QUESTION PAPER REPORT

2005

Q.7- Q.12
.7) a) Explain possible reasons for failure of Balanced Score Card?

Ans: The BSC is a system of financial and nonfinancial measures that reflect a balance between
leading and lagging indicators of performance and between outcome measures and measures that
drive performance. These measures are selected to complement the organization's strategy.

Moreover, many BSC implementations fail. Paul McCunn, a KPMG management consultant,
estimates the overall failure rate at 70%.3 Those survey participants whose BSC implementation
has failed may be reflected in our survey as nonusers. Breakdowns in communication and
difficulty in translating the strategy into action are common reasons for failure.4 It is often
difficult for employees to know what to do to improve performance. Measures and targets are
often chosen by management and conveyed to the employees. Getting employees involved in
picking measures and setting targets can help them to be more committed to reaching the goals.

PROVIDING INCENTIVE COMPENSATION: EASIER SAID THAN DONE

Sixty percent of regular users of the BSC provided financial incentives to employees for meeting
or exceeding targets that were congruent with BSC measures, according to our survey. At the top
level, CEOs are given stock options to provide an incentive to increase share prices. Business
unit managers, middle managers, and front-line supervisors can have their bonuses and salary
increases linked to their meeting or exceeding targets.

Linking BSC measures to compensation is difficult, though, and carries some risk. The difficulty
comes in determining the relative weights of the various performance measures on the scorecard.

There are two methods for determining the weightings of multiple performance measures for an
incentive pay scheme. One method uses predetermined weights for each measure in a prescribed
formula. For example, 15% of the incentive pay may be based on operating income, 10% on
revenue growth, 10% on customer satisfaction, 5% on internal defect rates, etc. The percentages
of weights would be determined before the beginning of the period and could not be changed by
the supervising manager.
Formula-based systems usually ignore most of the BSC measures, however, because of the
complexity of basing bonuses on a formula with 20 or more variables. Incentive pay based on a
few variables will focus the manager's attention on those variables that can increase his or her
compensation. The remaining variables will tend to be ignored even though they are also linked
to the organization's strategy. An incentive pay plan that focuses on only a few variables will also
tend to focus on financial measures, which are focused on short-term results and can be
manipulated easily.

Another method allows the supervising manager to subjectively determine the measurement
weights at the end of the period. Financial and BSC results are reported for a typical accounting
period, such as a month or quarter, and targets are established for each period. Kaplan and
Norton assert that BSC implementation makes it easier for managers to set bonuses and other
incentive rewards subjectively.5 They believe that the development of the performance measures
with their targets allows supervising managers an opportunity to better observe the performance
of subordinate managers and assess their abilities.6

The supervising managers then can set incentive rewards (such as bonuses and pay raises)
subjectively based on their overall assessment of the scorecard performance. Kaplan and Norton
believe that a subjective weighting scheme allows supervising managers to utilize key measures
for a defined time period and ignore other BSC measures that are not key for that period.

"OUT-GAMING" MANIPULATIVE MANAGERS

The subjective weighting scheme helps to ensure that subordinate managers cannot "game" the
system. One way to game the pay system is to trade performance on one measure to meet or
exceed the target on another measure. For example, an unscrupulous purchasing manager whose
bonus is based primarily on material prices might order excessive quantities of raw materials in
order to get quantity discounts. This practice could completely ignore the organization's
emphasis on keeping inventory levels low.

Another example would be a business unit manager whose bonus is heavily weighted toward
revenue growth. That growth might be achieved by discounting prices, giving favorable payment
terms, and selling to customers with poor credit ratings.
These attempts to trick the system should be apparent to the supervising manager with a BSC.
The supervising manager can thwart attempts to game the system by failing to pay incentives in
such situations. In this instance, the supervising manager has subjectively determined the weights
of the various measures in the incentive pay plan.

There are some risks in subjectively determining measurement weights. The following three
claims were made by employees of a major financial services firm that attempted to link the BSC
to its incentive compensation system. The firm later abandoned the BSC in favor of a formulaic
calculation of incentive pay based on revenues.7

* Too much emphasis may be placed on financial measures, which are lagging indicators of
performance that focus too much attention on gaining short-term results at the expense of long-
term performance. This happens because managers have historically used financial measures in
incentive pay plans.

