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Management control system

Management control system

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Management control system

  1. 1. 1 Management Control System MMS-IV Manjiri Dighe
  2. 2. 2 Elements of management control system Strategic Planning, Budgeting, Resource Allocation, Performance Measurement, Evaluation And Rewards, Responsibility Center Allocation And Transfer Pricing
  3. 3. 3 Introduction  Emergence / Development of Strategy  Execution or implementation of strategy  Basic Concepts:  Control: Detector: info about what is happening Assessor: Comparison with standard Effector: Behavior Alteration, if needed Control Device Entity being Controlled
  4. 4. 4 Contd..  Jungle law / Nature’s Law- climatic changes  Body temperature: self regulating  AC Thermostat  Automobile driver: no certainty, no automatic control  Steps in control process:  Setting standards  Measuring performance  Correction of deviation
  5. 5. 5 Contd..  Management:  Common goal  Management control Different from normal control • Standard is not reset, but a result of a conscious planning process. Involves both planning and control • Not automatic • Requires coordination among individuals • Action is not mechanical or fixed  System:  Prescribed and usually a repetitious way of carrying out an activity or a set of activities.  Rhythmic, Coordinated and recurring series of steps intended to accomplish a specific purpose.
  6. 6. 6 Boundaries of Management Control  Management Control:  Ensuring that the necessary resources are mobilized and are deployed effectively so that the planned objectives are met without much difficulty.  It is a process by which the managers influence other members of the organization to implement the organization's strategies. Strategy Formulation Management Control Task Control Goals, strategies and policies Implementation of strategies Efficient and effective performance of individual tasks Activity Nature of End Product
  7. 7. 7 Contd..  The management control process is the process by which managers at all levels ensure that the people they supervise implement their intended strategies.  Activities in Management Control  Planning what the organization should do  Coordinating the activities of several parts of the organization  Communicating information  Evaluating information  Deciding what, if any, action should be taken  Influencing people to change their behavior  Goal congruence:  Consistency of goals of individuals with that of organization itself.
  8. 8. 8 Tools for implementing strategy  Organizational structure specifies the roles, reporting relationships and division of responsibilities that shape decision making within organization.  HRM is the selection, training, evaluation, promotion and termination of employees  Culture refers to the set of common beliefs, attitudes and norms that explicitly or implicitly guide managerial actions. Strategy Performance Organization Structure Management Controls Culture Human Resource Management Stan C’s - Primeone
  9. 9. 9 Financial and non-financial emphasis  Management control system encompass the financial dimension that focuses on the monetary “bottom line”- net income, return on equity etc,  Non financial objectives- product quality, market share, customer satisfaction, employee morale etc.  Strategy formulation :  It is the process of deciding on the goals of the organization and the strategies for attaining these goals  Strategies state a direction in which senior management wants the organization to move.
  10. 10. 10 Strategy formulation  Strategy is an art or science of defining means by which an organization will deliver value to its customers (or shareholders)  It is the discipline of choosing between equally attractive alternatives.  It is a process that senior executives use to evaluate a company’s strengths and weaknesses in light of the opportunities and threats present in the environment and then to decide on strategies that fit the company’s core competencies with environmental opportunities  Strategies can be found at two levels  Strategies for whole organization  Strategies for business units within the organization.
  11. 11. 11 Strategy Formulation Environmental Analysis ------------------------------ • Competitor • Customer • Supplier • Regulatory • Social / political Internal Analysis ----------------------------------------- • Technology know-how • Manufacturing know-how • Marketing know-how • Distribution know-how • Logistics know-how Opportunities and Threats ------------------------------------------ Identify opportunities Strengths and Weaknesses ---------------------------------------- Identify core competencies Fix internal competencies With external opportunities Firm’s strategies
  12. 12. 12 Strategy formulation and Management Control  SF is the process of deciding on new strategies, MC is the process of implementing those strategies.  In SF threats, opportunities and new ideas do not occur at regular intervals, thus strategic decisions may be made at any time.  MC process involves managers and their staffs at all levels in the organization whereas, analysis of a proposed strategy usually involves very few people. Mostly senior management.
  13. 13. 13 Task control  Process of ensuring that specified tasks are carried out effectively and efficiently.  Seeing if rules are followed  Distinctions between task control and management control:  Many TC systems are scientific, MC involves behavior of managers and this cannot be expressed by equations  In MC, managers interact with other managers. In TC, either human beings are not involved at all.  In MC, the focus is on organizational units, in TC the focus is on specific tasks performed by these organizational units.  MC is concerned with the broadly defined activities of managers deciding what is to be done within the general constraints of strategies. TC relates to specified tasks, most of which require little or no judgment to perform
  14. 14. 14 Management Control System  Management control systems (MCS) is a system which gathers and uses information to evaluate the performance of different organizational resources like human, physical, financial and also the organization as a whole considering the organizational strategies.  MCS influences the behavior of organizational resources to implement organizational strategies.  Management control systems are tools to aid management for steering an organization toward its strategic objectives.  Management controls are only one of the tools which managers use in implementing desired strategies. However strategies get implemented through management controls, organizational structure, human resources management and culture  It is like a black box whose exact nature cannot be observed. MCS involves the behavior of managers and these behaviors cannot be expressed by equations.
  15. 15. 15 Contd..  According to Horngren et al. (2005), management control system is an integrated technique for collecting and using information to motivate employee behavior and to evaluate performance. According to Simons (1995), Management Control Systems are the formal, information-based routines and procedures managers use to maintain or alter patterns in organizational activities  According to Maciariello et al. (1994), management control is concerned with coordination, resource allocation, motivation, and performance measurement
  16. 16. 16 Purposes of a management control system  Clearly communicate the organization’s goals  Ensure that every manager and employee understands the specific actions required of him/her to achieve organizational goals  Communicate the results of actions across the organization  Ensure that the management control system adjusts to changes in the environment
  17. 17. 17 Management Control System Steps 1. Begin by specifying the organization's goals, subgoals and objectives  Goals are what the organization hopes to achieve in the long run  Sub-goals or key success factors are more specific and provide more focus to guide daily actions  Objectives are specific benchmarks which management would like to see achieved  Important to keep all three in balance to avoid concentrating solely on short-run achievements at the expense of long run goals 2. Establish responsibility centers 3. Develop performance measures 4. Measure and report on financial performance 5. Measure and report on non-financial performance
  18. 18. 18 The Management Control System Set Goals, Measures, Targets Feedback and Learning Monitor, Report Plan and Execute Evaluate, Reward
  19. 19. 19 Corporate Level Strategy  It is about being in the right mix of businesses.  It is concerned more with the question of where to compete than with how to compete in a particular industry (business unit strategy)  In this issue are: the definition of businesses in which the firm will participate and the deployment of resources among those businesses.  It results in decision involving businesses to add, to retain, to emphasize, to deemphasize and to divest.  Single industry firm-operates in one line of business  Related diversified firm-operates in several industries and the business units benefit from a common set of core competencies.  It typically grows internally through R&D  Unrelated business firm - operates in businesses that are not related to one another
  20. 20. 20 Business Unit Strategy  What is a business unit?  A small company within a big one that has accountability for a unique customer or market segment or service or product line  A business unit in one firm competes with a business unit in another firm. (J & J’s Baby powder unit and WIPRO baby powder unit)  Revenues are generated and costs are incurred here.  Business unit strategies deal with how to create ad maintain competitive advantage in each of the industries in which a company has chosen to participate.
