BABASAHEB GAWDE INSTITUTE OF MANAGEMENT STUDIES

MANAGEMENT CONTROL SYSTEM

SEMESTER IV

SUBMITTED TO: PROF. GANACHRI

Group member
Nitin mankeForum parmarPrkash thakkarAlok avasthiRitesh shirsat47 50 59 61 102

Q1. What are transfer pricing and its objectives? When market based transfer prices are most appropriate? Definition: Transfer Pricing  A transfer price is the internal price charged by a selling department, division, or subsidiary of a company for a raw material, component, or finished good or service which is supplied to a buying department, division, or subsidiary of the same company.  Transfer pricing refers to the setting, analysis, documentation, and adjustment of charges made between related companies for goods, services, or use of property including intangible property.  The concept of transfer pricing is fundamentally aimed at stimulating external market conditions within the organization so that the managers of individual business units are motivated to perform well.

Objective of Transfer Pricing:

y It should provide unit with the relevant information it needs to

determine the optimum trade-off between company cost and revenues. y It should bring goal correspondence decision i.e., the system should be designed so that decision that improve business unit profit will also improve company profits. y It should help to measure the economic performance of the individual business units. y The system should be simple to understand and easy to administer. Thus, from the objective, it is understandable that the Transfer price is mainly transferring of goods and services from one unit to another where much important is not given to accounting basis but also to all other effect.

Methods of Transfer Pricing

Market-based Transfer Pricing y When the outside market for the good is well-defined, competitive, and stable, firms often use the market price as an upper bound for the transfer price. y When the outside market is neither competitive nor stable, internal decision making may be distorted by dependence on market-based transfer prices. Negotiated Transfer Pricing y The firm does not specify rules for the determination of transfer prices. Divisional managers are encouraged to negotiate a mutually agreeable transfer price. Cost-based Transfer Pricing y In the absence of an established market price many companies base the transfer price on the production cost of the supplying division.

When market based transfer price are more appropriate?

y Microeconomic theory shows that when divisional managers attempt to

maximize divisional profits, a market-based transfer price supports their incentives with owners incentives of maximizing overall corporate profits. y Market based transfer price appropriate, if the selling profit center can sell all of its product to either insider or outsider and if the buying center can obtain all of its requirement from either outsider or insider. y The market price represent the opportunity cost to the seller of selling the product inside. This is because if the product were not sold inside ,it would be sell outside . y From company point of view , the relevant cost of the product is the market price because that is the amount of cash that has been forgone by selling inside .

Other situation market based transfer price are more appropriate :Competent people:Manager should be interested in long-run as well as the short-run performance of their responsibility center. Good Atmosphere:Manager must regard profitability, as measure in their income statement , as an important goal and a significant consideration in the judgment of their performance. Freedom to source:Alternative source should exist, and manager should be permitted to choose the alternative that is in their own best interests. The buying manger should be free to buy from outside, and selling manager should be free to sell outside. In this circumstance, the transfer price policy simply gives the manager of each profit center the right to deal with either insider or outsider. The market thus establishes the transfer price. Full information:Manager must know about available alternatives and relevant cost and revenues of each. Negotiation:There should smoothly working mechanism for negotiating contract between business units.

Q2. What do you understand by investment centre? Explain 2 different methods by which the performance of this canters are measured. Also discuss their advantages and disadvantages

Investment centre
y It is a classification used for business units within an

enterprise. y The essential element of an investment center is that it is treated as a unit which is measured against its use of capital.

y Mantra to govern investment centre is

Profitable the case then invest else disinvest.

Objective:
y To make sound investment decision y Covers responsibilities of all the other responsibility centers y It is concerned with the profit earned against the assets employed y It is interested in earning profit and using the assets at its disposal

in most effective manner

Investment centre relation with other centre:

Task - Effective utilization of factor

Investment centre

Profit centre

Task- Earn Profit

Revenue centre
Task- Generate sales

Cost centre
Task- control costs

EXAMPLE

Formal relationship possibleProfits earned are related to Capital employed

Inputs (Money invested in carrying out the task)

Task/Work

Outputs (Money Profits earned)

To successful implement an investment centre controller must deliberate on following considerations/issues

Decision rights need to be granted to centre manager about Input mix Labour, material, supplies Product mix Selling price Capital investment Performance measure to be used Actual ROI Actual Residual income i.e. EVA Actual ROI and RI in comparison with budgeted ROI Typically used when Responsibility centre manager has knowledge about correct price/quantity Responsibility centre manager has knowledge to select optimal product mix

Performance measures for Investment Centre

ROI
y It is the profitability ratio

EVA
y It emphasizes the net present

which relates the profits to the investment. y Investment in turn represents the assets based utility by the unit to earn the profit.

value concept in performance evaluation over accounting standards. y It looks mare to long tern then short term decisions.

3. What do you understand by non-profit organization? How do these organizations price their products? What criteria are used to measure their performance?

y Non profit organization (NPO) is refers to an organization that

uses surplus revenues to achieve its goals rather than to distribute them as profit or dividends.
y A non-profit company is like any other Company. There is only

one important difference. It is not supposed to make profits. In other words, it does not exist for commercial gain.
y While Non-profit organizations are permitted to generate

surplus revenues they must be retained by the organization for its self-preservation, expansion, or plans.

