Management control system

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Management Control System
MMS-IV
Manjiri Dighe

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Elements of management control system
Strategic Planning,
Budgeting,
Resource Allocation,
Performance Measurement,
Evaluation And Rewards,
Responsibility Center Allocation And
Transfer Pricing

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Introduction
 Emergence / Development of Strategy
 Execution or implementation of strategy
 Basic Concepts:
 Control:
Detector: info about
what is happening
Assessor: Comparison
with standard
Effector: Behavior
Alteration, if needed
Control Device
Entity being
Controlled

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Contd..
 Jungle law / Nature’s Law- climatic changes
 Body temperature: self regulating
 AC Thermostat
 Automobile driver: no certainty, no automatic
control
 Steps in control process:
 Setting standards
 Measuring performance
 Correction of deviation

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Contd..
 Management:
 Common goal
 Management control Different from normal control
• Standard is not reset, but a result of a conscious planning
process. Involves both planning and control
• Not automatic
• Requires coordination among individuals
• Action is not mechanical or fixed
 System:
 Prescribed and usually a repetitious way of carrying out an
activity or a set of activities.
 Rhythmic, Coordinated and recurring series of steps
intended to accomplish a specific purpose.

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Boundaries of Management Control
 Management Control:
 Ensuring that the necessary resources are mobilized and are
deployed effectively so that the planned objectives are met without
much difficulty.
 It is a process by which the managers influence other members of
the organization to implement the organization's strategies.
Strategy Formulation
Management Control
Task Control
Goals, strategies and policies
Implementation of strategies
Efficient and effective
performance of individual tasks
Activity Nature of End Product

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Contd..
 The management control process is the process by which managers
at all levels ensure that the people they supervise implement their
intended strategies.
 Activities in Management Control
 Planning what the organization should do
 Coordinating the activities of several parts of the organization
 Communicating information
 Evaluating information
 Deciding what, if any, action should be taken
 Influencing people to change their behavior
 Goal congruence:
 Consistency of goals of individuals with that of organization itself.

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Tools for implementing strategy
 Organizational structure specifies the roles, reporting relationships and division
of responsibilities that shape decision making within organization.
 HRM is the selection, training, evaluation, promotion and termination of
employees
 Culture refers to the set of common beliefs, attitudes and norms that explicitly or
implicitly guide managerial actions.
Strategy Performance
Organization
Structure
Management
Controls
Culture
Human
Resource
Management
Stan C’s -
Primeone

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Financial and non-financial emphasis
 Management control system encompass the financial
dimension that focuses on the monetary “bottom line”-
net income, return on equity etc,
 Non financial objectives- product quality, market share,
customer satisfaction, employee morale etc.
 Strategy formulation :
 It is the process of deciding on the goals of the organization and
the strategies for attaining these goals
 Strategies state a direction in which senior management wants
the organization to move.

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Strategy formulation
 Strategy is an art or science of defining means by which an
organization will deliver value to its customers (or shareholders)
 It is the discipline of choosing between equally attractive
alternatives.
 It is a process that senior executives use to evaluate a company’s
strengths and weaknesses in light of the opportunities and threats
present in the environment and then to decide on strategies that fit
the company’s core competencies with environmental opportunities
 Strategies can be found at two levels
 Strategies for whole organization
 Strategies for business units within the organization.

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Strategy Formulation
Environmental
Analysis
------------------------------
• Competitor
• Customer
• Supplier
• Regulatory
• Social / political
Internal Analysis
-----------------------------------------
• Technology know-how
• Manufacturing know-how
• Marketing know-how
• Distribution know-how
• Logistics know-how
Opportunities and Threats
------------------------------------------
Identify opportunities
Strengths and Weaknesses
----------------------------------------
Identify core competencies
Fix internal competencies
With external opportunities
Firm’s strategies

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Strategy formulation and Management
Control
 SF is the process of deciding on new strategies, MC
is the process of implementing those strategies.
 In SF threats, opportunities and new ideas do not
occur at regular intervals, thus strategic decisions
may be made at any time.
 MC process involves managers and their staffs at all
levels in the organization whereas, analysis of a
proposed strategy usually involves very few people.
Mostly senior management.

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Task control
 Process of ensuring that specified tasks are carried out effectively
and efficiently.
 Seeing if rules are followed
 Distinctions between task control and management control:
 Many TC systems are scientific, MC involves behavior of managers and
this cannot be expressed by equations
 In MC, managers interact with other managers. In TC, either human
beings are not involved at all.
 In MC, the focus is on organizational units, in TC the focus is on specific
tasks performed by these organizational units.
 MC is concerned with the broadly defined activities of managers
deciding what is to be done within the general constraints of strategies.
TC relates to specified tasks, most of which require little or no judgment
to perform

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Management Control System
 Management control systems (MCS) is a system which gathers and uses
information to evaluate the performance of different organizational resources like
human, physical, financial and also the organization as a whole considering the
organizational strategies.
 MCS influences the behavior of organizational resources to implement organizational
strategies.
 Management control systems are tools to aid management for steering an
organization toward its strategic objectives.
 Management controls are only one of the tools which managers use in implementing
desired strategies. However strategies get implemented through management
controls, organizational structure, human resources management and culture
 It is like a black box whose exact nature cannot be observed. MCS involves the
behavior of managers and these behaviors cannot be expressed by equations.

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Contd..
 According to Horngren et al. (2005), management control system is
an integrated technique for collecting and using information to
motivate employee behavior and to evaluate performance.
According to Simons (1995), Management Control Systems are the
formal, information-based routines and procedures managers use to
maintain or alter patterns in organizational activities
 According to Maciariello et al. (1994), management control is
concerned with coordination, resource allocation, motivation, and
performance measurement

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Purposes of a management control
system
 Clearly communicate the organization’s goals
 Ensure that every manager and employee understands
the specific actions required of him/her to achieve
organizational goals
 Communicate the results of actions across the
organization
 Ensure that the management control system adjusts to
changes in the environment

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Management Control System Steps
1. Begin by specifying the organization's goals, subgoals and
objectives
 Goals are what the organization hopes to achieve in the long run
 Sub-goals or key success factors are more specific and provide
more focus to guide daily actions
 Objectives are specific benchmarks which management would
like to see achieved
 Important to keep all three in balance to avoid concentrating
solely on short-run achievements at the expense of long run goals
2. Establish responsibility centers
3. Develop performance measures
4. Measure and report on financial performance
5. Measure and report on non-financial performance

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The Management Control System
Set Goals,
Measures,
Targets
Feedback
and
Learning
Monitor,
Report
Plan
and
Execute
Evaluate,
Reward

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Corporate Level Strategy
 It is about being in the right mix of businesses.
 It is concerned more with the question of where to compete than
with how to compete in a particular industry (business unit strategy)
 In this issue are: the definition of businesses in which the firm will
participate and the deployment of resources among those
businesses.
 It results in decision involving businesses to add, to retain, to
emphasize, to deemphasize and to divest.
 Single industry firm-operates in one line of business
 Related diversified firm-operates in several industries and the
business units benefit from a common set of core competencies.
 It typically grows internally through R&D
 Unrelated business firm - operates in businesses that are not
related to one another

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Business Unit Strategy
 What is a business unit?
 A small company within a big one that has
accountability for a unique customer or market segment
or service or product line
 A business unit in one firm competes with a business
unit in another firm. (J & J’s Baby powder unit and
WIPRO baby powder unit)
 Revenues are generated and costs are incurred here.
 Business unit strategies deal with how to create ad
maintain competitive advantage in each of the industries
in which a company has chosen to participate.

