the service it provides is of paramount importance. There are tissue reviews of surgical
procedures. Peer review of individual physicians, and, in recent years, outside review
agencies mandated by the federal government

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Management Control Process
Subject to the characteristics described above, the management control process in the health
care industry is similarly to that a nonprofit organizations, as defined in law, is an
organization that cannot distribute assets or income to, or for the benefit of, its members,
officers, of directors,. The organization can, of course compensate its employee including
officers and members, for services rendered and for goods supplied.

In many industry groups, there are both nonprofit and profit-oriented( i.e., business)
organizations. There are nonprofit and for-profit hospitals, nonprofit and for profit (“
proprietary”) school and colleges, and even for-profit religious organizations.
Special Characteristics
1 Absence of the profit Measure.The absences if a assuagement control problem
in a nonprofit organization.
2 Contributed Capital. There is only one major difference between the
accounting transactions in a business and those in a nonprofit organization; it relates to
the equity section of the balance sheet. A business corporation has transactions with its
shareholders-issuance of stock and the payment of dividends-that a nonprofit
organization doesn’t have. A nonprofit organization receives contributed capital, which
few businesses have . (In both businesses and nonprofit organizations, equity is
increased by canning income)
3 Fund Accounting many nonfat organizations use an accounting system that is
called “fund accounting. “Accounts are kept separately for several funds, each of which
is self-balancing (i.e., the sum or the debit balances equals the sum of the crudity
balances). Most organizations have (1) a general fund or operating fund, which
corresponds closely to the set of operating accounts mentioned above; (2) a plant fund
and an endowment fund, which account for contributed capital assets and equates
mentioned above; and (3) a bariety of other funds for special purposes. Others are useful
for internal control purposes. For management control purposes, the primary focus is on
the general fund.

Governance, Nonprofit organizations are governed by boards of trustees. Trustees usually are
not paid and many of them are unfamiliar with business management. Therefore, they

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generally exercise less control than the directors of a business corporation. Moreober, because
performance is more difficult to measure n a nonprofit organization than in a business, the
board is less able to identify actual or incipient problems.

The need for a strong governing board in a nonprofit organization is grater than that in a
business, because the vigilance of the governing board may be the only effective way of
detecting when the organization is in difficulty.

Management control systems

Product pricing many nonprofit organizations give inadequate attention to their pricing
policies. Pricing of services at third full cost is desirable.

A "full-cost” price is the sum of direct costs, indirect costs, indirect costs, and, perhaps; a
small allowance for increasing the organization’s equity. This principle applies to services
that are directly related to the organization’s objectives. Pricing for peripheral activities
should be market-based. Thus, a nonprofit hospital should price its health care services at full
costs, but prices in its gift shop should be market-based.
In general, the smaller and more specific unit of service that is priced, the better the basis for
decisions about the allocation of resurges. For example, a comprehensive daily rate for
hospital care, which was common practice a few decades ago, masks the revenues for the mix
of services actually provided. Beyond a certain point, of course, the cost of the paperwork
associated with pricing units of service outweighs the benefits.

As a general rule, management control is facilitated when prices are established prior to the
performance of the service. If an organization is able to recover its incurred costs,
management is not motivated to worry about cost control.

Strategic planning and Budget Preparation. In nonprofit organizations that must decide how
best to allocate limited resurged to worth while activities, strategic planning is a more
important and more time-consuming process than in the typical business.
Variations in management control

The budget preparation process is similar to that in colleges and universes, welfare
organizations, and organization in certain other nonprofit industries know, before the budget

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year begins, the approximate amount of their revenues. They do not have the option of
increasing revenues during the year by increasing their marketing efforts. They budget
experiments to the organization will at least break even at the estimated amount of revenues.
They require that managers of responsibility centers limit spending close to the budget
amounts. The budget is, therefore, the most important management control tool, at least with
respect to financial activates.

Operation and EVAluation. In most nonprofit organizations, there is no way of knowing what
the optimum operating costs are. Responsibility center managers, therefore, tend to spend
whatever is allowed in the budget, even though the budgeted amount may be higher than is
necessary. Conversely, they may refrain from making expenditures tha have an excellent
payoff simply because the expenditure as not included in the budget.

Although nonprofit organizations had a reputation for operating inefficiently, this perception
has been changing in recent year, for good reasons many organizations have had increasing
difficulty in resign funds, especially from government sources. This has led to belt-tightening
and to increased at tension to management control. As mentioned above, the most dramatic
change has been n hospital costs, with the introduction of reimbursement on the basis of
standard prices for diagnostic-related groups.

