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Mcs merged doc 2009.

  1. 1. UNIVERSITY OF MUMBAI MANAGEMENT CONTROL SYSTEM ANSWER SET: YEAR 2001 TO 2008Selected Questions (Conceptual + Numerical)
  2. 2. INDEXSR.NO PARTICULAR PAGE.NO. 1 Set 1 (numerical 2004 & 2008) 3-11 2 Set 2 (numerical 2004 & 2008) 12-20 3 Set 3 (numerical 2004 & 2007) 21-31 4 Set 4 32-43 5 Set 5 (numerical 2004) 44-65 6 Set 6 66-74 7 Set 7 75-86 8 Set 8 87-91 9 Set 9 92-96 10 Set 10 97-103 11 Set 11 104-112 12 Set 12 113-128 2
  3. 3. SET. 1Questions1) Explain briefly features of an IDEAL management control system? What is the concept of free cash flow as applied to an organization? Explain process of computation?2)3) What is Balance Scorecard? What is the process of implementation and difficulties in implementation? Girish Engineering ( MCS-2004) Numerical?4) ABC ltd. (MCS-2008) Numerical?5) 3
  4. 4. Q.1) Explain briefly features of an IDEAL management control system?Management control is a process of assuming that resources are obtained and used effectively and efficiently in theaccomplishment of the organization’s objectives. It is a fundamental necessity for the success of a business and hencefrom time to time the current performance of the various operations is compared to a predetermined standard or idealperformance and in case of variance remedial measures are adopted to confirm operations to set plan or policy.Some of the features of MANAGEMENT CONTROL SYSTEM are as follows: Total System: MANAGEMENT CONTROL SYSTEM is an overall process of the enterprise which aims to fit together the separate plans for various segments as to assure that each harmonizes with the others and that the aggregate effect of all of them on the whole enterprise is satisfactory. Monetary Standard: MANAGEMENT CONTROL SYSTEM is built around a financial structure and all the resources and outputs are expressed in terms of money. The results of each responsibility centre in respect to production and resources are expressed in terms of a common denominator of money. Definite pattern: It follows a definite pattern and time table. The whole operational activity is regular and rhythmic. It is a continuous process even if the plans are changed in the light of experience or technology. Coordinated System: It is a fully coordinated and integrated system. Emphasis: Management control requires emphasis both on the search for planning as well as control. Both should go hand in hand to achieve the best results. Function of every manager: Manager at every level as to focus towards future operational and accounting data, taking into consideration past performance, present trends and anticipated economic and technological changes. The nature, scope and level of control will be governed by the level of manager exercising it. Existence of goals and plans: MANAGEMENT CONTROL SYSTEM is not possible without predetermined goals and plans. These two provide a link between such future anticipations and actual performance. Forward looking: MANAGEMENT CONTROL SYSTEM is on the basis of evaluation of past performance that the future plans or guidelines can be laid down. Management Control involves managing the overall activity of the enterprise for the future. It prevents deviations in operational goals. Continuous process: It is a continuous process over the human and material resources. It demands vigilance at every step. Deciding, planning and regulating the activities of people associated in the common task of attaining the objectives of the organization is a the primary aim of MANAGEMENT CONTROL SYSTEM. People oriented: It is the managers, engineers and operators which implement the ideas and objectives of the management. The coordination of the main division of an organization helps in smoother operations and less friction which results in the achievement of the predetermined objectives. 4
  5. 5. Scope of controlMANAGEMENT CONTROL SYSTEM is an important process in which accounting information is used toaccomplish the organizations objectives. Therefore the scope of control is very wide which covers a very wide rangeof management activities. Policies control: Success if a business depends on formulation of sound policies and their proper implementation. Control over organization: It involves designing and organizing the various departments for the smooth running of the business. It attempts to remove the causes of such friction and rationalizes the organizational structure as and when the need arises. Control over personnel: Anything that the business accomplishes is the result of the action of those people who work in the organization. It is the people, and not the figures, that get things done. Control over costs: The cost accountant is responsible to control cost sets, cost standards, labour material and over heads. He makes comparisons of actual cost data with standard cost. Cost control is a delicate task and is supplemented by budgetary control systems. Control over techniques: It involves the use of best methods and techniques so as to eliminate all wastages in time, energy and material. The task is accomplished by periodic analysis and checking of activities of each department with a view to avoid an eliminate all non-essential motions, functions and methods. Control over capital Expenditure: Capital budget is prepared for the whole concern. Every project is evaluated in terms if the advantage it accrues to the firm. For this purpose capital budgeting, project analysis, study of cost of capital etc are carried out. Overall control: A master plan is prepared for overall control and all the departments of the concern are involved in this procedure. 5
  6. 6. Q.2 What is the concept of free cash flow as applied to organization. Explain process of computation?We define net cash flow as net income plus non cash adjustment which typically means net income plus depreciationthough that cash flows cannot be maintained over time unless depreciated fixed assets are replaced. So management isnot completely free to use its cash flows however it chooses. Therefore we define the term free cash flows.Free cash flow is the cash flow actually available for distribution to investor after the company has made all theinvestment in fixed assets and working capital necessary to sustain ongoing operation. When we studied incomestatement in accounting the emphasis was probably on the firm’s net income, which is accounting profit. However thevalue of company’s operation is determined by the stream of cash flows that the operations will generate now and inthe future. To be more specific, the value of operation depends on all the future expected free cash flows, defined asafter- tax operating profit minus the amount of new investment in working capital and fixed assets necessary tosustain the business. Therefore the way for managers to make their companies more valuable is to increase their freecash flow.Uses of FCF:1. Pay interest to debt holders, keeping in mind that the net cost to the company is the after tax interest expense.2. Repay debt holders, that is, pay off some of debt.3. Pay dividends to shareholders.4. Repurchase stock from shareholders.5. Buy marketable securities or other non operating assets.In practice, most companies combine these five uses in such a way that the net total is equal to FCF. For example, acompany might pay interest and dividends, issue new debts, also sell some of its marketable securities. Some of theseactivities are cash outflows (paying interest and dividends) and some are cash inflows (issuing debt and sellingmarketable securities), but the net cash flow from these five activities is equal to free cash flows.Computation of free cash flows:Eg:Suppose the company had a 2001 NOPAT of $170.3million and depreciation is only the non cash charge which is$100million then its operating cash flow in 2001 would be NOPAT plus any non cash adjustment on the statement ofcash flows. Operating cash flow =NOPAT +depreciation (non cash adjustment) = $17.03 + $100 = $270.3Company has $1,455million operating assets, at the end of 2000, but $1,800 at the end of 2001.it made a netinvestment in operating assets of Net investment in operating assets = $18, 00 - $1,455 = $345million 6
  7. 7. If net fixed assets rose from $870million to $1000million however company reported $100million of depreciation.So its gross investment in fixed assets would be Gross investment = net investment + depreciation = $130 + $100 = $230millionCompany free cash flows in 2001 was FCF = operating cash flow – gross investment in operating assets = $270.3 - $445 = - $174.7millionAn algebraically equivalent equation is FCF = NOPAT - Net investment in operating assets = $170.3- $345 = - $174.7millionEven though company had a positive NOPAT, its very high investment in operating assets resulted in a negative freecash flow. Because free cash flow is what is available for distribution to investor, not only was there nothing forinvestors, but investor actually had to provide additional money to keep the business ongoing. A negative current FCFnot necessarily bad provided it is due to the high growth or to support the growth. There is nothing wrong withprofitable growth; even it causes negative free cash flow in the short termQ.3) What is Balance Scorecard? What is the process of implementation and difficulties in implementation?The Balanced Scorecard (BSC) is a performance management tool which began as a concept for measuring whetherthe smaller-scale operational activities of a company are aligned with its larger-scale objectives in terms of vision andstrategy.By focusing not only on financial outcomes but also on the operational, marketing and developmental inputs to these,the Balanced Scorecard helps provide a more comprehensive view of a business, which in turn helps organizations actin their best long-term interests. 7
  8. 8. Organizations were encouraged to measure—in addition to financial outputs—what influenced such financial outputs.For example, process performance, market share / penetration, long term learning and skills development, and so on.The underlying rationale is that organizations cannot directly influence financial outcomes, as these are "lag"measures, and that the use of financial measures alone to inform the strategic control of the firm is unwise.Organizations should instead also measure those areas where direct management intervention is possible. In so doing,the early versions of the Balanced Scorecard helped organizations achieve a degree of "balance" in selection ofperformance measures. In practice, early Scorecards achieved this balance by encouraging managers to selectmeasures from three additional categories or perspectives: "Customer," "Internal Business Processes" and "Learningand Growth."The balance scorecard suggests that we view the organization from four perspectives, and to develop metrics, collectdata and analyze it relative to each of these perspectives: 8