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Business Unit Strategies
 It deals with how to create and maintain competitive advantage in
each of the industries in which a company has chosen to participate.
Planning Models: Business Unit Mission: The BCG Model
“Star”
Hold
“Question mark”
Build
“Cash cow”
Harvest
“Dog”
Divest
High
High High
High
Low
Low
Low
Low
Cash
Use
Market
Growth
rate
Cash source
Relative market share
Hold
Harvest
Build
Divest
CashUse
High
LowHigh

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Contd..
 Question marks –
 Question marks are businesses or products with low market share but which operate in
higher growth markets. This suggests that they have potential, but may require substantial
investment in order to grow market share at the expense of more powerful competitors.
Management have to think hard about "question marks" - which ones should they invest in?
Which ones should they allow to fail or shrink?
 Stars –
 Stars are high growth businesses or products competing in markets where they are
relatively strong compared with the competition. Often they need heavy investment to
sustain their growth. Eventually their growth will slow and, assuming they maintain their
relative market share, will become cash cows.
 Cash Cows –
 Cash cows are low-growth businesses or products with a relatively high market share.
These are mature, successful businesses with relatively little need for investment. They
need to be managed for continued profit - so that they continue to generate the strong cash
flows that the company needs for its Stars.
 Dogs –
 Unsurprisingly, the term "dogs" refers to businesses or products that have low relative share
in unattractive, low-growth markets. Dogs may generate enough cash to break-even, but
they are rarely, if ever, worth investing in.

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Financial Goal Setting
 Normally 4 steps can be applied to any financial goal
setting exercise for individuals
1. Identify and write down your financial goals, (e.g. for
individuals, to send your kids to college or University, a new
car, house purchase, vacation, retirement etc
2. Break each financial goal down into several short-term (less
than 1 year), medium-term (1 to 3 years) and long-term (5
years or more) goals
3. Educate yourself and do your research
4. Evaluate your progress as often as needed. Review your
progress monthly, quarterly, or at any other interval you feel
comfortable with, but at least semi-annually, to determine if
your program is working.

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Financial Goal Setting
 Investment centers represent decentralized units where
the manager is given maximum freedom for making
decision pertaining not only to the product mix, pricing,
customer relationships and production methods but also
to determine the level and type of assets used in the
unit.
 The performance of an investment centre is thus gauged
on the basis of assets employed and by relating the
profits to the assets employed. This approach is known
as Return on Investment (ROI)

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Return on Investment (ROI)
 It is the percentage of return on funds invested in the
business by its owners
 In short, this ratio tells the owner whether or not all the
efforts put into the business has been worthwhile.
 If the ROI is less than the rate of return on an alternative,
risk-free investment such as a bank savings account, the
owner may be wiser to sell the instrument, put the
money in such a savings instrument, and avoid the daily
struggles of small business management.

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Return on Investment (ROI)
 The ROI is calculated as follows:
Return on Investment = Net Profit before Tax / Net Worth
 Financial statements express only monetary aspects;
businesses don’t get reflected. Thus ROI doesn’t give a
complete picture of the happenings in a business.
 ROI leads to excessive focus on improving profitability
and not wealth maximization or shareholder value
maximization, recognition, social wealth etc.

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Economic Value Added (EVA)
 Implies the difference between net operating profits after
taxes and total cost of funds
 It offers a consistent approach to setting goals and
measuring performance, communicating with investors,
evaluating strategies and allocating capital.
 It is the measure that captures the true economic profit
of the organization.
 Maximizing EVA means the same as maximizing long-
term yield on shareholders’ investment.
 EVA= Net operating profits after taxes (-) (total
capital*WACC)
 NOPAT = Operating Income x (1 - Tax Rate)

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Contd..
 It is based on the past performance of the corporate
enterprise.
 Basically to determine whether the firm is earning a
higher rate of return on the entire invested funds than the
cost of such funds
 If positive- increase in shareholders value
 Else, erosion of existing wealth of its shareholders. It indicates
that the company is destroying value even though it has a
positive and growing EPS
 EVA requires company to be more careful about resource
mobilization, allocation and investment decisions
 It measures the productivity of all the factors of production
 It holds the company accountable for the cost of capital used for
expansion or growth.
 It is based on the past performance of the corporate
enterprise.
 Basically to determine whether the firm is earning a
higher rate of return on the entire invested funds than the
cost of such funds
 If positive- increase in shareholders value
 Else, erosion of existing wealth of its shareholders. It indicates
that the company is destroying value even though it has a
positive and growing EPS
 EVA requires company to be more careful about resource
mobilization, allocation and investment decisions
 It measures the productivity of all the factors of production
 It holds the company accountable for the cost of capital used for
expansion or growth.

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EVA versus ROI
 ROI is Comprehensive measure in which anything that affects
financial statements is reflected in this ratio
 ROI is Simple to calculate, easy to understand and meaningful in an
absolute sense
 In ROI, the performance of different units or against competitors can
be used as a basis for comparison, whereas, absolute amount of
EVA doesn’t provide basis for comparison.
 With EVA all business units have the same profit objective for
comparable investments, whereas, ROI provides different incentives
for investments across business units.
 Decision that increases a center’s ROI may decrease its overall
profits.

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EVA versus ROI
 If an investment center’s performance is measured by
EVA, investments that produce a profit in excess of the
cost of capital will increase EVA and therefore be
economically attractive to the manager.
 Different interest rates may be used for different types of
assets to take into account different degrees of risk.
 EVA has a stronger positive correlation with changes in a
company’s market value.

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Contd..
 EVA ranks project on profits in excess of the cost of
capital (EVA increases).
 With EVA, all business units have the same profit
objective for comparable investments.
 EVA permits the use of different interest rates for
different investment projects.
 EVA has greater correlation with a firm’s market value (it
optimizes shareholder value).
 Unlike ROI – a percentage, EVA is a dollar amount and
does not allow for intra and inter company comparisons.

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Free cash Flow (FCF)
 A measure of financial performance calculated as operating cash
flow minus capital expenditures.
 It represents the cash that a company is able to generate
after laying out the money required to maintain or expand its asset
base
 Free cash flow is important because it allows a company to pursue
opportunities that enhance shareholder value. Without cash, it's
tough to develop new products, make acquisitions, pay dividends
and reduce debt. FCF is calculated as:
Net income + (Amortization / Depreciation) - changes in
working capital - capital expenditure (same as cash from
operations)

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Market Gap
An opportunity in a market where no
supplier provides a product or service that
buyers need
Gap analysis: Simply ask two questions -
where are we now? and where do we
want to be? The difference between the
two is the GAP

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RONW (Return On Net Worth) / ROE
 Calculated as, Net Income or PAT/ Shareholder’s equity
 It measures a firm's efficiency at generating profits from
every unit of shareholders' equity (net assets or assets
minus liabilities).
 It shows how well a company uses investment funds to
generate earnings growth.
 Useful for comparing the profitability of a company to
that of other firms in the same industry.

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EPS (Earning Per Share)
EPS measures the profits available to the
equity shareholders on each share held.
The formula is:
EPS = Net Profits Available to Equity
Holders / Number of Ordinary Shares
Outstanding

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P/E (Price To Earning Ratio)
It is the ratio between the market price of the
shares of a firm and the firm's earnings per
share. The formula is:
P/E ratio = Market Price of Share / Earnings
per Share
It indicates the growth, shareholder
orientation, and corporate image of a
company.

