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1. 1. MMS : SEM-IV Management Control System ASSIGNMENT NO. 1 Submitted by : Deepak R Gorad MMS : C-9 (Marketing) submitted to: Prof. Jyoti Singhal
2. 2. Q.1 How is RI (EVA) analysis carried out? Explain advantages and disadvantages. Ans. The EVA method is based on the past performance of the corporate enterprise. The underlying economic principle in this method is to determine whether the firm is earning a higher rate of return on the entire invested funds than the cost of such funds (measured in terms of weighted average cost of capital, WACC). If the answer is positive, the firm‟s management is adding to the shareholders value by earning extra for them. On the contrary, if the WACC is higher than the corporate earning rate, the firm‟s operations have eroded the existing wealth of its equity shareholders. In operational terms, the method attempts to measure economic value added (or destroyed) for equity shareholders, by the firm‟s operations, in a given year. Since WACC takes care of the financial costs of all sources of providers of invested funds in a corporate enterprise, it is imperative that operating profits after taxes (and not net profits after taxes) should be considered to measure EVA. The accounting profits after taxes, as reported by the income statement, need adjustments for interest costs. The profit should be the net operating profit after taxes and the cost of funds will be the product of the total capital supplied (including retained earnings) and WACC EVA= [Net operating profits after taxes – [Total Capital * WACC] Example; Following is the condensed income statement of a firm for the current year; Particulars Amt (in lakhs) Sales Revenue 500 Less: Operating costs 300 Less: Interest costs 12 Earnings before taxes 188 Less: Taxes (0.40) 75.2 Earnings after taxes 112.8 The firm‟s existing capital consists of Rs 150 lakhs Equity funds, having 15% cost and of Rs 100 lakh 12% debt. Determine the economic value added during the year. Solution (I) Determination of Net Operating Profit After Taxes Particulars Amt (in lakhs) Sales revenue 500 Less: Operating Costs 300 Operating profit (EBIT) 200 Less: Taxes (0.40) 80 Net operating profit after taxes (NOPAT) 120 (II) Determination of WACC Particulars Equity (150 lakh * 15%) 12% Debt (100 lakh * 7.2%) Total Cost Amt (in lakhs) 22.5 7.2 29.7
3. 3. (III) WACC (29.7 lakh/ 250 lakh) 11.88% Cost of debt= 12% (1 – 0.4 tax rate) = 7.2% Determination of EVA EVA = NOPAT – (Total capital * WACC) Rs 120 lakh – (Rs 250 lakh * 11.88%) Rs 120 lakh – Rs 29.7 lakh = Rs 90.3 lakh During the current year, the firm has added an economic value of Rs.90.3 lakh to the existing wealth of equity shareholders. Essentially, the EVA approach is a modified accounting approach to determine profits earned after meeting all financial costs of all the providers of capital. Its major advantage is that this approach reflects the true profit position of the firm. RI (EVA) has the following advantages: (i) (ii) (iii) (iv) It avoids suboptimal decisions as investments are not rejected merely because they lower the divisional manager‟s ROI. It maximizes the growth of the company and increases shareholders‟ wealth by accepting opportunities which earn a rate of return in excess of the cost of capital. The cost of capital charge on divisional investments ensures that divisional managers are aware of the opportunity cost of funds. Charging each division with the company‟s cost of capital ensures that decisions taken by different divisions are compatible with the interests of the organization as a whole. RI (EVA) has the following weaknesses: (i) (ii) (iii) Like ROI it is difficult to have satisfactory definitions of „divisional profits‟ and „divisional investment‟. It may be difficult to calculate an accurate cost of capital. Also, decision has to be taken whether to use the company‟s cost of capital or a specific divisional cost of capital. The former enhances divisional goal congruency and the latter reflects each division‟s level of risk. Identifying controllable and uncontrollable factors at the divisional level may be difficult. Many experts regard EVA as a concept superior to ROI and yet in certain cases, EVA does not solve all the problems of measuring profitability in an investment center. In particular, it does not solve the problem of accounting for fixed assets discussed above unless annuity depreciation is also used, and this is rarely done in practice. If gross book value is used, a business unit can increase its EVA by taking actions contrary to the interests of the company, as shown in TABLE If net book value is used, EVA will increase simply due to the passage of time. Furthermore, EVA will be temporarily depressed by new investments because of the high net book value in the early years. EVA does solve the problem created by differing profit potentials. All
4. 4. business units, regardless of profitability, will be motivated to increase investments if the rate of return from a potential investment exceeds the required rate prescribed by the measurement system. Moreover, some assets may be undervalued when they are capitalized, and others when they are expensed. Although the purchase cost of fixed assets is ordinarily capitalized, a substantial amount of investment in start-up costs, new product development, dealer organization, and so forth may be written off as expenses, and, therefore, not appear in the investment base. This situation applies especially in marketing units. In these units the investment amount may be limited to inventories, receivables, and office furniture and equipment. When a group of units with varying degrees of marketing responsibility are ranked, the unit with the relatively larger marketing operations will tend to have the highest EVA. 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 capital charge for the items as an element of cost in the business unit income statement. This acts both to motivate business unit 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 completion audits to determine whether the anticipated cash flows, in fact, materialized. This is far from being completely satisfactory because actual savings or revenues from a fixed asset acquisition may not be identifiable. For example, if a new machine produces a variety of products, the cost accounting system usually will not identify the savings attributable to each product. The argument for evaluating profits and capital investments separately is that this often is consistent with what senior management wants the business unit manager to accomplish; namely, to obtain the maximum long-run cash flow from the capital investments the business unit manager controls and to add capital investments only when they will provide a net return in excess of the company's cost of funding that investment. Investment decisions, then, are controlled at the point where these decisions are made. Consequently, the capital investment analysis procedure is of primary importance in investment control. Once the investment has been made, it is largely a sunk cost and should not influence future decisions. Nevertheless, management wants to know when capital investment decisions have been made incorrectly, not only because some action may be appropriate with respect to the person responsible for the mistakes but also because safeguards to prevent a
5. 5. recurrence may be appropriate. Q.2(a) Explain how different types of expenses centers operates with the help of sketches? Answer: Expense centers are responsibility centers whose inputs are measured in monetary terms whose output are not. There are two general types of expenses centers: - engineered and discretionary. These labels relates to two types of cost. Engineered costs are those for which the „right‟ or „proper‟ amount can be estimated with reliability. For example, factory‟s costs for direct labour, direct material, components supplier and utilities. Discretionary costs are those for which no such engineered estimate is feasible. In discretionary expenses centers, the cost incurred depends on management‟s judgment as to the appropriate amount under the circumstances.