  9. 9.  The learning and growth perspective : “To achieve our vision, how will we sustain our ability to change and improve?” • The business process perspective : “To satisfy our shareholders and customers what business processes must we excel at?” • The customer perspective : “To achieve our vision, how should we appear to our customer?” • The financial perspective : “To succeed financially, how should we appear to our shareholders?”Implementing a Balanced ScorecardWe 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 theorganization Define StrategyThe balance scorecard builds a link between strategy and operational action. As a result it is necessary to begin theprocess of defining a balanced scorecard by defining the organization goals are explicit and what that targets have beendeveloped. Define Measures of StrategyThe next step is to develop measures in support of the articulate strategy. It is imperative that the organization focuseson a few critical measures at this point; otherwise management will be overloaded with measures. Also, it is importantthat the individual measures be linked with each other in a cause effect manner Integrated Measures into the management systemThe balanced scorecard must be integrated with the organization formal and informal structure, its culture, and itshuman resources practice. While the balanced Scorecard gives some means for balancing measures, the measures canstill become unbalanced by others system in the organization such as compensation policies that compensate themanager strictly based on financial performance. Review Measures and result FrequentlyOnce the balance scorecard is up and running it must be consistently reviewed by senior management. Theorganization should be looking for the following  How do the outcome measures say the organization is doing?  How do the driver measures say the organization is doing?  How has the organization’s strategy changed since the last review?  How has the scorecard measures changed?The most important aspects of these reviews are as follows;  They tell management whether the strategy is being implemented correctly and how successfully the strategy is working.  They show that management is serious about the importance of these measures.  They maintain alignment of measure to ever changing strategies. 9
  10. 10.  Difficulties in implementing Balanced ScorecardThe following problems unless suitably dealt with, could limit the usefulness of the balanced scorecard approach: • Poor correlation between nonfinancial measures and result. • Fixation on financial result. No mechanism for improvement. • No mechanism for improvement. • Measures overload. Poor Correlation between Nonfinancial measures and resultSimply put there is no guarantee that future profitably will allow targets achievement in any nonfinancial area. This isprobably the biggest problem with the balanced scorecard because there is an inherent assumption that futureprofitability does follow from achieving the scorecard measures, identifying the cause effect relationships among thedifferent measures is easier said than done.This will be a problem with any system that is trying to develop proxy measures for future performance. While thisdoes not mean that the balanced Scorecard should be abandoned it is imp that comp adopting such a system understandthat the links between nonfinancial measures and financial performance are still poorly understood. Fixation on Financial ResultsAs previously discussed not only are most senior managers well trained and very adept with financial measures butthey also most keenly feel pressure regarding the financial performance of their comp. Shareholder are vocal and theboard of directors often applies pressure on the stakeholders behalf .this pressure often overwhelms the long termuncertain payback of the nonfinancial measures. Non mechanism for ImprovementOne of the most overlooked pitfalls of the balanced scorecard is that a company cannot achieve Stretch goals if theCompany has no mechanism for improvement .Unfortunately achieving many of these goals require complete shifts inthe way that business is done yet the company often does not have mechanism to make those shifts . The mechanismavailable takes additional resource and requires a changed in the company culture. These changes do not happenovernight nor do they respond automatically to a new stretch targets. Inertia often works against the companyemployees are accustomed to a self limited cycle of setting targets, missing those targets and readjusting the targets toreflect what was actually achieved. Without a method for making improvement, improvements are unlikely toconsistently happen no matter how good the stretch goal sound. Measurement overloadHow many critical measures can one manager track at one time without losing? Unfortunately there is no right answerto this question except it is more than 1 and less than 50. It too few then the manager is ignoring measures that arecritical to creating success. If it too many then the manager may risk losing focus and trying to do too many things atonce. 10
  11. 11. Q.4) Girish Engineering (MCS-2004) Numerical Responsibility budgeting was introduced in a medium sized organization Girish Engineering.Monthly report (in part) for an expense centre in factory is: All figures in Rs. Lacs Actual VarianceDirect Labour 100.13 0.21 (Favourable)Indirect Labour 66.34 8.10 (Unfavourable)Total Controllable Costs 168.47 8.50 (Unfavourable)Department Fixed Costs 38.82 --------Allocated Costs 53.62 --------Questions: 1. Why no variance is shown in two items? Is this correct approach in performance reporting? 2. Should overhead expenses mentioned above be included in Controllable Costs? Why? Why not?Solution (a):Variances between actual and budgeted departmental fixed costs are obtained simply by subtraction, since these costsare not affected by either the volume of sales or the volume of production. That’s why no variance is shown fordepartmental fixed costs.Allocated costs are a share of the costs of a resource used by a project, where the same resource is also used by otheractivities. These are different to the Incurred costs because these costs are not exclusively related to any individualproject. However, the cost of the resource still needs to be recovered, and making a fair and reasonable charge to allprojects using the resource does this.The key difference between costs and Allocated costs is that the latter will be charged based upon an estimate, ratherthan actual cash values. Thus as it is charged based upon an estimate the budgeted figure is the same as the actualfigure and hence no variances.Solution (b):Overhead Expenses mentioned above should not be included in controllable costs because some costs areuncontrollable like fixed costs. . They dont vary with the change in short run managerial decisions and output. Andsome costs are controllable i.e. they can be managed and changed with the managerial decisions and output.As the above overhead expenses would have certain portion of fixed expenses this is hard to control. So, these shouldnot be a part of controllable cost. 11
  12. 12. Q.5ABC ltd. (MCS-2008) Numerical Particulars Division X (Rs.) Division Y (Rs.) ROI 28% 26% Sales 100 Lacs 500 lacs Investment 25 lacs 100 Lacs EBIT 7 Lacs 26 lacsAnalyze and comment upon performances of both the divisionsSolution:Division XROI = (Profit / investment)* 100Profit = (28/100)*25lacs = 7lacsProfit margin = (Profit/sales)*100 = (7/100)*100 = 7lacsTurnover of investments = (Sales/investment)*100 = (100/25)*100 = 4 timesDivision YROI = (Profit / investment)* 100Profit = (26/100)*100lacs = 26lacsProfit margin = (Profit/sales)*100 = (26/500)*100 = 5.2lacsTurnover of investments = (Sales/investment)*100 = (500/100)*100 = 5 timesProfit margin of X is better than profit margin of division Y. Turnover of investment of division Y is better thanDivision X.Hence cost management of Division X is better than Division Y. 12
  13. 13. SET. 2Q1. MCS designers apparently disagree whether single measure to evaluate the profit performance and capitalinvestment performance is preferable or SEPARATE measures for each are preferable – COMMENT ?ANS. There should be different measures used for evaluating profit performance and capital investment performanceas needed.The goal of performance measurement systems is to implement strategy. In setting up such systems, seniormanagement selects measures that best represent the companys strategy. These measures can be seen as current andfuture critical success factors; if they are improved, the company has implemented its strategy. The strategys successdepends on its soundness. A performance measurement system is simply a mechanism that improves the likelihoodthe organisation will implement its strategy successfully. Measuring ProfitabilityThere are two types of profitability measurements used in evaluating a profit center, just as there are in evaluating anorganization as a whole. First, there is a measure of management performance, which focuses on how well themanager is doing. This measure is used for planning, coordinating, and controlling the profit centers day-to-dayactivities and as a device for providing the proper motivation for its manager. Second, there is the measure ofeconomic performance, which focuses on how well the profit center is doing as an economic entity. The messagesconveyed by these two measures may be quite different from each other. For example, the management performancereport for a branch store may show that the stores manager is doing an excellent job under the circumstances, whilethe economic performance report may indicate that because of economic and competitive conditions in its area thestore is a losing proposition and should be closed. The necessary information for both purposes usually cannot be obtained from a single set of data. Because themanagement report is used frequently, while the economic report is prepared only on those occasions when economicdecisions must be made, considerations relating to management performance measurement have first priority insystems design-that is, the system should be designed to measure management performance routinely, with economicinformation being derived from these performance reports as well as from other sources. 13