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Sensitivity Analysis
 A technique used to determine how different values of an
independent variable will impact a particular dependent variable under a
given set of assumptions.
 It is very useful when attempting to determine the impact the actual outcome
of a particular variable will have if it differs from what was previously
assumed. By creating a given set of scenarios, the analyst can determine
how changes in one variable (s) will impact the target variable.
 E.g. an analyst might create a financial model that will value a company's
equity (the dependent variable) given the amount of earnings per share (an
independent variable) the company reports at the end of the year and the
company's price-to-earnings multiple (another independent variable) at that
time. The analyst can create a table of predicted price-to-earnings multiples
and a corresponding value of the company's equity based on different
values for each of the independent variables.

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Organization Hierarchies and behavior
Individuals work in different
hierarchies and handle different
responsibilities & may have
different goals.
But they must come together as far
as Company’s Goal is concerned,
(their action must speak Co’s
language.)
Goal Congruence

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Contd..
 Goal congruence ensures that the action taken by the manager in
their best interest is also in the best interest of the organization.
 E.g. the marketing department has launched an impressive
advertising campaign which promises good returns but, say due to
the cash crunch company’s current position may not let to lose the
strings.
 The HR manager has devised an HR training program to enhance
the skills of its sales personnel, with an objective to enhance their
productivity. But if company is in strategic need of attaining a
certain sales volume in a given quarter, it can not do so on account
of non availability of personnel.

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Significance of Goal Congruence
● Ensures frictionless working.
● Ensures achievement of organization’s goal/strategic objective
● Ensures coordination & motivation of all concerned.
● Ensures consistency in the working of all concerned.
● Gives fair chance to its employees to achieve their personal
goals.
● Enhances the loyalty towards the company.

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Informal factors that influence goal
congruence
 External factors: Norms of desirable behavior that exist in the
society of which the organization is a part
 Set of attitudes of the society, work ethics of the society.
 Some of these attitudes are local - specific to city, region, or industry
specific.
 Internal Factors: factors within the organization
1. Culture: common beliefs, shared values, norms of behavior &
assumptions implicitly accepted and explicitly built into.
2. Management Style – Informal / Formal- the attitude comes from top mgmt
3. The Communication Channels
4. Perception and Communication – formal- e.g. Budget informal- e.g.
conversation.
 Conflict of messages received from different sources.
 Budget (meaning)  A strict profit control plan Budget  A tentative
guiding profit plan,

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Formal Control System
 MCS strategy itself
 Rules – Instructions, manuals and circulars, ethical
guidelines.
 Range from petty to the most important and big
 Exceptions
 Positive requirements like fire drills at prescribed intervals
 Certain rules never to be broken
 Specific types of rules:
 Physical controls: security guards, vaults, passwords, TV
surveillance
 Manuals: of rules
 System safeguards: cross checking totals with details,
signatures, cash counting, auditing
 Task control system: Automated tasks

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MCS - A Formal process Relating MCS to Organizational Goal
Co’s Goals & Strategies
Satisfactory Non-Satisfactory
Compare Actual V/s
Budgeted
Report Actual &
Budgeted
Measure Responsibility
Center’s Performance
Prepare Annual
Programs/ Budgets
Prepare Strategic Plans
for ImplementationRevise
Revise
Corrective Action
Reward
(Feedback)
Feedback
Revise the
Goals /Policies
(Interactive
MCS)
Everything
percolates from
the Company’s
strategic goal.
Anything loosing
the sight of goal
will be immediately
taken note of and
a corrective action
is initiated to bring
back the activity
on the track.

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Types of organization
1. Functional organizations –
 Each manager is responsible for a specified function such as
production or marketing to bear on decisions related to a specific
function
 Skilled higher-level managers are able to provide better
supervision of lower-level managers in the same or similar
function. So, main advantage is efficiency
 No unambiguous way of determining the effectiveness of the
separate functional managers, as each function contributes jointly
to the organization’s final output. So, difficult to measure what
fraction of profit is contributed by each.
 Economies of scale with efficient use of resources
 High quality technical problem solving
 In-depth training and skill development within functions
 Clear cut career paths within functions

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Contd..
 Disadvantages:
 Poor communication and coordination across functions,
 Inadequate for a firm with diversified products and markets. So, it
typically work well for smaller and less complex organizations dealing
with only one or a few products or services.
 A loss of clear responsibility for product or service delivery, and slow
innovation in response to environmental changes
 Members of functional departments become overspecialized, develop
self-centered, narrow viewpoints, and lose the total system perspective
sometimes.
 Failure to communicate and extend support across department lines is
common situations. This often slows decision making because problems
must be referred up the hierarchy for resolution

49
Forms of Organizational Structure
VP
Production
VP
Marketing
VP
Human Resources
VP
Finance
Staff
Functional
Staff
VP
Division B
VP
Division A
VP
Division C
President
Divisional
Functional VPs
Divisional
VPs
Matrix
A
B
C
Mkt. Prod. H.R. Fin.
President
President
Head
Marketing
Head
Production

50
Types of organization
2 Divisional / Business Units
 Designed to solve the problems inherent in the functional
structure
 It is responsible for all the functions involved in producing and
marketing a specified product line, planning and coordinating
the work of the separate functions
 Business unit is closer to the market for its products than
headquarter is, its manager may make sounder production
and marketing decisions than headquarters might and the unit
as a whole can react to new threats or opportunities more
quickly.
 Improved coordination across functional departments
 Easier growth or reduction in size by adding or deleting
divisions
 Clear points of responsibility for product or service delivery

51
Contd..
 Disadvantages:
 May reduce economies of scale, disperse
technical competence and expertise
 Even create unhealthy rivalries among operating
units
 May also increase costs by duplicating resources
and efforts across divisions and causing an
overemphasis on divisional versus organizational
goals.

52
3. Matrix structure ( HUL- Dove/Lakme)
 Matrix structure groups employees by both function and product.
This structure can combine the best of both separate structures.
 E.g. Company that produces two products, "product A" and "product
B". Using the matrix structure, this company would organize
functions within the company as follows:
 "product A" sales department, "product A" customer service department,
"product A" accounting, "product B" sales department, "product B "
customer service department, "product B" accounting department.
 Matrix structure is the most complex of the different organizational
structures. often found in organizations pursuing growth in dynamic
and complex environments
 It provides a way of coordinating different functional contributions to
serve specific program needs
 It makes easier to add, remove and change the focus of teams to
reflect new program directions or basic changes in business size

53
Contd..
 It clearly identifies program managers who can be held accountable
for performances results; this helps top managers stay informed
about what is going on and why
 The matrix forces decision making and problem solving down to the
team level, where the best information exists
 Matrix helps keep top managers free of routine decisions and
enables them to devote their time to more strategic management
concerns.
 Disadvantages:
 Power struggles, which may result from the two boss system
 Team members may become too focused on themselves and develop
“groupitis ” losing sight of important goals.
 Often creates increased costs as overhead rises in the form of extra
salaries for program managers

54
Functions of the Controller
 He is the person who is responsible for designing,
developing and operating the management control
system as the controller…(CFO). He takes charge
of control as well as that of treasury functions of the
organization.
 Designing and operating information and control systems:
 Preparation of medium term plans to implement the organization’s
strategy.
 Implementation of the control plans so developed.
 Preparing financial statements and financial reports for shareholders
and other external parties

55
Contd..
 Preparing and analyzing performance reports, interpreting
these reports for managers and analyzing program and
budget proposals from various segments of the company
and consolidating them into an overall annual budget
 Supervising internal audit and accounting control
procedures to ensure the validity of information,
establishing adequate safeguards against theft and fraud
and performing operational audits.
 Developing personnel in the control area. Aims at
continuous improvement of the control function through
upgradation of skills of control personnel.