  21. 21. 21 Business Unit Strategies  It deals with how to create and maintain competitive advantage in each of the industries in which a company has chosen to participate. Planning Models: Business Unit Mission: The BCG Model “Star” Hold “Question mark” Build “Cash cow” Harvest “Dog” Divest High High High High Low Low Low Low Cash Use Market Growth rate Cash source Relative market share Hold Harvest Build Divest CashUse High LowHigh
  22. 22. 22 Contd..  Question marks –  Question marks are businesses or products with low market share but which operate in higher growth markets. This suggests that they have potential, but may require substantial investment in order to grow market share at the expense of more powerful competitors. Management have to think hard about "question marks" - which ones should they invest in? Which ones should they allow to fail or shrink?  Stars –  Stars are high growth businesses or products competing in markets where they are relatively strong compared with the competition. Often they need heavy investment to sustain their growth. Eventually their growth will slow and, assuming they maintain their relative market share, will become cash cows.  Cash Cows –  Cash cows are low-growth businesses or products with a relatively high market share. These are mature, successful businesses with relatively little need for investment. They need to be managed for continued profit - so that they continue to generate the strong cash flows that the company needs for its Stars.  Dogs –  Unsurprisingly, the term "dogs" refers to businesses or products that have low relative share in unattractive, low-growth markets. Dogs may generate enough cash to break-even, but they are rarely, if ever, worth investing in.
  23. 23. 23 Financial Goal Setting  Normally 4 steps can be applied to any financial goal setting exercise for individuals 1. Identify and write down your financial goals, (e.g. for individuals, to send your kids to college or University, a new car, house purchase, vacation, retirement etc 2. Break each financial goal down into several short-term (less than 1 year), medium-term (1 to 3 years) and long-term (5 years or more) goals 3. Educate yourself and do your research 4. Evaluate your progress as often as needed. Review your progress monthly, quarterly, or at any other interval you feel comfortable with, but at least semi-annually, to determine if your program is working.
  24. 24. 24 Financial Goal Setting  Investment centers represent decentralized units where the manager is given maximum freedom for making decision pertaining not only to the product mix, pricing, customer relationships and production methods but also to determine the level and type of assets used in the unit.  The performance of an investment centre is thus gauged on the basis of assets employed and by relating the profits to the assets employed. This approach is known as Return on Investment (ROI)
  25. 25. 25 Return on Investment (ROI)  It is the percentage of return on funds invested in the business by its owners  In short, this ratio tells the owner whether or not all the efforts put into the business has been worthwhile.  If the ROI is less than the rate of return on an alternative, risk-free investment such as a bank savings account, the owner may be wiser to sell the instrument, put the money in such a savings instrument, and avoid the daily struggles of small business management.
  26. 26. 26 Return on Investment (ROI)  The ROI is calculated as follows: Return on Investment = Net Profit before Tax / Net Worth  Financial statements express only monetary aspects; businesses don’t get reflected. Thus ROI doesn’t give a complete picture of the happenings in a business.  ROI leads to excessive focus on improving profitability and not wealth maximization or shareholder value maximization, recognition, social wealth etc.
  27. 27. 27 Economic Value Added (EVA)  Implies the difference between net operating profits after taxes and total cost of funds  It offers a consistent approach to setting goals and measuring performance, communicating with investors, evaluating strategies and allocating capital.  It is the measure that captures the true economic profit of the organization.  Maximizing EVA means the same as maximizing long- term yield on shareholders’ investment.  EVA= Net operating profits after taxes (-) (total capital*WACC)  NOPAT = Operating Income x (1 - Tax Rate)
  28. 28. 28 Contd..  It is based on the past performance of the corporate enterprise.  Basically to determine whether the firm is earning a higher rate of return on the entire invested funds than the cost of such funds  If positive- increase in shareholders value  Else, erosion of existing wealth of its shareholders. It indicates that the company is destroying value even though it has a positive and growing EPS  EVA requires company to be more careful about resource mobilization, allocation and investment decisions  It measures the productivity of all the factors of production  It holds the company accountable for the cost of capital used for expansion or growth.  It is based on the past performance of the corporate enterprise.  Basically to determine whether the firm is earning a higher rate of return on the entire invested funds than the cost of such funds  If positive- increase in shareholders value  Else, erosion of existing wealth of its shareholders. It indicates that the company is destroying value even though it has a positive and growing EPS  EVA requires company to be more careful about resource mobilization, allocation and investment decisions  It measures the productivity of all the factors of production  It holds the company accountable for the cost of capital used for expansion or growth.
  29. 29. 32 EVA versus ROI  ROI is Comprehensive measure in which anything that affects financial statements is reflected in this ratio  ROI is Simple to calculate, easy to understand and meaningful in an absolute sense  In ROI, the performance of different units or against competitors can be used as a basis for comparison, whereas, absolute amount of EVA doesn’t provide basis for comparison.  With EVA all business units have the same profit objective for comparable investments, whereas, ROI provides different incentives for investments across business units.  Decision that increases a center’s ROI may decrease its overall profits.
  30. 30. 33 EVA versus ROI  If an investment center’s performance is measured by EVA, investments that produce a profit in excess of the cost of capital will increase EVA and therefore be economically attractive to the manager.  Different interest rates may be used for different types of assets to take into account different degrees of risk.  EVA has a stronger positive correlation with changes in a company’s market value.
  31. 31. 34 Contd..  EVA ranks project on profits in excess of the cost of capital (EVA increases).  With EVA, all business units have the same profit objective for comparable investments.  EVA permits the use of different interest rates for different investment projects.  EVA has greater correlation with a firm’s market value (it optimizes shareholder value).  Unlike ROI – a percentage, EVA is a dollar amount and does not allow for intra and inter company comparisons.
  32. 32. 35 Free cash Flow (FCF)  A measure of financial performance calculated as operating cash flow minus capital expenditures.  It represents the cash that a company is able to generate after laying out the money required to maintain or expand its asset base  Free cash flow is important because it allows a company to pursue opportunities that enhance shareholder value. Without cash, it's tough to develop new products, make acquisitions, pay dividends and reduce debt. FCF is calculated as: Net income + (Amortization / Depreciation) - changes in working capital - capital expenditure (same as cash from operations)
  33. 33. 36 Market Gap An opportunity in a market where no supplier provides a product or service that buyers need Gap analysis: Simply ask two questions - where are we now? and where do we want to be? The difference between the two is the GAP
  34. 34. 37 RONW (Return On Net Worth) / ROE  Calculated as, Net Income or PAT/ Shareholder’s equity  It measures a firm's efficiency at generating profits from every unit of shareholders' equity (net assets or assets minus liabilities).  It shows how well a company uses investment funds to generate earnings growth.  Useful for comparing the profitability of a company to that of other firms in the same industry.
  35. 35. 38 EPS (Earning Per Share) EPS measures the profits available to the equity shareholders on each share held. The formula is: EPS = Net Profits Available to Equity Holders / Number of Ordinary Shares Outstanding
  36. 36. 39 P/E (Price To Earning Ratio) It is the ratio between the market price of the shares of a firm and the firm's earnings per share. The formula is: P/E ratio = Market Price of Share / Earnings per Share It indicates the growth, shareholder orientation, and corporate image of a company.