* It may be difficult for the employee to understand just how bonuses were determined.

* Those who receive less incentive compensation than they expected may allege favoritism or
bias.

Even with the problems of linking the BSC to management compensation noted above, it may be
necessary to make this connection in order to implement this management tool successfully
because managers usually focus on items that affect their compensation directly. In fact, the
survey provides evidence of a correlation between improved operating performance and the
linking of the BSC to compensation. In another survey result, we found that 65% of the
respondents who did not see an increase in operating performance did not use the BSC to
determine management compensation. Of those respondents who did see an increase in operating
performance, 66% used the BSC to determine management compensation.

While linking BSC performance goals to compensation may present additional complexity, this
step seems to be a valuable tool in implementing the BSC successfully.
Q.7) b) Discuss special challenges faced in controlling R&D activities and possible management
initiatives?

Ans: The challenges faced by R & D:

1. Difficulty in Relating Results to Inputs: The results of research and development

activities are difficult to measure quantitatively. In contrast to administrative activities,
R & D usually has at least a semi-tangible output in the form of patents, new products, or
new processes; but the relationship of output to input is difficult to appraise on an annual
basis because the completed product of an R&D group may involve several years of
effort. Thus, inputs as stated in an annual budget may be unrelated to outputs. Further-
more, even when such a relationship can be established, it may not be possible to reliably
estimate the value of the output. And even when such an evaluation can be made, the
technical nature of the R&D function may defeat managements attempt to measure
efficiency. A brilliant effort may come up against an insuperable obstacle, whereas a
mediocre effort may, by luck, result in a bonanza.
2. Lack of Goal Congruence: The goal congruence problem in R&D centers is similar to
that in administrative centers. The research manager typically wants to build the best
research organization money can buy, even though that may be more expensive than the
company can afford. A further problem is that research people often do not have
sufficient knowledge of (or interest in) the business to determine the optimum direction
of the research efforts.
R & D Activities:
The activities conducted by R&D organizations lie along a continuum, with basic research at one
extreme and product testing at the other. Basic research has two characteristics:
1. It is unplanned, with management at best specifying the general area to be explored; and
2. There is often a significant time lapse between the initiation of research and the
introduction of a successful new product.
Example: In the biotechnology field nearly 26 years elapsed from the time Watson and Crick
defined the structure of the DNA molecule, in 1958, until the first product resulting from that
work was launched. And it took nearly 24 years (from 1936 to 1960) for basic research efforts to
culminate in the successful introduction of a copy machine by Xerox Corporation.
Because financial control systems have little value in managing basic research activities,
alternative procedures are often employed. In some companies, basic research is included as a
lump sum in the research program and its budget. In others, no specific allowance is made for
basic research as such, but there is an understanding that scientists and engineers can devote part
of their time (perhaps 15%, or one day a week) to exploring in whatever direction they find most
interesting, subject only to the informal agreement of their supervisor.
Examples: The discovery of warm superconductivity in 1986, one of the most important
breakthroughs of the decade, was made by two scientists at the IBM research laboratory in
Zurich, who were working on their own time. IBM senior management in Armonk, New York,
did not even know that such research was under way.
Scientists at 3M Corporation were allowed, indeed expected, to spend up to 15% of their
working time toward projects of their own choosing and for which prior approval from superiors
was not required.
R&D Program
There is no scientific way of determining the optimum size of an R&D budget. Many companies
simply use a percentage of average revenues as a base. The specific percentage applied is
determined in part by a comparison with competitors R&D expenditures and in part by the
companys own spending history. Depending on circumstances, other factors may also come into
play: For example, senior management may authorize a large and rapid increase in the budget if
it appears that there has been a significant breakthrough.
Annual Budgets
If a company has decided on a large-range R&D program and has implemented this program
with a system of project approval, the preparation of the annual R&D budget is a fairly simple
matter, involving mainly the calendarization of the expected expenses for the budget period.
Measurement of Performance
At regular intervals, usually monthly or quarterly, most companies compare actual expenses with
budgeted expenses for all responsibility centers and ongoing projects. These comparisons are
summarized for managers at progressively higher levels to assist the managers of responsibility
centers in planning their expense and to assure their superiors that those expenses are remaining
at approved levels.

