Mba 518

Punjab Technical University

World over distance Education is fast growing mode of education because of the unique benefits it provides to the learners. Universities are now able to reach the community which has for so long been deprived or higher education due to various reasons including social, economic and geographical considerations. Distance Education provides them a second chance to upgrade their technical skills and qualifications.

Some of the important considerations in initiating distance education in a country like India, has been the concern of the government in increasing access and reach of higher education to a larger student community. As such, only 6-8% of students in India take up higher education and more than 92% drop out before reaching 10+2 level. Further, avenues for upgrading qualifications, while at work, is limited and also modular programs for gaining latest skills through continuing education programs is extremely poor. In such a system, distance education programs provide the much needed avenue for:

Increasing access and reach of higher education:

Equity and affordability of higher education to weaker and disadvantaged sections of the society;

Increased opportunity for upgrading, retraining and personal enrichment of latest knowledge and know-how;

Capacity building for national interests.

One of use important aspects of any distance education program is the learning resources. Learning material provided to the learner must be innovative, thought provoking, comprehensive and must be tailor-made for self-learning. It has been a continuous process for the University in improving the quality of the learning material through well designed course materials in the SIM format (self-instructional material). While designing the material, the university has researched the methods and process of some of the best institutions in the world imparting distance education.

About the University

Punjab Technical University (PTU) was set up by the Government of Punjab in 1997 through a state Legislative ACT. PTU started with a modest beginning in 1997, when University had only nine Engineering and thirteen Management colleges affiliated to it. PTU now has affiliated 43

Engineering colleges, 56 colleges imparting Management and Computer Application courses, 20 institutions imparting pharmacy education, 6 Architecture institutions, 2 Hotel Management and 12 Regional Centres for imparting M. Tech and Ph. D Programs in different branches of Engineering and Management. During a short span of nine years, the University has undertaken many innovative programs. The major development during this period is that University has restructured its degree program and upgraded syllabi of the course in such a way as to increase the employability of the student and also to make them self-reliant by imparting Higher Technical Education. We at Punjab Technical University are propelled by the vision and wisdom of our leaders and are striving hard to discharge our duties for the overall improvement of quality of education that we provide.

During a short span of nine years, the University has faced various challenges but has always kept the interest of students as the paramount concern. During the past couple of years, the University has undertaken many new initiatives to revitalize the educational programs imparted with the colleges and Regional centers.

Though knowledge and skills are the key factors in increasing the employability and competitive edge of students in the emerging global environment, an environment of economic growth and opportunity is necessary to promote the demand for such trained and professional manpower. The University is participating in the process of technological growth and development in shaping the human resource for economic development of the nation.

Keeping the above facts in mind Punjab Technical University, initiated the distance education program and started offering various job oriented technical courses in disciplines like information technology, management, Hotel Management, paramedical, Media Technologies and Fashion Technology since July 2001. The program was initiated with the aim of fulfilling the mandate of the ACT for providing continuing education to the disadvantaged economically backward sections of society as well as working professionals for skill up-gradation.

The University has over the years initiated various quality improvement initiatives in running its distance education program to deliver quality education with a flexible approach of education delivery. This program also takes care of the overall personality development of the students. Presently, PTU has more than 60 courses under distance education stream in more than 700 learning centers across the country.

About Distance Education Program of PTU

Over the past few years, the distance education program of PTU has gained wide publicity and acceptance due to certain quality features which were introduced to increase the effectiveness of learning methodologies. The last comprehensive syllabus review was carried out in the year 2004-05 and the new revised syllabus was implemented from September 2005. The syllabus once reviewed is frozen for a period of 3 years and changes, if any, shall be taken up in the year 2008. Various innovative initiatives have been taken, which has increased the popularity of the program. Some of these initiatives are enumerated below:

1. Making a pyramid system for almost all courses, in which a student gets flexibility of continuing higher education in his own pace and per his convenience. Suitable credits are imparted for courses taken during re-entry into the pyramid as a lateral entry student.

2. Relaxed entry qualifications ensure that students get enough freedom to choose their course and the basics necessary for completing the course is taught at the first semester level.

3. A comprehensive course on „Communications and Soft Skills‰ is compulsory for all students, which ensures that students learn some basic skills for increasing their employability and competing in the globalized environment.

4. Learning materials and books have been remodeled in the self-Instructional Material format, which ensures easy dissemination of skills and self-learning. These SIMs are given in addition to the class notes, work modules and weekly quizzes.

5. Students are allowed to take a minimum of 240 hours of instruction during the semester, which includes small group interaction with faculty and teaching practical skills in a personalized manner.

6. Minimum standards have been laid out for the learning centers, and a full time counselor and core faculty is available to help the student anytime.

7. There is a wide network of Regional Learning and Facilitation Centers (RLFC) catering to each zone, which is available for student queries, placement support, examination related queries and day-to-day logistic support. Students need not visit the University for any of their problems and they can approach the RLFC for taking care of their needs.

8. Various facilities like Free Waiver for physically challenged students, Scholarship scheme by the government for SC/ST candidates, free bus passes for PRTC buses are available to students of the University.

The university continuously aims for higher objectives to achieve and the success always gears us for achieving the improbable. The PTU distance education fraternity has grown more than 200% during the past two years and the students have now started moving all across the country and abroad after completing their skill training with us.

We wish you a marvelous learning experience in the next few years of association with us!

DR. R. P. SINGH Dean

Distance Education

Dr. S. K. Salwan Vice Chancellor

Dr. S. K. Salwan is an eminent scientist, visionary and an experienced administrator. He is a doctorate in mechanical engineering from the IIT, Mumbai. Dr. Salwan brings with him 14 years of teaching and research experience. He is credited with establishing the Department of Design Engineering at the institute of Armament Technology, Pune. He was the founder-member of the integrated guided missile programme of defence research under His Excellency Honorable Dr. A.P.J. Abdul Kalam. He also established the high technology missile center, RCI at Hyderabad. He has been instrumental in implementing the Rs 1000-crore National Range for Testing Missiles and Weapon Systems at Chandipore, Balance in a record time of three years. He was director of the Armament Research and Development Establishment, Pune. Dr. Salwan has been part of many high level defence delegations to various countries. He was Advisor (Strategic project) and Emeritus Scientist at the DRDO. Dr. Salwan has won various awards, including the Scientist of the Year 1994; the Rajiv Ratan Award, 1995, and a Vashisht Sewa Medal 1996, the Technology Assimilation and Transfer Trophy, 1997 and the Punj Pani Award in Punjab for 2006.

Dr. R.P. Singh Dean, Distance Education

Dr. R.P. Singh is a doctorate in physics from Canada and has been a gold medallist of Banaras Hindu University in M.Sc. Dr. Singh took over the Department of Distance Education in November 2004 and since then the University has embarked on various innovations in Distance Education.

Due to combined efforts of the department, the RLFCÊs and Centers, and with active support of the Distance Education Council headed by Dr. O.P. Bajpai, Director University College of Engineering Kurukshetra University the distance education program of PTU is now a structured system which empowers the learner with requisite skills and knowledge which can enhance their employability in the global market. Dr. R. P. Singh is promoting distance education at the national level also and is a founder member of Education Promotion Society of India and is member of various committees which explores innovative ways of learning for the disadvantages sections of society. The basic aim of the distance education programs has been to assimilate all sections of society including women by increasing the access. Reach, equity and affordability of higher education in the country.

MANAGEMENT CONTROL

SYSTEM

MBA – 518

This SIM has been prepared exclusively under the guidance of Punjab Technical University (PTU) and reviewed by experts and approved by the concerned statutory Board of Studies (BOS). It conforms to the syllabi and contents as approved by the BOS of PTU.

Copyright © Ravindhar Vadapalli, 2008

No part of this publication which is material protected by this copyright notice may be reproduced or transmitted or utilized or stored in any form or by any means now known or hereinafter invented, electronic, digital or mechanical, including photocopying, scanning, recording or by any information storage or retrieval system, without prior written permission from the publisher. Information contained in this book has been published by Excel Books Pvt. Ltd. and has been obtained by its authors from sources believed to be reliable and are correct to the best of their knowledge. However, the publisher and its author shall in no event be liable for any errors, omissions or damages arising out of use of this information and specifically disclaim any implied warranties or merchantability or fitness for any particular use.

Published by Anurag Jain for Excel Books Pvt. Ltd., A-45, Naraina, Phase-I, New Delhi-110 028 Tel: 25795793, 25795794 email: [email protected]

PTU DEP SYLLABI-BOOK MAPPING TABLE MBA – 518 MANAGEMENT CONTROL SYSTEM

Syllabi Mapping in Book

Section I

Management Control System: Basic concepts, nature and scope. Control environment – Concept of goals and strategies. Behavioral considerations.

Responsibility Centers: Revenue and expense centers, Profit centers, Investment centers.

Section II

Transfer Pricing: Objectives and methods.

Budgeting: Budget preparation, Types of budgets. Behavioral aspects of budgets.

Section III

Variance analysis and reporting. Performance analysis and measurement. Impact on management compensation.

Modern Control Methods: JIT, TQM and DSS. Control in service organisations.