  14. 14.  Capital Investment MeasurementMost proposals require significant new capital. Techniques for analyzing capital investment proposals attempt to findeither (a) The net present value of the project, that is, the excess of the present value of the estimated cash inflowsover the amount of investment required, or(b) The internal rate of return implicit in the relationship between inflows and outflows. An important point is thatthese techniques are used in only about half the situations in which, conceptually, they are applicable.There are at least four reasons for not using present value techniques in analyzing all proposals. 1) The proposal may be so obviously attractive that a calculation of its net present value is unnecessary. A newly developed machine that reduces costs so substantially that it will pay for itself in a year is an example. 2) The estimates involved in the proposal are so uncertain that making present value calculations is believed to be not worth the effort-one cant draw a reliable conclusion from unreliable data. This situation is common when the results are heavily dependent on estimates of sales volume of new products for which no good market data exist. In these situations, the "payback period" criterion is used frequently. 3) The rationale for the proposal is something other than increased profitability. The present value approach assumes that the "objective function" is to increase profits, but many proposed investments win approval on the grounds that they improve employee morale, the companys image, or safety.4) There is no feasible alternative to adoption. Environmental laws may require investment in a new program,as an example. The management control system should provide an orderly way of deciding on proposals that cannot be analyzed by quantitative techniques. Systems that attempt to rank non-quantifiable projects in order of profitability wont work. Many projects do not fit into a mechanical ranking scheme. 14
  15. 15. Q2: What are the different methods to measure profits of a profit center in organizations? Which differentmessages each type of measure is likely to convey to managers? Ans: When financial performance in a responsibility center is measured in terms of profit, which is the difference between the revenues and expenses, the responsibility center is called a profit center.Profit as a measure of performance is especially useful since it enables senior management to use one comprehensive measure instead of several measures that often point to different directions. There are two types of profitability measurements in a profit center, just as there are for the organization as a whole. There is, first, a measure of management performance, in which the focus is on how well the manager is doing. This measure is used for planning, coordinating and controlling the day-to-day activities of the profit center. Second, there is a measure of economic performance, in which the focus is on how well the profit center is doing as an economic entity. The message given by these two measures may be quite different.  Types of Profitability measures: In order to evaluate the economic performance of a profit center, one must use net income after allocating all costs. However, in evaluating the performance of manager, any of five different measures of profitability can be used. 1) Contribution Margin: The logic behind using contribution margin as a measure is that fixed expenses are not controllable by the manager, and therefore he should focus on maximizing the spread between revenue and expenses. But the problem with this is that some fixed costs are controllable and all fixed costs are partially controllable. A focus on the contribution margin tends to direct attention away from this responsibility. 2) Direct Profit: This measure shows the amount that the profit center contributes to the general overhead and profit of the corporation. It incorporates all expenses incurred in or directly traced to the profit center, regardless of whether these items are entirely controllable by the profit center manager. A weakness of this measure is that it does not recognize the motivational benefit of charging headquarters costs. 3) Controllable Profit: Headquarters expenses are divided into two categories: controllable and non- controllable. The controllable expenses are controlled by business unit manager. Consequently, if these costs are included in the management system, the profit will be after the deduction of all expenses that are influenced by profit center manager. 15
  16. 16. 4) Income before Taxes: In this measure, all corporate overhead is allocated to profit centers. The basis of allocation reflects the relative amount of expense that is incurred for each profit center. If corporate overheads are allocated to profit centers, budgeted costs, not actual costs, should be allocated. Then the performance report will show an identical amount in the “budget” and “actual” columns for such overheads.5) Net Income: Here, companies measure performance of domestic profit centers at the bottom line, the amount of net income after income tax. There are two arguments 1) Income after tax is constant percentage of the pretax income, so there is no advantage in incorporating income taxes 2) many decisions that have impact on income taxes are made at headquarters, and it is believed that profit center manager should not be judged by the consequences of these decisions. 16
  17. 17. Q3: Explain special characteristics of professional organizations which impact Management Control. What areinteractive controls?Special Characteristic of a Professional Organization:1. GoalsA goal of a manufacturing company is to earn a satisfactory profit specially a satisfaction profit, specially a satisfactoryreturn on assets its principle assets is the skill of its professional staff which doesn’t appear on its balance sheet .returnon assets employed therefore is essential meaningless in such organization .their financial goal is to provide adequatecompensation to the professional.2. ProfessionalsProfessional organization is labour intensive and the labour is of a special type. Research and developmentorganization use in setting selling price and for other management purposes .standard cost system ,separation of fixedand variable cost and analyses of variance were built on the foundation are example of organization whose product areprofessional service. Professional tends to give in adequate weight to the financial implication of their decision theywant to do the best job they can regardless of its cost.Because profession are the organization most important resource some authors have advocated that the value of theseprofession should be counted as assets the system that does this is called human resource accounting .in the 1970’smany books and articles were written on this subject but few comp actually such a system and we do not know of anythat one current .the problem of measuring the value of human assets is intractable.3. Output and input measurementThe output of a profession organisation cannot be measured in physical terms, use in setting selling price and for othermanagement purposes .standard cost system, seperstion of fixed and variable cost and analyses of variance were builton the foundation. We can measures the number of patient a physician treats n a day and even classify these visit bytype of complaint but this is by no means equivalent to measuring the amt or quality earned is one measures of outputin some professional organization but these monetary amts at most relate to the quantity of service rendered not to theirquality.Some profession notably scientist engineer, and professional are reluctant to keep track of how they spend their timeand this complicate the track of measuring performance .this reluctant seems to have its root in tradition usually it canbe overcome if senior management is willing to put appropriate emphasis on the necessity for accurate timereporting .nevertheless difficult problem arise in deciding how time should be charged to clients .if the normal workweek is 40 hrs should a job be charged for 1/40th of a week compensation for each other spent on it? If so how shouldwork done on evening and weekend be counted how to account for time spent reading literature ,going to meeting ,andotherwise keeping up to date? 17
  18. 18. 4. Small SizeWith a few exception such as some law firm and accounting firms ,professional organisations are relatively small andoperate at a single location .senior management in such organisations can personally observe what is going on andpersonally motivate employee .thus there is less need for a sophisticated management control system ,with profitcentres and formal performance reports nevertheless even a small organisations need a budget a regular comparison ofperformance against budget ,and a way relating compensation to performance.5. MarketingIn a manufacturing company there is a dividing line between marketing activities and production activities only seniormanagement is concerned with both .such a clean separation does not exist in most Professional organisation, howevertheir time and this complicate the track of measuring performance .this reluctant seems to have its root in traditionusually it can be overcome if senior management is willing to put appropriate emphasis on the necessity for accuratetime reporting. Nevertheless difficult problem arise in deciding how time should be charged to clients .if the normalwork. These marketing activities are conducted by professional usually by professional, usually by professional whospend much of their time in production work that is working for clients.In such situation it is difficult to assign appropriate credit to the person responsible for selling a new customer; in aconsulting firm for example a new engagement may result from a conversation between a member of the firm or fromthe reputation of one of the firm professional as an outgrowth of speeches or articles. Moreover the profession al whois responsible for obtaining the engagement may not personally involved in carrying it out .until fairly recently thesemarketing contribution were rewarded subjectively –that is they were taken into account in promotion andcompensation decisions .some organisation now give explicit credit, perhaps as a percentage of the project revenue, ifthe person revenue, if the person who hold sold the project can be identified. What is Interactive Control?Interactive control alerts management of strategic uncertainties either trouble or opportunities that become the basis formanager to adapt to a rapidly changing environments by thinking about new strategies. 1. A subset of the management control information that has a bearing on the strategic uncertainties facing the buss becomes the focal point. 2. Senior executive take such information seriously. 3. Managers at all levels of the org focus attention on the information produced by the system. 18