Q.8) a) What are advantages in conducting internal Audit?

Ans: The internal audit is an essentialand now much discussedpart of business. The Institute
of Internal Auditors, an international association of internal auditors, offers this definition: An
independent, objective assurance and consulting activity designed to add value and improve an
organizations operations. It helps an organization accomplish its objectives by bringing a
systematic, disciplined approach to evaluate and improve the effectiveness of risk management,
control, and governance processes. To this end, internal auditing furnishes staff with analyses,
appraisals, and recommendations relating to these activities.

An internal audit offers several advantages.

It directs managements attention to the key business issues. The audit analyzes
weaknesses in the system of control, and becomes the basis for practical
recommendations for improvement.
It gives management confidence when controls are operating satisfactorily.

It identifies opportunities for improving efficiency and effectiveness.

It gives early notice of potential problems, so that management can take action to head
them off.

It dispenses the need to employ external consultants to act as internal auditors hence
saving large sum of money. This is even especially true when an internal audit
department is properly run with well trained and experienced internal auditors;

The internal auditors are intimately acquainted with the business as they are continuously
employed in the same concern and have access to much confidential information and to
all levels of management. Hence, they really are special personnel who have very in
depth inner knowledge which can then contribute to the company;

The Internal Audit maintains a group of highly skilled people available to cope with non-
recurring and exceptional jobs which no many employee could deal with efficiently and
effectively;

It ensures that the organization detailed standard policy and procedures are running
smoothly. This compared to the external auditors primary role of the ability to express
the true and fair view of the clients financial statements audit;
 Internal auditors are invaluable in areas like operational audits, constant examination of
internal check controls, the detailed application of normal auditing method and detailed
review of the various type of management reporting;

Last but not least, it provides an excellent training ground for future executives. Trainee
personnel obtain intimate knowledge of the business which they can study problems of
all kinds at different levels

Q.8) b) Illustrate difference between Financial and Management audit?

Ans:

Points Financial Audit Management Audit

Purpose The Purpose of financial audit is to The Purpose of management audit is
find out whether the accounts present to review the management
true and fair financial state of affairs operations with a view to bring about
of the concern. necessary improvements.
Nature The financial audit is a post-mortem The management audit is a
examination. preventive as well as curative check.
Basis In financial audit, only financial data The management audit is based on
from internal sources are used for the financial as well as non-financial
purpose of examination. data derived from internal and
external sources.
Statutory Financial audit is legally compulsory There is no statutory provision for
Provision and legal rules and regulations have undertaking the management audit,
to be observed for that. and it is not legally compulsory but
discretionary.
Qualification In financial audit, it can be There is no prescribed qualification
undertaken by the chartered for the management auditor and any
accountants only. expert on the management may be
asked to undertake it.
Process The financial audit examines The management auditor examines
financial accounts, statements and the managerial activities and
schedules and generally accepted operations and adopts operations
audit techniques are applied for the management technique for the
 purpose. purpose.
`Norms for In financial audit, the principles, In case of management audit, the
Evaluation conventions and postulates are used generally accepted management
as norms. standards or norms are used for the
purpose of evaluation and
examination.
Precision In financial audit, absolute precision In management audit, only relative
is quite necessary. precision is necessary.
Area of Study In financial audit, it is necessary to In management audit the study may
examine the accounts of the entire be related to the entire organisation
organisation. or part.
Periodicity In financial audit, it has to be While there is no fixed for
undertaken every year. management audit.
Reporting In case of financial audit, the report While the management auditor is
of the financial audit has to be appointed by the management and
submitted to the shareholders, who hence, the report has to be submitted
appoint the auditor. to the shareholders, who appoint the
auditor.
Liability The financial auditor can be held While the management auditor
criminally liable under the cannot be held criminally liable.
Companies Act, 1956.

Q.11

Pre Installation

Particulars Amount (in crores)

Turnover 225
 Income Tax 40%

Variable Expenses 150

Fixed Expenses 49.5

Interest 3

Net Working Capital 36

Fixed Assets 51

Borrowings 36

Equity 51

a) Return On capital employed:

Return = (Sales Turnover- Fixed & Variable Expenses)

225 199.5 = 25.5 cr

Capital Employed = Fixed Assets + Net Working Capital

51 + 36 = 87 cr.