Unit 1: Introduction to Management Control System

(Page 3-14)

Unit 2: Responsibility Centres (Page 15-29)

Unit 6: ModernControl Methods

(Page 93-105)

Unit 3: Transfer Pricing (Page 33-37)

Unit 4: Budgeting (Page 39-68)

Unit 5: Variance Analysisand Reporting

(1-92)

Contents Section-I

UNIT 1 INTRODUCTION TO MANAGEMENT CONTROL SYSTEM 3

Introduction Basic Concepts Characteristics of a Management Control System (MCS) Nature of Management Control Scope of MCS Control Environment Behavioural Considerations Summary Keywords Review Questions Further Readings

UNIT 2 RESPONSIBILITY CENTRES 15

Introduction Expense Centre Cost Centre Profit Centres Investment Centre Residual Income (RI) Summary Keywords Review Questions Further Readings

Section-II

UNIT 3 TRANSFER PRICING 33

Introduction Objectives of Transfer Pricing Methods of Transfer Pricing Summary Keywords Review Questions Further Readings

UNIT 4 BUDGETING 39

Introduction Process of Budget Preparation Classification of Budget Sales Budget

Sales Overhead Budget Cash Budget Factory Overheads Budget Flexible Budget Zero-base Budgeting Behavioural Aspects of Budgeting Summary Keywords Review Questions Further Readings

Section-III

UNIT 5 VARIANCE ANALYSIS AND REPORTING 71

Introduction Variance Analysis Material Cost Variance (MCV) Material Price Variance Overhead Variance Sales Variance Reporting The Budget Summary Keywords Review Questions Further Readings

UNIT 6 MODERN CONTROL METHODS 93

Introduction JIT Total Quality Management Decision Support System (DSS) Summary Keywords Review Questions Further Readings

Unit 1

Introduction to Management Control System

Unit 2 Responsibility Centres

SECTION-I

Introduction toManagement Control System

Notes

Punjab Technical University 3

Unit 1 Introduction to Management Control System

Unit Structure • Introduction • Basic Concepts • Characteristics of a Management Control System (MCS) • Nature of Management Control • Scope of MCS • Control Environment • Behavioural Considerations • Summary • Keywords • Review Questions • Further Readings

Learning Objectives At the conclusion of this unit you should be able to: • Define management control system. • Describe features, nature and areas of management control • Know what are the goals and strategies of effective control system • Discuss the behavioural aspects of management control system

Introduction Management controls are used daily by managers and employees to accomplish the identified objectives of an organization. Simply put, management controls are the operational methods that enable work to proceed as expected. Most controls can be classified as preventive or detective. Preventive controls are designed to discourage errors or irregularities. For example:

A manager's review of purchases prior to approval prevents inappropriate expenditures of office funds.

A computer program which asks for a password prevents unauthorized access to information.

Detective controls are designed to identify an error or irregularity after it has occurred. Examples include the following:

An exception report that detects and lists incorrect or incomplete transactions.

A manager's review of long distance telephone charges will detect improper or personal calls that should not have been charged to the account.

Often, management controls are documented in terms of policies and procedures. However, sometimes as an organization undergoes structural and functional changes,

Management Control System

Notes

4 Self-Instructional Material

people within the organization create or adopt ways of ensuring that work proceeds normally. Many times, these methods (controls) are not documented. The purpose of a Management Control Review (MCR) is to evaluate the entire system or management controls to help your unit operate more efficiently and effectively, and to provide a reasonable level of assurance that the process and products for which you are responsible are adequately protected.

A MCR provides a variety of benefits which promote sound management, including the following:

Ensuring that administrative, financial, and programmatic risks have been adequately addressed.

Eliminating excessive controls that may have accumulated over the years, allowing for more efficient operations.

Increased confidence that responsibilities are being carried out according to plan.

Basic Concepts Management Control is a process of assuming that resources are obtained and used effectively and efficiently in the accomplishment of the organisationÊs objectives. Some leading definitions of managing control are as follows:

„Management Control seeks to compel events to conform to plans.‰

·Billy, E. Goaz

„Some sort of systematic effort to compare current performance to a predetermined plan or objective, presumably in order to take any remedial action required.‰

·William Travers Jerome

Control, in its managerial sense, can be defined as, „the presence of that force in a business which guides it to a predetermined objective by means of predetermined policies and decisions.‰

·Mc Farland, D.E.

„Control is that function of the system which provides direction in conformance to the plans.‰

·Rosen, J.K.

The above definitions indicate very clearly that management control has to do with the outgoing operation of the business. Control is a fundamental necessity for the success of a business. It is the function of the management that helps realisation of the business objectives. From time to time current performance of the various operations is compared to a predetermined standards or ideal performance and in case of variance remedial measures are adopted to conform operations to the set plan or policy.

Characteristics of a Management Control System (MCS) The main characteristics of Management Control are the following:

1. A Total System: Management Control System is a total system as it covers all aspects of the companyÊs operations. It is an overall process of the enterprise to fit together the separate plans for various segments so as to assure that each harmonises with one another and that the aggregate effect of all of them on the whole enterprise is satisfactory.


Notes


2. Monetary Standards: Barring some exceptions, the MCS is built around a financial structure and all the resources and outputs are expressed in terms of money. The results of each responsibility centre, in respect to production and resources, are expressed in terms of the common denominator of money.

3. Definite Pattern: The management control process follows a definite pattern and timetable. The whole operational activity is regular and rhythmic. It is a continuous process even if the plans are changed in the light of experience or change in technology.

4. Coordinated System: Management Control System is fully coordinated and integrated system. For instance, if the information for one purpose varies from that collected for another purpose, the data reconcile with one another. It is, therefore, more feasible to consider the interlocking sub-processes as a single set for achieving the objectives of the enterprise.

5. Line Managers: Figures themselves are nothing more than marks on pieces of paper. Anything that the business accomplishes is the result of the actions of the people. Information collected from various sources has to be properly organised. The line managers are the focal points in management control system who alone can influence others to improve the performance. Business budgets are prepared on their advice and suggestion. They can encourage persons to work efficiently in the interests of the enterprise as to achieve the objectives set forth.

6. Emphasis: Management control emphasises on search for planning as well as control. Both should go hand in hand to achieve the best results. It has an organisational aspect also inasmuch as lines of communication are required for the collection and transmission of control information.

Nature of Management Control It is through control that the management assures itself that what the organisation does conform to management plans and policies. Accounting information is used in control as a means of communication of motivation and of appraisal. It is not managementÊs job to work personally but it sees to it that the work gets done by others. Control is an important element of the process of managing. In managerial terminology, control is ensuring work accomplishment according to plans. It is the process that guides and controls operations towards some predetermined goods. According to Prof. R.N. Anthony „Management control is the process by which managers assure that resources are obtained and used effectively and efficiently in the accomplishment of an organisationÊs objectives.‰ It seeks to compel events to conform to plans. It is a process by which the people in the organisation are made to work properly and most efficiently with a view to attain the best results. It is concerned with measuring and evaluating performance so as to secure the best results under the circumstances. An effort is made to compare the current performance to a predetermined objective or plan. Thus control is a fundamental function of the management to ensure work accomplishment according to predetermined plans and standards.

Other Characteristics of control are as follows:

1. Control is an essential function of every manager: Managers at every level have to focus attention towards future operational and accounting data taking into consideration past performance, present trends and anticipated economic and technological changes. The nature, scope and level of control will be governed by the level of manager exercising it.


Notes


2. Control implies the existence of goals and plans: Without predetermined goals and plans management control is not possible. These two provide a link between such future anticipations and actual performance, as the future gets converted into present and past with the passage of time. Managers quantify their hopes and ambitions of the future on a realistic basis and to use them later as standards for measurement of actual performance. In the absence of objections and goals the results are likely to be different from what desired. Plans complement objectives which can be attained on the basis of proper plans. Policy sets the intention while control looks and ascertains how far the objectives are attained.

3. Control is forward looking: Planning is the process of deciding what action should be taken in the future. One cannot change the events that have happened in the past. The nature of managerial control is forward looking. It is on the basis of evaluation of past performance that the future plans or guidelines can be laid down. Management control involves managing the overall activity of the enterprise for the future. It prevents deviations in operational goals.

4. Management Control a continuous process: Control is a continuous process over the human and material resources. It demands eternal vigilance of every step. Regulating the activities of people associated in the common task of attaining the objectives of the organisation is the primary aim of management control which requires strict and careful vigilance. Success can be achieved only when the management controls the men and circumstances around him on a regular basis. Business conditions are always changing so management must be always adapting itself to the changed circumstances. Therefore, management control is a continuing activity.

5. People oriented: Management control is significant to internal control system as its approach is people oriented. People assume a new role, attitudes, and motivations under a sound management. Control is attained through people and not lifeless materials. It is the managers, engineers and operators who implement the ideas and objectives of the management. It is people who make or mar a thing. The coordination of the main divisions of a concern makes for smoother operation and less friction which results in the achievement of predetermined objectives.

Scope of MCS Managerial Control, as we know, is an important process in which accounting information is used as to accomplish the organisationÊs objectives. Therefore, the scope of control is very wide that covers a broad range of management activities. According to Holden, Fish and Smith the main areas of control are as follows:

1. Policies Control: The success of a business hangs on formulation of sound policies and their proper implementation. There is a great need of control over policies.

2. Control over Organisation: For the control over organisation the management uses organisationÊs manual and organisational chart. Designing and organising various departments for the smooth running of the business is very essential. If any problem or conflict arises the management control attempts to remove the causes of such frictions and rationalise the organisational structure as to ensure its efficient working.

3. Control over Personnel: Anything that the business accomplishes is the result of the action of those people who work in the organisation. It is the people,


Notes


not figures, that get things done. The personnel manager is responsible to draw a control plan for having control over the personnel of the concern.