56
Contd..
 Relation to Line organization:
 Controller may be responsible for developing and analyzing control
measurements and for recommending actions to management.
 Monitoring adherence to the spending limitations laid down by the chief
executive, controlling the integrity of the accounting system and
safeguarding company assets from theft and fraud.
 Controller doesn’t make or enforce management decisions.
Responsibility for actually exercising control runs from the CEO down
through the line organization.
 Important role in preparation of strategic plans and budgets
 Scrutiny of performance reports to ensure accuracy and to call line
managers’ attention to items deserving further inquiry.
 Monitoring adherence to the spending limitations laid down by the chief
executive, controlling the integrity of the accounting system and
safeguarding company assets from theft and fraud.

57
The business unit controller
 Dual reporting: one to the corporate controller and the
other to the managers of their own units
 He provides staff assistance to business unit manger on
one hand and assisting the corporate controller to
exercise his overall controlling duty.
 Business unit general manager is the controller’s
immediate boss and has ultimate authority in the hiring,
training, transferal, compensation, promotion and firing
of controllers within that business unit.

58
Responsibility Centers
 It is an organization unit that is headed by a manager who is
responsible for its activities.
 Based on principle of responsibility accounting which holds that
managers should be evaluated on the activities which they can
influence or control
 It exists to accomplish one or more purposes, termed its objectives.
 Objective is to help implement the strategies set by senior
management.
 The products produced may be furnished either to another
responsibility center – input for them or, to the outside marketplace
– outputs of the organization as a whole.
 Relationship between inputs and outputs

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Measuring inputs and outputs
 The inputs (resources) are translated into monetary
terms called – cost.
 Easier to measure the cost of inputs than to calculate
the value of outputs. It can be stated as physical
measurements – hours of labour, materials etc..
 E.g. annual revenue for profit oriented organization is
an important measure, but it will not reflect work done
by R&D, PR Dept, advertising, human resource
training, quality control department or a legal staff.

60
Efficiency and effectiveness
 Both can be measured only on comparative basis.
 Efficiency is the ratio of outputs to inputs
 Lesser inputs same output or
 Same input, more output or
 Comparison of actual costs with some standard
 Effectiveness is determined by the relationship between
a responsibility center’s output and its objectives. The
more this output contributes to the objectives, the more
effective the unit is.
 It is normally expressed in subjective, non-analytical
terms
 Both are not mutually exclusive.

61
Contd..
 A responsibility center is efficient if it does things right
and it is effective if it does the right things.
 E.g. credit department if handles the paperwork
connected with delinquent accounts at a low cost per
unit, it is efficient but if, at the same time, it is
unsuccessful in making collections (or needlessly
antagonizes customers in the process), it is ineffective.
 Profit is an important measure of effectiveness..
 As profit is the difference between revenue and expense,
it is also a measure of efficiency.
 Thus profit measures both effectiveness and efficiency.

62
Types of Responsibility Centers
1. Revenue centers:
 Output is measured in monetary terms.
 No formal attempt to relate input (i.e. expenses or costs) to output.
 They are marketing organizations that don’t have profit responsibility.
 Area primarily responsible for generating sales such as a sales office /
marketing unit
 Measurement of actual sales to the budgeted.
 Unit manager is responsible for the direct expenses within the unit but the
primary measurement is revenue
 Manager doesn’t have knowledge that is needed to make the cost /
revenue trade off required for optimum marketing decisions.
 They don’t set selling prices and are not charged for the cost of goods.

63
Types of Responsibility Centers
2. Expense centers:
 Inputs or expenses are measured in monetary
terms, but outputs are not.
 Two general types of expense centers:
i. Engineered expense centers:
 Engineered costs are for which the ‘right’ or ‘proper’
amount can be estimated with reasonable reliability’
 Inputs can be measured in monetary terms
 Their outputs can be measured in physical terms
 The optimum amount of input required to produce one
unit of output can be determined
 Usually found in manufacturing operations,
warehousing, distributions

64
Contd..
 The difference between the theoretical and the actual cost
represents the efficiency of the expense center being
measured.
 Expense supervisors are responsible for the quality,
volume of production etc also in addition to cost
efficiency.
 So, the type and amount of production is prescribed
with quality standards.
 They are also responsible for training, not related to
production.

65
Contd..
ii. Discretionary expense centers:
 Discretionary costs (managed costs) for which no such engineered
estimate is feasible.
 The costs incurred depend on the management’s judgment as to the
appropriate amount under the circumstances.
E.g. number of staff members
 Management’s view about the proper level of costs is subject to change
with change in management.
 Includes administrative and support units like accounting, legal, PR, HR,
R&D, operations
 The output cant be measured in monetary terms
 The difference between budget and actual expense is not a measure of
efficiency rather, it is simply the difference between the budgeted input
and the actual input and does not incorporate the value of the output.

66
Contd..
a. Administrative and Support centers
 Administrative centers include sr. corporate management
and business unit management along with the mangers
of supporting staff units.
 Support centers are units that provide services to other
responsibility centers and they often charge for the
same.
 Support centers often charge the other responsibility
centers for the services that they provide.
 E.g. IT dept can charge sales dept for the services
 Functions are virtually impossible to quantify, much less
evaluate.

67
Contd..
 Difficulty in measuring output ( advice, service), so not
possible to set cost standards
 E.g. development of an accounts receivable system job to
finance staff- comparison of costs would not tell
effectiveness of the job done.
 Typically managers of admin staff offices strive for
functional excellence.
 It seems to be congruent with company goals. Results in
safeguarding one’s position without regard to the welfare
of the company. E.g. legal staff or controller.

68
Contd..
b. Research and Development centers
 Carry some R&D activities, like product development. Product
testing, developing improved production and quality methods,
market research etc.
 Difficulty in relating results to inputs
 Lack of goal congruence
 Research manager wants to build the best research organization
money can buy, might be unaffordable to company.
 Research people many a times don’t have sufficient business
knowledge to determine the optimum direction of the research
efforts.
 Projects involving testing, no precise time and cost estimation

69
Responsibility Budgeting
 It is the plan for the allocation of financial resources to each
organizational responsibility center for the budget period.
1. Incremental budgeting:
 Identify the current level of expenses as a starting point. And then adjust
these amounts for expected growth i.e. workload, inflation, etc.
 However no scope for evaluation with past performance and therefore the
basis for setting standard for future may itself be wrong.
 Managers go for demanding higher resources.
 Current level of expenditure is not reexamined during the budget
preparation process.
 Sometimes new management reduces costs drastically without any
adverse consequences

70
Contd..
2. Zero-Based Budgeting:
 Each responsibility center calculates its resource needs based on
the coming year’s priorities rather than on the previous year's
budget.
1. Develop a decision package for their responsibility centers – start from
scratch.
2. Top management reviews decision package and ranks them
3. Top management allocates resources based on rankings.
4. Comparison is done
 It is a time consuming process
 Likely to be a traumatic experience of the managers whose
operations are being reviewed.
 Many companies due to recession, conducted zero base reviews
– downsizing, restructuring

71
Signs of Inadequate Budget Control
Systems
 Deadlines missed frequently
 Poor quality of goods and services
 Declining or stagnant sales or profits
 Loss of leadership position or market share
 Inability to obtain data to evaluate employee or departmental
performance
 Low employee morale and high absenteeism
 Insufficient employee involvement and management-employee
communication
 Excessive company debts, uncertain cash flow, unpredictable
borrowing
 Insufficient use of people, material, equipment, and facilities.

72
Profit Centers
 When a responsibility center’s financial performance is
measured in terms of profit, the center is called as
profit center.
 Area responsible for controlling costs and generating
revenues
 Relationship between the inputs and output can be
easily established.
 Performance evaluation and the control becomes
comparatively easier exercise.