  37. 37. 40 Sensitivity Analysis  A technique used to determine how different values of an independent variable will impact a particular dependent variable under a given set of assumptions.  It is very useful when attempting to determine the impact the actual outcome of a particular variable will have if it differs from what was previously assumed. By creating a given set of scenarios, the analyst can determine how changes in one variable (s) will impact the target variable.  E.g. an analyst might create a financial model that will value a company's equity (the dependent variable) given the amount of earnings per share (an independent variable) the company reports at the end of the year and the company's price-to-earnings multiple (another independent variable) at that time. The analyst can create a table of predicted price-to-earnings multiples and a corresponding value of the company's equity based on different values for each of the independent variables.
  38. 38. 41 Organization Hierarchies and behavior Individuals work in different hierarchies and handle different responsibilities & may have different goals. But they must come together as far as Company’s Goal is concerned, (their action must speak Co’s language.) Goal Congruence
  39. 39. 42 Contd..  Goal congruence ensures that the action taken by the manager in their best interest is also in the best interest of the organization.  E.g. the marketing department has launched an impressive advertising campaign which promises good returns but, say due to the cash crunch company’s current position may not let to lose the strings.  The HR manager has devised an HR training program to enhance the skills of its sales personnel, with an objective to enhance their productivity. But if company is in strategic need of attaining a certain sales volume in a given quarter, it can not do so on account of non availability of personnel.
  40. 40. 43 Significance of Goal Congruence ● Ensures frictionless working. ● Ensures achievement of organization’s goal/strategic objective ● Ensures coordination & motivation of all concerned. ● Ensures consistency in the working of all concerned. ● Gives fair chance to its employees to achieve their personal goals. ● Enhances the loyalty towards the company.
  41. 41. 44 Informal factors that influence goal congruence  External factors: Norms of desirable behavior that exist in the society of which the organization is a part  Set of attitudes of the society, work ethics of the society.  Some of these attitudes are local - specific to city, region, or industry specific.  Internal Factors: factors within the organization 1. Culture: common beliefs, shared values, norms of behavior & assumptions implicitly accepted and explicitly built into. 2. Management Style – Informal / Formal- the attitude comes from top mgmt 3. The Communication Channels 4. Perception and Communication – formal- e.g. Budget informal- e.g. conversation.  Conflict of messages received from different sources.  Budget (meaning)  A strict profit control plan Budget  A tentative guiding profit plan,
  42. 42. 45 Formal Control System  MCS strategy itself  Rules – Instructions, manuals and circulars, ethical guidelines.  Range from petty to the most important and big  Exceptions  Positive requirements like fire drills at prescribed intervals  Certain rules never to be broken  Specific types of rules:  Physical controls: security guards, vaults, passwords, TV surveillance  Manuals: of rules  System safeguards: cross checking totals with details, signatures, cash counting, auditing  Task control system: Automated tasks
  43. 43. 46 MCS - A Formal process Relating MCS to Organizational Goal Co’s Goals & Strategies Satisfactory Non-Satisfactory Compare Actual V/s Budgeted Report Actual & Budgeted Measure Responsibility Center’s Performance Prepare Annual Programs/ Budgets Prepare Strategic Plans for ImplementationRevise Revise Corrective Action Reward (Feedback) Feedback Revise the Goals /Policies (Interactive MCS) Everything percolates from the Company’s strategic goal. Anything loosing the sight of goal will be immediately taken note of and a corrective action is initiated to bring back the activity on the track.
  44. 44. 47 Types of organization 1. Functional organizations –  Each manager is responsible for a specified function such as production or marketing to bear on decisions related to a specific function  Skilled higher-level managers are able to provide better supervision of lower-level managers in the same or similar function. So, main advantage is efficiency  No unambiguous way of determining the effectiveness of the separate functional managers, as each function contributes jointly to the organization’s final output. So, difficult to measure what fraction of profit is contributed by each.  Economies of scale with efficient use of resources  High quality technical problem solving  In-depth training and skill development within functions  Clear cut career paths within functions
  45. 45. 48 Contd..  Disadvantages:  Poor communication and coordination across functions,  Inadequate for a firm with diversified products and markets. So, it typically work well for smaller and less complex organizations dealing with only one or a few products or services.  A loss of clear responsibility for product or service delivery, and slow innovation in response to environmental changes  Members of functional departments become overspecialized, develop self-centered, narrow viewpoints, and lose the total system perspective sometimes.  Failure to communicate and extend support across department lines is common situations. This often slows decision making because problems must be referred up the hierarchy for resolution
  46. 46. 49 Forms of Organizational Structure VP Production VP Marketing VP Human Resources VP Finance Staff Functional Staff VP Division B VP Division A VP Division C President Divisional Functional VPs Divisional VPs Matrix A B C Mkt. Prod. H.R. Fin. President President Head Marketing Head Production
  47. 47. 50 Types of organization 2 Divisional / Business Units  Designed to solve the problems inherent in the functional structure  It is responsible for all the functions involved in producing and marketing a specified product line, planning and coordinating the work of the separate functions  Business unit is closer to the market for its products than headquarter is, its manager may make sounder production and marketing decisions than headquarters might and the unit as a whole can react to new threats or opportunities more quickly.  Improved coordination across functional departments  Easier growth or reduction in size by adding or deleting divisions  Clear points of responsibility for product or service delivery
  48. 48. 51 Contd..  Disadvantages:  May reduce economies of scale, disperse technical competence and expertise  Even create unhealthy rivalries among operating units  May also increase costs by duplicating resources and efforts across divisions and causing an overemphasis on divisional versus organizational goals.
  49. 49. 52 3. Matrix structure ( HUL- Dove/Lakme)  Matrix structure groups employees by both function and product. This structure can combine the best of both separate structures.  E.g. Company that produces two products, "product A" and "product B". Using the matrix structure, this company would organize functions within the company as follows:  "product A" sales department, "product A" customer service department, "product A" accounting, "product B" sales department, "product B " customer service department, "product B" accounting department.  Matrix structure is the most complex of the different organizational structures. often found in organizations pursuing growth in dynamic and complex environments  It provides a way of coordinating different functional contributions to serve specific program needs  It makes easier to add, remove and change the focus of teams to reflect new program directions or basic changes in business size
  50. 50. 53 Contd..  It clearly identifies program managers who can be held accountable for performances results; this helps top managers stay informed about what is going on and why  The matrix forces decision making and problem solving down to the team level, where the best information exists  Matrix helps keep top managers free of routine decisions and enables them to devote their time to more strategic management concerns.  Disadvantages:  Power struggles, which may result from the two boss system  Team members may become too focused on themselves and develop “groupitis ” losing sight of important goals.  Often creates increased costs as overhead rises in the form of extra salaries for program managers
  51. 51. 54 Functions of the Controller  He is the person who is responsible for designing, developing and operating the management control system as the controller…(CFO). He takes charge of control as well as that of treasury functions of the organization.  Designing and operating information and control systems:  Preparation of medium term plans to implement the organization’s strategy.  Implementation of the control plans so developed.  Preparing financial statements and financial reports for shareholders and other external parties
  52. 52. 55 Contd..  Preparing and analyzing performance reports, interpreting these reports for managers and analyzing program and budget proposals from various segments of the company and consolidating them into an overall annual budget  Supervising internal audit and accounting control procedures to ensure the validity of information, establishing adequate safeguards against theft and fraud and performing operational audits.  Developing personnel in the control area. Aims at continuous improvement of the control function through upgradation of skills of control personnel.