  19. 19. Q4: Kiran Company (MCS-2004) Numerical Budget versus Actual comparison for div Z of Kiran company is as follows: Budget Actual Actual better (worse) than budget Sales and other income 800 740 (60) Variable expenses 480 436 44 Fixed expenses 120 120 0 Sales promotional expenses 40 28 12 Operating profit 160 156 4 Net working capital 400 412 12 Fixed assets 160 148 (12)(a) Carry out and overall performance analysis to decide areas needing investigation. From the given data, we see that there is a certain amount of variance between the budgeted operating profit and actual operating profit. In order to analyze the variances, we need to understand the key causal factors that affect profit, namely, revenues and cost structure. The profit budget has embedded in it certain expectations about the state of total industry, company’s market share, selling prices and cost structure. Results from variance computation are actionable if changes in actual results are analyzed against each of this expectation.  Revenue variances, that is a negative Rs 60 lakhs, could be a result of selling price variance, mixed variance and/or volume variance. A combination of above three factors must have been unfavorable that is either the volume of sales must have been below the budgeted volumes ( this must be particularly true since actual variable expenses are less than budgeted) and/or the selling price must have been below expectation and/or the proportion of products sold with a higher contribution must have been less than budgeted. One more factor could have been the overall industry volume. However, this factor is beyond the managements control and largely dependent on the state of economy. 19
  20. 20.  Variable expenses : are directly proportional to volumes and hence as is evident are less than budgeted.Sales promotional expenses also show a negative variance which could be a cause of lower sales volumes.A cause of concern is that despite lower sales, the net working capital is more than budgeted which indicates capital block in higher inventory. Another issue is that the fixed assets are lower than the budget by Rs 12 lakhs which may indicate slower capacity expansion then expected or distressed sale of assets to tide over cash flow.(b) What are the remedial measures if any would you suggest based on analysis?The budgeted estimates may be too optimistic and far from reality, one needs to ensure that estimates the as realisticas possible. Given the estimates are correct, in that case depending upon the above analysis, the management needs totake corrective action areas needing improvement, sales volume could be improved by better marketing, qualitystandards and promotional efforts, product mix could be improved by selling more of higher contribution products.Better sales will ensure a higher inventory turnover. Better credit management to recover receivables, will ensureimprove cash flow situation since less capital will be tied up in working capital. 20
  21. 21. Q5: Shandilya Ltd. (MCS-2008) NumericalShandilya Ltd. has adopted Economic Value Added (EVA) technique for the appraisal of performance of its threedivisions A,B and C. Company charges 6% for current assets and 8 % for Fixed Assets, while computing EVArelevant data are given below :-Particulars Div A Div B Div C Total Budgeted Actual Budgeted Actual Budgeted Actual Budgete Actual dProfit 360 320 220 240 200 200 780 760Current Assets 400 360 800 760 1200 1400 2400 2520Fixed Assets 1600 1600 1600 1800 2000 2200 5200 5600Solution:Particulars Div A Div B Div C Total Budgeted Actual Budgeted Actual Budgeted Actu Budgete Actual al dROA 18% 16% 9% 9% 6% 6% 10% 9%EVA 208 170.4 44 50.4 -32 -60 220 160.8b) Comment upon both methods, based on results.There are three apparent benefits of an ROA measure. First, it is a comprehensive measure in that anything thateffects the financial statements is reflected in this ratio. Secondly, ROA is easy to calculate, easy to understand, andmeaningful in absolute sense. Finally, it is a common denominator that may be applied to any organizational unitsresponsible for profitability, no matter what its size or what business it practices. The performance of different unitsmay be compared directly to each other. Also, ROI data is available for competitors that can be used as a basis forcomparison. Nevertheless, the EVA approach has some inherent advantages over ROA.There are three compelling reasons to use EVA over ROI. First, with EVA all business units have the same profitobjective for comparable investments. The ROI approach, on the other hand, provides different incentives forinvestment across business units. For example, a business unit that is currently achieving 30% ROA would be mostreluctant to expand unless it is able to earn a ROI of 30% or more on additional assets. Second, decision that increasea centre’s ROI may decrease its overall profits. Third advantage of EVA is that different interest rates may be used fordifferent types of assets. For example, a relatively low rate May be used for inventories while a higher rate may beused for different types of fixed assets. SET .3 21
  22. 22. MANAGEMENT CONTROL SYSTEM Q.1) Describe differences in budgeting perspective of engineered and discretionary expense centre1.Expense centers:Expenses center are responsibility centers for which input or expenses are measured in monetary terms, butfor which outputs are not measured in monetary terms. There are two general types: engineered expensecenter and discretionary expense center. They correspond to two types of costs.. Engineered costs areelements of cost for which the right or proper amount of costs that should be incurred can be estimatedwith a reasonable degree of reliability. Costs incurred in factory for direct labour direct materialcomponent supplies and utilities are examples.2.Engineered expense centers:Engineered expense center have the following characteristics:1. Their inputs can be measured in monetary terms.2. Their output can be measured in physical terms.3. The optimal dollar amount of input required to produce one unit of output can be establishedEngineered expense center usually are found in manufacturing operations. Warehousing, distribution,trucking and similar units in the marketing organization also may be engineered expense center and somany certain responsibility center within administrative and support department. Examples are accountsreceivable account payable and payroll section in the controller department personnel record and cafeteriain the human resource department shareholder record in the corporate secretary department and thecompany motor pool. Such units perform repetitive task for which standard cost can be developedIn an engineered expense center the output multiplied by the standard cost or each unit produced representswhat the finished product should have cost. When this cost is compared to actual costs, the differencebetween the two represents the efficiency of the organization unit being measured.We emphasize that engineered expense centers have other important tasks not measured by cast alone. Theeffectiveness of these aspects of performance should be controlled. For example expenses center supervisorare responsible for the quality of good and for the volume of production in addition to their responsibilityfor cost efficiency. Therefore the type and amount of production is prescribed and specific qualitystandards are set so that manufacturing costs are not minimized at the expense of quality. Moreovermanager of engineered expense center may be responsible for activities such a training that are not relatedto current production judgment about their performance should include an appraisal of how well they carryout these responsibilities.There are few if any responsibility center in which all cost items are engineered. Even in highly automatedproduction department the amount of indirect labour and of various services used can vary withmanagement discretion.Thus, the term engineered costs center refers to responsibility center in which engineered cost predominatebut it does not imply that valid engineering estimates can be made for each and every cost item. 22
  23. 23. 3.Discretionary expense center:The output of discretionary expenses center cannot be measured in monetary terms. They includeadministration and support units research and development organization and most marketing activities.The term discretionary does not mean that management judgments are capricious or haphazard.Management has decided on certain policies that should govern the operation of the company. Onecompany may have a small headquarter staff another company of similar size and in the same industry mayhave a staff that is 10 time as large the management of both companies may be concerned that they madethe correct decision on staff size but there is no objective way judging which decision was actually bettermanager are hired and paid to make such decision after such a drastic change the level of discretionaryexpenses generally has a similar pattern from one year to the next.The difference between budgeted and actual expense is not a measure of efficiency in a discretionaryexpense centre it is simply the difference between the budgeted input and the actual input. It in no waymeasures the value of the output, if actual expense do not exceed the budget amount, the manager has‘lived within the budget ‘ however ,because by definition the budget does not purport to measure theoptimum amount of spending we cannot say that living within the budget is efficient performance .4.Differences in budgeting perspective of engineered and discretionary expense centre  Budget preparationThe decision that management make about a discretionary expense budget are different from the decisionsthat it makes about the budget for an engineered expense center. For the latter, management decideswhether the proposed operating budget represent the cost of performing task efficiently for the comingperiod. Management is not so much concerned with the magnitude of the task because this is largelydetermined by the actions of other responsibility centers, such as the marketing departments’ ability togenerate sales. In formulating the budget for a discretionary expense center, however management principaltask is to decide on the magnitude of the job that should be done.  Incremental budgeting:Here the current level expenses in a discretionary expense center is taken as a starting points this amount isadjusted for inflation for anticipated changes in the workload of continuing tasks for special tasks and ifthe data are readily available for the cost of comparable work in similar units.There are two drawbacks to incremental budgeting. First because managers of these centers typically wantto provide more service they tend to request additional resources in the budgeting process and if they makea sufficiently strong case these request will be granted. This tendency is expressed in Parkinson’s secondlaw: overhead costs tend to increase period. There is ample evidence that not all this upward creep in costis necessary.This problem is especially compounded by the fact that the current level of expenditure in the discretionaryexpenses center is taken for granted and is not re-examined during the budget preparation process. Secondwhen a company faces a crises or when a new management takes over overhead costs are sometimesdrastically reduced without any adverse consequences.Despite this limitation most budgeting in discretionary expense centers is incremental. Time does notpermit the more thorough analysis described in the next section. 23
