Notes/ Answers to important theory Qs

Q1. Explain briefly the various stages of management control process citing salient features of each.

Suggested Answer: Management Control is the process by which managers influence other members of the organisation to implement the organisations strategies. The main objective of management control is to implement the goals and strategies formulated by the CEO with the advice of senior management.

Management control involves the following activities: 1. 2. 3. 4. 5. 6. Planning what the organization should do Co-ordinating the activities of the different parts of the organization Communicating information Evaluating information Deciding what action is to be taken based on the evaluation Influencing the people to change their behaviour

These activities are operated through various stages of the following Formal Control Process chart:

Goals and Strategies (Block A)

Rules (Block E)

Other Information (Block F)

Reward

Yes Strategic Planning (Block B) Budgeting (Block C) Responsibility Center (Block D) Report actual versus plan (Block G) Was performance satisfactory? (Block (H) No Revise Revise Measurement

Feedback Communication

The salient features of each stage are as under: 1. The top management of the company, i.e., the CEO and senior management team, make its goals and strategies keeping in view the companys core competencies, other strengths, weaknesses, opportunities and threats. This is called strategy formulation. (Block A). 2. The Goals and Strategies are worked out in extensive details in the form of Strategic Planning (Block B) (Please note that the function carried out in Block A is called Strategy Formulation, whereas the function carried out in Block B is called Strategic Planning.

3. Keeping in view the organization structure (i.e., Functional Organization or Business Unit Organization or Matrix Organization), an Annual Master Budget for the organization is prepared. This forms the activity of Budgeting (Block C) 4. Through these Budgets, different Responsibility Targets or Plans are assigned to the various Responsibility Centers (Block D) 5. The Responsibility Centers also receive the various formal rules in the control process. These are shown through Block E. 6. Other necessary information required by the Responsibility Center is also provided through Block F. 7. The Responsibility Centers are required to give their actual performance as per the required format to enable proper comparison with the Centers Budgets. This is done on a monthly or quarterly basis as per the requirement of the System adopted by the company. This Report of Actual versus Plan is received (Block G). 8. The comparison of Reported Actual with the Plan is measured (quantified) and an analysis of the variance is done (both quantity and price/cost variance). 9. On this basis the Responsibility Center-wise conclusions are drawn whether the performance of each Center was satisfactory or not. (Block H). 10. If the Responsibility Centers performance was satisfactory, then the Center is given the positive feedback and suitably rewarded as per the System 11. If the Responsibility Centers performance was not satisfactory, then the feedback is given to (a) the Responsibility Center, (b) the Budgeting Dept, and (c) the Strategic Planning. This is because the unsatisfactory performance may not be purely because of underperformance of the Center; there may be a shortcoming in the Budget or in the Strategy Plan itself. This gives all the three the feedback so that they can independently assess whether (a) the Responsibility Center has slipped in performance, or (b) whether the Budget was not practical or proper, or (c) whether the strategy itself needs any alteration. 12. The revised course of action when the Responsibility Center has not performed satisfactorily is reworked and given to the concerned Center. 13. Thus the cycle of the Formal Control Process is completed and the next cycle begins. ________________________________________________________

Q2 (a)How do corporate level strategies differ from Business Unit level strategies? (b)How is budgeting done at SBU under different strategic mission?

(a)How do corporate level strategies differ from Business Unit level strategies? Suggested Answer: A companys CEO along with the senior management decides its goals such as (i) Profit, (ii) maximizing shareholder value, degree of Risk taking, and (iv) Multiple Stakeholder Approach. Strategies describe the general direction in which an organization plans to move to attain these goals. A firm develops its strategies by matching its core competencies with industry opportunities. Strategies are generally formed at two levels: (i) for the whole organization , and (ii) for the business units of the organization.

The way in which strategies at these two levels differ is given in the chart below:
Two Levels of Strategy Generic Strategic Options Primary Organisational levels involved

Strategy Level

Key Strategic Issues Are we in the right mix of industries? (i.e., is our core competence matching with the industry opportunity?) Which industries or subindustries should we be in? (same Question as above)

Corporate Level

(1) Single industry, or (2) Related Diversification, or (3) unrelated Diversification

Corporate Office

Business Unit Level

What should the mission of the Business Unit be?