Government organizations are service are service organizations and, except for business like
activates. They are nonprofit organizations. Thus the characteristics descried above for these
organization apply to government. Their business like activates, such as electric and water
utilities, operate like their private-sector counterparts.
Special Characteristics

Political Influences. In government organizations, decisions result from multiple and often
conflicting pressures. In party, these political pressures are an inevitable-and up to a point are
a desirable- subsides for the forces of the marketplace. Elected officials cannot function if
they are not reelected, and to be reelected, they must-up to a point-advocate the perceived
needs of their constituents, even though these need may not be n the best interest of society as
a whole. These conflicting pressures result in less than optimum decisions.

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Public information. In a democratic society the press and public believe that they have a right
to know everything there is to know abut a government organization. In the federal
government and in some states, this feeling is recognized by freedom of information statues,.
Channels for distributing this information may be biased, some media stores that describe
mismanagement tend to be exaggerated and to give inadequate resolution to the fact that
mistakes are inevitable in any organization. To reduce opportunities for unfavorable media
stories, government managers take steps to limit the maybe if sensitive, control system this
lessens the effectiveness of the system.

Attitude toward clients. For-profit companies and many nonprofit organizations are client
supported-that is, they obtain their revenues from clients. Additional clients mean additional
revenues, so these organizations welcome actual and potential clots and tart them well. Most
government organizations are public supported; they obtain their revenues from the general
public To them, additional clients are a burden, to be accepted with misgivings, because they
create an additional demand for a fixed amount of service capacity. Although this tendency
may be mitigated by the professional’s desire to a good job, it nevertheless exists and results
in well-known complaints about poor service and the surly attitude of “bureaucrats”
Red Tape.
The government, Especially the federal government, has promulgated huge and increasing
numbers of rues and regulations. Some of these are necessary every Internal Revenue service
examiner should use the same rules in resolving income tax issues. Other are reactors to
minor misdeeds that become highly publicized.

Management Compensation.
Managers and other professionals in government organizations tend to be less well
compensated than their counterparts in business. This results from a populist perception on
the part of the general public-feeling that “one person is as good as another” __ which, in turn,
influences legislators. Consequently, the best managers do not go into public service (unless
they have acquire wealth form other sources). There are exceptions to this generalizations.

Management Control System

Strategic planning and Budget preparation.

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Strategic planning is especially important in government organization. Managers and
legislators must make difficult decisions about the allocation of resources. Some of these
decisions reflect political pressures. Others, however, are the results of sophisticated analyses.
Especially in the federal government, benefit/ cost techniques are more highly developed and
more skillfully applied than in most business organizations. Until the 1960s, the process was
informal; but, with the development of the planning-programming-Budgeting system (PPBS)
in the federal government, it has become increasing formalized. The annual budget process is
an extremely important control device in government, as it in other nonprofit organization.
Performance Measurement,
Measurement, Income is the difference between revenues and expenses.
Expenses can be measured approximately as accurately in government organizations an in
business (although, currently the accounting systems in most government organizations do not
do a good job of this). Revenue is not a measure of out put in government organizations,
however, In the absence of this monetary measure, government have developed momentary
indicators, These measures can be classified in various ways. One classification based on
what they purport to measure is (1) results measures, (2) process measures, and (3) social
indicators.

Merchandising organizations
Retailers, distributors, wholesalers, and similar organizations usually are not classified as
service organizations; however, they obviously are not manufacturing organizations either.
To avoid omitting them entirely, they discussed briefly in this section.
Unlike service organizations, inventory is important in merchandising organization. Indeed,
department heads in these organization usually are called “buyers”, rather than “managers,”
which indicates the importance of the procurement function. A principal control device is
open to buy, which is the maximum amount that the buyer can have in inventory and on order
at and time. Control of working capital is especially important in merchandising companies.
Many companies reduce inventories by systems that automatically place orders with vendors
when an item reaches a reorder point. Receivables have greatly decreased in sized because
credit sales are now handled largely by credit-card companies.
For retailers, sales (or gross margin) per foot of shelf space of per square foot of showroom
space is an important control device. Similar products from different manufacturers must

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complete with one another for scarce space. Merchandising industries have well-developed
management control systems. Although we have tended to emphasize techniques in
manufacturing companies, similar techniques have been used for many years in
merchandising companies. Furthermore, trade associations and private organizations have
developed systems for collecting information on revenues, costs, and other elements , which
are useful in comparing one company’s performance with averages in the industry