4. Control over Wages and Salaries: Control over wages and salaries is sometimes assigned to the personnel department or a specially constituted wage and salary committee.

5. Control over Costs: The cost accountant who is responsible to control costs sets cost standards, labour material and overheads. He makes comparisons of actual cost data with standard cost. Cost control is a delicate task and is supplemented by budgetary control systems.

6. Control over Techniques: It implies the use of best methods and techniques so as to eliminate all wastage in time, energy and material. The task is accomplished by periodic analysis and checking of activities of each department with a view to avoid and eliminate all non-essential motions, functions and methods.

7. Control over Capital Expenditure: Various projects entailing huge amounts require control. This is exercised through a system of evaluation of projects in terms of capital. Capital budget is prepared for the whole concern. Every project is evaluated in terms of the advantages accruing to the firm. For this purpose capital budgeting, project analysis, breakeven analysis, study of cost of capital etc. are carried on extensively.

8. Production Control: The function of production control is to plan, organise, direct and control the necessary activities to provide products and services. Once the production system is designed and activated the problems arise in the areas of production, planning and control. Market needs and attitudes of consumers are studied minutely for revision in product lines and their rationalising. Routing, scheduling, dispatching, follow up, Inventory control, Quality control are the various techniques of production control.

9. Overall Control: A master plan is prepared for overall control and all the concerned departments are made to involve in this procedure.

10. Control over External Relations: Public relations department should always be alert in improving external relations. It may also prescribe norms and measures for other operating departments to insist on cordial relations with all the parties.

11. Control over Research and Development: Research activities, being technical in nature, cannot be controlled directly. But it should be seen that all facilities are provided to the research staff to improve their ability and keeping in touch with the up-to-date techniques and devices. Training facilities should also be provided by having a research budget in the business.

Process of Control 1. Well-defined Objectives and Goals: The objectives and goals of the

organisation should be crystal clear and well-defined in the process of control. The organisational goals should be split into sub-goals at departmental level. The operation of the various functions and their coordination should be vested in the hands of the executives who are armed with sufficient authority or power to fulfil their responsibility. The planned goals of the enterprise or of a particular department serve as a standard for performance measurement.

2. Determination of Strategic Point of Control: The responsibility centres and strategic points of control should be selected and fixed. To make the control


Notes


process effective, the management should concentrate upon strategic points only.

3. Establishment of Control Standards: These standards are established criteria against which actual performance can be compared and measured in terms of money, time, physical units or some other index. The object of predetermined standards is that comparison between actual performance and targets performance is made possible. Continuous comparison is very necessary. This requires tabulating the targets framed, collecting and collating data regarding actual performance and reporting variations periodically to the controlling authorities. It is obvious that control is not possible unless actual performance and the standard against which it is being measured are comparable.

4. Determination of Controllable Costs and Control Period: Optimum control does not mean excessive control. Sometimes good results are achieved only if critical points are identified. Secret of good control is to establish strategic points where corrective actions will be the cheapest and most effective.

5. Strengthening the Organisation: The complete framework of control is aimed at strengthening the organisation. Planning is a prerequisite. Control should be tailored to fit the organisation. There should be a system of checks on the managerial activity of subordinates. The organisation should be strengthened first to overcome the weaknesses of deviations. Controls should incorporate sufficient flexibility in them so as to remain effective despite the failure of plan.

6. Measurement of Performance: It is not only a process of comparison of actual performance with the objectives, but to initiate steps to achieve the objective. This is done without encroaching upon the authority and scope of authority of the manager concerned. The evaluation of performance is very necessary. It involves the measurement of performance in respect of work and in terms of control standards. In the opinion of Peter F. Drucker, the measurement of performance must be clear, simple, rational, relevant and reliable. The effectiveness of a control system depends upon the prompt reporting of past results to the persons who have power to produce changes. The next step is to compare the performance with the planned standards. It is important to determine the limits within which the variations can be held and still to be regarded within control when performance is measured accurately. The management is not only required to find out the extent of variations but the causes of variations must also be ascertained correctly. The manager should be able to distinguish between minor and unimportant variation and variations indicating need for immediate correction. To assess whether actual performance is in accordance with the target comparison with the standard has to be made and the variation is properly analysed to understand the reason for the variation. The comparison should be done at frequent intervals so that immediate corrective action could be taken.

7. Control Period: The proper control period is the shortest period of time in which management can usefully intervene and in which significant changes in performance are likely. The period is different for different responsibility centres and for different items within responsibility centres. Spoilage rates in a production operation may be measured hourly or often. The key cost element of the centre may be measured daily. Reports on overall performance, particularly those going to the levels of management are often on a monthly basis and sometimes for quarterly or longer intervals, since top management does not have either the time or the inclination to explore the local temporary problems.


Notes


Adequate or Effective Control System Management control is that function of the managers, next in line to top level, by which they ensure that the objectives of the organisation are achieved. It is not only a process of comparison of actual performance with the objectives but to initiate steps to achieve the object, if not achieved. This is done without encroaching upon the autonomy and scope of authority of the manager concerned. This involves the assessment of a managerÊs performance in quantitative terms and at the same time not to lay too much emphasis on quantitative data. In fact, some of the objectives themselves cannot be exactly quantified, for instance, objectives in respect of research and development, industrial relations etc. Thus management control is the process by which managers assume that resources are obtained and used effectively, and efficiently in the accomplishment of organisationÊs objectives.

„Since Management control involves the behaviour of human beings, the relevant principles are those drawn from such disciplines as social psychology and organisational behaviour rather than from Economics, Mathematics or any discipline.‰ The following are important requirements for making any control system effective in application :

1. Control by Objectives: The control must be goal-oriented and by objectives. As objectives classify the expected results in meaningful and realistic terms, they provide the control standards by which actual performance can be measured. The control system should be according to the nature and needs of organisation.

2. Direct Control: Control should be exercised on people who work on machines and materials. Thus, it should be employee-oriented rather than work-oriented. It is people who resent control and not the inanimate articles. It is, therefore, necessary to alter the attitude of personnel who oppose control measures. An attempt should be made to understand the attitude of the people by proper education.

3. Forward Looking Control: Control should always be forward looking. It should bring out the deviation in light as soon as possible. It must focus on strategic points with exception.

4. Managerial Self-Control: Control should be enforced through managerial positions in the organisational structure. Each Manager must be vested with adequate authority for exercising control and taking decisions. Alleviation of duties and responsibilities goes a long way towards securing effective control in the organisation.

5. Simple and Balanced Control: To be effective control must be simple and well-balanced. Any control device which is not intelligible cannot be put in practice. So, control lines must-be simple and intelligible both to the controller and the controlled.

6. Flexibility: There should be nothing like rigidity in control. Even the best plans and other predetermined criteria need to be charged from time to time to meet a particular situation. However, an effective control system should retain its basic structure.

7. Economy: A simple control system is bound to be economical. It should not be cumbersome and expensive. Economy is the basic requirement of any good control system.

8. Feedback: Feedback is the process of adjusting future actions based upon information about past performance. Recently this concept of feedback has


Notes


received considerable attention. It proves the worth and utility of control process.

Control should not be negative. It should be positive, constructive and helpful. Control is not a command; it is guidance. The system is really concerned with arrangements for implementing the decisions made in strategic planning.

Control Environment The COSO framework describes the control environment as setting the tone of an organization and influencing the control consciousness of its people. An effective control environment supports and strengthens the other control elements, whereas a weak control environment undermines the other elements, rendering them useless. In an effective control environment, employees know that doing the right thing is expected and will be supported by upper level management, even if it hurts the bottom line. In a weak environment, control procedures are frequently overridden or ignored, providing an opportunity for fraud.

Traditionally, auditors' assessments of the control environment have included issuing a questionnaire to senior management to determine whether management policies and procedures, such as a code of ethics, have been implemented. The problem with this approach is that it measures management's efforts to create a sound environment, not its effectiveness in doing so. A more direct method of evaluating whether management has created an environment in which ethical behavior is encouraged is for internal auditors to survey the people who work in that environment. The focus of the assessment should not be on the message management thinks it is sending, but on the message employees are actually receiving.

The control environment is one of the key components of an entity's internal control; it sets the tone of an entity, influences the control consciousness of people within all organization and is the foundation for all other components of the internal control system.

Management is responsible for evaluating and reporting on a company's controls. The external auditors are responsible for auditing management's assertion and independently coming to their own conclusions about the company's internal control effectiveness. They must evaluate management's assessment and also perform their own, independent tests in many areas, including the control environment.

The control environment has a pervasive structure that affects many business process activities. It includes elements such as management's integrity and ethical values, operating philosophy and commitment to organizational competence.

Adding to the difficulty of the task is the fact that the control environment is not transaction-oriented. Tests of controls that auditors are accustomed to performing, such as walk-through or the re-performance of the control for a sample of items, will not be possible. And focusing solely on activity-level controls is inappropriate.

Tests of the Control Environment will consist of a combination of procedures, including a review of relevant documentation of the design, inquiries of management and employees and direct observation.

Auditors will have to probe for understanding and awareness and try to understand the company's attitude toward internal control over financial reporting. They also should ask management for a self-assessment.


Notes


Practical Tips to Remember Don't focus your internal control tests exclusively on activity-level controls.

You have to evaluate and test the control environment, too.

Establish a benchmark, such as the internal control reliability model, that will be used to gauge internal control effectiveness. Use this model to design your tests of the control environment.