  24. 24.  Zero based review:An alternative approach is to make a thorough analysis of each discretionary expense center on a schedulethat will cover all of them over a period of five year or so. That analysis provides a new base. There is alikelihood that expenses will creep up gradually over the next five years and this is tolerated at the end offive years, another new base is established. Such an analysis is often called a zero base review.In contrast with incremental budgeting which takes the current level of spending as the starting point thismore intensive review attempts to build up de now the resources that actually are needed by the activity.Basic question are raised;(1) should use customer?(2) what should the quality level be ?are we doing toomuch(3)should the function be performed in this way (4) how much should it cost?  Cost variability:In discretionary expense center costs tend to vary with volume from one year to the next but they tend notto vary with short run fluctuation in volume within a given year. By contrast costs in engineering expensecenter are expected to vary with short run changes in volume. In part this reflect the fact that volumechanges do have an impact throughout the company even though their actual impact cannot be measures the; in part this reflect the fact that volume changes do have an impact throughout the company even thoughtheir actual impact cannot be measured in part this result from a management personnel and personnelrelated costs are by far the largest expense item in most discretionary expense center the annual budget forthese center tend to be a constant percentage of budgeted sales volume. Q.2) Explain some factors which may influence top management style and the implication of the top management style on management control.The management control function in an organization is influenced by the style of senior management. Thestyle of the chief executive officer affects the management control process in the entire organization.Similarly, the style of the business unit manager affects the units management control process, and thestyle of functional department managers affects the management control process in their functional areas.  Differences in Management StylesManagers manage differently. Some rely heavily on reports and certain formal documents; others preferconversations and informal contacts. Some are analytical; others use trial and error. Some are risk takers;others are risk averse. Some are process oriented; others are results oriented. Some are long-term oriented;others are short-term oriented. Some emphasize monetary rewards; others emphasize a broader set ofrewards.Management style is influenced by the managers background and personality. Background includes thingslike age, formal education, and experience in a given function, such as manufacturing, technology,marketing, or finance. Personality characteristics include such variables as the managers willingness totake risks and his or her tolerance for ambiguity.  Implications for Management ControlThe various dimensions of management style significantly influence the operation of the control systems.Even if the same reports with the same set of data go with the same frequency to the CEO, two CEOs withdifferent styles would use these reports very differently to manage the business units.Style affects the management control process – how the CEO prefers to use the information, conductsperformance review meetings, and so on – which in turn affects how the control system actually operates, 24
  25. 25. even if the formal structure does not change under a new CEO. In fact, when CEOs change, subordinatestypically infer what the new CEO really wants based on how he or she interacts during the managementcontrol process. 25
  26. 26.  Personal versus Impersonal ControlsPresence of personal versus impersonal controls in organizations is an aspect of managerial style. Managersdiffer on how much importance they attach to formal budgets and reports as well as informal conversationsand other personal contacts. Some managers are "numbers oriented"; they want a large flow of quantitativeinformation, and they spend much time analyzing this information and deriving tentative conclusions fromit. Other managers are "people oriented"; they look at a few numbers, but they usually arrive at theirconclusions by talking with people, judging the relevance and importance of what they learn partly on theirappraisal of the other person. They visit various locations and spend time talking with both supervisors andstaff to get a sense of how well things are going.Managers attitudes toward formal reports affect the amount of detail they want, the frequency of thesereports, and even their preference for graphs rather than tables of numbers, and whether they wantnumerical reports supplemented with written comments. Designers of management control systems need toidentify these preferences and accommodate them.  Tight versus Loose ControlsA managers style affects the degree of tight versus loose control in any situation. The manager of a routineproduction responsibility center can be controlled relatively tightly or loosely, and the actual controlreflects the style of the managers superior. Thus, the degree of tightness or looseness often is not revealedby the content of the forms or aspects of the formal control documents, rules, or procedures. It is a factor ofhow these formal devices are used. The degree of looseness tends to increase at successively higher levelsin the organization hierarchy: higher-level managers typically tend to pay less attention to details and moreto overall results.The style of the CEO has a profound impact on management control. If a new senior manager with adifferent style takes over, the system tends to change correspondingly. It might happen that the managersstyle is not a good fit with the organizations management control requirements. If the manager recognizesthis incongruity and adapts his or her style accordingly, the problem disappears. If, however, the manageris unwilling or unable to change, the organization will experience performance problems. The solution inthis case might be to change the manager. 26
  27. 27.  Q.3) Explain advantages and disadvantages of two step transfer pricing and profit sharing methods  Transfer pricing: If two or more profit center is jointly responsible for product development manufacturing and marketing each should share in the revenue that is generated when the product is finally sold. The transfer price is not primarily an accounting tool; rather, it is a behavioral tool that motivates manager to make the right decisions. In particular the transfer price should be designed so that it accomplishes the following objective: It should provide each segment with the relevant information required to determine the optimum tradeoff between company cost and revenues It should induce goal congruent decisions that is the system should be so designed that decision improve business unit to earn more profit It should help measure the economic performance of the individual profit center  Two step pricing: First, a charge is made for each unit sold that is equal to the standard variable cost of production. Second a periodic charge is made for the buying unit. One or both of these components should include a profit margin. The two step pricing method correct this problem by transferring variable cost on a per unit basis, and transferring fixed cost and profit on a lump sum basis under this method the transfer price for product A would be 5$ for each unit that unit Y purchases plus $20000 per month for fixed cost. Plus $10000 per month for profit: if transfer of product A in a certain month are at the expected amount 5000 units then under the two step method unit y will pay the variable cost of $25000 plus $30000 for the fixed cost and profit a total of $55000 .this is the same amount as the amount it would pay unit x if the transfer price is less than 5000 units say 4000unoits.unit y would pay $50000 under the two step methods compared with the $44000 it would pay if the transfer price were $11 per unit. The difference is their transfer prices were for not using a portion of unit X capacity that it has reserved. Note that under two step method the company variable cost for product A is identifiable to unit Y variable cost for the product, and unit Y will make the correct short term marketing decisions. Unit Y also has information on upstream fixed costs and profit related to product A and it can use these data for long term decision.The fixed cost calculation in the two step pricing method is based on the capacity that is reserved for the production of product A that is sold to unit Y the investment represented by this capacity is allocated to product A. The return on investment that unit X earns on competitive product is calculated and multiplied by the investment assigned to the product. In the example we calculated the profit allowance as a fixed monthly amount. It would be appropriate under some circumstance to divide the investment into variable and fixed component. Then, a profit allowance based on a return on investment on variable assets would be added to the standard variable cost for each unit sold. 27