(1)Build / (2) Hold / (3) Harvest, or (4)Divest

Corporate office and BU General Manager

How should the business unit compete to realise its mission? India examples of :

(1) Low Cost or (2) Differentiation

BU General Manager

Single Industry Corporate e.g., Asian Paints Ltd.. Dr. Reddys Laboratories Ltd. Related Diversified Corporate e.g., Hindustan Unilever Ltd. (HUL) (food:Knorr Soups, Kwality Walls icecream, Lipton Redlabel Tea personal care: Closeup, Dove, Lux, Sunsilk haircare home care: Surf Excel, Vim, Sunlight) Unrelated Business Corporate e.g., Reliance ADAG (financial services, communications, infrastructure, insurance, entertainment, power) Note: 1. overall objectives are referred to as "mission" 2. competition happens at the BU level, not at the corporate level.
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The basic definitions of the four missions i.e., Build, Hold, Harvest and Divest are given below. Build: It indicates that the BU's goal is to increase market share, even at the expense of short-term earnings and cash flow. BUs with low market share in high growth industry, typlically pursue a 'Build' mission. Hold: The mission aims to protect the BU's market share and competitive position. Generally, BUs with high market share in high growth industries pursue a 'hold' mission. Harvest: It has the objective of maximising short-term earnings and cash flows even at expense of market share. Generally the BUs with high market share in a low growth industry pursue this mission. Divest: It indicates a decision to withdraw from the business either through liquidation or outright sale. Typically BUs with low market share in low growth industries are divested.

(b)How is budgeting done at SBU under different strategic mission?

Suggested Answer: Build: Under the Build mission, the BU is working towards increasing its market share. Thus there is requirement of finance for both capital expenditure and working capital. The performance has to continuously increase and there is enormous activity in budgeting. Also, through the budgeting process, we will be able to assess the long term finance and short term finance of the firm. Thereafter, the firm will have to raise these finances. Thus, there is a large amount of budgeting activity in Build mission and it becomes critical to the growth plans. Hold: Under the Hold mission, the firm is making efforts to hold the existing market share and competitive position in a high growth industry. Thus there is growth to the extent of the growth rate of the industry, both in capital expenditure and working capital finance. Budgeting is necessary and important, although it is not as critical as in Build mission. Harvest: in this case, the industry growth is low. As such, there is no plan for growth, which means no plans for capital expenditure and working capital finance. On the other hand, the company is trying to maximize the short term earnings and cash flows. Thus there will be cash inflows in the company. Budgeting process is not so important, mainly because process of maximizing
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short term earnings is largely dependent on the market rather than the companys internal plans or budgets. Divest: In case of Divest mission, the company is making efforts to withdraw or exit. Normally this is done through liquidation or outright sale. Under both options, budgeting has very little role to play since the firm is working on legal front for liquidation or on market front to search for a suitable buyer.

Please note the charts for Corporate level strategies and BU level strategies as under:

Q3. (a) Briefly describe Engineered Expense Centres and Discretionary Expense Centres. (b) How is budget prepared in each and how performance evaluated in each.? Suggested Answer: Expense centres are those responsibility centres whose inputs are measured in monetary terms, but whose outputs are not measured in monetary terms. There are 2 types of expense centres: A. Engineered Expense Centres B. Discretionary Expense Centres A. Engineered Expense Centres are those expense centres for which the right or proper amount of input can be estimated, e.g., direct material cost, direct labour cost, cost of components, cost of utilities, etc.