Therefore Return On Capital Employed = Return/ Capital Employed

= 25.5/ 87 =

0.293 or 29.3%

b) Return On Equity:

Profit available to equity shareholders = Profit before Interest

& Taxes Interest Taxes

= 25.5 3 - 40%

= 22.5 40% = 13.5 cr

 Equity Capital= 51 cr

Therefore Return on Equity = Profit available to Equity / Equity Capital

= 13.5 / 51 =

0.264 Or 26.4%

2) Major Changes after installation of new machine worth 4.5 Cr for enhancing
quality:

Turnover increased by 6%
Variable expenses to turnover ratio reduced by 2%.
Increased Fixed Expenses by 8.48%.
Increase in Working capital by 1.8 Cr over current

POST INSTALLATION

Particulars Amount

Turnover 238.5

Variable Expenses 154.21

Fixed Expenses 53.69

Net Working Capital 37.8

Return on Capital Employed

Return = Sales turnover Fixed &variable expenses

= 238.5 (154.21+ 53.69)
= 30.60

Capital Employed = Fixed Assets + Net Working Capital

= 51 + 37.8
= 88.8
 Thus Return On Capital Employed = Return / Capital Employed
= 30.60 / 88.8 =
0.3445 or 34.45%

Return on Equity

Profit available to equity shareholders = Profit before Interest &

Taxes Interest Taxes

= 30.60 3 -40% =16.54

Equity Capital = 51 cr

Thus Return on Equity = Profit available to Equity / Equity Capital

= 16.51/ 51 =
0.3243 or 34.23%

Comparison

Particulars Pre Installation Post Installation

Return On Capital 29.3% 34.55%

Employed

Return On Equity 26.4% 32.43%

Q.12

(a) i) Budget Quarter 1:

To analyze the performance we need to calculate Return on

Investments (ROI) which can be described on a formula:

ROI = Profit Margin * Asset Turnover

Profit Margin = Net Profit / Sales

Net Profit = Sales Cost which includes Fixed Costs, marketing Costs, freight,
Administrative Expenses.

SALES -- 40

- Fixed Costs = 21
- Marketing Costs= 7
- Freight = 1
- Administrative Expenses = 3
_____
32
_____
8

Thus Profit Margin = 8 / 40 = 20%

Asset Turnover = Net Sales / Total Assets

Total Assets =

Accounts Receivable =8
Cash =4
Inventory = 18
Fixed costs = 20
____
50
Thus Asset turnover = 40 /50 = 0.8 times.

Therefore ROI = 0.20 * 0.8 = 0.16 or 16%

ACTUALS Quarter 1

Profit Margin = Net Profit / Sales

Net Profit = Sales Cost which includes Fixed Costs, marketing Costs, freight,
Administrative Expenses.

SALES -- 34

- Fixed Costs = 17
- Marketing Costs= 3
- Freight = 0.60
- Administrative Expenses = 3.2
_____
24
_____
Net Profit 10
 Thus Profit Margin = 10 /34 = 29.41%

Asset Turnover = Net Sales / Total Assets

Total Assets =

Accounts Receivable = 8.50

Cash =2
Inventory = 21.50
Fixed costs = 20
____
52

Thus Asset turnover = 34 / 52 = 0.65 times.

Therefore ROI = Profit Margin * Assets Turnover.

= 0.2941 * 0.65 = 0.1911 or 19.11%

Budgeted Quarter 2

ROI = Profit Margin * Asset Turnover

Profit Margin = Net Profit / Sales

Net Profit = Sales Cost which includes Fixed Costs, marketing Costs, freight,
Administrative Expenses.

SALES -- 36

- Fixed Costs = 19
- Marketing Costs= 6
- Freight = 0.90
- Administrative Expenses = 2.6
_____
28.5
_____
Net Profit 7.5

Thus Profit Margin = 7.5 / 36 = 20.83%

Assets Turnover = Net Sales / Total Assets

 Total Assets =

Accounts Receivable = 7.5

Cash =4
Inventory = 16.5
Fixed costs = 20
____
48

Thus Asset turnover = 36/48 = 0.75

Therefore ROI = Profit Margin * Assets Turnover.

= 20.83 % * 0.75 = 0.15622 or 15.622%