Check Your Progress Exercise

Write about the special characteristics of the
A) Service organizations in general
B) Professional organizations
C) Healthcare organizations
D) Non profit organizations
E) Government organizations
F) Merchandising organizations
What types of management control systems are to be maintained in the service organizations
in general?
UNIT 16. MANAGEMENT CONTROL OF PROJECTS

Contents
16. 0 Aims and Objectives
16.1 Introduction
16.2 Nature of the Projects
16.3 Distinction Between Project Control and Ongoing Operation Control
16.4 The Project Control Environment:
16.5 The Steps in the Project Control
16.5.1 Project Planning
16.5.2 Project Execution
16.5.3 Project Evaluation

16.0 AIMS AND OBJECTIVES

When you have studied this chapter, you should be able to:

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  Understand what the projects are,
 To know the process of management control in projects
 To know the how the control of projects differ from regular operations
 To discuss the nature and scope of the projects
 To understand the environment of the control of projects

To discuss about the various steps of project control

This chapter is concerned with the process that is used in management control of projects.
After, it discusses the nature of the projects and how the management control process for
projects differs from the control of ongoing operations. And the environment of project
control and the steps in the project control.

16.2 NATURE OF THE PROJECTS

Definition:
A project is a set of activities intended to accomplish a specified end result of sufficient
importance to be of interest to management.
The types of projects include:
 Construction projects
 The production of unique product
 Re arrangement of plant, developing and marketing a new product
 Consulting engagements
 Audits
 Acquisitions and mergers
 Financial restructuring
 Installation of cost accounting systems
 Development and Installations of accounting or management information systems

Normally the project starts when the management ha approved the project in general and has
allocated a certain amount of resources for the first phase of that project and normally ends
when its objectives has been accomplished or when it has been dropped or cancelled

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Nature
The projects are different from ongoing operations. For example, the construction of the
building is a project whereas the maintenance of the building is a regular ongoing operation.
Some times, the project after completion, may lead to an ongoing operation.

Projects vary greatly depending on the size and the amount of resources consumed by it.
Projects may be simple or complex. The simple project may be the audit of a small business
firm by the auditors for a particular year. The complex project may be to launch a satellite in
the sky.
However, the natures of these problems and of the appropriate management control systems
more or less are similar for all the projects irrespective of their size and variations.

Characteristics of the projects:

(Distinction between project control and ongoing operation control)

Single Objective
A project has normally a single objective whereas the ongoing activities have multiple
objectives the decisions in the case of projects are made only for and up to the end of the
projects. And also its performance is judged mainly in terms of the end product.
Organization structure
The projects may be operated as independent form the organization routine activities and as
apart of the ongoing activities. The organization structure for project management will depend
on the situation in which the projects are implemented.

Focus on the project

Project control focus on the project, within time and cost constraints in contrast the
management control of ongoing activities tends to be on cost, with control of quality and time
on exception basis

Need for trade offs

The projects time can be reduced either reducing the scope of the project or incurring
overtime costs and vice versa. The trade offs between scope, schedule and costs are present in
case of projects rather than in ongoing activities.

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Standards are not reliable
Many projects are sufficiently different from previous projects and the performance standards
tend to be less reliable for projects than for ongoing operations.

Frequent changes in plans

Plans for projects tend to be changed frequently and drastically. Unforeseen conditions,
environment, the results of execution of initial stages of the projects may be the reasons for
the frequent changes in plans for the projects

Ups and downs in activity level

Most projects start small, build up to a peak activity and then taper off as completion nears
and only the finishing needs to be done. Normally ongoing activities tend to operate at the
same activity level for a considerable time and then to change in either direction, from that
level to another.

Greater influence of the environment

Projects are subject to the greater influence of external environment compared to the influence
of internal environment of ongoing operations.

Exceptions to the above

All the projects may not have all the characteristics discussed above; there may be certain
situations where there are deviations. Some of them may be applicable some may not,

16.4 THE PROJECT CONTROL ENVIRONMENT

Project organization structure

A project is a temporary organization. A team is assembled for running the projects and the
team is disbanded when the project comes to an end. The team may consists of
Employees of sponsoring organization
Hire for the specific purpose
Some of them may be under a contract with an outside organization.