The main features of Engineered Expense Centres are: 1. Input can be measured in monetary terms 2. Output can be measured in physical terms 3. Optimum rupee amount of input required to produce a unit of output can be determined 4. Usually found in manufacturing operations

Optimal relationship established

INPUTS (Rupees)

Work

OUTPUTS (Physical)

Schematic diagram of Engineered Expense Centre

Budget preparation and performance evaluation in engineered expense centres:

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1. Obtain the output in physical terms 2. Multiply the output in physical terms by standard cost per unit of output, to give the budgeted cost. This gives what the finished product should have cost. (Standard costing involves the creation of estimated (i.e., standard) costs for some or all activities within a company. 3. Find the difference between the budgeted cost and actual costs which are the known actual input costs . This difference is called the variance This difference gives the extent to which the company has performed favourably or adversely. B. Discretionary Expense Centres (also called Managed Expense Centres) are those expense centres for which it is not feasible to estimate the right or proper amount of input.

Optimal relationship is not established

INPUTS (Rupees)

Work

OUTPUTS (Physical)

Schematic diagram of Discretionary Expense Centre Discretionary Expense Centres mainly include: (i) (ii) (iii) Administrative and support services (such as accounting, legal, human resources, industrial relations, public relations), Research & Development Operations, Marketing Activities.

The term discretionary refers to the managements discretion in judgement regarding the policies such as: (a) Whether to match or exceed the marketing efforts of the competitiors (b) The level of service to customers (c) Appropriate amount of R&D spending Discretionary does not mean adhoc. On the basis of such discretion, a budget is prepared for discretionary expense centres.

Management formulates the discretionary budget usually in one of the following ways:
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1. Incremental method for continuing expenses: in such a case, current level is taken as starting point and incremental build-up is provided for inflation and additions (e.g., preparing financial statements of the company) 2. One-shot method for special work (e.g., developing and installing a profitbudgeting system in a newly acquired division. 3. A technique often used is management by objectives to accomplish specific jobs and performance evaluation. 4. Zero-Base Review: Thorough analysis of existing budget and make a fresh budget to be reviewed every year. Time consuming but many advantages (particularly for newly acquired companies). These efforts have led to down sizing, right sizing, restructuring, process re-engineering. The difference between budget and actual is not a measure of efficiency (unlike, as in Engineered Expense Centres). There is no budget to compute efficiency. Additional info on Zero Base review: Discretionary Expense Centre: Some noteworthy outcomes of Zero-Base Review 1. In 2002, Nissan Motors Co., under its restructuring, disposed of non-core businesses, changed supplier relationships, trimmed cross shareholdings in partner firms, set tough performance targets and eliminated lifetime employment and seniority based promotions. (#42 in Fortune 500, CEO: Carlos Ghosn) 2. IBM decided to sell its personal computing div to Lenovo Group(leading PC brand in China and Asia) to exit from low margin business. IBM holds 18% stake and has made Lenovo preferred supplier of personal computers to IBM. (IBM#19, Lenovo #370 in Fortune 500) 3. ABB slashed corporate staff after every acquisition. (#19 in Fortune 500)

____________________________________________________________________

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Q4. How is an investment center different from a profit center? What are the different methods of judging their performance? Which is a better method? Suggested Answer: Difference between Profit Center and Investment Center: Profit Center: A Business Unit, which is responsible for both revenues and expenses, and thus profit, is a Profit Center. The focus is on profit as measured by the difference between revenues and expenses The Profit center, is however, not responsible for investment. Investment Center: An investment center is an autonomous sub-unit of an organization which is responsible for profit and investment. In such business units, the profit is compared with the assets employed in earning it. Such business units are referred to as strategic-business-units or SBUs. The head of the SBU is accountable for the in the overall performance, usually measured by return on capital employed, which in turn depends on the revenue, costs, and investment. Thus, an investment center is a special type of profit center, rather than a separate parallel category. Performance measurement of a Profit Center: Profit Center: There are two types of measurements used in evaluating a Profit Center: 1. Measure of management performance. This focuses on how well the manager is doing. This measure is used for planning, co-ordinating and controlling the day-to-day activities and for providing proper motivation to the manager. 2. Measure of economic performance. This focuses on how well the Profit Center is doing as an economic activity. (It can sometimes so happen that the Profit Center manager is doing an excellent job, but the unit may be a losing proposition due to adverse economic conditions or intense competition) The economic performance is always measured by net income (i.e., profit after tax). However, the performance is evaluated by five different measures at different stages: 1. Contribution Margin i.e., Revenues minus Variable expenses 2. Direct Profit i.e., Contribution Margin (from 1 above) minus Fixed expenses of the Profit Center 3. Controllable Profit i.e., Direct Profit (from 2 above) minus controllable corporate charges 4. Profit before taxes i.e., Controllable Profit (from 3 above) minus corporate allocations 5. Profit after taxes i.e., Profit before taxes (from 4 above) minus taxes