  53. 53. 56 Contd..  Relation to Line organization:  Controller may be responsible for developing and analyzing control measurements and for recommending actions to management.  Monitoring adherence to the spending limitations laid down by the chief executive, controlling the integrity of the accounting system and safeguarding company assets from theft and fraud.  Controller doesn’t make or enforce management decisions. Responsibility for actually exercising control runs from the CEO down through the line organization.  Important role in preparation of strategic plans and budgets  Scrutiny of performance reports to ensure accuracy and to call line managers’ attention to items deserving further inquiry.  Monitoring adherence to the spending limitations laid down by the chief executive, controlling the integrity of the accounting system and safeguarding company assets from theft and fraud.
  54. 54. 57 The business unit controller  Dual reporting: one to the corporate controller and the other to the managers of their own units  He provides staff assistance to business unit manger on one hand and assisting the corporate controller to exercise his overall controlling duty.  Business unit general manager is the controller’s immediate boss and has ultimate authority in the hiring, training, transferal, compensation, promotion and firing of controllers within that business unit.
  55. 55. 58 Responsibility Centers  It is an organization unit that is headed by a manager who is responsible for its activities.  Based on principle of responsibility accounting which holds that managers should be evaluated on the activities which they can influence or control  It exists to accomplish one or more purposes, termed its objectives.  Objective is to help implement the strategies set by senior management.  The products produced may be furnished either to another responsibility center – input for them or, to the outside marketplace – outputs of the organization as a whole.  Relationship between inputs and outputs
  56. 56. 59 Measuring inputs and outputs  The inputs (resources) are translated into monetary terms called – cost.  Easier to measure the cost of inputs than to calculate the value of outputs. It can be stated as physical measurements – hours of labour, materials etc..  E.g. annual revenue for profit oriented organization is an important measure, but it will not reflect work done by R&D, PR Dept, advertising, human resource training, quality control department or a legal staff.
  57. 57. 60 Efficiency and effectiveness  Both can be measured only on comparative basis.  Efficiency is the ratio of outputs to inputs  Lesser inputs same output or  Same input, more output or  Comparison of actual costs with some standard  Effectiveness is determined by the relationship between a responsibility center’s output and its objectives. The more this output contributes to the objectives, the more effective the unit is.  It is normally expressed in subjective, non-analytical terms  Both are not mutually exclusive.
  58. 58. 61 Contd..  A responsibility center is efficient if it does things right and it is effective if it does the right things.  E.g. credit department if handles the paperwork connected with delinquent accounts at a low cost per unit, it is efficient but if, at the same time, it is unsuccessful in making collections (or needlessly antagonizes customers in the process), it is ineffective.  Profit is an important measure of effectiveness..  As profit is the difference between revenue and expense, it is also a measure of efficiency.  Thus profit measures both effectiveness and efficiency.
  59. 59. 62 Types of Responsibility Centers 1. Revenue centers:  Output is measured in monetary terms.  No formal attempt to relate input (i.e. expenses or costs) to output.  They are marketing organizations that don’t have profit responsibility.  Area primarily responsible for generating sales such as a sales office / marketing unit  Measurement of actual sales to the budgeted.  Unit manager is responsible for the direct expenses within the unit but the primary measurement is revenue  Manager doesn’t have knowledge that is needed to make the cost / revenue trade off required for optimum marketing decisions.  They don’t set selling prices and are not charged for the cost of goods.
  60. 60. 63 Types of Responsibility Centers 2. Expense centers:  Inputs or expenses are measured in monetary terms, but outputs are not.  Two general types of expense centers: i. Engineered expense centers:  Engineered costs are for which the ‘right’ or ‘proper’ amount can be estimated with reasonable reliability’  Inputs can be measured in monetary terms  Their outputs can be measured in physical terms  The optimum amount of input required to produce one unit of output can be determined  Usually found in manufacturing operations, warehousing, distributions
  61. 61. 64 Contd..  The difference between the theoretical and the actual cost represents the efficiency of the expense center being measured.  Expense supervisors are responsible for the quality, volume of production etc also in addition to cost efficiency.  So, the type and amount of production is prescribed with quality standards.  They are also responsible for training, not related to production.
  62. 62. 65 Contd.. ii. Discretionary expense centers:  Discretionary costs (managed costs) for which no such engineered estimate is feasible.  The costs incurred depend on the management’s judgment as to the appropriate amount under the circumstances. E.g. number of staff members  Management’s view about the proper level of costs is subject to change with change in management.  Includes administrative and support units like accounting, legal, PR, HR, R&D, operations  The output cant be measured in monetary terms  The difference between budget and actual expense is not a measure of efficiency rather, it is simply the difference between the budgeted input and the actual input and does not incorporate the value of the output.
  63. 63. 66 Contd.. a. Administrative and Support centers  Administrative centers include sr. corporate management and business unit management along with the mangers of supporting staff units.  Support centers are units that provide services to other responsibility centers and they often charge for the same.  Support centers often charge the other responsibility centers for the services that they provide.  E.g. IT dept can charge sales dept for the services  Functions are virtually impossible to quantify, much less evaluate.
  64. 64. 67 Contd..  Difficulty in measuring output ( advice, service), so not possible to set cost standards  E.g. development of an accounts receivable system job to finance staff- comparison of costs would not tell effectiveness of the job done.  Typically managers of admin staff offices strive for functional excellence.  It seems to be congruent with company goals. Results in safeguarding one’s position without regard to the welfare of the company. E.g. legal staff or controller.
  65. 65. 68 Contd.. b. Research and Development centers  Carry some R&D activities, like product development. Product testing, developing improved production and quality methods, market research etc.  Difficulty in relating results to inputs  Lack of goal congruence  Research manager wants to build the best research organization money can buy, might be unaffordable to company.  Research people many a times don’t have sufficient business knowledge to determine the optimum direction of the research efforts.  Projects involving testing, no precise time and cost estimation
  66. 66. 69 Responsibility Budgeting  It is the plan for the allocation of financial resources to each organizational responsibility center for the budget period. 1. Incremental budgeting:  Identify the current level of expenses as a starting point. And then adjust these amounts for expected growth i.e. workload, inflation, etc.  However no scope for evaluation with past performance and therefore the basis for setting standard for future may itself be wrong.  Managers go for demanding higher resources.  Current level of expenditure is not reexamined during the budget preparation process.  Sometimes new management reduces costs drastically without any adverse consequences
  67. 67. 70 Contd.. 2. Zero-Based Budgeting:  Each responsibility center calculates its resource needs based on the coming year’s priorities rather than on the previous year's budget. 1. Develop a decision package for their responsibility centers – start from scratch. 2. Top management reviews decision package and ranks them 3. Top management allocates resources based on rankings. 4. Comparison is done  It is a time consuming process  Likely to be a traumatic experience of the managers whose operations are being reviewed.  Many companies due to recession, conducted zero base reviews – downsizing, restructuring
  68. 68. 71 Signs of Inadequate Budget Control Systems  Deadlines missed frequently  Poor quality of goods and services  Declining or stagnant sales or profits  Loss of leadership position or market share  Inability to obtain data to evaluate employee or departmental performance  Low employee morale and high absenteeism  Insufficient employee involvement and management-employee communication  Excessive company debts, uncertain cash flow, unpredictable borrowing  Insufficient use of people, material, equipment, and facilities.
  69. 69. 72 Profit Centers  When a responsibility center’s financial performance is measured in terms of profit, the center is called as profit center.  Area responsible for controlling costs and generating revenues  Relationship between the inputs and output can be easily established.  Performance evaluation and the control becomes comparatively easier exercise.