73
Contd..
 Profit focuses the responsibility center’s efforts towards the ultimate
goal, it motivates the responsibility centers to employ its assets /
resources in most efficient manner.
 In case of expenses center-cost needs to be controlled, but in case
of profit center- achieving better trade off between the cost incurred
and profit earned.
 Before establishing such center, relative advantages and
disadvantages of having it need to be analyzed.
 E.g. Auto industry- sales division - profit center, but, after-sales
service - not a profit center but to create and maintain company’s
image.

74
General considerations
 Conditions for delegating profit responsibility
 Proposal to increase expenses with expectation of even
greater increase in sales revenue. Includes expense /
revenue trade – off E.g. advertising expenses , quality
control expenses. Two conditions for safely delegating the
trade-off :
1. The manager should have the relevant information to make trade-
off
2. There should be some way to measure how effectively the
manager is making these trade offs.
 Management must decide whether the advantages of
giving profit responsibility offset the disadvantages.

75
Advantages of profit centers
 Improved quality of decisions as decisions taken by mangers
closest to the point of decision
 Increased speed
 Headquarters management can concentrate on broader issues
 Managers are freer to use their imagination and initiative
 Provide a training ground.
 Enhancement in profit consciousness
 Management of performance is broadened.
 Provides top management with information on profitability of the
company’s individual components
 Always try to improve their competitive performance

76
Difficulties with profit centers
 Loss of control
 If profit center manger is less capable, quality of decisions at unit
level may be reduced
 Increase in friction due to arguments over allocation of common
costs, credit of revenues etc
 Competition between profit centers
 Increase in overall management costs due to divisionalization.
 There may be more focus on short run profitability at the expense of
long run profitability
 Not necessary that if the profits of each individual profit centers are
optimized, it ensures the optimization of the profits of the company
as a whole.

77
Transfer Pricing
 Decentralization- accounting for the transfer of goods
and services from one profit center to another.
 The method followed while establishing price for such
transfers is called transfer pricing.
 Inappropriate pricing for inter divisional transfer of goods
or services draws a wrong performance
 TP is a mechanism for distributing the revenue
generated collectively

78
Objectives of transfer pricing
 It should provide each segment with the relevant
information required to determine the optimum
trade-off between company costs and revenues.
 To measure the real performance and
profitability of the division
 To allow autonomy to division but not at the cost
of the firm’s goal
 To keep up motivation of all concerned divisions.
 To ensure the cost control at every division.

79
Cost based transfer pricing
 Used when there is no outside buyer available
for division’s intermediate products. Or
 No competitive market exists for a division’s
products. Or
 There exists only one buyer.
 It remains less satisfactory than the market
price.
 Two decisions to be taken
 Determine the cost of product
 Set the profit mark up

80
Contd…
1. Standard cost as transfer price
 Scientifically predetermined cost of production and not
actual costs.
 It motivates the division to contain its costs within
prescribed limits.
2. Full cost as transfer price
 Recovery of full cost of production
 But here, the inefficiencies of one division will be passed on
to the another division and no incentive for cost control.

81
Contd…
3. Variable cost as transfer price
 Only variable cost of production is taken into
consideration by ignoring the fixed cost.
 Logic is, why to consider fixed cost which has
already been committed irrespective of the
purchase decision of another division.
 But, neither profit nor the recovery of the full
cost.

82
Market based pricing
1. Market price as transfer price
 It is the best transfer price, as it represents the
opportunity cost from the point of view of both the
divisions are concerned. Primary conditions for
establishing MP as transfer price are:
 There should be open market for the one’s products i.e.
the other has open option to outsource its requirements.
 The market price is determined by fair & competitive
market forces.

83
Contd..
 It is possible that due to corporate constraints such as
interdependent production capacities, one division being
the sole producer exists, company has heavily invested
in production facilities which doesn’t allow its division to
go for outsourcing its purchases. Due to these reasons
if..
• Incase the company doesn’t indulge with outside market then
competitive prices can be determined by using
i. Published market price
ii. Market price set by bid
iii. Adding certain % over and above its standard cost of
manufacturing.
 Incase excess or shortage of capacity – no point in
selling division asking for market price.

84
Contd..
2 Modified (negotiated) Market Price (MMP)
 Both division need to settle for a transfer price
which has been discounted for all non influencing
cost factors. E.g. packaging
 No selling and distribution cost to the selling
division
 Due to guaranteed high order/off take, production
cost per unit will be lower-saves cost
 Quality, quantity and delivery aspects of supply is
higher assured and at lesser than market price.

85
Contd..
3 Transfer price lower than market price
 If selling division is operating at its full
capacity, it cant reduce the price,
 But if having idle capacity then only can settle
for a lower than market price, as the
opportunity cost for them would be zero.

86
Margin based pricing
4 The profit markup
 Two decisions,
a) what the profit markup is based on and
b) The level of profit allowed
 Widely used base is a % of costs, or % of investment.
 To the extent possible the profit allowance should
approximate the rate of return that would be earned if the
business unit were an independent company selling to
outside customers.

87
Pricing corporate services
 Charging business units for services furnished by
corporate staff units.
 This excludes the cost of central service staff units over
which business units have no control. E.g. central
accounting, public relations, administration. They are
allocated and the allocations don’t include a profit
components. The allocations are not transfer prices.
 Two types of transfers
1. For central services that the receiving unit must accept but can
at least partially control the amount used
2. For central services that the business unit can decide whether
or not to use.

88
Contd..
Multinational companies- use to minimize
their worldwide taxes, duties and tariffs.-
company may follow it among its divisions
such that it will facilitate transfer its funds
from high tax bracket country to tax
heaven country.

89
1 Control over amount of service
 BU may be required to use company staffs for services
such as Information technology and R&D.
 Here BU manager cant control the efficiency with which
these activities are performed but can control the
amount of the service received. Three schools of
thought about such services:
1. BU should pay the standard variable cost of the discretionary
services. If it pays less than this, it will be motivated to use
more of the service than is economically justified. If pays
higher, they might not elect to use services that sr.
management believes worthwhile.

90
Contd..
2 A price equal to the standard variable cost plus a fair
share of the standard fixed costs i.e. the full cost but
not more than MP. Because, if BU don’t believe their
services are worth at least this amount, then there is
something wrong with either the quality or the
efficiency of the service unit.
3 A price that is equivalent to the market price or to
standard full cost plus a profit margin. The market
price would be used if available. The capital employed
by the service unit should earn a return just as the
capital employed by manufacturing unit

91
2 Optional use of services
 BU can choose whether to use central service units.
They may procure the service from outside, develop their
own capability or choose not to use the service at all.
 Most often found for information technology, internal
consulting groups and maintenance work.
 These service centers are independent, they must stand
on their own feet.
 Here, BU managers control both the amount and the
efficiency of the central services.

92
Administration/ Implementation of transfer
prices
 How the selected policy should be implemented-the
degree of negotiation allowed in setting TP, methods
of resolving TP conflicts and classification of products
according to the appropriate method
1. Negotiation:
 TP not set by central staff group, but BUs negotiate it with
each other. This keeps intact the autonomy of the divisions.
 Authority and responsibility both given to the profit center.
 Also knowledge about the local condition, so intervention not
required.

93
Contd..
 When an open market price is available, there should
be no intervention at all of any nature by anybody.
 In case companies’ headquarters have rule, that BU
are free to deal with each other or with outsiders as
they see fit – if no agreement on price, they can deal
with outsiders
 If as per rule, BU are required to deal with one
another – no threat of competitors, headquarters staff
must develop a set of rules that govern both pricing
and sourcing of intra-company products.