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Investment Center: There are two types of measurements used in evaluating a SBU: 1. Measure of management performance. This focuses on how well the manager is doing. This measure is used for planning, co-ordinating and controlling the day-to-day activities and for providing proper motivation to the manager. 2. Measure of economic performance. This focuses on how well the SBU is doing as an economic activity. (It can sometimes so happen that the SBU manager is doing an excellent job, but the unit may be a losing proposition due to adverse economic conditions or intense competition) Measurement of economic performance in SBUs is made in two ways: 1. Return on Investment (ROI) , and 2. Economic Value Added (EVA) (i.e., Net Profit minus capital charge), [Capital Charge is (Cost of capital) multiplied by (Capital Employed)]

Which is a better method? ROI and EVA are more comprehensive than just profit (revenue minus expenses). Between ROI and EVA, EVA is better since it goes a step beyond ROI. The capital charge , [i.e.,( the cost of capital)multiplied by the (Capital Employed)] is deducted from the Net Profit.

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Q5 What are the objectives of transfer pricing? What are the different methods to arrive at transfer price? Discuss the appropriateness of each method. Explain with example. Suggested Answer: Transfer Price is the price which one responsibility centre of an organization charges for the product or service supplied by it to another responsibility centre of the same organization. Transfer Pricing is a mechanism for distributing revenue between different divisions which jointly develop, manufacture and market products and services. The term Transfer Pricing is also used in a wider sense for the price which one subsidiary company charges to another subsidiary company, when both companies belong to the same holding company. Objectives of Transfer Pricing System: The main objectives of transfer pricing system are as follows: (i) (ii) (iii) To provide each Division with relevant information required to make optimal decisions for the Division and for the organization as a whole. To promote Goal Congruence i.e., the actions taken by Divisional Managers to optimize Divisional performance should automatically optimize the firms performance. To facilitate measuring Divisional Performance. This will foster a commercial attitude in those Divisional Managers which are responsible for the performance of their Divisions. The main emphasis is on profitability. This objective compels the units to improve their profit position. To optimize the profit of the concern over a short period of time. Here, the stress is on maximum utilization of plant capacity. To optimize the allocation of the concerns financial resources. This is a long term objective. The allocation of resources is based on relative performance of various profit centres, which in turn are influenced by transfer pricing policies.

(iv) (v)

A. Methods of Transfer Pricing: The methods of transfer pricing usually employed in industry when goods and services are transferred from one unit to another can be broadly classified under the following three main categories: 1. At cost or variants thereof e.g., actual manufacturing cost; standard cost; full cost and full cost and full cost plus mark-up. 2. At market price. 3. At bargained or negotiated price. Other methods of transfer pricing are as follows: (i) Two step method (ii) Profit sharing method (iii) Two sets of pricing method