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If the members of the project team are employees of the sponsoring organization, they have
two bosses such an arrangement is called a matrix organization.
Different types of managers and management methods are necessary at various stages of the
projects

In the planning stage, architectures, cost accountants, engineers predominate, in execution

stage, the production managers and in the final stage, marketing managers required getting the
acceptance of the sponsor,

Contractual relationships
The form of the contractual arrangement has an important impact on management control
contracts are of two types:

Fixed price and cost reimbursements contracts with many variations within each type.
On contract model may be used for the whole project or instead, Different types of contracts
may be used for different activities on the project as per the mutual understanding between the
executor and the sponsor.

Information structure
In project control system, information is structured by elements of the project. The smallest
element is called a work package and the way in which these work packages are aggregated is
called the work break down structure.

A work package is a measurable increment of work with an identifiable completion point,

which is called milestone. Each work package is the responsibility of a single manager. If the
project has similar work packages, each work package should be defined in the same way to
facilitate comparison.

For administrative and support activities the cost accounts are established, unlike the work
packages, these activities have no defined output.

If during the project it turns out hat the work breakdown structure or the accounting system is
not useful it should be revised. Revising the information structure in midstream is a difficult,
time consuming frustrating task. To avoid this work, the project planners should give

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considerable attention, before the project starts, to designing and installing a sound
management control system.

The steps in the project control: Project planning:

The planning process is itself a sub project within the overall project
There should also be a control system to insure that the planning activities are properly carried
out. In the planning phase the project planning team takes as a starting point the rough
estimates that were used as the basis for decisions to undertake the project. It refines these
estimates into detailed specifications for the products, detailed schedules and a cost budget. It
also develops a management control system and underlying task control systems and an
organization chart.

In case of complex project, there is plan for planning, that is a description of each planning
task, who is responsible for it, when it should be completed and the interrelationships among
tasks.

The first plan consists of three related parts:

Scope
Schedule
Cost
The scope part states the specifications of each work package and the name of the person or
organization unit responsible. It should as far as possible brief and general. The schedule part
states the estimated time required to complete each work package and the interrelation ships
among work packages. The set of these relationships are arranged in the form of networks.

Costs are stated in the project budget. These are shown only in AGGREGATES, breakups
will be provided only when convenient and necessary.

Resources to be used in individual work packages are stated in non- monetary amounts such
as man days, cubic yards of concrete etc.,

The control budget is prepared close to the inception of the work, allowing just enough time
for approval by decision makers prior to the commitment costs.

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The control budget is an important link between planning and the control of performance. It
represents both the sponsors’ expectations about what the project will cost and project
manager’s commitment to carryout the project at that cost.

During the planning phase, other activities are performed, material is ordered, permits are
obtained, preliminary interviews are conducted, personnel are selected and so on. All these
activities must be controlled and integrated into the overall effort.

Project Execution
Execution is concerned only to follow the planning. In the execution stage, the sponsor and
the project manager are concerned with the following questions:
1. Is the project going to be finished by the scheduled completion date?
2. Is the completed work going to meet the stated specifications?
3. Is work going to be done within the estimated cost?
If, during the course of the project the answer to these on of these questions is no, the sponsor
and the project manager need to know why and they need to know the alternative courses of
action. And these three questions are to be considered together than separately from one
another.

In execution process, the managers, in order to keep the things under control, need three types
of reports

Troubles reports, which report on the trouble that had happenend aswell, the likely
troubles in future execution period.

It is important that these reports are in time so that the appropriate manager can take the
corrective action.

The reports may take several forms such as Face to face conversation, Telephone, Of
facsimile and normally reported vaguely, and if the matter reported is significant then they
may also be provided in the written form. the managers have to decide the priority of the
troubles from these reports The managers has to decode which problems get his attention,
which will be delegated to some one else, and which will be disregarded on the premise that
operating managers will take the necessary corrective action.

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Progress reports
Which report about the progress of the project in implementation, in this report, variances
associated with price, schedule delays and similar factors may be identified and measured
quantitatively using techniques for variance analysis that are similar to those used in the
analysis of ongoing operations.

Financial reports
Which are accurate reports of project costs that must be prepared as the basis for progress
payments as per contractual arrangements. However, these reports are less important for
management control purposes than the cost information contained in the progress reports.