94
Contd..
2. Arbitration and conflict resolution
 Arbitrator should be a senior management personality
from finance / a committee of experts / an executive
depending upon the intensity of heat.
 Main task is to set appropriate transfer price, establish
the rule / policies in this regard and reviewing the
sourcing changes.
 With a formal system, both parties submit a written
case – arbitrator reviews their positions and decides
on prices.

95
Contd..
 4 ways to resolve conflict-
 Forcing
 Smoothing
 Bargaining
 Problem solving
Conflict avoidance
Conflict resolution

96
Contd..
3 Product Classification
 Categorization of company’s products helps in
administration of TP
 Class I- include the products which needs strict control of
head quarter. These products represent high volume
requirements of another division / which need special care
about quality /secrecy. Normally no outside source exists
 Class II- include rest of the products which don’t need
special corporate care and control. Relatively of small
volume, produced with general purpose equipment. These
products can be transferred at market price.

97
Why relate profits to investments?
The Manager’s Responsibility
 First, a manager should invest in assets only if
the assets will produce adequate returns.
 Second, when an asset is not providing
adequate return (the expected return could
change over the years), it is time to “disinvest”
or reduce further investments into this asset.

98
Measuring and controlling assets
employed
 The purpose of measuring assets employed:
 To provide information that is useful in making decisions about
assets employed and to motivate managers to make sound
decision - that is decisions in the best interests of the company
 To measure the performance of the business unit as an
economic entity.
 Relating profit to the investment base
 The % return on investments or assets employed (ROI) and
 Residual or economic value added. (effectively same concepts)

99
Contd..
 A focus merely on profits without consideration of the
assets employed to generate those profits is an
inadequate basis for control
 BU managers in general have these performance
objectives
 They should generate adequate profits from the resources at
their disposal
 They should invest in additional resources only when such an
investment will produce an adequate return.
 Also they should disinvest if the expected annual profits of any
resource, discounted at the company’s required earnings rate, is
less than the cash that could be realized from its sale.

101
Measuring assets employed
 Deciding what investment base to use to evaluate investment
center managers, headquarters asks 2 question
 What practices will induce business unit managers to use their
assets most efficiently and to acquire the proper amount and kind
of new assets?
 What practices best measure the performance of the unit as an
economic entity?
1. Cash
 Normally centrally controlled, Coz it permits the use of a smaller
cash balances than would be the case if each BU held cash
balances sufficient to provide the necessary buffer for the
unevenness of its cash inflows and outflows.
 Many companies therefore calculate the cash to be included in the
investment base by means of a formula.

102
Contd..
2 Receivables
 BU managers can influence the level of receivables
indirectly, by their ability to generate sales and directly
by establishing credit terms and approving individual
credit limits and by their drive in collecting overdue
amounts.
 At SP or at COGS is debatable.
 Real investment in accounts receivable is only the
COGS.
 On the other hand, BU has the opportunity to reinvest
the money collected
 Normal practice is to include receivables at book amount
i.e. SP less an allowance for bad debts.

103
Contd..
3. Inventories
 Depend on the method used for valuation (LIFO, FIFO,
average costs)
 If WIP inventory is financed by advance payments from the
customer, as is typically the case with goods that require a
long manufacturing period, these payments are either
subtracted from the gross inventory amounts or reported as
liabilities.
 Some companies subtract A/c payable from inventory on the
grounds that they represent financing of part of the inventory
by vendors, at zero cost to the business unit.

104
Contd..
4 Working capital in general
 Considerable variation in how working capital items
are treated.
 Can include, all current assets in the investment base
with no offset for any current liabilities – motivational
standpoint if BU have no influence over accounts
payable or other current liabilities.
 Or, all current liabilities may be deducted from current
assets- provides a good measure of the capital
provided by the corporation, on which it expects the
BU to earn a return.

105
Contd..
5. Property, plant and equipment
 FA taken at acquisition cost and are written off through
depreciation. But this faces some problems.
a) Acquisition of new equipment
 New Machine costs 100,000. Life 5 years, gives cash
inflow of 27000 per year.
i. Economic calculation:
Investment in machine 100
PV of Cash inflow (27000*3.791) 102.4
NPV 2.4
Decision: Acquire the asset

106
Contd..
ii. As reflected in BU income statement
• New Machine costs 100,000. Life 5 years, gives cash
inflow of 27000 per year. 10% rate of return.
• Savings by using the new machine 27,000 per year or
on a Present Value basis for five years, 102,400 with a
net present value of 2,400 (102,400 - 100,000).
• Before this new asset is acquired, the annual
depreciation on fixed assets was 50,000 per year and
• After the new asset is purchased, the annual
depreciation will go up to 50,000 + 100,000 / 5) =
70,000

107
computations for before and after
purchase of asset -
Before 1 year after
Purchase Purchase
of asset of asset
Profit before depreciation 1,000,000 1,000,000
Expenses (w/o Deprecn.) (850,000) (823,000)
Profit before depreciation 150,000 177,000
Depreciation (50,000) (70,000)
Profits after depreciation 100,000 107,000
Equity 500,000 500,000
Capital charge at 10% 50,000 60,000
EVA (Profits – Cap. Charge) 50,000 47,000
ROI 20% 21.4%

108
Interpretation
 The profit before depreciation has remained constant
at 100,000 before and after purchase of the asset and
yet
 The ROA went up from 20% to 21.4%. Why? Simply
because the depreciation expenses went up.
 In contrast, the EVA declined from 50,000 to 47,000
making it look like profits decline after purchase of the
asset (even though the income before taxes had
actually increased from $100,000 to $107,000).

109
Contd..
 That is, a manager can make the wrong decision not to
purchase the asset based on these computations.
 In later years, the EVA will go up and so will the ROA
because of additional depreciation.
 It is evident that BU that have old, almost fully depreciated
assets will tend to report larger EVA than units that have
newer assets
 Conclusion: if depreciable assets are included in the
investment base at net book value, BU profitability is
misstated and BU managers may not be motivated to
make correct acquisition decisions.

110
Contd..
b) Gross Book Value
 Such fluctuation can be avoided by including depreciable assets in the
investment base at gross book value rather than at net book value. But, in
that case it understates the true return.
 In example- 7000 additional income, 7% ROI, EVA reduces by 3000
c) Disposition of assets
 New machine considered as a replacement for an existing machine that
has some undepreciated book value is irrelevant in the economic analysis
of proposed purchase.
 Removal of book value of old machine-substantial effect on profitability
 Managers are encouraged to replace old equipment with new one, even in
situations in which such replacement is not economically justified.
 If included at original cost- managers try to get rid of it as the investment
base gets reduced.

111
Contd..
d) Leased assets
 If BU sells its Fixed asset and then lease back the asset at a
rental, its income before taxed reduces coz rental expenses >
depreciation cost
 Whereas, EVA would be increased coz the capital charge would
be reduced.
 Due to this, BU managers have tendency to lease assets rather
than owning them.
d) Idle assets
 Idle assets, which can be used by other units, BU can exclude
them from the investment base.
 But if they cant be used by any other unit, then removal from
investment based could result in dysfunctional actions. i.e.
removal of assets not giving the optimum returns.

112
Contd..
6. Intangible assets
 Amortized over a period of time. This method has the
potential to change how the BU manager views these
expenditures.
 Changing the accounting for items such as R&D from an
immediate expense to a long term investment, the BU
manager will gain less short-term benefits from reducing
R&D.
 If R&D expenditures are expensed immediately, each
dollar of R&D cut would be a dollar increase in pretax
profits.

113
Contd..
7. Non-current Liabilities
 BU receive its permanent capital from corporate pool of
funds. The corporation obtain them from debt, equity
and retained earnings.
 BU that builds or operates residential or office buildings
uses a much larger proportion of debt capital than is the
case with typical manufacturing and marketing units.
 Since this is obtained on mortgage of assets, then
accounting for the borrowed funds to be done separately
and then EVA can be calculated based on the assets
those were obtained from general corporate sources,
rather than on total assets.