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1. Pricing at cost or variants thereof: (a) Actual manufacturing cost: under this method, goods or services are transferred at their actual cost of production. This method is the simplest of all the methods used. It is useful for those units where the responsibility centre is centralized. Under this method it is difficult to measure the performance of each profit centre. (An example is a small manufacturing unit, which is treated as a cost or expense centre, not as a profit centre) . (b) Standard Cost: under this method, all transfer of goods and services are made at their standard cost. Any difference between actual and standard cost viz., variances, are usually absorbed by the supplying unit. In some cases, the variances are transferred to the user unit as well. This will result in the inventory being carried at identical standard cost by both the supplying and receiving units. Here also the profit performance responsibility is centralized and thus it cannot be measured for individual units involved. (that is, the manufacturing unit is treated as a cost or expense centre, not as a profit centre). (c) Full Cost: under this method, goods or services are supplied to another unit at full cost. Here, full cost means cost of production, plus expenses like selling and distribution, administration, research and development cost, etc. Under this method, the supplying unit is not allowed to make any profit on transfers to other units. But it is free to earn profits on outside sale. One good thing about this method is that the supplying unit is allowed to recover the full cost of the goods /services transferred. (d) Full Cost plus mark-up: Under this method, the supplying unit transfers goods and services at full cost plus some mark-up. The mark-up added to full cost is either expressed as a percentage of the full cost or of capital employed. Selling expenses here are recovered by the supplying unit without incurring them, specially when the goods / services are transferred internally. To overcome this defect, either the use of standard cost plus or actual cost plus are preferred. Use of either of the preceding methods facilitates the task of measuring profit performance and efficiency of the units involved.

2. Pricing at market price: Under this method, the transfer prices of goods / services transferred to other divisions are based on market prices. When the outside market for the goods /services is well-defined, competitive and stable, this method is used. In a competitive market, goods / services cannot be transferred to its users at a higher price. Such a competitive market provides an incentive to efficient production. Since market prices will, by and large, be determined by demand and supply position in the long run, profits which result under this method, will provide a good indicator of the overall efficiency of the various units. Competitive market prices provide reliable measures of divisional income because these prices are established independently rather than by individuals who have an interest in the results. The main limitations of this method are: 15

(i) (ii)

Difficulty in obtaining market prices. Sometimes it is difficult to obtain any market price for those specific products which are manufactured for only internal consumption. Difficulty in determining the elements of selling and distribution expenses such as commission, discounted, advertisement and sales promotion, so that necessary adjustments may be made to provide benefit of these expenses to the profit centre receiving the goods.

Examples of Transfer Pricing at Market Price: An oil company transfers crude oil from the Drilling Division to the Refinery to be used in the production of petrol. Here, the output of the Drilling Division is crude oil, which is the input for the Refinery which refines it into petrol. The Drilling Division can either sell its output of crude oil in the market (i.e., at market price) to refineries of other companies or to the refinery of its own company (at the same market price). 3. Pricing at Bargained or Negotiated prices: This method is a refinement of market price method. Under this method, each decentralized unit is considered as an independent unit and such units decide the transfer price by negotiations or bargaining. Divisional Managers have full freedom to purchase their requirement from outside if the prices quoted by their sister unit are not acceptable to them. A system of negotiated prices develops business like attitude amongst the division of the company. The buying division may be tempted to purchase outside source if the outside prices are lower than the internal divisions price. In order to avoid any reduction in the overall profits of the company, the top management may impose restriction on the external purchase / sale of goods/ services. In order to have an effective system of intra-company transfer pricing, the following points should be kept in view: 1. Prices of all transfers in and out of a profit centre should be determined by negotiation between the buyer and seller. 2. Negotiations should have access to full data on alternative sources and markets and to public and private information about the market prices. 3. Buyers and sellers should be completely free to deal outside the company. 4. Other Transfer Pricing methods: In integrated companies such as in oil companies and paper companies, special issues arise in assigning transfer prices known as upstream fixed costs and profits. Hence, in such integrated companies, the following methods of transfer pricing are adopted: An integrated oil company is one which is active along the entire supply chain from locating deposits, drilling and extracting crude oil, transporting it around the world, refining it into petroleum products such as petrol / gasoline, to distributing the fuel to company-owned retail stations, for sale to consumers (e.g., Indian Oil Corporation Ltd., Hindustan Petroleum Corporation Ltd.)

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A fully-integrated paper mill is one that receives forest logs or wood chips and processes them to the individual fiber level. The fully-integrated paper mill processes this fiber to a pulp slurry, which is then made into a sheet of paper (e.g., Ballarpur Industries Ltd, ITC Ltd.) 4(i) Two step method: Under this, a charge is firstly made for each unit sold. This is equal to the standard variable cost of production. Secondly, a charge is made periodically that is equal to the fixed costs of the facility reserved for the buying unit. A profit margin is included in either of these components. Generally, a month is chosen as the period for the periodic charge.