  28. 28.  Profit sharing: If the two step pricing system just described is not feasible, a profit sharing system might be used to ensure congruence of business unit interest with company interest. This system operates somewhat as follows.1. The product is transferred to the marketing unit at standard variable cost.2. After the product is sold, the business units share the contribution earned which is selling price minus the variable manufacturing and marketing costs. This method of pricing may be appropriate if the demand for the manufactured product is not steady enough to warrant the permanent assignment of facilities as in the two step method. In general, this method accomplished the purpose of making the marketing unit’s interest congruent with the companies. There are several practical problems in implementing such profit sharing system. First, there can be arguments over the way contribution is divided between the two profit centers. Which is costly, time consuming and work against basic reason for decentralization namely autonomy of the business units mangers. Second, arbitrarily divided up the profit between units does not give valid information on the profitability of each segment of the organization. Third since the contribution is not allocated until after the sale has been made the manufacturing units contribution depends upon the marketing unit’s ability to sell and on the actual selling price. Manufacturing units may perceive this situation to be unfair  Two set of price: in this method, the manufacturing unit’s revenue is credited at the outside sales price, and the buying unit is charged the total standard costs. The difference is changed to a headquarter account and eliminated when the business unit statement are consolidated, this transfer pricing method is sometimes used when there are frequent conflict between the buying and selling units that cannot be resolved by one of the other method both the buying and selling  There are several disadvantages to the system of having two set of transaction prices, however the sum of the business unit profit is greater than overall company profits, senior management must be aware of this situation in approved budget for the business units and in subsequent evaluation of performance against these budget. Also, this system create an illusion feeling that business units are making money while in fact the overall company might be losing after taking account of the debits to headquarter. Further this system might motivate business unit to concentrate more on internal transfers at the expense of outside sales  The fact that the conflict between the business units would be lessened under this system could be viewed as a weakness. Sometime, it is better for the headquarter to be aware of the conflict arising out of transfer prices because such conflict may signal problem in either the organizational structure or In other management systems. Under the two sets of prices method these conflicts are smoothed over thereby not alerting senior management to these problems. 28
  29. 29.  Q.4) Discuss special challenges faced in controlling R & D activities and possible management initiatives  Type of financial control: The financial control exercised in a discretionary expense center is quite different from that in engineered center the latter attempts to minimize operating cost by setting a standard and reporting actual costs against this standards. The main purpose of a discretionary expense budget on the other hand is to allow the manager to control Cost for particular in the planning. Costs are controlled primarily by deciding what task should be undertaken and what level of effort is appropriate for each. Thus in a discretionary expense center financial control is primary exercised at the planning stage before the amount are incurred.  Measurement of performance: The primary job of the manager of a discretionary expense center is to accomplish the desired output spending an amount that is on budget is satisfactory. This is in contrast with the report in an engineered expense center which helps higher management to evaluate the manger efficiency. If these two types of responsibility center are carefully distinguished management may treat the performance report for the discretionary expense center as if it were an indication of efficiency Control over spending can be exercised by requiring that the manger approved be obtain before the budget is over sometimes a certain percentage of overrun is permitted without additional approval if the budget really set forth the best estimate of actual cost there is 50 percent probability that it will overrun and this is the reason that some latitude is often permitted.  Control problems: The control of R & D centers, which are also discretionary expense center is difficult for the following at least a semi tangible output reasons.1. Results are difficult to measure quantitatively. As contrasted with administrative activities, R&D usually has at least a semi tangible output in patent, new products, or new processes. Nevertheless, the relationship of these outputs to inputs is difficult to measure and appraise. A complete product of an R&D group may require several year of effort; consequently input as stated in an annual budget may be unrelated to outputs. Even if an output can be identified a reliable estimate of its value often cannot be made. Even if the value of the output can be calculated, it is usually not possible for management to evaluate the efficiency of the R&D effort because of its technical nature. A brilliant effort may come up against an insuperable obstacle, whereas a mediocre effort may, by luck result in a bonanza.2. The goal congruence problem in R&D center is similar to that in administrative centers. The research managers typically want to build the best research organization that money can buy, even though this is more expensive than the company can afford. A further problem is that research people often may not have sufficient knowledge of the business to determine the optimum direction of the research efforts. 29
  30. 30. 3. Research and development can seldom be controlled effectively on an annual basis. A research project may take year s to reach fruition, and the organization must be built up slowly over a long time period. The principal cost is for the work force obtaining highly skilled scientific talented is often difficult, and short term fluctuation in the work force are in efficient. It is not reasonable, therefore to reduce R&D costs in years when profits are low and increase them in year when profits are high. R&D should be looked at as a long term investment not as an activity that varies with short run corporate profitability. The R&D continuum:Activities conducted by R&D organization lie along a continuum. At one extreme is basic research; the other extreme is product testing. Basic research has two characteristics: first, it is unplanned management at most can specify the general area that is to be explored second there is often a very long time lag before basic research result in successful new product introductions. Financial control system has little value in managing basic research activities. In some companies, basic research in included as a lump sum in the research program and budget. In others, no specific allowance is made for basic research as such; there is an understanding that scientists and engineers can devote part of their time to explorations in whatever direction they find most interesting, subject only to informal agreement with their supervisor.For product testing projects, on the other hand, the time and financial requirement can be estimated, not as accurately as production activities. 30
  31. 31.  Q.5) Explain problems faced in pricing corporate services provided to business units organized as Profit CentersServices are intangible in nature. This characteristic of services makes it difficult for pricing. Chargingbusiness units for services furnished by corporate staff units becomes challenging work due to intangibilityof services. While pricing corporate services, we exclude the cost of central service staff units over whichbusiness units have no control (e.g., central accounting, public relations, and administration). If these costsare charged at all, they are allocated, and the allocations do not include a profit component. The allocationsare not transfer prices. We need to consider two types of transfers: O For central services that the receiving unit must accept but can at least partially control the amount used. O For central services that the business unit can decide whether or not to use.Business units may be required to use company staffs for services such as information technology andresearch and development. In these situations, the business unit manager cannot control the efficiency withwhich these activities are performed but can control the amount of the service received. There are threeschools of thought about such services.One school holds that a business unit should pay the standard variable cost of the discretionary services. Ifit pays less than this, it will be motivated to use more of the service than is economically justified. On theother hand, if business unit managers are required to pay more than the variable cost, they might not electto use certain services that senior management believes worthwhile from the companys viewpoint. Thispossibility is most likely when senior management introduces a new service, such as a new project analysisprogram. The low price is analogous to the introductory price that companies sometimes use for newproducts.A second school of thought advocates a price equal to the standard variable cost plus a fair share of thestandard fixed costs-that is, the full cost. Proponents argue that if the business units do not believe theservices are worth at least this amount, something is wrong with either the quality or the efficiency of theservice unit. Full cost represents the companys long run costs, and this is the amount that should be paid.A third school advocates a price that is equivalent to the market price, or to standard full cost plus a profitmargin. The market price would be used if available (e.g., costs charged by a computer service bureau); ifnot, the price would be full cost plus a return on investment. The rationale for this position is that thecapital employed by service units should earn a return just as the capital employed by manufacturing unitsdoes. Also, the business units would incur the investment if they provided their own service. Optional Use of ServicesIn some cases, management may decide that business units can choose whether to use central service units.Business units may procure the service from outside, develop their own capability, or choose not to use theservice at all. This type of arrangement is most often found for such activities as information technology,internal consulting groups, and maintenance work. These service centers are independent; they must standon their own feet. If the internal services are not competitive with outside providers, the scope of theiractivity will be contracted or their services may be outsourced completely.For example, Commodore Business Machines outsourced one of its central service activities-customerservice-to Federal Express. James Reeder, Commodores vice president of customer satisfaction, said, "At 31