  70. 70. 73 Contd..  Profit focuses the responsibility center’s efforts towards the ultimate goal, it motivates the responsibility centers to employ its assets / resources in most efficient manner.  In case of expenses center-cost needs to be controlled, but in case of profit center- achieving better trade off between the cost incurred and profit earned.  Before establishing such center, relative advantages and disadvantages of having it need to be analyzed.  E.g. Auto industry- sales division - profit center, but, after-sales service - not a profit center but to create and maintain company’s image.
  71. 71. 74 General considerations  Conditions for delegating profit responsibility  Proposal to increase expenses with expectation of even greater increase in sales revenue. Includes expense / revenue trade – off E.g. advertising expenses , quality control expenses. Two conditions for safely delegating the trade-off : 1. The manager should have the relevant information to make trade- off 2. There should be some way to measure how effectively the manager is making these trade offs.  Management must decide whether the advantages of giving profit responsibility offset the disadvantages.
  72. 72. 75 Advantages of profit centers  Improved quality of decisions as decisions taken by mangers closest to the point of decision  Increased speed  Headquarters management can concentrate on broader issues  Managers are freer to use their imagination and initiative  Provide a training ground.  Enhancement in profit consciousness  Management of performance is broadened.  Provides top management with information on profitability of the company’s individual components  Always try to improve their competitive performance
  73. 73. 76 Difficulties with profit centers  Loss of control  If profit center manger is less capable, quality of decisions at unit level may be reduced  Increase in friction due to arguments over allocation of common costs, credit of revenues etc  Competition between profit centers  Increase in overall management costs due to divisionalization.  There may be more focus on short run profitability at the expense of long run profitability  Not necessary that if the profits of each individual profit centers are optimized, it ensures the optimization of the profits of the company as a whole.
  74. 74. 77 Transfer Pricing  Decentralization- accounting for the transfer of goods and services from one profit center to another.  The method followed while establishing price for such transfers is called transfer pricing.  Inappropriate pricing for inter divisional transfer of goods or services draws a wrong performance  TP is a mechanism for distributing the revenue generated collectively
  75. 75. 78 Objectives of transfer pricing  It should provide each segment with the relevant information required to determine the optimum trade-off between company costs and revenues.  To measure the real performance and profitability of the division  To allow autonomy to division but not at the cost of the firm’s goal  To keep up motivation of all concerned divisions.  To ensure the cost control at every division.
  76. 76. 79 Cost based transfer pricing  Used when there is no outside buyer available for division’s intermediate products. Or  No competitive market exists for a division’s products. Or  There exists only one buyer.  It remains less satisfactory than the market price.  Two decisions to be taken  Determine the cost of product  Set the profit mark up
  77. 77. 80 Contd… 1. Standard cost as transfer price  Scientifically predetermined cost of production and not actual costs.  It motivates the division to contain its costs within prescribed limits. 2. Full cost as transfer price  Recovery of full cost of production  But here, the inefficiencies of one division will be passed on to the another division and no incentive for cost control.
  78. 78. 81 Contd… 3. Variable cost as transfer price  Only variable cost of production is taken into consideration by ignoring the fixed cost.  Logic is, why to consider fixed cost which has already been committed irrespective of the purchase decision of another division.  But, neither profit nor the recovery of the full cost.
  79. 79. 82 Market based pricing 1. Market price as transfer price  It is the best transfer price, as it represents the opportunity cost from the point of view of both the divisions are concerned. Primary conditions for establishing MP as transfer price are:  There should be open market for the one’s products i.e. the other has open option to outsource its requirements.  The market price is determined by fair & competitive market forces.
  80. 80. 83 Contd..  It is possible that due to corporate constraints such as interdependent production capacities, one division being the sole producer exists, company has heavily invested in production facilities which doesn’t allow its division to go for outsourcing its purchases. Due to these reasons if.. • Incase the company doesn’t indulge with outside market then competitive prices can be determined by using i. Published market price ii. Market price set by bid iii. Adding certain % over and above its standard cost of manufacturing.  Incase excess or shortage of capacity – no point in selling division asking for market price.
  81. 81. 84 Contd.. 2 Modified (negotiated) Market Price (MMP)  Both division need to settle for a transfer price which has been discounted for all non influencing cost factors. E.g. packaging  No selling and distribution cost to the selling division  Due to guaranteed high order/off take, production cost per unit will be lower-saves cost  Quality, quantity and delivery aspects of supply is higher assured and at lesser than market price.
  82. 82. 85 Contd.. 3 Transfer price lower than market price  If selling division is operating at its full capacity, it cant reduce the price,  But if having idle capacity then only can settle for a lower than market price, as the opportunity cost for them would be zero.
  83. 83. 86 Margin based pricing 4 The profit markup  Two decisions, a) what the profit markup is based on and b) The level of profit allowed  Widely used base is a % of costs, or % of investment.  To the extent possible the profit allowance should approximate the rate of return that would be earned if the business unit were an independent company selling to outside customers.
  84. 84. 87 Pricing corporate services  Charging business units for services furnished by corporate staff units.  This excludes the cost of central service staff units over which business units have no control. E.g. central accounting, public relations, administration. They are allocated and the allocations don’t include a profit components. The allocations are not transfer prices.  Two types of transfers 1. For central services that the receiving unit must accept but can at least partially control the amount used 2. For central services that the business unit can decide whether or not to use.
  85. 85. 88 Contd.. Multinational companies- use to minimize their worldwide taxes, duties and tariffs.- company may follow it among its divisions such that it will facilitate transfer its funds from high tax bracket country to tax heaven country.
  86. 86. 89 1 Control over amount of service  BU may be required to use company staffs for services such as Information technology and R&D.  Here BU manager cant control the efficiency with which these activities are performed but can control the amount of the service received. Three schools of thought about such services: 1. BU should pay the standard variable cost of the discretionary services. If it pays less than this, it will be motivated to use more of the service than is economically justified. If pays higher, they might not elect to use services that sr. management believes worthwhile.
  87. 87. 90 Contd.. 2 A price equal to the standard variable cost plus a fair share of the standard fixed costs i.e. the full cost but not more than MP. Because, if BU don’t believe their services are worth at least this amount, then there is something wrong with either the quality or the efficiency of the service unit. 3 A price that is equivalent to the market price or to standard full cost plus a profit margin. The market price would be used if available. The capital employed by the service unit should earn a return just as the capital employed by manufacturing unit
  88. 88. 91 2 Optional use of services  BU can choose whether to use central service units. They may procure the service from outside, develop their own capability or choose not to use the service at all.  Most often found for information technology, internal consulting groups and maintenance work.  These service centers are independent, they must stand on their own feet.  Here, BU managers control both the amount and the efficiency of the central services.
  89. 89. 92 Administration/ Implementation of transfer prices  How the selected policy should be implemented-the degree of negotiation allowed in setting TP, methods of resolving TP conflicts and classification of products according to the appropriate method 1. Negotiation:  TP not set by central staff group, but BUs negotiate it with each other. This keeps intact the autonomy of the divisions.  Authority and responsibility both given to the profit center.  Also knowledge about the local condition, so intervention not required.
  90. 90. 93 Contd..  When an open market price is available, there should be no intervention at all of any nature by anybody.  In case companies’ headquarters have rule, that BU are free to deal with each other or with outsiders as they see fit – if no agreement on price, they can deal with outsiders  If as per rule, BU are required to deal with one another – no threat of competitors, headquarters staff must develop a set of rules that govern both pricing and sourcing of intra-company products.