Use several different testing techniques to gather information about the control environment from a broad range of entity personnel.

Student Activity „Environmental surveillance on an ongoing basis, for understanding the nature and implications of the emerging developments and their implications for the effective control system, is imperative.‰ Describe the statement with suitable examples.

Concept of Goals and Strategy A strategy invariably indicates the long-term goals toward which all efforts are directed. For example, long-term goals might be to Âdominate the market, to be the technology leader or to be the premium quality firmÊ. Such enduring goals help employees give their best in a unified manner and enable the firm to specify its competitive position very clearly to its rivals.

Strategy is the overall plan of a firm deploying its resources to establish a favourable position and compete successfully against its rivals. Strategy describes a framework for charting a course of action. It explicates an approach for the company that builds on its strengths and is a good fit with the firmÊs external environment. It is basically intended to help firms achieve competitive advantage. Competitive advantage allows a firm to gain an edge over rivals when competing. Competitive advantage comes from a firmÊs unique ability to perform activities more distinctively and more effectively than rivals. A firmÊs distinctive competence or unique ability here implies, those special capabilities, skills, technologies or resources that enable a firm to distinguish itself from its rivals and create competitive advantage (such as superior quality, design skills, low-cost manufacturing, superior distribution etc.). The term ÂterrainÊ is highly relevant in explaining the concept of strategy more clearly. From a business sense, terrain refers to markets, segments and products used to win over customers. The essence of strategy is to match strengths and distinctive competence with terrain in such a way that oneÊs own business enjoys a competitive advantage over rivals competing in the same terrain. The basic premise of strategy, as things stand now, is that an adversary can defeat a rival–even a larger, more powerful one–if it can maneuver a battle or engagement onto a terrain favourable to its own capabilities. The term ÂcapabilityÊ refers to the ability or capacity of a bundle of resources deployed by a firm to perform an activity (Pitts and Lie).

Elements of a Strategy Any coherent strategy (as the above expert opinions reveal) should have four important elements (Saloner et al):

a. Goals: A strategy invariably indicates the long-term goals toward which all efforts are directed. For example long-term goals might be to Âdominate the market, to be the technology leader or to be the premium quality firmÊ. Such enduring goals help employees give their best in a unified manner and enable the firm to specify its competitive position very clearly to its rivals. A recent


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advertisement from Maruti Suzuki for example, claims: „we donÊt just sell more cars than No.2. We sell more cars than the entire competition put together‰. MarutiÊs commitment to being number one (sales, distribution network, lowest cost producer, highest resale value, one stop solution provider etc) or two in the markets it serves, sends clear signals to its rivals in more than one way.

b. Scope: A strategy defines the scope of the firm that is, the kind of products the firm will offer, the markets (geographies, technologies, processes) it will pursue and the broad areas of activity it will undertake. It will, at the same time, throw light on the activities the firm will not undertake.

c. Competitive Advantage: A strategy also contains a clear statement of what competitive advantages the firm will pursue and sustain. Competitive advantage arises when a firm is able to perform an activity that is distinct or different from that of its rivals. Firms build competitive advantage when they take steps that help them gain an edge over their rivals in attracting buyers. These steps vary, for example, making the highest quality product, offering the best customer service, producing at the lowest cost or focusing resources on a specific segment or niche of the industry.

d. Logic: This is the most important element of strategy. For example, a firmÊs strategy is to dominate the market for inexpensive detergents by being the low-cost, mass-market producer. Here the goal is to dominate the detergent market. The scope is to produce low-cost detergent powder for the Indian mass market. The competitive advantage is the firmÊs low cost. Yet this example does not explain why this strategy will work. Why the firm will get ahead of others by limiting its scope and by being the low cost producer (competitive advantage) in the detergent industry. The ÂwhyÊ is the logic of the strategy. To see how logic is the core of a strategy, consider the following expanded version of a strategy: Âour strategy is to dominate the Indian market for inexpensive detergent powder by being the low cost producer selling through mass-market channels. Our low price will generate high volumes. This, in turn, will makes us a high volume, low-cost producer. The economies of scale would help us improve our bottom-line even with a low price‰.

Student Activity „The purpose of strategy is to define the nature of relationship between a firm and its environment.‰ Critically examine the statement.

Behavioural Considerations A control system is necessary in any organization in which the activities of different divisions, departments, sections, and so on need to be coordinated and controlled. Most control systems are past-action-oriented and consequently are inefficient or fail. For example, there is little an employee can do today to correct the results of actions completed two weeks ago.

Steering controls, on the other hand, are future-oriented and allow adjustments to be made to get back on course before the control period ends. They therefore establish a more motivating climate for the employee.

What's more, although many standards or controls are simply estimates of what should occur if certain assumptions are correct, they take on a precision in today's control systems that leaves little or no margin for error. Managers would be better off establishing a range rather than a precise number and changing standards as time passes and assumptions prove erroneous. This would be fairer and would positively


Notes


motivate employees. There are three fundamental beliefs underlying most successful control systems.

First, planning and control are the two most closely interrelated management functions.

Second, the human side of the control process needs to be stressed as much as, if not more than, the tasks or 'numbers crunching' side.

Finally, evaluating, coaching, and rewarding are more effective in the long term than measuring, comparing, and pressuring or penalizing.

This is perhaps because the task side of control is noticed and the behavioral or human side is largely overlooked. But as previously noted, managers should carefully consider the behavioral aspects of the process when designing a control system if employees are to be motivated to accomplish assigned tasks.

The evaluate focus of most organizational control systems is on the management of the institutionÊs financial resources. However, controlling on only one aspect of institutional performance often results in dysfunctional decisions [Caplan, 1971; Dalton and Lawrence, 1917]. Therefore, important managerial accounting problems found in both are private and public sectors are (1) how to select non-monetary performance measures and (2) how to integrate them into the organizational control system.

Conceptually, the problems are straightforward. The accountant must select one of the established financial accounting systems and modify it so that submit performance as it affects non-financial performance evaluation also is reflected in the financial accounting system. A financial accounting system available for such modification is the cost allocation system, in particular the allocation of joint costs. The accountant may view cost allocation from the standpoint of providing management control data and/or expense measurement [Vatter, 1945]. These perspectives may conflict. As a consequence, selection of cost allocation criteria and, hence, selection of the based by which costs may be allocated should be approached with concern for the motivational dimension present in any allocation which affects financial performance.

Behavioral accounting is the application of social science concepts to some areas of accounting research such as budgeting, decision making, control and finance reporting. The newly emerging sub-discipline attempts to focus on the "human element" in what has essentially been a quantitative subject area.

Summary Management control system primarily deals with the outgoing operations of the business. It is concerned with all types of forecasts. It is a continuous exercise and even as the work proceeds, plans are changed in the light of the experience gained. One of the basic concepts of management control system is that it works on the basis of continuously collected information. Because large number of people are involved in collecting the information, therefore, the flow of information has to be properly organised and channelled. Thus, management control is that function through which it has been ensured that resources are obtained and used effectively to achieve the organisationÊs objects. The control system emphasises simultaneously on both planning and control.

Keywords Management Control System: It is the process of comparing actual performance with standards and taking any necessary corrective action.


Notes


Control Environment: It is one of the key component of an entity is internal control; it sets the tone of an entity, influences the control consciousness of people within all organization and is the foundation for all other components of the internal control system.

Strategy: It is the overall plan of a firm deploying its resources to establish a favourable position and complete successfully against its rivals.

Review Questions 1. Discuss the concept of Management Control. Give the essential elements of a

Management Control System.

2. Explain the concept of Management Control and discuss the necessity of such control.

3. „Control is a fundamental management function that ensures work accomplishment according to plans.‰ Analyse the statement describing the importance of control and the steps involved in the control function.

4. What are the elements of an adequate or effective control system?

Further Readings D.K. Sinha, Management Control System, Excel Books, 2008

Ravindhra Vadapalli, Management Control System, Excel Books, 2008

Rober N. Anthony and V. Govindarajan, Management Control Systems, McGraw Hill/Irwin, 2000

Keneth Merchant, Wim Van der Stede, Management Control Systems, Pearson Education, 2007

Responsibility Centres

Notes


Unit 2 Responsibility Centres

Unit Structure • Introduction • Expense Centre • Cost Centre • Profit Centres • Investment Centre • Residual Income (RI) • Summary • Keywords • Review Questions • Further Readings

Learning Objectives At the conclusion of this unit you should be able to: • Describe meaning and features of responsibility centres • Discuss revenue and expense centres • Point out the advantages of profit centres • Distinguish between different types of profit centres • Know the meaning, features and performance management of investment centres

Introduction The entire organization should be divided into various responsibility centres. Each responsibility centre is led by a manager or the head of the centre who has been assigned the responsibility.

Organisation

Marketing Finance R & D Production HRD

Marketing Manager

Finance Manager

R&D Manager

ProductionManager

HRD Manager

Marketing Budget

Finance Budget

R&D Budget

ProductionBudget

HRD Budget


Notes


From the given Diagram, it is clearly understood that every organization is normally classified into various responsibility centres to the tune of different functions viz. Marketing, Finance, Research & Development, Production and Human Resources. These responsibility centres are headed by the responsibility managers.

The responsibility centre is the department, which is headed by the responsible person i.e. the manager of that particular function. It is a part of the organization, through which information is processed and communicated at every position. The decision of the responsibility centre is taken by the head, by considering the positional responsibilities. The responsibility centre is classified into various categories: Revenue and Expense Centre, Profit Centre, Investment Centre, etc.