  32. 32. that time we didnt have the greatest reputation for customer service and satisfaction. But this was FedExsspecialty, handling more than 300,000 calls for service each day. Commodore arranged for FedEx to handlethe entire telephone customer service operation from FedExs hub in Memphis. 32
  33. 33. After losing $29 million online the previous year, Borders Group turned to rival Amazon.com to manage itsonline sales. Borders get to maintain an Internet sales channel and gains the operational effectivenessprovided by Amazon.com while being able to focus on the growth of its bricks and mortar business.In this situation, business unit managers control both the amount and the efficiency of the central services.Under these conditions, these central groups are profit centers. Their transfer prices should be based on thesame considerations as those governing other transfer prices. (Numerical) MCS – 2004Division B of Shayana company contracted to buy from Div. A, 20,000 units of a components whichgoes into the final product made by Div. B. The transfer price for this internal transaction was set atRs. 120 per unit by mutual agreement. This comprises of (per unit) Direct and Variable labour cost ofRs. 20; Material Cost of Rs.60; Fixed overheads of Rs.20 (lumpsum Rs.4 lacs) and Rs.20 lacs that Div.A would require for this additional activity. During the year, actual off take of Div. B from Div. Awas 19,600 units. Div. A was able to reduce material consumption by 5% but its budgeted investmentovershot by 10%.a) As Financial controller of Div. A, compare Actual Vs Budgetred Performanceb) Its implications for Management Control?Solution:a) Particulars Budgeted Budgeted Actual Actual (Rs. Per (Total in Rs.) (Rs. Per Unit) (Total in Rs.) Unit) For 20,000 Units For 19,600 Units Direct and 20 4,00,000 20 3,92,000 Variable Labour Cost Material Cost 60 12,00,000 57 11,17,200 Fixed Overheads 20 4,00,000 4,00,000 Total Cost 100 20,00,000 19,09,200 Transfer Price 120 24,00,000 119.86 23,49,200 Profit 20 4,00,000 4,40,000 Investment 20 20,00,000 22,00,000 ROI = 20% 20% Profit/InvestmentDespite of increase in investment by 10%, there is negligible difference in transfer price. Also the saleshave decreased by 400 units. Therefore we can say that additional investment has not achieved any positiveresults. 33
  34. 34. MCS – 2007Two Divisions A and B of Satyam Enterprises operate as Profit centers. Division A normallypurchases annually 10,000 nos. of required components from Div. B; which has recently informedDiv. A that it will increase selling price per unit to Rs.1,100. Div. A decided to purchase thecomponents from open market available at Rs. 1000 per unit. Naturally, Div. B is not happy andjustified its decision to increase price due to inflation and added that overall company profitabilitywill reduce and the decision will lead to excess capacity in Div. B, whose variable and fixed costs perunit are respectively Rs. 950 and Rs. 1,100.a) Assuming that no alternate use exists for excess capacity in Div. B, will company as a whole benefit if div A buys from the market.b) If the market price reduces by Rs. 80 per unit. What would be the effect on the company (assuming Div. B still has excess capacity) if A buys from the marketc) If excess capacity of Div. B could be used for alternative sales at yearly cost savings of Rs. 14.5 lacs, should Div. A purchase from outside?Justify your answers with figures.Solutiona) Option A ( Div A buys from outside) Total Purchase Cost = 10,000 Units * Rs. 1000 = Rs. 1,00,00,000 Total outlay if transferred inside = 10,000 Units * Rs. 950 = Rs. 95,00,000 Since total outlay if transferred inside is lesser than total purchase cost if bought from outside, relevant cost is the lesser one i.e. Rs. 95,00,000 and overall benefit for the company would be Rs. 5,00,000b) Option B ( if the market price is reduced by Rs. 80 per unit and A buys from the market) Total Purchase Cost = 10,000 Units * Rs. 920 = Rs. 92,00,000 Total outlay if transferred inside = 10,000 Units * Rs. 950 = Rs. 95,00,000 Since total purchase cost is lesser than the total outlay if transferred inside, relevant cost is the lesser one i.e. 92,00,000 and overall benefit for the company would be Rs. 3,00,000c) Option C ( if excess capacity of Div B could be used for alternative sales at yearly cost savings of Rs 14.5 lacs, should Div A purchase from outside) Total Purchase Cost = 10,000 Units * Rs. 1,000 = Rs. 1,00,00,000 Total outlay if transferred inside = 10,000 Units * Rs. 950 = Rs. 95,00,000 Total opportunity cost if transferred inside = Rs. 14,50,000 Total relevant cost becomes Rs. 1,00,00,000 If Div A purchase from outside, overall benefit for the company would be Rs. 9,50,000. Therefore, Div A should purchase from outside. Particulars Option A Option B Option C Amount Amount AmountTotal Purchase Cost 1,00,00,000 92,00,000 1,00,00,000Total outlay if transferred inside 95,00,000 95,00,000 95,00,000Total opportunity cost if transferred inside - - 14,50,000Total relevant cost 95,00,000 92,00,000 1,00,00,000Net advantage/disadvantage to company as a whole if it 5,00,000 (3,00,000) (9,50,000)buys from inside 34
  35. 35. SET.4Q.1) Explain the concept of ROI. What are its advantages?Many experts regard EVA as a concept is superior to ROI and yet in certain cases, EVA does not do justice tothe evaluation of investment centre. Explain this phenomenon with illustration.Q.2) What are the different methods to evaluate the performance of an investment centre? Discuss the meritsand demerits of each? Which method would you recommend?Q.3) What are the objectives of Transfer Pricing? What is ideal transfer price in the situations of LimitedMarket Shortage of Capacity in the industryQ.4) When do you use Cost Based Transfer Pricing?- Transfer Pricing is not an accounting tool” comment with illustration.- Market Price is ideal transfer price even in limited markets. Comments.Q.5 ) Aparna Company Manufacturers (MCS-2004) Numerical 35
  36. 36. Q.1) A)Explain the concept of ROI. What are its advantages?Return on investment (ROI) is the ratio of profit before tax to the gross investment.ROI is calculated with the help of the following formula:ROI = (Pre-Tax Profit/Sales) X (Sales/Net Assets) or (Pre-Tax Profits/Net Assets)The numerator is profit before tax as reported in the P&L account. The profit should include only the profits arisingout of the normal activities of the division. Unusual items of receipts and expenses should be excluded from the profitfigure. One should also ignore windfalls and income from investments not related to the operations of the division.Tax is excluded from the numerator because the marginal of the SBU is not responsible for or in control of the taxpaid.Capital employed can be ascertained from the balance sheet by including fixed and current assets. Assets not currentlyput to divisional use should be excluded from the investment base. One also needs to exclude their relative earnings ifany. The company should also exclude intangible assets like goodwill, deferred revenue expenses, preliminaryexpenses, etc.ROI can be improved by:Increasing the profit margin on sales.Increasing the capital turnoverIncreasing both profit margin and capital turnover.Reducing cost as that adds to the total earnings of the firm.Increasing the profits by expanding present operations or developing new product line, increasing market share, etc.Diversifying, introducing productivity imporevement measures, expansion, replacement of old equipmentsAdvantages of ROIROI relates return to the level of investment and not sales as the rate of return is more realistic.ROI can be decomposed into other variables as shown. These variables have tremendous analytical value.ROI is an effective tool for inter-firm comparison. 36
  37. 37. Question 1 (b):Many experts regard EVA as a concept superior to ROI and yet in certain cases, EVA does not do justice to theevaluation of investment center. Explain this phenomenon with as illustration.EVA does not solve all the problems of measuring profitability in an investment center. In particular, it does not solvethe problem of accounting for fixed assets discussed above unless annuity depreciation is also used, and this is rarelydone in practice. If gross book value is used, a business unit can increase its EVA by taking actions contrary to theinterests of the company, as shown in Exhibit 7-3. If net book value is used, EVA will increase simply due to thepassage of time. Furthermore, EVA will be temporarily depressed by new investments because of the high net bookvalue in the early years. EVA does solve the problem created by differing profit potentials. All business units,regardless of profitability, will be motivated to increase investments if the rate of return from a potential investmentexceeds the required rate prescribed by the measurement system.Moreover, some assets may be undervalued when they are capitalized, and others when they are expensed. Althoughthe purchase cost of fixed assets is ordinarily capitalized, a substantial amount of investment in start-up costs, newproduct development, dealer organization, and so forth may be written off as expenses, and, therefore, not appear inthe investment base. This situation applies especially in marketing units. In these units the investment amount may belimited to inventories, receivables, and office furniture and equipment. When a group of units with varying degrees ofmarketing responsibility are ranked, the unit with the relatively larger marketing operations will tend to have thehighest EVA.In view of all these problems, some companies have decided to exclude fixed assets from the investment base. Thesecompanies make an interest charge for controllable assets only, and they control fixed assets by separate devices.Controllable assets are, essentially, receivables and inventory. Business unit management can make day-to-daydecisions that affect the level of these assets. If these decisions are wrong, serious consequences can occur-quickly.For example, if inventories are too high, unnecessary