  91. 91. 94 Contd.. 2. Arbitration and conflict resolution  Arbitrator should be a senior management personality from finance / a committee of experts / an executive depending upon the intensity of heat.  Main task is to set appropriate transfer price, establish the rule / policies in this regard and reviewing the sourcing changes.  With a formal system, both parties submit a written case – arbitrator reviews their positions and decides on prices.
  92. 92. 95 Contd..  4 ways to resolve conflict-  Forcing  Smoothing  Bargaining  Problem solving Conflict avoidance Conflict resolution
  93. 93. 96 Contd.. 3 Product Classification  Categorization of company’s products helps in administration of TP  Class I- include the products which needs strict control of head quarter. These products represent high volume requirements of another division / which need special care about quality /secrecy. Normally no outside source exists  Class II- include rest of the products which don’t need special corporate care and control. Relatively of small volume, produced with general purpose equipment. These products can be transferred at market price.
  94. 94. 97 Why relate profits to investments? The Manager’s Responsibility  First, a manager should invest in assets only if the assets will produce adequate returns.  Second, when an asset is not providing adequate return (the expected return could change over the years), it is time to “disinvest” or reduce further investments into this asset.
  95. 95. 98 Measuring and controlling assets employed  The purpose of measuring assets employed:  To provide information that is useful in making decisions about assets employed and to motivate managers to make sound decision - that is decisions in the best interests of the company  To measure the performance of the business unit as an economic entity.  Relating profit to the investment base  The % return on investments or assets employed (ROI) and  Residual or economic value added. (effectively same concepts)
  96. 96. 99 Contd..  A focus merely on profits without consideration of the assets employed to generate those profits is an inadequate basis for control  BU managers in general have these performance objectives  They should generate adequate profits from the resources at their disposal  They should invest in additional resources only when such an investment will produce an adequate return.  Also they should disinvest if the expected annual profits of any resource, discounted at the company’s required earnings rate, is less than the cash that could be realized from its sale.
  97. 97. 101 Measuring assets employed  Deciding what investment base to use to evaluate investment center managers, headquarters asks 2 question  What practices will induce business unit managers to use their assets most efficiently and to acquire the proper amount and kind of new assets?  What practices best measure the performance of the unit as an economic entity? 1. Cash  Normally centrally controlled, Coz it permits the use of a smaller cash balances than would be the case if each BU held cash balances sufficient to provide the necessary buffer for the unevenness of its cash inflows and outflows.  Many companies therefore calculate the cash to be included in the investment base by means of a formula.
  98. 98. 102 Contd.. 2 Receivables  BU managers can influence the level of receivables indirectly, by their ability to generate sales and directly by establishing credit terms and approving individual credit limits and by their drive in collecting overdue amounts.  At SP or at COGS is debatable.  Real investment in accounts receivable is only the COGS.  On the other hand, BU has the opportunity to reinvest the money collected  Normal practice is to include receivables at book amount i.e. SP less an allowance for bad debts.
  99. 99. 103 Contd.. 3. Inventories  Depend on the method used for valuation (LIFO, FIFO, average costs)  If WIP inventory is financed by advance payments from the customer, as is typically the case with goods that require a long manufacturing period, these payments are either subtracted from the gross inventory amounts or reported as liabilities.  Some companies subtract A/c payable from inventory on the grounds that they represent financing of part of the inventory by vendors, at zero cost to the business unit.
  100. 100. 104 Contd.. 4 Working capital in general  Considerable variation in how working capital items are treated.  Can include, all current assets in the investment base with no offset for any current liabilities – motivational standpoint if BU have no influence over accounts payable or other current liabilities.  Or, all current liabilities may be deducted from current assets- provides a good measure of the capital provided by the corporation, on which it expects the BU to earn a return.
  101. 101. 105 Contd.. 5. Property, plant and equipment  FA taken at acquisition cost and are written off through depreciation. But this faces some problems. a) Acquisition of new equipment  New Machine costs 100,000. Life 5 years, gives cash inflow of 27000 per year. i. Economic calculation: Investment in machine 100 PV of Cash inflow (27000*3.791) 102.4 NPV 2.4 Decision: Acquire the asset
  102. 102. 106 Contd.. ii. As reflected in BU income statement • New Machine costs 100,000. Life 5 years, gives cash inflow of 27000 per year. 10% rate of return. • Savings by using the new machine 27,000 per year or on a Present Value basis for five years, 102,400 with a net present value of 2,400 (102,400 - 100,000). • Before this new asset is acquired, the annual depreciation on fixed assets was 50,000 per year and • After the new asset is purchased, the annual depreciation will go up to 50,000 + 100,000 / 5) = 70,000
  103. 103. 107 computations for before and after purchase of asset - Before 1 year after Purchase Purchase of asset of asset Profit before depreciation 1,000,000 1,000,000 Expenses (w/o Deprecn.) (850,000) (823,000) Profit before depreciation 150,000 177,000 Depreciation (50,000) (70,000) Profits after depreciation 100,000 107,000 Equity 500,000 500,000 Capital charge at 10% 50,000 60,000 EVA (Profits – Cap. Charge) 50,000 47,000 ROI 20% 21.4%
  104. 104. 108 Interpretation  The profit before depreciation has remained constant at 100,000 before and after purchase of the asset and yet  The ROA went up from 20% to 21.4%. Why? Simply because the depreciation expenses went up.  In contrast, the EVA declined from 50,000 to 47,000 making it look like profits decline after purchase of the asset (even though the income before taxes had actually increased from $100,000 to $107,000).
  105. 105. 109 Contd..  That is, a manager can make the wrong decision not to purchase the asset based on these computations.  In later years, the EVA will go up and so will the ROA because of additional depreciation.  It is evident that BU that have old, almost fully depreciated assets will tend to report larger EVA than units that have newer assets  Conclusion: if depreciable assets are included in the investment base at net book value, BU profitability is misstated and BU managers may not be motivated to make correct acquisition decisions.
  106. 106. 110 Contd.. b) Gross Book Value  Such fluctuation can be avoided by including depreciable assets in the investment base at gross book value rather than at net book value. But, in that case it understates the true return.  In example- 7000 additional income, 7% ROI, EVA reduces by 3000 c) Disposition of assets  New machine considered as a replacement for an existing machine that has some undepreciated book value is irrelevant in the economic analysis of proposed purchase.  Removal of book value of old machine-substantial effect on profitability  Managers are encouraged to replace old equipment with new one, even in situations in which such replacement is not economically justified.  If included at original cost- managers try to get rid of it as the investment base gets reduced.
  107. 107. 111 Contd.. d) Leased assets  If BU sells its Fixed asset and then lease back the asset at a rental, its income before taxed reduces coz rental expenses > depreciation cost  Whereas, EVA would be increased coz the capital charge would be reduced.  Due to this, BU managers have tendency to lease assets rather than owning them. d) Idle assets  Idle assets, which can be used by other units, BU can exclude them from the investment base.  But if they cant be used by any other unit, then removal from investment based could result in dysfunctional actions. i.e. removal of assets not giving the optimum returns.
  108. 108. 112 Contd.. 6. Intangible assets  Amortized over a period of time. This method has the potential to change how the BU manager views these expenditures.  Changing the accounting for items such as R&D from an immediate expense to a long term investment, the BU manager will gain less short-term benefits from reducing R&D.  If R&D expenditures are expensed immediately, each dollar of R&D cut would be a dollar increase in pretax profits.