114
Contd..
8. The capital charge
 Determination of capital charge is done
normally by HO.
 It should be higher than the corporation's
rate for debt financing- coz it’s a mix of debt
as well as higher cost equity.
 Different rates should be used for business
units with different risk characteristics.

115
Additional considerations in evaluating
managers
 Due to problems in ROI method implementation, EVA tool is
recommended, but it also doesn’t solve the problem of accounting of
fixed assets
 Like discussed, if gross book value is used, BU tries to increase its
EVA by taking actions contrary to the interests of the company
 If net book value is used, EVA increases with passage of time.
 Also, EVA is temporarily depressed whenever a new investment is
done.
 EVA does solve the problem created by differing profit potentials.
 BU, regardless of profitability, will be motivated to increase
investments if the rate of return from a potential investment exceeds
the required rate prescribed by the measurement system.

116
Contd..
So, in some units, investment amount
generally is limited to inventories,
receivables, furniture, equipments etc. e.g.
marketing units.
Due to this, some companies exclude
fixed assets from the investment base.
Interest charge only for controllable assets
(essentially working capital items).

117
Contd..
 BU manager’s efficiency would affect the level of
these assets.
 Whereas, investments in fixed assets are
controlled by the capital budgeting process and by
post completion audits to determine whether the
anticipated cash flows in fact materialized.
 Actual savings or revenues from a fixed asset
acquisition may not be identifiable.

118
Performance Measurement and control
 Managers function- to ensure that the work gets done efficiently
and effectively. They literally don’t “control costs”. They try to
influence the actions of the people who are responsible for
incurring the costs
 Performance measurement improves the likelihood the
organization will implement its strategy successfully.
 In MCS, the manager works through others in the following ways
1. Selecting employees
2. Making sure the employees are adequately trained
3. Deciding where the employees fit best in the organization
4. Empowering employees
5. Providing advice and suggestions
6. Solving problems

119
Contd..
7. Ensuring that the work environment is satisfactory
8. Disciplining
9. Resolving disputes within the responsibility center
10. Approving proposed actions that employees are not
authorized to take
11. Interacting with other managers to obtain their cooperation
and to resolve problems when their activities impede the
work of the responsibility center
12. Seeking to create a climate that induces employees to work
efficiently and effectively.
 To carry on these activities managers need information

120
Information
 Anything that reduces the user’s uncertainty
1. Informal information
 Manager receives through observation, face-to-face
conversations, telephone conversations, memorandum and
meetings.
 Most managers find this more important than any formal
report.
2. Task Control Information
 Production control system provides information that schedules
the flow of material, labor and other resources.
 Procurement, payroll, storage and other activities.
 With computers any information available at speed and at low
cost per transaction.

121
Contd..
3. Budget Reports
 A report that compares actual revenues and expenses with
budgeted amounts is the principal financial report.
 Although an import guide to the responsibility center manager,
the budget is only a guide. In case if manager discovers better
way of achieving the same objective or if any circumstances
change, he can depart from budget.
 Adherence to the budget is not necessarily good and
departure from it is not necessarily bad.
3. Budget signals
 Operating managers to understand which budget amounts are
expected amounts, which are ceilings and floors.

122
Contd..
5. Non-financial information
 They are key indicators of how well the chosen
strategy is being implemented.
 Key variables, strategic factors, key success factors,
critical success factors, pulse points or key
performance indicators.

123
Performance Measurement Systems
 PMS have the goal of strategy implementation.
 In setting up a PMS, senior management selects a
series of measures that best represent the company’s
strategy. These measures can be seen as current and
future critical success factors. If these factors are
improved, then the company has implemented its
strategy.
 It is a mechanism for improving the likelihood of the
organization successfully implementing a strategy

124
Contd..
 Financial measures of corporate success-profits and revenues,
show the results of past decisions the company has taken.
 Under PMS, a blend of financial and non-financial measurements
are used at all levels in the organization.
 Financial measures indicate the results of past decisions, whereas
non-financial are leading indicators of future performance.
 A PMS like dashboard, has a series of measures that provide
information about the operation of many different processes.
 Example of PMS is Balanced Scorecard.

125
The Balanced Scorecard
 It fosters a balance between otherwise disparate strategic measures
in an effort to achieve goal congruence, thus encouraging
employees to act in the best interest of the organization.
 The balanced scorecard is tool for focusing the organization,
improving communication, setting organizational objectives and
providing feedback on strategy.
 Every measure on a balanced scorecard addresses an aspect of a
company’s strategy.
 In creating the balance scorecard, executives must choose a set of
measurements that
1. Accurately reflect the critical factors that will determine the success
of the company’s strategy
2. Show the relationships among the individual measures in a cause-
effect manner, indicating how non-financial measures affect long-
term financial results and
3. Provide a broad-based view of the current status of the company.

126
Contd..
 The balanced scorecard approach also focuses on what
managers are currently doing to create future
shareholder value.
 Performance reporting approach which links
organizational strategy to actions of managers and
employees
 Combines financial and operating measures
 Links performance to rewards
 BU should be assigned goals and then measured from
the four perspectives.

127
Contd..
 The balanced scorecard tries to create a
blend of strategic measures:
1. Outcome and driver measures
 Indicates the result of a strategy (increased
revenue, improved quality)
 The amount by which revenue increase is the result
of the successful implementation of the
organization’s strategy.
 They tell management what has happened.
 Whereas, driver measures are ‘leading indicators’,
showing the key areas in implementing a strategy.

128
Contd..
2. Financial and non-financial measures
 Sophisticated systems are developed to measure
financial performance, whereas, many organizations
have failed to incorporate non financial measures like
quality and customer satisfaction, because these
measures tend to be much less sophisticated than
financial measures and senior management is less
adept with their use.
2. Internal and external measures
 Good balance between external measures such as
customer satisfaction and internal measures like
manufacturing yields.

129
The Balanced Scorecard Dimensions
Financial Perspective
Is company achieving
financial goals?
Financial Perspective
Is company achieving
financial goals?
Internal Process
Is company improving
critical internal processes?
Internal Process
critical internal processes?
Customer Perspective
Is company meeting
customer expectations?
Customer Perspective
Is company meeting
customer expectations?
Learning and Growth
its ability to innovate?
Learning and Growth
its ability to innovate?
Strategy

130
Contd..
 Financial perspective:
 Return on capital employed
 Cash flow
 Project profitability
 Profit forecast reliability
 Sales backing
 Internal business perspective
 Hours with customers
 Tender success rate
 Rework
 Safety incident index
 Project closeout cycle
How do we look
to stockholders?
What must we excel
At internally

131
Contd..
 Customer perspective
 Customer ranking survey
 Customer satisfaction index
 Market share
 Innovation and learning perspective
 % revenue from new services
 Rate of improvement index
 Staff attitude survey
 No. of employee suggestions
 Revenue per employee
How do customers
See us?
How do we learn
And innovate to create
The future

132
Implementation of balanced scorecard
 Four general steps
1. Define strategy
 It builds a link between strategy and operational action
 For a single industry firm, the scorecard should be developed
at the corporate level and then cascaded down to functional
levels and below
 However, for a multibusiness firm, the business unit should be
the starting point for developing the scorecard
2. Define measures of strategy
 Focus on few critical measures
 Individual measures be linked with each other in a cause-
effect manner

133
Contd..
3. Integrate measures into the
management system
 The balanced scorecard must be integrated
with the organization’s formal and informal
structures, its culture and its human resource
practices.