6. 6. 1. Engineered expenses centers:- it have following characteristics:- 2. The profit input can be measured in monetary terms. 3. Their output can be measured in physical terms. 4. The optimum dollars amount of input required to produce one output can be determined. Diagram:Optimal relationship can be established Output Input Manufacture function Work (Dollar) (Physical) Engineered expense centers are usually found in manufacturing operation, warehouse distribution and similar units within the marketing organization may also be engineered expenses centers as certain responsibility centers within administrative and support departments for instance, account receivable, account payable and pay roll sections in controller department. Such unit performs repetitive task for which standard cost can be developed. These centers are usually located within departments that are discretionary expenses centers. In engineered expenses centers output are multiplied by standard cost of each unit produce measured what the finished products should have cost. Managers of engineered expenses center may be responsible for activities such as training and employee development that are not related to current production. The term engineered expense center refers to responsibility centers in which engineered cost predominate, but it does not imply that valid engineered estimates can be made for each and every cost items. Discretionary expenses centers:Discretionary expenses centers include administrative and supports units, research and developments operation and most marketing activities. The output of these centers can not be measured in monetary terms. Diagram:Optimal relationship cannot be established
7. 7. Output Input R&D function Work (Dollar) (Physical) The term discretionary does not imply that managements judgment to optimum cost is capricious rather it reflects managements decision regarding certain policies, whether to match the marketing effort of competitors; the level of service the company should provide to its customer and appropriate amount to spend for R&D, public relations and other activities. One company may have a similar small head quarter‟s staff, while another company of similar size and same industry may have staff 10 times as large. The senior manager of each company may each to be convinced that their respective decision on staff size are correct but their is no objective to judge which is right; both decision may be equally good under the circumstances with the differences in the two companies. In discretionary centers, the differences between budget and actual expenses are not a measure of efficiency. Rather it is simply the differences between the budgeted input and actual does not incorporate the value of output if actual expenses do not exceed the budget amount, the manager has “ lived within the budget”, but since by definition the budget does not to predict the optimum amount of spending living within the budget does not necessarily indicate efficient performance. Q.3 Explain with illustrations the different ways in which the profit objective of a profit centre can be stated and controlled.What role do corporate overhead allocations play in this process? Ans. The different ways in which the profit objective of a profit centre can be stated and controlled can be explained with the help of, types of profitability measurements used in evaluating a profit center. First, there is the measure of management performance, which focuses on how well the manager is doing. This measure is used for planning, coordinating, and controlling the profit center‟s day-to-day activities and as a device for providing the proper motivation for its manager. Second, there is the measure of economic performance, which focuses on how well the profit center is doing as an economic entity. The messages conveyed by these two measures may be quite different from each other.
8. 8. For eg: The management performance report for a branch store may show that the store‟s manager is doing an excellent job under the circumstances, while the economic performance report may indicate that because of economic and competitive conditions in its area the store is a losing proposition and should be closed. Types of Profitability Measures A profit center‟s economic performance is always measured by net income (i.e., the income remaining after all costs, including a fair share of the corporate overhead, have been allocated to the profit center). The performance of the profit center manager, however, may be evaluated by five different measures of profitability : 1. 2. 3. 4. 5. Contribution margin, direct profit, controllable profit, income before income taxes, or net income. 1) Contribution Margin Contribution margin reflects the spread between revenue and variable expenses. The principal argument in favour of using it to measure the performance of profit center managers is that since fixed expenses are beyond their control, managers should focus their attention on maximizing contribution. The problem with this argument is that its premises are inaccurate, in fact, almost all fixed expenses are at least partially controllable by the manager, and some are entirely controllable. Many expense items are discretionary; that is, they can be changed at the discretion of the profit center manager. Presumably, senior management wants the profit center to keep these discretionary expenses in line with amounts agreed on in the budget formulation process. A focus on the contribution margin tends to direct attention away from this responsibility. Further, even if an expense, such as administrative salaries, cannot be changed in the short run, the profit center manager is still responsible for controlling employees‟ efficiency and productivity. 2) Direct Profit This measure reflects a profit center‟s contribution to the general overhead and profit of the corporation. It incorporated all expenses either incurred by or directly traceable to the profit center, regardless of whether or not these items are within the profit center manager‟s control. Expenses incurred at headquarters, however, are not included in this calculation. A weakness of the direct profit measure is that it does not recognize the motivational benefit of charging headquarters costs. Example: Knight-Ridder, the second-largest newspaper publisher in the United States, measured each of its newspapers based on direct profit. The publisher set specific targets for direct profit at each of its newspapers. For 1996 the Miami Herald had a target of 18 percent and the Philadelphia Inquirer and the Philadelphia Daily (which were operated as one unit) had a target of 12 percent.