Characteristics of Not-for-profit organizations (NPOs)

y The objective of such organizations is not to make profit but to

provide service to its members . y The main source of income is admissions fees, subscriptions, donations, grant-in-aid, etc. y They also prepare their accounts following the same accounting principles and systems that are followed by business for profit organizations that are run with an objective to earn profits.

PRODUCT PRICING
y A full cost price is sum of direct cost, indirect cost and perhaps a

small allowance for increasing the organization equity. This principle is applies to services that are directly related to the organization objective. Pricing for peripheral activity should be market based. Thus a NP hospital should price its health care services at full cost.

Measurement of NPO Performance

y The best indicators of the performance of a NPO are generally

not measurable in rupee (currency) terms, though rupee is the language of financial reporting. It, thus, follows that it is more difficult to measure performance in a Not-For-Profit Organization than in a for-profit organization.
y Indeed the research shows that most NPOs are attempting results

measurement of some type, but all are struggling with developing quantitative measures to track their works impact on their mission.

4. Explain the element of control and how each element is helping the management control, with diagram.

y An organization must also be controlled; that is, devices must be

in the place to ensure that is strategic intentions are achieved. But controlling the organization is much more complicated than controlling a car.

Element of control system:

y Every control system has at least four elements:
Control device 2. Assessor- comparison with standard

1. Detector- information about what is happening 3. Effectors- behavior alteration, if needed

Entity being controlled

y A detector or sensor- a device that measures what is actually

happening in the process being controlled. y An assessor- the device that determine the significance of what is actually happening by comparing it with standard or expectation of what should happen. y An effector a device (often called feedback) that alter the behavior if the assessor indicates the need to do so. y A communication network- device that transmit information between the detector and assessor and between the assessor and the effector.

Steps in control system

Short Note:

Balance scorecard Interactive control Internal control

Balance scorecard
y Balanced Scorecard (BSC) is a performance management tool y Comprehensive view

Implementing a Balanced Scorecard

We can summarize the implantation of a balanced scorecard in four general steps; 1. Define strategy. 2. Define measure of strategy. 3. Integrate measures into the management system. 4. Review measures and result frequently. Each of these steps is iterative, requiring the participation of senior executive and employees throughout the organization

Difficulties in implementing Balanced Scorecard

The following problems unless suitably dealt with, could limit the usefulness of the balanced scorecard approach:
y Poor correlation between nonfinancial measures and result. y Fixation on financial result. y No mechanism for improvement. y Measures overload.

Interactive control

Internal Control
y Internal control is the process designed to ensure reliable

financial reporting, effective and efficient operations, and compliance with applicable laws and regulations. y internal control objectives relate to the reliability of financial reporting, timely feedback on the achievement of operational or strategic goals, and compliance with laws and regulations. y Roles and responsibilities in Internal Control Management Board of Directors Auditors y Limitations

Case Study

North Country Auto

Background
y Five Departments i.e. the new cars sales and used cars

sales, service, parts, body shop and oil change operated as part of one business. y New leader assumed that the existing compensation system not enough for motivating the employees. y He developed a system for so that each department will be treated as decentralized profit centers to track the departmental performance effectively.

Background
y This new system requires that cost be broken down per

department. Also, the bonuses per each department head will be based on departmental gross profits. y Earlier the Department Managers were paid salaries and a year-end bonus from Company profits. y Issues of setting of transfer prices and allocation of costs and profits between departments, as well as intercompany transactions, the divisional structure (use of profit or cost center), and the proper allocation of company profits.

Issues
Problem y The different departments of North Country Auto, must choose between three pricing systems: base on market price, full retail better than others, and based on book value. y Also, the company must decide whether they should continue treating each department independently in order to gain huge profits considering that the managers incentives are determined upon the departments earnings.

Executive Summary
y North Country Auto Inc. was restructured by George

Liddy so that each department will operate as an independent profit center. y However, a recent new car purchase sparked friction and disagreements among division heads on setting of transfer prices and allocation of costs and profits. y Issues that needed to be resolved include setting of transfer prices between departments, formalizing intercompany transactions, the divisional structure (use of profit or cost center), and the proper allocation of company profits among departments.

Solution
Return On Sales: y A ratio widely used to evaluate a company's operational efficiency. ROS is also known as a firm's "operating profit margin". It is calculated using this formula: = Net income before interest and tax / sales

Return On Sales
y This measure is helpful to management, providing insight

into how much profit is being produced per dollar of sales. y As with many ratios, it is best to compare a company's ROS over time to look for trends, and compare it to other companies in the industry. y An increasing ROS indicates the company is growing more efficient, while a decreasing ROS could signal looming financial troubles. y In some instances, a low return on sales can be offset by increased sales.

Hybrid Transfer Pricing

y A hybrid transfer-pricing system would be the best system

to implement. y Since the departments rely on each other to maximize efficiency, it seems unfair to charge full retail price within your own organization. y Furthermore, some of the departments (service) have a higher standard profit margin, on average, then some of the other departments (sales).

Recommendation
y Incentives should be based on company profits. y A better system should be established such that managers of the

two departments are given incentives based not on the gross profits of their respective departments but on the profits of the company as a whole. y This would help ensure that conflicts of the two departments will be lessened and that the two departments will no longer compete but will work together to enrich the value of the firm. y Here we can use return on sales ratio to determine the effectiveness of respective departments. This will be enough for Mr. Liddys expectations and it will solve any inter-departmental conflict too.

Thank you