Project EVAluation
The EVAluation of the project has two separate aspects
1. EVAluation of performance in executing the project which is carried out shortly after
the project has been completed and
2. An EVAluation of the results obtained from the project, which may not be feasible for
several years
The EVAluation fo the performance in executing the project has two aspects
1. An EVAluation of the project management to assist in decisions regarding the project
managers including rewards, promotions, constructive criticism or reassignment.
2. An EVAluation of the process of the management to discover better ways of
conducting future projects
The EVAluations may be formal or informal a formal EVAluation is a worthwhile for it
identifies the techniques that will improve performance on future projects. EVAluation of the
project is more subjective than EVAluation of production activities. While EVAluating the
performance of projects, the effect of external performance must be taken into account.

The success of a project cannot be EVAluated until enough time has elapsed to permit the
measurement of its actual benefits and costs for this may take several years. For many
projects, EVAluation of results is complicated by the fact that the expected benefits were not
stated in objectives, measurable terms, and the actual benefits were also not measurable.

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SUMMARY
The most important difference between the management control over ongoing operations and
the management control of projects is that ongoing operations continue indefinitely, where as
the projects will end.

The elements in the management control of operations recur:

One leads to the next in a prescribed way and a prescribed time. Although some operating
activities change to one month to next, many of them continue relatively unchanged, m0nth
after month. Even year after year.

By contrast, a project starts, moves forward from one milestone to the next, and then stops.
During its life, plans are made, they are executed, and the results are EVAluated. The
EVAluations are made at regular intervals, and this may leads to revision of the plan.

Key Points

 A project is a set of activities intended to accomplish a specified end result of

sufficient importance to be of interest to management.
 Normally the project starts when the management has approved the project in general
and has allocated a certain amount of resources for the first phase of that project and
normally ends when its objectives has been accomplished or when it has been dropped
or cancelled
 The projects are different from ongoing operations..
 Some times, the project after completion, may lead to an ongoing operation.
 Projects vary greatly depending on the size and the amount of resources consumed by
it.
 Projects may be simple or complex.
 However, the nature of these problems and of the appropriate management control
systems more or less are similar for all the projects irrespective of their size and
variations.

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 Characteristics of the projects:
o Single objective
o Organization structure
o Focus on the project
o Need for trade offs
o Standards are not reliable
o Frequent changes in plans
o Ups and downs in activity level
o Greater influence of the environment
o Exceptions to the above
 A project is a temporary organization. A team is assembled for running the projects
and the team is disbanded when the project comes to an end. The team may consists of
 Employees of sponsoring organization
 Hired for the specific purpose.
 Some of them may be under a contract with an outside organization.
 The form of the contractual arrangement has an important impact on management
control contracts are of two types: Fixed price and cost reimbursements contracts with
many variations within each type.
 In project control system, information is structured by elements of the project. The
smallest element is called a work package and the way in which these work packages
are aggregated is called the work break down structure.
 A work package is a measurable increment of work with an identifiable completion
point, which is called milestone.
 the project planners should give considerable attention, before the project starts, to
designing and installing a sound management control system.
 The planning process is itself a sub project within the overall project
 In case of complex project, there is plan for planning, that is a description of each
planning task, who is responsible for it, when it should be completed and the
interrelationships among tasks.
 The first plan consists of three related parts:

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 o Scope
o Schedule
o Cost
 During the planning phase, other activities are performed, material is ordered, permits
are obtained, preliminary interviews are conducted, personnel are selected and so on.
All these activities must be controlled and integrated into the overall effort.

 Execution is concerned only to follow the planning. In the execution stage, the sponsor
and the project manager are concerned with the following questions:
o Is the project going to be finished by the scheduled completion date?
o Is the completed work going to meet the stated specifications?
o Is work going to be done within the estimated cost?

 In execution process, the managers, in order to keep the things under control, need
three types of reports
o Troubles reports,.
o Progress reports.
o Financial reports
 The EVAluation of the project has two separate aspects
 EVAluation of performance in executing the project which is carried out shortly after
the project has been completed and
 An EVAluation of the results obtained from the project, which may not be feasible for
several years
 An EVAluation of the process of the management to discover better ways of
conducting future projects
 The success of a project cannot be EVAluated until enough time has elapsed to permit
the measurement of its actual benefits and costs for this may take several years.

Check Your Progress Exercise

1. Define project?

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 2. List the characteristics of the projects?
3. Differentiate the projects from ongoing operations in the management control process?
4. Discuss about the project control environment?
5. Explain the steps in the project control process.?
6. Write a shot notes on
 Project planning and its nature
 Project execution
 Project EVAluation.