  109. 109. 113 Contd.. 7. Non-current Liabilities  BU receive its permanent capital from corporate pool of funds. The corporation obtain them from debt, equity and retained earnings.  BU that builds or operates residential or office buildings uses a much larger proportion of debt capital than is the case with typical manufacturing and marketing units.  Since this is obtained on mortgage of assets, then accounting for the borrowed funds to be done separately and then EVA can be calculated based on the assets those were obtained from general corporate sources, rather than on total assets.
  110. 110. 114 Contd.. 8. The capital charge  Determination of capital charge is done normally by HO.  It should be higher than the corporation's rate for debt financing- coz it’s a mix of debt as well as higher cost equity.  Different rates should be used for business units with different risk characteristics.
  111. 111. 115 Additional considerations in evaluating managers  Due to problems in ROI method implementation, EVA tool is recommended, but it also doesn’t solve the problem of accounting of fixed assets  Like discussed, if gross book value is used, BU tries to increase its EVA by taking actions contrary to the interests of the company  If net book value is used, EVA increases with passage of time.  Also, EVA is temporarily depressed whenever a new investment is done.  EVA does solve the problem created by differing profit potentials.  BU, 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.
  112. 112. 116 Contd.. So, in some units, investment amount generally is limited to inventories, receivables, furniture, equipments etc. e.g. marketing units. Due to this, some companies exclude fixed assets from the investment base. Interest charge only for controllable assets (essentially working capital items).
  113. 113. 117 Contd..  BU manager’s efficiency would affect the level of these assets.  Whereas, investments in fixed assets are controlled by the capital budgeting process and by post completion audits to determine whether the anticipated cash flows in fact materialized.  Actual savings or revenues from a fixed asset acquisition may not be identifiable.
  114. 114. 118 Performance Measurement and control  Managers function- to ensure that the work gets done efficiently and effectively. They literally don’t “control costs”. They try to influence the actions of the people who are responsible for incurring the costs  Performance measurement improves the likelihood the organization will implement its strategy successfully.  In MCS, the manager works through others in the following ways 1. Selecting employees 2. Making sure the employees are adequately trained 3. Deciding where the employees fit best in the organization 4. Empowering employees 5. Providing advice and suggestions 6. Solving problems
  115. 115. 119 Contd.. 7. Ensuring that the work environment is satisfactory 8. Disciplining 9. Resolving disputes within the responsibility center 10. Approving proposed actions that employees are not authorized to take 11. Interacting with other managers to obtain their cooperation and to resolve problems when their activities impede the work of the responsibility center 12. Seeking to create a climate that induces employees to work efficiently and effectively.  To carry on these activities managers need information
  116. 116. 120 Information  Anything that reduces the user’s uncertainty 1. Informal information  Manager receives through observation, face-to-face conversations, telephone conversations, memorandum and meetings.  Most managers find this more important than any formal report. 2. Task Control Information  Production control system provides information that schedules the flow of material, labor and other resources.  Procurement, payroll, storage and other activities.  With computers any information available at speed and at low cost per transaction.
  117. 117. 121 Contd.. 3. Budget Reports  A report that compares actual revenues and expenses with budgeted amounts is the principal financial report.  Although an import guide to the responsibility center manager, the budget is only a guide. In case if manager discovers better way of achieving the same objective or if any circumstances change, he can depart from budget.  Adherence to the budget is not necessarily good and departure from it is not necessarily bad. 3. Budget signals  Operating managers to understand which budget amounts are expected amounts, which are ceilings and floors.
  118. 118. 122 Contd.. 5. Non-financial information  They are key indicators of how well the chosen strategy is being implemented.  Key variables, strategic factors, key success factors, critical success factors, pulse points or key performance indicators.
  119. 119. 123 Performance 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. If these factors are improved, then the company has implemented its strategy.  It is a mechanism for improving the likelihood of the organization successfully implementing a strategy
  120. 120. 124 Contd..  Financial measures of corporate success-profits and revenues, show the results of past decisions the company has taken.  Under PMS, a blend of financial and non-financial measurements are used at all levels in the organization.  Financial measures indicate the results of past decisions, whereas non-financial are leading indicators of future performance.  A PMS like dashboard, has a series of measures that provide information about the operation of many different processes.  Example of PMS is Balanced Scorecard.
  121. 121. 125 The Balanced Scorecard  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.  The balanced scorecard is 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 balance scorecard, executives must choose a 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 a cause- effect manner, indicating how non-financial measures affect long- term financial results and 3. Provide a broad-based view of the current status of the company.
  122. 122. 126 Contd..  The balanced scorecard approach also focuses on what managers are currently doing to create future shareholder value.  Performance reporting approach which links organizational strategy to actions of managers and employees  Combines financial and operating measures  Links performance to rewards  BU should be assigned goals and then measured from the four perspectives.
  123. 123. 127 Contd..  The balanced scorecard tries to create a blend of strategic measures: 1. Outcome and driver measures  Indicates the result of a strategy (increased revenue, improved quality)  The amount by which revenue increase is the result of the successful implementation of the organization’s strategy.  They tell management what has happened.  Whereas, driver measures are ‘leading indicators’, showing the key areas in implementing a strategy.
  124. 124. 128 Contd.. 2. Financial and non-financial measures  Sophisticated systems are developed to measure financial performance, whereas, many organizations have failed to incorporate non financial measures like quality and customer satisfaction, because these measures tend to be much less sophisticated than financial measures and senior management is less adept with their use. 2. Internal and external measures  Good balance between external measures such as customer satisfaction and internal measures like manufacturing yields.
  125. 125. 129 The Balanced Scorecard Dimensions Financial Perspective Is company achieving financial goals? Financial Perspective Is company achieving financial goals? Internal Process Is company improving critical internal processes? Internal Process Is company improving critical internal processes? Customer Perspective Is company meeting customer expectations? Customer Perspective Is company meeting customer expectations? Learning and Growth Is company improving its ability to innovate? Learning and Growth Is company improving its ability to innovate? Strategy
  126. 126. 130 Contd..  Financial perspective:  Return on capital employed  Cash flow  Project profitability  Profit forecast reliability  Sales backing  Internal business perspective  Hours with customers  Tender success rate  Rework  Safety incident index  Project closeout cycle How do we look to stockholders? What must we excel At internally
  127. 127. 131 Contd..  Customer perspective  Customer ranking survey  Customer satisfaction index  Market share  Innovation and learning perspective  % revenue from new services  Rate of improvement index  Staff attitude survey  No. of employee suggestions  Revenue per employee How do customers See us? How do we learn And innovate to create The future
  128. 128. 132 Implementation of balanced scorecard  Four general steps 1. Define strategy  It builds a link between strategy and operational action  For a single industry firm, the scorecard should be developed at the corporate level and then cascaded down to functional levels and below  However, for a multibusiness firm, the business unit should be the starting point for developing the scorecard 2. Define measures of strategy  Focus on few critical measures  Individual measures be linked with each other in a cause- effect manner
  129. 129. 133 Contd.. 3. Integrate measures into the management system  The balanced scorecard must be integrated with the organization’s formal and informal structures, its culture and its human resource practices.