Student Activity Highlight the corporate examples in fixing the responsibility on the managerial positions.

Expense Centre The responsibility centre which incurs only expenses, and measures them, is known as expense centre. The expense centres of the organization are mostly the service centres which only usually incur expenses.

The contribution of service department and office & administration department to the company cannot be denominated in monetary terms, but instead in terms of quality of services to assist the entire organization.

The output of the sales/production departments are denominated in monetary terms unlike others.

Cost Centre Cost centres are divisions that add to the cost of the organization, but only indirectly add to the profit of the company. Typical examples include Research and Development, Marketing and Customer service.

Companies may choose to classify business units as cost centres, profit centres, or investment centres. There are some significant advantages to classifying simple, straightforward divisions as cost centres, since cost is easy to measure. However, cost centres create incentives for managers to under fund their units in order to benefit themselves, and this under funding may result in adverse consequences for the company as a whole (reduced sales because of bad customer service experiences, for example).

Because the cost centre has a negative impact on profit (at least on the surface) it is a likely target for rollbacks and layoffs when budgets are cut. Operational decisions in a contact centre, for example, are typically driven by cost considerations. Financial investments in new equipment, technology and staff are often difficult to justify to management because indirect profitability is hard to translate to bottom-line figures.

Business metrics are sometimes employed to quantify the benefits of a cost centre and relate costs and benefits to those of the organization as a whole. In a contact centre, for example, metrics such as average handle time, service level and cost per call are used in conjunction with other calculations to justify current or improved funding.

When the manager is held accountable only for costs incurred in a responsibility centre, it is called a cost centre. More precisely, it is the inputs and not outputs that are measured in terms of money. In a cost centre of responsibility, the accounting system


Notes


records only costs incurred by the centre/unit/division, but the revenues earned (output) are excluded from the purview. This only means that a cost centre is a segment whose financial performance is measured in terms of cost. The costs are the planning and control data in cost centres, since managers are not made responsible for profits and investments in assets. The performance of the managers is evaluated by comparing the costs incurred with the budgeted costs. The management focuses on the cost variances for ensuring proper control. The performance of a cost centre is measured by cost alone, without taking into consideration, its attainments in terms of „output‰.

A cost centre does not serve the purpose of measuring the performance of the responsibility centre, since it ignores the output (revenues) measured in terms of money.

Profit Centres

Situational Requirements for Successful Implementation When profit is used to express expectations for a responsibility unit and for evaluating its performance, that responsibility unit is known as a profit centre and its manager has the responsibility for attaining a certain level of profit. If he or she is to be evaluated on the basis of profit performance, the profit centre manager must have sufficient authority to make whatever decisions are necessary to ensure an adequate profit. Joel Dean details three situational characteristics of profit centres as follows (Dean, 1955, p. 67):

1. Operational Independence: Each profit centre manager must have the authority to make most if not all of the key operating decisions that affect his profits, subject to broad policy directions from the top. The areas where independence cannot exist should properly be considered to be service centres.

2. Access to sources and markets: The profit centre manager must have control over all source and market decisions and be free to buy and sell in alternative markets. This freedom to trade dissolves alibis and helps establish responsibility.

3. Quantifiable costs and revenues: A profit centre must be able to identify its true costs and establish a reasonable price for its product. Otherwise, measurement by profit is questionable.

The characteristics necessary for effective operation of a profit centre indicate that before a responsibility unit can be considered to be a profit centre, its manager must have the power to generate revenues and control sources of supply and other costs.

Identifying a responsibility unit whose revenues and costs can both be controlled by the manager is not sufficient to conclude that the unit can be planned and controlled as a profit centre. At least three additional conditions must also be present.

1. Top management must be committed to decentralization: A profit centre system must have the wholehearted commitment of top management. They must be willing to relinquish some of their intimate knowledge of day-to-day operations and also some of their authority to subordinates. Top management must allow the profit centre manager to make the key operating decisions. Although it may be difficult especially in a company with only one major business but they must do so if the system is to work effectively.

2. Adequate staff and information systems: The cost of implementing a profit centre system may be quite high. Most likely a new management information


Notes


system will be necessary in order to provide top management with the data it needs to control decentralized operations. Further, each profit centre manager will now need information to make decisions. Accounting reports will be the primary source of information about a unitÊs performance, so top management must provide these reports and must also know how to use them.

3. Capable profit centre managers: A company using a profit centre system must have managers capable of heading them. The implementation of profit centres requires a great deal of education to train managers up and down the line to understand and think in terms of profits. They must be made to understand that their performance is now being measured by their contribution to company profits and that they must now make decisions based on profit contribution. Each profit centre manager must be made aware of the key variables of the organization as a whole, the managerÊs strategic variables, and the relationship between these, so that he or she will not make decisions to maximize his or her own welfare at the expense of the organization as a whole.

The Benefits of Profit Centres Treating responsibility units as profit centres is one way to realize the benefits of decentralization. Successful decentralization brings with it the following benefits:

A way of managing large entities: In large organizations it is difficult for one manager or a small group of managers to understand every aspect of the business. Sheer size prohibits management by face-to-face contact and informal or interpersonal methods. Large organizations must, therefore, forego some of the benefits of integration by decomposing themselves into more manageable operating units.

Better decisions: When a large organization is divided into smaller, more manageable units it achieves many of the advantages of a small company. Because the decision-makers responsible for each unit are closer to the problems in their environment, they are better able to make the relevant revenue/costs decisions. Because decision making can also be speeded up, a decentralized organization can be more responsive to environmental change. Furthermore, because they are held responsible for all their activities, managers are far more aware of their ultimate impact and are extremely sensitive to what they are doing for the company.

Motivation: If responsibility is motivating, and monetary measures are one means of establishing responsibility, then the manager who is responsible for revenues and revenue/cost trade-offs will probably be more committed than a manager who is responsible for costs alone. Profit measures allow managers to focus on a familiar, well-understood goal, and give them the feeling of being in business for themselves.

Frees Top Management: By definition, decentralization frees top management. When profit centres are established, top management no longer needs to get involved in the day-to-day operations of each unit. Top management can devote its time to more important issues, such as strategic planning or coordinating the efforts of a number of profit centres. Because they do not have to concentrate on all elements of their business, they can practice management by attending to those areas where a strong influence will be most beneficial. If one profit centre begins to experience difficulty, management can then spend its time helping this centre to correct its problems.

Thus it appears that management can achieve many of the benefits of decentralization through profit centres. When decentralized operating units are made into profit centres, each manager has a common goal·profit. Decentralized units can be planned and controlled according to their contribution to organizational profitability. Complete responsibility can be assigned because profit is a comprehensive measure of


Notes


all activity, and each manager can then be judged on his or her ability to manage a complete operating unit as a separate and distinct business.

At the same time, central management can realize the benefits of a large organizationÊs economies by maintaining central staff functions such as economic planning, forecasting, technical analysis, accounting, and perhaps management information systems. These services can be provided to the profit centres on a charge basis to ensure that they are used efficiently.

Types of Profit Centres An effective planning and control system for managers is one that motivates them to act in their best interests while simultaneously achieving what is best for the organization as a whole. Using this as the criterion for evaluation, let us examine two types of profit centres in order to determine the effectiveness of the profit measure as a basis for planning and control.

Independent (natural) profit centres: If a responsibility unit operates independently of the other units in the organization, that is, if it is effectively in its own business, then a manager who maximizes his or her own profits is also automatically maximizing the profits of the organization as a whole. The manager has discretion over sourcing of inputs and revenues to be charged. Decisions can be based on meaningful values derived from market-based, armÊs-length transactions. Profit is a clear measure of efficiency and performance.

This type of responsibility unit is termed a natural or independent profit centre.

Interdependent (artificial) profit centres: Many organizational structures do not lend themselves to decomposition into natural profit centres. Because of their size, however, these organizations may still require some form of decentralization and may want to realize the benefits of a profit centre system. For example, in a functionally organized automobile company (e.g., Ford, Case 4.1) the engine division or the chassis division may transfer parts to the assembly division. In an integrated oil company, the exploration and production division discovers oil and transports it to the manufacturing division which, in turn, ships it to marketing for disposal to the consumer market. But to be a profit centre an organizational unit must act both as a seller, with the discretion to set prices and output volumes, and as a buyer, with discretion on how much to consume at various price levels. It must also be able to choose whether to deal with a unit inside the company or with one outside.

Organizations such as the automobile and oil companies described above do not meet the criteria for profit centre systems. Can units within the same organization that deal with each other regularly nevertheless be decentralized as profit centres? Many organizations do just this. Artificial or interdependent profit centres are responsibility units which are considered to be profit centres, even though they do not satisfy the usual criteria. The automobile assembly division is a good example. It can be considered to buy components from other divisions, assemble the car, and then sell it to a sales division. But clearly the assembly division manager is not free to buy and sell at will. In the absence of a free market, how his prices are going to be determined?

Two Styles of Profit Centre Management One way is to establish specific performance expectations and to enforce firm commitment to their accomplishment. Alternatively, initially formulated expectations may serve only as guidelines; performance is later evaluated in light of the actual conditions and constraints in effect at the time of performance.


Notes


Profit as a Specific Performance Objective

Establishing a specific profit goal and attempting to obtain rigid commitment to this goal can have many dysfunctional consequences. Yet the benefits of ensuring that managers are sensitive to the effect of their activities on profits still makes the profit measure extremely useful. How, then, can its potentially dysfunctional consequences be averted?