Question bank
SUBJECT: MANAGEMENT CONTROL SYSTEMS
SHORT ANSWER QUESTIONS

1. CORPORATE LEVEL STRATEGY

2. MANAGEMENT CONTROL SYSTEM
3. GOAL CONGRUENCE
4. NONFINANCIAL OBJECTIVES OF THE COMPANY.
5. RESPONSIBILITY CENTRES.
6. INCOME SUMMARY STATEMENT OF A PROFIT CENTRE.
7. EVA VS ROI
8. STRATEGIC PLANNING POCESS.
9. TYPES AND PURPOSES OF BUDGET.
10. LIMITAAITONS OF VARIANCE ANALYSIS.
11. JUST IN TIME. (JIT)

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 12. TOTAL QUALITY MANAGEMENT (TQM)
13. COMPUTER INTEGRATED MANUFACTURING(CIM)
14. DECISION SUPPORT SYSTEM(DSS)
15. MCS IN PROFESSIONAL ORGANISAIONS
16. MCS IN NON GOVERNAMENTAL ORGANISATIONS
17. MCS IN HEALTH CARE ORGANISATIONS
18. METHODS OF TRANSFER PRICING.
19. VALUE CHAIN ANALYSIS
20. BCG (2X2) MATRIX
21. EFFICIENCY AND EFFECTIVE NESS
22. CONTROLLABLE PROFIT.
23. GE / MCKINSEY (3X3) MATRIX
24. ABC ANALYSIS.
25. MBO
26. OPERATING BUDGET
27. STATEMENT OF ANALYSIS OF VARIANCE.
28. FACTORS AFFECTING THE CHOICE OF TIGHT VS LOOSE CONTROLS.
29. INTERAC TIVE CONTROLS.
30. LONGTEM INCENTIVE PLANS.

SECTION –2

1. DEFINE MCS? EXPLAIN THE BOUNDARIES OF MANAGEMENT CONTROL.

HOW IS IT RELATED TO MANAGEMENT ACCOUNTING AND INTERNAL
AUDITING.
2. .DISTINCTION BETWEEN STRATEGY FORMULATION AND TASK
CONTROL.
3. EXPLAIN THE CORPORATE LEVEL STRATEGIES AND BUSINESS UNIT
STRATEGIES.
4. EXPLAIN THE CONCEPT OF GOALS AND LIST THE GOALS OF THE
ORGANISATION.

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5. EXPLAIN ABOUT THE INFORMAL FACTORS THAT INFLUENCE GOAL
ONGRUENCE PROCESS.
6. DEFINE PROFIT CENTRES AND ALSO LIST THE ADVANTAGES AND
DIFFCULTIES WITH PROFIT CENTRES.
7. WHAT ARE THE OBJECIVES OF TRANSFER PRICING AND EXPLAIN THE
METHODS OF TRANSFER PRICES IN DETAIL.
8. DEFINE STRATEGIC PLANNING. EXPLAIN THE NATURE OF STRATEGIC
PLANNING AND IT S RELATION TO STRATEGIC FORMULATION AND LIST
THE BENEFITS AND LIMITAIONS OF SP.
9. EXPLAIN THE TECHNIQUES OF ANALYSING
a. PROPOSED PROGRAMMES
b. ONGOING PROGRAMMES
10. DEFEINE BUDGET. DISCUSS THE NATURE OF THE BUDGET. AND
EXPLAIN ITS RELATIION TO STRATEGIC PLANNING AND FORECASTING.
11. WHAT ARE THE USES OF BUDGET AND EXPLAIN THE DIFFERENT TYPES
OF BUDGET.
12. EXPLAIN THE BUUDGET PREPARATION PROCESS.
13. EXPLAIN THE INTERACTIVE CONTROLS AND ITS CHARACTERISTICS
AND OBJECTIVES
14. EXPLAIN THE STEPS IN IMPLEMENTING BALANCED SCORECARD
APPROACH.AND LIST THE PITFALLS OF THE BALANCED SCORE CARD
APPROACH.
15. EXPLAIN DIFFERNET TY PES OF INCENTIVE PLANS.
16. EXPLAIN THE AGENCY THEORY OF MNAGEMENT CONTROL.
17. WRITE ABOUT THE PROJECT CONTOL ENVIRONMENT
18. EXPLAIN THE PROJECT CONTROL POCESS.
19. DEFINE PROJECTS AND NATURE OF PROJECTS IN RELATION TO MCS.
20. WHAT ARE THE CHARACTERISTICS OF SERVICE ORGANISATIONS IN
GENERAL?

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