4(ii) Profit sharing method: Under this method, the product is transferred to the marketing profit centre at standard variable cost. Once the product is sold, the contribution (sales price minus variable costs) earned is shared by the business units.

4(iii) Two sets of pricing method: This method envisages credit of the manufacturing profit centres revenue at the external sale price and purchasing profit centre is charged the total standard costs in respect of the product transferred. The corporate headquarters account is charged with the difference. During the consolidation of business unit statements, the same is eliminated. This method is occasionally used when the frequency of conflicts between the buying and selling units cannot be settled by any other method.

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Q 6a. Short note on Free Cash Flow: A Cash Flow Statement is a part of the full set of financial statements. The model of a Cash Flow Statement as per Indian Accounting Standards classifies cash flows into three categories: 1. Operating Activities: Principal revenue producing activities of an entity. They generally include the transactions and other events that enter into determination of net income. 2. Investing Activities: Activities related to capital expenditure, inter-corporate investments and acquisitions. Receipt of interest and dividend are investment activities. Disposal of non-current assets is included in investing activities 3. Financing Activities: Financing activities relate to transactions and activities that change the capital structure i.e., they are transactions with the financiers. A. Definition of Free Cash Flow: Free Cash Flow is the difference between net cash flows from Operating activities and Investing activities. Thus Free Cash Flows can be positive or negative. Positive free cash flow means that the net cash generated from operations is more than what a firm can use in investing activities. Firms having stable levels of operations and normal growth generally have positive free cash flow. Negative free cash flow means that the firm is investing more cash in new assets than it generates from operations. Negative free cash flow in case of a firm with stable operations and normal capital expenditure implies that the firms working is adverse. However, negative free cash flows in healthy firms growing rapidly and investing heavily in expansion, modernization, renovation, acquisitions is not adverse. These investments are expected to earn high returns in future and pay off favorably to the shareholders. B. Where Free Cash Flow is used: Free Cash Flow is a popular basis for valuation of enterprises. Analysts use the free cash flow metric to value firms that produce a stable positive free cash flow year after year and expect to have a similar trend in the future (e.g., cement or steel industry). The free cash flow is discounted at an estimated cost of capital to arrive at the value of a firm. C. Limitations of where Free Cash Flow can be used in valuation: Free cash flow metric is less suitable for valuing high growth firms that are investing substantially year after year (e.g., telecommunication industry).

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Q 6b. Short Note on Zero Based Budgeting: Zero Based Budgeting (ZBB) is an expenditure control budget. ZBB can be compared to the traditional budgeting approach, which is incremental in nature. The traditional approach seeks to identify changes from the previous years budget. In contrast, managers using ZBB must start from scratch each year in identifying the funds necessary for the smooth operation of the business unit and then must justify this need. Although this process will require a great deal of effort, companies which adopt ZBB approach do so for the following main reasons: i) ii) iii) iv) increases the management involvement in the budgeting process. Greater visibility to the use and need of funds Increased efficiency in resource allocation Wasteful budgets of the past get eliminated

The main limitations are : i) ii) ZBB is time consuming and also costly It is possible only with strong backing of the top management

Texas Instruments Inc. introduced ZBB in 1969. In the present situation, due to globalization, competition (including cost/price competition) is constantly increasing. Companies need to regularly review their cost structure and the cost of different activities going into their products and services. They need to continuously ask the following questions, which are best answered through ZBB: i) Should the function under review be performed at all? Does it add value to the customer? What activities can we stop? What activities can we simplify or aggregate? What should the level of quality be? Are we doing too much? Should the function be performed in this way? How much should it cost?

ii) iii) iv)

In india, there is a concerted move for several public sector organizations including public sector banks to adopt ZBB since many of the past activities may not be relevant today and this would sizeably trim the budgets. Indian corporates acquiring companies generally adopt ZBB.

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