One way is to adopt a management by objectives approach to commitment and evaluation and to apply this approach over short time spans of discretion. First, a level of profit is negotiated and agreed upon, and a short performance evaluation interval is set. The profit centre manager also agrees to discuss all major decisions affecting profits with top management before they are finalized.

Frequent communication and short evaluation periods may seem strange prescriptions for a profit centre system, since they appear to negate the benefits of decentralization. However, when considered in the overall management by objective approach, whose aims are to achieve initial commitment, periodically review performance, and coach the subordinate to achieve the objectives he or she has specified, these methods can help overcome the adverse effects of performance evaluation. Evaluation is not merely a period-based measure of profitability; rather, it is an ongoing process that examines the quality of the decisions reached as well as their eventual results. The strength of this method is involvement and communication; if it is properly applied, it can achieve many of the motivational benefits of a management by objectives system.

Profit as a Guiding Objective

A second approach to profit centre management is to use profit expectations merely as general objectives or guidelines. In this approach expectations are used for planning and orientation and are considered to be initial targets only. They are the best estimates that can be made at the time, and can be revised radically later on if necessary. This approach lessens the pressure on a profit centre manager to maximize short-term performance. It permits him or her a greater amount of discretion. However, appropriate time spans for evaluation must still be established; too long a time interval also carries with it the risks and costs of inappropriate behaviour.

If profit is used only as a general guide and performance is evaluated over a longer period of time, the following conditions must also apply. First, each profit centre must be supported by an adequate information system. Detailed analyses and reconciliations of past performance to expectation must be continually provided to top management to demonstrate that the profit centre manager understands what is going on. This reporting keeps top management aware of the quality of decision-making and performance. But any formal information system, regardless of how efficiently computerized it is, is still too slow to perform an early warning function for management. Continual communication between profit centre managers and corporate staff is necessary. Hence, the second requirement of this approach is that an appropriate climate for free and open communication be established.

This style of management may require the involvement of advisory staff groups, top-management committees, and perhaps a group vice president. Informal channels of communication are the real key to predicting problems in a profit centre and its ability to handle them.

Student Activity Discuss the organisational structures and/or types of responsibility centre that are most likely to be planned and controlled as profit centre.


Notes


Investment Centre It is the responsibility centre at which the manager is responsible for the effective utility of assets in order to earn the best rate of return out of the investments or assets employed. The exact volume of assets employed cannot be easily assessed for single department or responsibility centre. The difficulty in the assessment on the volume of assets is only due to the utility of the assets, which is not only in one responsibility centre but also in more than one.

When the manager is held responsibility for costs and revenues as well as for the investment in assets of a responsibility centre, it is called an Investment Centre. In an investment centre, the performance is measured not by profit alone, but it is related to investments effected, since the manager of an investment centre is always interested to earn a satisfactory return. The return on investment which is usually referred to as ROI, serves as a criterion for the performance evaluation of the manager of an investment centre. Viewed from this angle, investment centres may be considered as separate entities wherein the managers are entrusted with the overall responsibility of managing inputs, outputs and investment. This only represents an extension of the responsibility idea.

Return on Investment (ROI) A company is decentralized with respect to profit responsibility when each responsibility unit manager is accountable for achieving some level of profit. The assets employed in generating this profit form the asset base of the unit. Responsibility unit managers who are responsible for their investment base as well as their profitability are known as investment centre managers. The most commonly used investment-based measure of performance is return on investment (ROI), the ratio of profit to investment.

The use of ROI for financial planning and control of decentralized units, originated by the Du Pont Corporation, grew from its need to plan and evaluate the performance of the independent entities making up its diversified operations. The use of ROI solved the problem of motivating managers, ensuring consistent decision-making, and controlling decentralized divisions.

As used by Du Pont, return on investment is the quotient of the accounted profit earned by a unit divided by the investment assigned to the unit. The investment is made up of both fixed assets, such as machinery and equipment, and working capital items, such as inventory, receivables, and cash. ROI allows the measurement and evaluation of each responsibility centre manager according to how productively he or she uses the assets entrusted to him or her. It allows managers the latitude to make trade-off decisions between investments, revenues, and operating costs, and then to be evaluated on these decisions by one comprehensive performance figure. Planning and controlling the operations of decentralized investment centres by ROI have all the benefits of a profit centre approach, and in addition can be used to measure the productivity of the assets employed.

Calculation of the Investment Base Two critical procedures in the computation of ROI are specifying the investment base to be used for productivity measurements, and separating it into its controllable and non-controllable components for evaluation. In discussion of alternative methods of measuring an investment base, Solomon (1968) raises the following questions:

1. Should investment be interpreted to mean all assets, net assets (total assets-liabilities), or fixed assets plus net current assets?


Notes


2. How investment is defined and how should it be measured? Should fixed assets be included at cost, net book value (i.e., deducting accumulated depreciation), or at appraised value?

3. How should assets which are either shared or controlled centrally be computed in the return on investment? That is, when a responsibility unit does not hold separate cash balances or if it does not control its own receivables, how should these be allocated?

4. When inventories are valued on a LIFO basis, is any adjustment necessary when the investment base is computed?

5. When should the investment base be measured·at the beginning or at the end of the period, or should the average over the period be used?

After an extensive analysis of the implications of each of these alternatives, Solomon concludes that for calculating returns and for evaluating performance, investment should be defined as follows:

1. Total investment is best defined as total assets. Measures of productivity should be based on the total amount of capital committed, irrespective of how it was financed, because differences in financing strategies are irrelevant to the way assets are used, and also because financing decisions are usually made centrally rather than by the investment centre manager. However, to determine controllable investment, a deduction should be made for controllable liabilities. Changing these also changes net controllable investment, which should be the basis of the ROI figure used for evaluation.

2. Fixed assets should be included at gross cost. No deduction should be made for accumulated depreciation because such arbitrary deductions, and the resulting net book values, may bear no relationship to the productivity of the assets involved. ROI, based on net book value, increases as accumulated depreciation increases and net book value decreases. To negate the effects of changing price levels and to establish a basis of comparison between investment centres acquiring assets at different times, index number adjustments may be used.

3. Fixed assets held under corporate control (e.g., a research laboratory or computer centre) should be allocated to investment centres only if there exists a reasonable basis to do so. An alternative is to rely on a charge for services rendered, although this method involves all the difficulties of a transfer pricing scheme. The allocation of centrally controlled working capital is appropriate if a basis can be found that reflects incremental demands for such capital; for example, centrally held bank balances can be allocated on the basis of incremental cash demands while receivables can be allocated on the basis of sales. Allocated assets form part of a divisionÊs total investment, but not part of its controllable investment.

4. Investment in inventory is generally controllable and should be valued on a FIFO basis to approximate replacement cost on the balance sheet and avoid the distortions of LIFO.

5. The point in time at which the investment base should be measured depends on the length of the period considered and the time it takes for changes in assets to have an effect on profits. In calculating the rate of return for a period shorter than a quarter, the investment at the beginning of the period is a suitable base. For a longer interval, however, average investment should be used.

The five questions cited above are not an exhaustive coverage of all aspects of investment-based measurement, but they do demonstrate the types of choices to be


Notes


made. A review of SolomonÊs recommendations and his underlying reasoning reveals how arbitrary these measurements of the investment base really are. In considering the alternatives, Solomons appears to have assessed the implications of each kind of measurement according to what appears most „correct‰ from the standpoint of economic productivity and performance. There is, therefore, a significant amount of subjectivity in his choices. One could argue that productivity measures would be better based on the appraised value of assets, not historical costs, or that index number adjustments to only a part of a companyÊs assets produce misleading information. But debates on the „correctness‰ of alternative investment-based measurements could (and probably will) go on forever. As in many other accounting-related areas of contention, there are no „right‰ answers.

In deciding among alternative ways to compute an investment base, a system designer must consider how these measures are to be used. If their purpose is to motivate the investment centre manager to behave in certain desired ways (e.g., to keep minimal levels of inventory), then they should stress the controllable components of investment. If, on the other hand, the measures are to be used as aids for decision-making, they should stress economic reality. In sum, like most components of a planning and control system, how the components of an investment base should be measured depends on the characteristics of the situation and on the behaviour that the measures are intended to influence.

Advantages of ROI

In addition to all the benefits of profit measures, ROI has two more advantages. The first and foremost of these is that it provides a single, comprehensive, financial measure of performance. It not only reflects the increment to wealth, such as the profit measure, but it also relates profit to the assets employed in generating it. Second, because it is expressed as a ratio, ROI is an excellent way of comparing operations of different sizes and types.

Disadvantages of ROI

When ROI was first introduced by Du Pont to control its decentralized operations, it was far superior to other methods. Since then, however, numerous flaws have been uncovered in the ROI measure. Return on investment was originally intended to guide the planning and decision-making of unit managers and to give top management a basis by which to control and evaluate performance. However, from both of these perspectives ROI has several defects.

First, ROI suffers from all the defects of conventional accounting measures, it suffers even more from the arbitrariness of accounting conventions. For example, many expenditures which benefit the firm for more than a single accounting period, are expensed rather than capitalized, such as research and development expenditures and advertising outlays. And the historical costs at which assets are measured do not reflect their true economic value at any time subsequent to initial acquisition. Depreciation reduces book values and so increases ROI artificially. Book values are not adjusted for the changing value of the dollar, so that in times of inflation a substantial part of the reported profits may actually result from holding and using older assets while pricing products at current market levels, rather than from normal operations.