capital is tied up, and the risk of obsolescence is increased;whereas, if inventories are too low, production interruptions or lost customer business can result from the stockouts.To focus attention on these important controllable items, some companies, such as Quaker Oats, 17 include a capitalcharge for the items as an element of cost in the business unit income statement. This acts both to motivate businessunit management properly and also to measure the real cost of resources committed to these items.Investments in fixed assets are controlled by the capital budgeting process before the fact and by post completionaudits to determine whether the anticipated cash flows, in fact, materialized. This is far from being completely satis-factory because actual savings or revenues from a fixed asset acquisition may not be identifiable. For example, if anew machine produces a variety of products, the cost accounting system usually will not identify the savings attribut-able to each product.The argument for evaluating profits and capital investments separately is that this often is consistent with what seniormanagement wants the business unit manager to accomplish; namely, to obtain the maximum long-run cash flowfrom the capital investments the business unit manager controls and to add capital investments only when they willprovide a net return in excess of the companys cost of funding that investment. Investment decisions, then, arecontrolled at the point where these decisions are made. Consequently, the capital investment analysis procedure is ofprimary importance in investment control. Once the investment has been made, it is largely a sunk cost and should notinfluence future decisions. Nevertheless, management wants to know when capital investment decisions have beenmade incorrectly, not only because some action may be appropriate with respect to the person responsible for the mis-takes but also because safeguards to prevent a recurrence may be appropriate.Illustration 37
  38. 38. Q.2 SolnWhat are the different methods to evaluate the performance of an investment centre? Discuss the merits and demeritsof each? Which method would you recommend?The following techniques are useful in evaluating the performance of an investment centre:1. Return on investment (ROI):The rate of return on investment is determined by dividing net profit or income by the capital employed or investmentmade to achieve that profit.ROI = Profit / Invested capital * 100ROI consists of two components viz.Profit marginInvestment turnoverROI = Net profit / Investment = (Net profit / Sales) * (Sales / Investment in assets)It will be seen from the above formula that ROI can be improved by increasing one or both of its components viz. theprofit margin and the investment turnover in any of the following ways:Increasing the profit marginIncreasing the investment turnoverIncreasing both profit margin and investment turnoverCapital employed is taken to be the total of shareholders funds, loans etcThe profit figure used is in calculating ROI is usually taken from the profit and loss account, profit arising out of thenormal activities of the company should only be taken. 38
  39. 39. Capital employed for the company as a whole can be arrived at as follows:Share capital of the company xxxReserves and surplus xxxLoans (secured/unsecured) xxx ------ xxxLess: a. Investment outside the business xxx b. Preliminary expenses xxx c. Debit balance of P & L A/c xxx xxx ------- xxxxMerits:Return on investment analysis provides a strong incentive for optimum utilization of the assets of the company. Thisencourages managers to obtain assets that will provide a satisfactory return on investment and to dispose off assetsthat are not providing an acceptable return. In selecting amongst alternative long-term investment proposals, ROIprovides a suitable measure for assessment of profitability of each proposal.Demerits:ROI analysis is not very suitable for short-term projects and performances. In the initial stages a new investment mayyield a small ROI which may mislead the management. Most likely the rate would improve in course of time whenthe initial difficulties are overcome.The book value of assets decline due to depreciation, the investment base will continuously decrease in value, causingthe rate of return to increase.2. Residual income:Residual income can be defined as the operating profit (or income) of the company less the imputed interest on theassets used by the company. In other words, interest on the capital invested in the company is treated as a cost and anysurplus is the residual income. Residual income is profit minus notional interest charge on capital employed.Residual income is affected by the size of the organization and therefore will not provide a basis for evaluation oforganizational performance. This is probably the main reason why the management continues to make use of ROIwhich is relative measure.Not all projects start off with positive or sufficiently large positive profits in the early years of a project to produce apositive increment to residual income.It has been argued that a more suitable measure of performance for investment centres, which could encouragemanagers to be more willing to undertake marginally profitable projects, is residual income.We recommend RI as a method of evaluating performance of an investment centre. Because when RI is adopted forevaluation purposes, emphasis is placed on marginal profit amount above the cost of capital rather than on the rateitself. 39
  40. 40. Q.3 SolutionWhat are the objectives of Transfer Pricing?Transfer price if designed appropriately has the following objectives:It should provide each segment with the relevant information required to determine the optimum trade-off betweencompany costs and revenues.It should induce goal congruent decisions-i.e. the system should be so designed thatdecisions that improve business unit profits will also improve company profits. It should help measure the economicperformance of the individual profit centers. The system should be simple to understand and easy to administer.What is ideal transfer price in the situations of Limited Market Shortage of Capacity in the industryThe ideal transfer price in the situations of Limited MarketBy limited market it means that the markets for buying and selling profit centers may be limited.Even in case of limited market the transfer price that is ideal or satisfies the requirement of a profit center system isthe competitive price. In case if a company is not buying or selling its product in an outside market there are someways to find the competitive price. They are as follows:If published market prices are available, they can be used to establish transfer prices. However, these should be pricesactually paid in the market-place and the conditions that exist in the outside market should be consistent with thoseexisting within the company.For example, market prices that are applicable to relatively small purchases are not valid in this case.Market prices are set by bids. This generally can be done only if the low bidder has a reasonable chance of obtainingthe business. One company accomplishes thisby buying about one-half of a particular group of products outside the companyand one-half inside the company.The company then puts all of the products out to bid, but selects one-half to stay inside. The company obtains validbids, because low bidders can expect to get some of the business. By contrast, if a company requests bids solely toobtain a competitive price and does not award the contracts to the low bidder, it will soon find that either no one bidsor that the bids are of questionable value.If the production profit center sells similar products in outside markets, it is often possible to replicate a competitiveprice on the basis of the outside price.If the buying profit center purchases similar products from the outside market, it may be possible to replicatecompetitive prices for its proprietary products. This can be done by calculating the cost of the difference in design andother conditions of sale between the competitive products and the proprietary products.Shortage of Capacity in the industryIn this case, the output of the buying profit center is constrained and again company profits may not be optimum.Some companies allow either buying profit center to appeal a sourcing decision to a central person or committee. Inthis scenario a buying profit center could appeal a selling profit center’s decision to sell outside.The person/group would then make a sourcing decision on the basis of the company’s best interests. In every case thetransfer price would be the competitive price. In other words, the profit center is appealing only the sourcing decision. 40
  41. 41. Even if there are constraints on sourcing, the market price is the best transfer price. If the market price can beapproximated, it is ideal transfer price.When do you use Cost Based Transfer Pricing?We use cost-based transfer pricing if there is no way of approximating valid competitive price.Transfer prices may be set up on the basis of cost plus a profit, even though such transfer prices may be complex tocalculate and the results less satisfactory than a market-based price.Two aspects need to be considered for cost-based transfer pricing:The cost basis: The usual basis is the standard cost. Actual costs should not be used because production inefficiencieswill then be passed on to the buying profit center. If the standard costs are used, there is a need to provide an incentiveto set tight standards and to improve standards.The profit markup: In calculating the profit markup, there also are two decisions:What is the profit markup to be based?The simplest and most widely used base is percentage of costs. If this base is used, however, no account is taken ofcapital required. A conceptually better base is a percentage of investment. But there may be a major practical problemin calculating the investment applicable to a given product. If the historical cost of the fixed assets is used, newfacilities designed to reduce prices could actually increase costs because old assets are undervaluedWhat is the level of profit allowed?The second problem with the profit allowance is the amount of the profit. The conceptual solution is to base the profitallowance on the investment required to meet the volume needed by the buying profit centers. The investment wouldbe calculated at a “standard” level, with fixed assets and inventories at current replacement costs. This solution iscomplicated and, therefore, rarely used in practice. 41

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