134
On the one hand the Balanced Scorecard gives insight
into complex information, on the other hand it
communicates and reflects the corporate strategy

135
MCS in service and Non-profit
organizations
 Service organizations in general
 Characteristics
 Different from the process ion manufacturing
companies.
1. Absence of inventory buffer
 Services cannot be stored.
 Cannot earn revenue in the future from products
that are on hand today like a manufacturing
company.
 It must try to minimize its unused capacity.
 Cost of many such organizations is fixed in short
run.

136
Contd..
 A key variable in most service organizations, is the
extent to which current capacity is matched with
demand. This can be done in two ways
• They try to stimulate demand in off-peak periods by marketing
efforts and price concessions
• If feasible, they adjust the size of the work force to the
anticipated demand, by such measures as scheduling training
activities in slack periods and compensating for long hours in
busy periods.
2. Labour intensive
 People cannot be replaced by equipments.
 Adds costs
2. Pricing of product – No sound cost base

137
Contd..
4. Difficulty in controlling quality
 Quantity and quality cannot be measured visually or with
instruments
 Subjective judgments.
5. Multi-unit organizations
 Fast food restaurant chains, auto rental companies, etc.
 Some of the units are owned, others operate under a franchise.
 Similarity of these separate units provides a basis for analyzing
budgets and evaluating performance that is not present in the
usual manufacturing company
 Information for each unit can be compared with systemwide or
regional averages and high performers and low performers can be
identified

138
Contd..
6. Very few tangible assets - ROI may be meaningless
7. Special class of labor - seeks more autonomy in
working.
8. Input and output measurement is difficult - difficult to
arrive at effectiveness and efficiency of a professional.
9. Cost of services is of flexible nature such as traveling
expenses, communication expenses therefore building
standards is difficult process.

139
Professional service organizations
Organizations whose products are
professional services
R&D organizations, law firms, accounting
firms, health care, engineering,
architectural, consulting firms, ad
agencies, sports organizations etc.

140
Special characteristics
1. Goals
 Relatively few tangible assets
 Principal asset is the skill of its professional staff
 Financial goal is to provide adequate compensation to
the professionals.
 A related goal is to increase their size.
 Large public accounting firms need to have enough
local offices to enable them to audit clients who have
facilities located throughout the world.

141
Contd..
2. Professionals
 Labour intensive
 Many professionals prefer to work independently ,
rather than as part of a team.
 Professionals who are also managers tend to work
only part time on management activities
 They tend to give inadequate weight to the financial
implications of their decisions. They want to do the
best job they can, regardless of its cost.
 This attitude affects the attitude of support staffs and
nonprofessionals in the organization and leads to
inadequate cost control.

142
Contd..
3. Output and input measurement
 Cannot be measured in physical terms.
 Revenues earned is one measure of output in some
professional organizations; but these monetary
amounts, at most, relate to the quantity of services
rendered, not to their quality (poor quality- reduced
revenues in long run)
 The work done by many professionals is non-
repetitive.
 So, its difficult to plan the time required for a task, to
set reasonable standards for task performance and to
judge how satisfactory the performance was.

143
Contd..
4. Small size
 Except for some law firms and accounting
firms, normally professional organizations are
relatively small and operate at a single
location.
 Sr. management can personally observe what
is going on and personally motivate
employees.
 Less need for sophisticated MCS.

144
Contd..
5. Marketing
 In manufacturing cos- clear dividing line between
marketing activities and production activities; only sr.
management is concerned with both.
 This doesn’t exist in most of professional
organizations
 In some cases, law medicines, accounting,
profession’s ethical code limits the amount and
character of explicit marketing efforts by professionals.
 Difficult to assign appropriate credit to the person
responsible for selling a new customer.

145
MCS in service organizations
1. Pricing
 In a profession where members keep track of their
time, fees are related to professional time spent on the
engagement
 The hourly billing rate typically is based on the
compensation of the grade of the professional plus a
loading for overhead costs and profit.
 In other professions, say investment banking, fee is
based on the monetary size of the security issue.
 Total value of organization > sum of what the value of
the individuals would be if they worked separately.

146
Contd..
2. Profit centers and transfer pricing
 Support units, such as maintenance, information
processing, transportation, telecommunication,
printing, procurement of material and services, charge
consuming units for their services.
2. Strategic planning and budgeting
 Formal strategic planning systems are not as well
developed as in manufacturing companies of similar
size.

147
Contd..
4. Control of operations
 Much attention should be give to scheduling the time
of professionals. The billed time ratio, i.e. hours billed
to total professional hours available.
 Inability to set standards for task performance, the
desirability of carrying out work by teams and the
behavioral characteristics of professionals complicate
the planning and control of the day-to-day operations
in a professional organization.

148
Contd..
5. Performance measurement and appraisal
 In most circumstances, the assessment of
performance is a matter of human judgments made by
superiors, peers, self, subordinates or clients.
 Use formal system to collect performance appraisals
as a basis for personnel decisions and for discussion
with the professional.
 In some organizations self appraisals
 Client’s feedbacks
 Budget can be used as the basis for measuring cost
performance and the actual time taken can be
compared with the planned time.

149
Nonprofit organizations
Organization that cannot distribute assets
or income to, or for the benefit of, its
members, officers or directors.
It can compensate its employees for
services rendered and for goods supplied.
It prohibits only the distribution of profits
and not earning of profits.

150
Characteristics
1. Absence of the profit measure
 Many of them have several goals.
 Absence of a satisfactory, quantitative, overall
measure of performance is the most serious
management control problem in such
organizations.
 Net income should average only a small
amount above zero.
 Financial goal though not priority, still
necessary.

151
Contd..
2. contributed capital
 Issuance of stock, payments of dividends, transactions with
the shareholders are missing.
 Receives contributed capital, which few businesses have
 Two principal categories:
 Plant - includes contributions of building and equipment or
contributions of funds to acquire these assets, works of art and
other museum objects and
 Endowment consists of gifts whose donors intend that the
principal amount will remain intact indefinitely, only the income
on this principal will be used to finance current operations.

152
Contd..
 Thus, such organizations have two sets of financial
statements
• One set relates to operating activities - balance sheet,
cash flow statement
• Second set relates to contributed capital, a statement of
inflows and outflows of contributed capital during a
period and a balance sheet that reports contributed
capital assets and the related liabilities

153
Contd..
3. Fund Accounting
 Accounts are kept separately for several funds
 A general or operating fund - corresponds to
the set of operating accounts
 A variety of other funds for special purposes,
like pension fund etc.

154
4. Governance
 Governed by boards of trustees, who are
usually not paid and many of them are
unfamiliar with business management.
 Less control than the directors of a business
corporation.
 The need for a strong governing board is
greater because the vigilance of the governing
board may be the only effective way of
detecting when the entity is in difficulty.

155
MCS in non profit organizations
1. Product pricing
 Pricing of services at their full cost is desirable
(for directly related services) e.g. health care
services
 Others should be market based. E.g. gift shop
 If an organization is able to recover its
incurred costs, management is not motivated
to worry about cost control

156
Contd..
2. Strategic planning and budget preparation
 More important and time-consuming
 Budget preparation process is similar to other
industries
 E.g. colleges, universities, welfare organizations etc
know before the budget year begins, the approximate
amount of their revenues.
 They cant increase revenues with marketing efforts.
 Budgeting of expenses atleast for break even.
 It is the most important management control tool at
least with respect to financial activities.

157
Contd..
3. Operation and evaluation
 Difficult to know what the optimum operating
costs are.
 Even if responsibility center manager knows
that a particular expenditure would give a
good payoff, still they might refrain themselves
from doing so.

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