A second set of problems results from using ROI as a performance measure. As such, it should be controllable by the unit manager. However, many if not all of the assets entrusted to him are acquired through a host of past decisions outside his control. Nevertheless, these decisions are almost unavoidably reflected in any measure of performance, so that the use of ROI for evaluation may lead to distortion after all. As


Notes


a measure of performance, ROI suffers not only from all the dysfunctional consequences associated with improper use of the profit measure, but it may encourage other undesirable behavior as well. Assume that the objective of an investment centre manager is to maximize or at least to maintain his or her current ROI level. The manager may do so not only by improving profit performance, but also by minimizing his or her investment. For instance, minimizing assets by leasing, as opposed to buying, will have an immediate effect on ROI performance.

Pressure to achieve a specific ROI level may lead to incongruent decisions about asset replacement and disposal. In ROI performance measurement, asset replacement decisions are a function of the book value of an asset, not salvage values. Furthermore, ROI can be increased by scrapping assets which are earning less than the current ROI, thereby increasing the overall average. Scrapping unused assets increases ROI because these assets no longer are depreciated, nor do they appear in the asset base. Therefore, retaining idle assets is entirely undesirable. Also, because ROI is an overall measure of the use of assets, in some cases it can be increased by any action that reduces the asset base; and such decisions, while productive in the short run, may not be so in the long run.

Because ROI increases simply with the passage of time and depreciation (especially accelerated depreciation), it may also discourage new investments. The older the asset base of an organization, the higher is its ROI, and therefore, the higher is the return required on new investments in order to maintain or improve this average. Thus there may be a tendency to keep older equipment operating as long as possible in order to show high ROI rates, even when replacement would be better in the long run.

It is important to recognize that ROI is simply the quotient of profit over investment, and may differ from an organizationÊs cost of capital. It is also a single-year measurement, not a rate of return computed over the life cycle of an entire project. Hence while it may provide an appropriate criterion for short-term current operating decisions, it is certainly no guide for capital investments. ROI is based on current performance using existing assets, and does not reflect the cost of financing additional investments. Thus it is improper to use ROI as a decision criterion or hurdle rate against which to evaluate new investment proposals.

Investments should be made if their return exceeds the cost of making them. It is well known that different types of financing have different costs. For example, cash can be borrowed from a bank, acquired through the issuance of securities, or obtained by liquidating fixed assets. Each source of an organizationÊs financing, be it debt or equity, carries a separate implicit or explicit cost. The weighted average of an organizationÊs financing costs is known as its cost of capital. It provides the decision criteria that the organization should use. If a new investment earns an amount greater than its costs, there is a net positive increment to the organizationÊs overall worth. Therefore, if an organizationÊs objective is to maximize the net present value of its current shareholders, then it is in the shareholdersÊ best interest to undertake any investment whose return exceeds the organizationÊs current cost of capital.

It is important to recognize that ROI does not measure the cost of resources to an organization; it measures only the rate currently being earned on the money already invested. And so, investment opportunities which earn less than the organizationÊs ROI rate but more than the organizationÊs cost of capital may be rejected because they reduce average ROI. This sort of behaviour is undesirable because it foregoes potential increments to shareholderÊs wealth. Yet once a responsibility centre manager has committed himself to a specific ROI rate, it is unreasonable to expect him to propose a capital investment that will earn a lesser rate of return.

Thus it can be seen that the use of ROI as a criterion for investment decisions may lead a manager to make decisions which are incongruent with and inappropriate for


Notes


overall organizational objectives. The use of ROI may not always motivate the manager to behave in a way that benefits himself while simultaneously benefiting the organization as a whole·the criterion for an effective planning and control system.

Residual Income (RI) Residual income is another asset-based measure of financial performance. It is used in an attempt to overcome some of the weaknesses of ROI and to move closer toward the net present value notion of financial decision-making. The RI of an investment centre is its current operating profit (revenues – operating expenses) minus a capital charge for the assets employed in generating this profit. A capital charge is simply the cost to the firm of each particular type of asset it uses. RI is thus the net income of a responsibility unit after the cost of the capital used in its operations has been deducted.

Advantages of RI

One strength of RI is that it counters the need to maintain at least an average rate of ROI in considering new investment decisions. If an investment has a positive residual income, it will be undertaken even if its ROI is lower than the current average ROI. With an RI decision criterion, all investments will be accepted as long as they earn more than their capital costs. RI, therefore, encourages congruent investment decision-making, so that each responsibility centre is able to contribute to overall shareholder welfare by increasing the net present worth of the firm.

A second strength of RI is its use of capital charges in weighing assets. Because RI employs capital charges, each separate class of assets can be treated in a different manner, as appropriate. Assets which are more liquid and involve less risk to the firm or which are more readily available may be costed at rates substantially different from those which are hard to obtain or especially expensive. Assets which must be irretrievably committed to a project, and hence involve high risk, may be priced differently from those that can be recovered easily at full value. By pricing assets appropriately, an RI system can motivate managers to use assets in the proportions deemed most suitable from the standpoint of the organization as a whole.

Disadvantages of RI

The residual income measure shares many of the problems of ROI, however. The same problem of measuring fixed assets still exists, since the capital charges have to be applied against specific asset amounts and must be classified into controllable and non-controllable components. Furthermore, RI is measured in absolute dollars, not as a ratio, making it more difficult to compare responsibility units of different sizes. Like ROI, RI is a comprehensive financial measurement of performance. But it cannot include non-financial factors, of course, so many relevant key variables may be ignored. And finally, although many of the limitations of conventional accounting can be partly ameliorated, management usually cannot or will not use accounting techniques such as annuity depreciation and replacement cost accounting that would make the use of RI more realistic.

Therefore, although residual income is a more helpful formula than ROI for making decisions about asset acquisitions, it does not overcome the dysfunctional temptation to reduce assets (so as to minimize capital charges, in this case). In short, although it is perhaps superior to ROI in some ways, it still must be applied with the greatest of care.


Notes


Effective Use of Investment-Based Performance Measures The best information available on the use of RI and ROI comes from a survey conducted more than a decade ago. Mauriel and Anthony (1966) surveyed 3,525 U.S. companies with sales of over $20 million. Of the 2,658 companies that responded to the questionnaire, 60% used either ROI or RI or some combination of both in their planning and control of decentralized units. Only 3.8% of the total surveyed used residual income only. A follow-up study conducted by the same researchers revealed that 60% of their 981 respondents relied solely on ROI as a measure of responsibility centre performance. The responses indicated that most companies use accounting-based measures for computing their asset base. Of the companies responding, 93% measured divisional performance on the basis of either gross book value (18.5%), net book value (73.2%), or a combination of these two (1.6%). Hence, in spite of the many deficiencies associated with the use of both ROI and RI, it appears that investment-based performance measurements are widely used in management practice today.

Investment-based performance measurements present the designer of any planning and control system with a dilemma. On the one hand it is recognized that both ROI and RI have many of the drawbacks of a single performance measurement. They do not lead to correct investment decisions because they fail to mediate effectively between the short and the long term, and to reflect both the qualitative and quantitative aspects of any business operation. Furthermore, many non-financial key variables and intangible considerations (e.g., services) are not reflected in a unitÊs investment base, and therefore, cannot be accommodated by these types of measurement. But on the other hand, as the above surveys reveal, these investment-based performance measurements are in wide use today; and their acceptance by management is so widespread that it is unrealistic to assume that they will be done away with in the near future. So ways must be found to use these measures successfully. This means that if an organization relies heavily on a single performance measurement, its use ought to be accompanied both by a sharp awareness of the strengths and weaknesses of the measure, and also by an appropriate management style.

Both ROI and RI must emphasize trust and open communication if they are to be effective. They require the specification of appropriate key variables, the establishment of expectations in terms of these key variables, and finally, a consistent evaluation of the performance of each responsibility centre manager. These requirements also hold true when investment-based performance measures are used in the planning and control system.

If an investment-based criterion is used as a firm measure of expected performance, the determinants selected for the asset base must motivate the manager to make use of his or her assets appropriately. Clearly, residual income is superior to ROI in this respect; if each individual class of assets is properly priced, the encouragement of cost minimization will automatically ensure congruent actions. As before, performance can be controlled by establishing firm expectations and then having managers report to top management at short-time intervals. The constant involvement of top management will help to avoid the dysfunctional behaviours associated with investment-based performance measures.

If investment-based performance measures are established simply as guidelines, ROI or RI measures will serve not as a basis for evaluation but as a diagnostic tool. They are monitored to detect changes over time and to suggest potential improvements. To make them more useful for this purpose, accounting practices should be modified as needed. For example, modifying depreciation schedules and capitalizing expenditures such as advertising and research and development may be appropriate


Notes


for internal accounting purposes, although not for external reporting. With this approach, return on investment must be regarded simply as one of many key variables that affect performance.

An Alternative Approach to Planning and Controlling Investment Centres

The use of RI and ROI as measures of investment centre performance implies the validity of two assumptions: (1) that a single measure combining both profits and assets can describe efficient and effective behaviour, and (2) that a single-period measure of performance can guide appropriate behaviour. If these two assumptions are not valid, an organization must devise alternative means of planning and controlling investment centres. Specifically, it must answer the following questions:

1. What criteria should be used in making short-run operating decisions?

2. How should expenditures related to managed or discretionary short-run capacity costs (costs which cannot be associated with output) be planned and controlled?