  130. 130. 134 On the one hand the Balanced Scorecard gives insight into complex information, on the other hand it communicates and reflects the corporate strategy
  131. 131. 135 MCS in service and Non-profit organizations  Service organizations in general  Characteristics  Different from the process ion manufacturing companies. 1. Absence of inventory buffer  Services cannot be stored.  Cannot earn revenue in the future from products that are on hand today like a manufacturing company.  It must try to minimize its unused capacity.  Cost of many such organizations is fixed in short run.
  132. 132. 136 Contd..  A key variable in most service organizations, is the extent to which current capacity is matched with demand. This can be done in two ways • They try to stimulate demand in off-peak periods by marketing efforts and price concessions • If feasible, they adjust the size of the work force to the anticipated demand, by such measures as scheduling training activities in slack periods and compensating for long hours in busy periods. 2. Labour intensive  People cannot be replaced by equipments.  Adds costs 2. Pricing of product – No sound cost base
  133. 133. 137 Contd.. 4. Difficulty in controlling quality  Quantity and quality cannot be measured visually or with instruments  Subjective judgments. 5. Multi-unit organizations  Fast food restaurant chains, auto rental companies, etc.  Some of the units are owned, others operate under a franchise.  Similarity of these separate units provides a basis for analyzing budgets and evaluating performance that is not present in the usual manufacturing company  Information for each unit can be compared with systemwide or regional averages and high performers and low performers can be identified
  134. 134. 138 Contd.. 6. Very few tangible assets - ROI may be meaningless 7. Special class of labor - seeks more autonomy in working. 8. Input and output measurement is difficult - difficult to arrive at effectiveness and efficiency of a professional. 9. Cost of services is of flexible nature such as traveling expenses, communication expenses therefore building standards is difficult process.
  135. 135. 139 Professional service organizations Organizations whose products are professional services R&D organizations, law firms, accounting firms, health care, engineering, architectural, consulting firms, ad agencies, sports organizations etc.
  136. 136. 140 Special characteristics 1. Goals  Relatively few tangible assets  Principal asset is the skill of its professional staff  Financial goal is to provide adequate compensation to the professionals.  A related goal is to increase their size.  Large public accounting firms need to have enough local offices to enable them to audit clients who have facilities located throughout the world.
  137. 137. 141 Contd.. 2. Professionals  Labour intensive  Many professionals prefer to work independently , rather than as part of a team.  Professionals who are also managers tend to work only part time on management activities  They tend to give inadequate weight to the financial implications of their decisions. They want to do the best job they can, regardless of its cost.  This attitude affects the attitude of support staffs and nonprofessionals in the organization and leads to inadequate cost control.
  138. 138. 142 Contd.. 3. Output and input measurement  Cannot be measured in physical terms.  Revenues earned is one measure of output in some professional organizations; but these monetary amounts, at most, relate to the quantity of services rendered, not to their quality (poor quality- reduced revenues in long run)  The work done by many professionals is non- repetitive.  So, its difficult to plan the time required for a task, to set reasonable standards for task performance and to judge how satisfactory the performance was.
  139. 139. 143 Contd.. 4. Small size  Except for some law firms and accounting firms, normally professional organizations are relatively small and operate at a single location.  Sr. management can personally observe what is going on and personally motivate employees.  Less need for sophisticated MCS.
  140. 140. 144 Contd.. 5. Marketing  In manufacturing cos- clear dividing line between marketing activities and production activities; only sr. management is concerned with both.  This doesn’t exist in most of professional organizations  In some cases, law medicines, accounting, profession’s ethical code limits the amount and character of explicit marketing efforts by professionals.  Difficult to assign appropriate credit to the person responsible for selling a new customer.
  141. 141. 145 MCS in service organizations 1. Pricing  In a profession where members keep track of their time, fees are related to professional time spent on the engagement  The hourly billing rate typically is based on the compensation of the grade of the professional plus a loading for overhead costs and profit.  In other professions, say investment banking, fee is based on the monetary size of the security issue.  Total value of organization > sum of what the value of the individuals would be if they worked separately.
  142. 142. 146 Contd.. 2. Profit centers and transfer pricing  Support units, such as maintenance, information processing, transportation, telecommunication, printing, procurement of material and services, charge consuming units for their services. 2. Strategic planning and budgeting  Formal strategic planning systems are not as well developed as in manufacturing companies of similar size.
  143. 143. 147 Contd.. 4. Control of operations  Much attention should be give to scheduling the time of professionals. The billed time ratio, i.e. hours billed to total professional hours available.  Inability to set standards for task performance, the desirability of carrying out work by teams and the behavioral characteristics of professionals complicate the planning and control of the day-to-day operations in a professional organization.
  144. 144. 148 Contd.. 5. Performance measurement and appraisal  In most circumstances, the assessment of performance is a matter of human judgments made by superiors, peers, self, subordinates or clients.  Use formal system to collect performance appraisals as a basis for personnel decisions and for discussion with the professional.  In some organizations self appraisals  Client’s feedbacks  Budget can be used as the basis for measuring cost performance and the actual time taken can be compared with the planned time.
  145. 145. 149 Nonprofit organizations Organization that cannot distribute assets or income to, or for the benefit of, its members, officers or directors. It can compensate its employees for services rendered and for goods supplied. It prohibits only the distribution of profits and not earning of profits.
  146. 146. 150 Characteristics 1. Absence of the profit measure  Many of them have several goals.  Absence of a satisfactory, quantitative, overall measure of performance is the most serious management control problem in such organizations.  Net income should average only a small amount above zero.  Financial goal though not priority, still necessary.
  147. 147. 151 Contd.. 2. contributed capital  Issuance of stock, payments of dividends, transactions with the shareholders are missing.  Receives contributed capital, which few businesses have  Two principal categories:  Plant - includes contributions of building and equipment or contributions of funds to acquire these assets, works of art and other museum objects and  Endowment consists of gifts whose donors intend that the principal amount will remain intact indefinitely, only the income on this principal will be used to finance current operations.
  148. 148. 152 Contd..  Thus, such organizations have two sets of financial statements • One set relates to operating activities - balance sheet, cash flow statement • Second set relates to contributed capital, a statement of inflows and outflows of contributed capital during a period and a balance sheet that reports contributed capital assets and the related liabilities
  149. 149. 153 Contd.. 3. Fund Accounting  Accounts are kept separately for several funds  A general or operating fund - corresponds to the set of operating accounts  A variety of other funds for special purposes, like pension fund etc.
  150. 150. 154 4. Governance  Governed by boards of trustees, who are usually not paid and many of them are unfamiliar with business management.  Less control than the directors of a business corporation.  The need for a strong governing board is greater because the vigilance of the governing board may be the only effective way of detecting when the entity is in difficulty.
  151. 151. 155 MCS in non profit organizations 1. Product pricing  Pricing of services at their full cost is desirable (for directly related services) e.g. health care services  Others should be market based. E.g. gift shop  If an organization is able to recover its incurred costs, management is not motivated to worry about cost control
  152. 152. 156 Contd.. 2. Strategic planning and budget preparation  More important and time-consuming  Budget preparation process is similar to other industries  E.g. colleges, universities, welfare organizations etc know before the budget year begins, the approximate amount of their revenues.  They cant increase revenues with marketing efforts.  Budgeting of expenses atleast for break even.  It is the most important management control tool at least with respect to financial activities.
  153. 153. 157 Contd.. 3. Operation and evaluation  Difficult to know what the optimum operating costs are.  Even if responsibility center manager knows that a particular expenditure would give a good payoff, still they might refrain themselves from doing so.

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