3. How should an organization make capital investment decisions, and then evaluate the productivity of these investments?

To understand the role of investment-based performance measurements in the planning and control of any decentralized responsibility unit, it is essential to recognize that three types of decision-making occur. Two of these relate to short-run decisions and performance evaluation and the third to long-run expenditures.

The first type, current operating decisions, is concerned with the net contribution of any decision to the organizationÊs profit and overhead. The key criterion of these decisions is whether or not the benefits exceed the cost over the short run. These decisions are based solely on differential (incremental) revenues and costs; i.e., revenues as well as variable costs and other costs that will differ according to the alternative selected. All other costs, such as committed or sunk costs, are irrelevant to these decisions and their inclusion will only confuse the issue at hand. Furthermore, because of the short interval of time covered the time value of money can be ignored in these decisions. The cost-volume and contribution margin decision-making procedures familiar to any student of management accounting are the applicable techniques. The effective control of operating decision-making is essentially the same as the process involved in profit budgeting.

The second set of short-run decisions relates to the capacity to carry out business in the short run. These are the costs needed to do business and involve the fixed or committed costs needed to support current operations. Many components of these costs are independent of operating outputs and hence must be managed; i.e., their amounts are subject to the discretion of management rather than to an input-output relationship with volume of activity. Managed cost budgets, together with allocation schemes such as zero-base budgeting and interpersonal schemes such as management by objectives, are some techniques that will ensure the effective and efficient allocation of managed resources.

The third type of decision making and performance evaluation for investment centres relates to long-term expenditures. Capital expenditure decisions must reflect an organizationÊs cost of capital as well as other decision criteria that reflect a time period greater than one year, such as payout period, and the relative risk in the project over its full life cycle. Capital expenditure analysis is the primary means by which an organization approves acquisition of new assets, major changes from existing operations, and also the divestment of capital assets. It is the means by which an


Notes


organization ensures consistent and appropriate decision-making about capital expenditures throughout its decentralized entities. In any comprehensive programme of planning and control, the capital aspect of resource allocation decision-making is carried out independent of financially based criteria such as ROI and RI.

Both conceptually and operationally, capital expenditure analysis should be completely divorced from short-term measurements of investment productivity. The „correctness‰ of any investment decision can be evaluated only over the life cycle of a project. As an approximation of this evaluation, and to the extent that its effects are not contaminated by complex interrelationships among projects, a capital expenditure audit of an ongoing project can be carried out. This audit evaluates the expenditure decision either relative to the cash flow estimates originally made for it, or relative to modifications of these estimates that reflect activities that have taken place subsequently. In either case, the evaluation of an investment cannot be carried out by ROI or RI calculations because the initial decision to invest was not made on this basis.

When the total decision-making required by an organization to manage its economic resources is divided into these three broad classes, the role of ROI and RI measures in the planning and control of resources becomes more explicit. Each kind of decision should be kept separate and should be planned and controlled according to the specific decision process that guides it. If this is done, the arbitrary averaging, confusing interrelationships, and interperiod allocations that result from most accounting-based measurements can be avoided. Accounting measurements are useful for short-term decision-making and should be used where they are relevant; but long-term capital investment decisions should be based essentially on cash flows and an organizationÊs cost of capital, and should not be contaminated by accounting phenomena.

It should be recognized, however, that the return on investment figure derived from accounting data may be used for extra corporate evaluation. Many outsiders who rely on financial statements to assess corporate productivity examine the ratio of income to assets employed. Outsiders are, of course, forced to use financial statements because these are the only data available to them. It must, therefore, be recognized that, to the extent that external evaluation criteria influence internal decisions, investment-based performance measurements such as ROI may, in fact, be relevant to decisions concerning resource allocations.

Summary The responsibility centre is the department, which is headed by the responsible person, i.e., the manager of that particular function. It is classified into various groups like revenue and expense centre, profit centre, investment centre, etc.

A profit centre is an operating unit whose manager has responsibility for the attainment of a given level of profit. The advantages of the profit centre system are that it is a way of managing large entities through decentralization, it leads to better operating decisions because of closer proximity to the environment, it motivates managers by giving them a sense of control, and it frees top management from day-to-day operations so that they, can concentrate on specific problems and long-term strategies.

Keywords Responsibility Centre: A department, which is headed by the responsible person, i.e., the manager of that particular function.


Notes


Expense Centre: The responsibility centre which incurs only expenses, and measures them, is known as expense centre.

Profit Centre: The responsibility centre which is measured in terms of both the expense incurred as well as revenue earned is known as profit centre.

Investment Centre: It is the responsibility centre at which the manager is responsible for the effective utility of assets in order to earn the best rate of return out of the investments or assets employed.

Review Questions 1. What do you understand by responsibility centre. Illustrate various

classifications of responsibility centre.

2. Explain the process of setting up of responsibility centre.

3. Does the designation of a responsibility unit as a profit centre rule out the use of other key variables in its planning and control?


Ravindhar Vadapalli, Management Control System, Excel Books, 2008



Unit 3

Transfer Pricing

Unit 4 Budgeting

SECTION-II

Transfer Pricing

Notes


Unit 3 Transfer Pricing Unit Structure • Introduction

• Objectives of Transfer Pricing

• Methods of Transfer Pricing • Summary

• Keywords • Review Questions

• Further Readings

Learning Objectives At the conclusion of this unit you should be able to: • Describe the meaning and objectives of transfer pricing • Understand the determination of transfer pricing

• Discuss the methods and significance of transfer pricing

Introduction Transfer pricing refers to the pricing of contributions (assets, tangible and intangible, services, and funds) transferred within an organization. For example, goods from the production division may be sold to the marketing division, or goods from a parent company may be sold to a foreign subsidiary. Since the prices are set within an organization (i.e. controlled), the typical market mechanisms that establish prices for such transactions between third parties may not apply. The choice of the transfer price will affect the allocation of the total profit among the parts of the company. This is a major concern for fiscal authorities who worry that multi-national entities may set transfer prices on cross-border transactions to reduce taxable profits in their jurisdiction. This has led to the rise of transfer pricing regulations and enforcement, making transfer pricing a major tax compliance issue for multi-national companies.

Objectives of Transfer Pricing The main objective of transfer pricing is to determine the optimal output of each division and of the firm as a whole and in evaluating divisional performance and determining divisional rewards.

Since the prices directly affect profit centre profitability, the manner in which these prices are established critically affects the stability and effectiveness of an interdependent profit system.

Transfer pricing problems have been extensively researched by a number of scholars. It is well recognized that transfer pricing problems have a multiple-criteria (objectives) feature and can be formulated as a model of multiple-criteria linear programming. However, few methods have the capability of dealing with all possible optimal trade-offs of multiple criteria in optimal solutions of the models. In this paper a linear multiple-factor model is developed to provide managers with a more systematic and comprehensive scenario of all possible optimal transfer prices depending on both multiple criteria and multiple constraint levels. The trade-offs of all possible optimal transfer prices can be used as a basis for managers of a


Notes


corporation to make a high-quality decision in selecting their transfer pricing systems for business competition.

Transfer pricing systems are designed to accomplish the following objectives:

1. to provide each division with relevant information required to make optimal decisions for the organisation as a whole;

2. to promote goal congruence – that is, actions by divisional managers to optimise divisional performance should automatically optimise the firm's performance; and

3. to facilitate measuring divisional performances.

Companies use variations of market-based and cost-based transfer pricing mechanisms to achieve the objective of goal congruence. Transfer-pricing system must have in-built mechanisms for smooth negotiation and conflict resolution.

Although there is sound economic theory behind the selection of transfer pricing methods, companies use transfer price methods to achieve certain other objectives even at the cost of goal congruence. Often in family run businesses, decisions are taken at the group level.

Therefore, decisions aim to optimise group performance. When group companies produce products that are used within the group, transfer price is established with an aim to optimise the group performance, although it may hurt the selling or the buying company within the group.

An issue that is often ignored is that whether this practice undermines the interest of minority shareholders. If there is no minority shareholder in the company that is hurt, the ethical/corporate governance issue does not arise. Otherwise, this is an important issue and need to be addressed by the board of directors of individual companies.

For multinational corporations, it may be advantageous to arbitrarily select prices such that most of the profit is made in a country with low taxes, thus shifting the profits to reduce overall taxes paid by a multinational group.

Methods of Transfer Pricing A transfer price is simply the amount recorded for a transfer of goods or services between units. Although, there is considerable variety in transfer price methods. Following are the four most popular methods:

1. Full-cost plus: Perhaps the simplest method of transfer pricing is to use full historical cost. The full cost of a product is the material, labor, and overhead required to produce and ship the product to the buying unit. Full costs are the most economical transfer prices to develop because they are routinely prepared for inventory evaluation. However, if goods are transferred at cost then the selling division is only a cost centre, or a profit centre budgeted at zero profitability if standard costs are used as the transfer price.

Some firms have attempted to use simple cost-based transfer prices yet provide for profit by adding a normal markup to cost. Of course, this method produces an artificial profit system which is dictated by corporate policy on markups rather than by market forces. The realism of this method, therefore, depends on the extent to which it approximates the pricing practices in the industry as a whole.

2. Marginal cost: The marginal cost of a unit is the additional cost required to produce it. If the transfer pricing system is designed to ensure efficient allocation of resources then the best transfer price to use is marginal (or incremental) cost. Decision-making based on incremental cost determines the

Transfer Pricing

Notes


benefits of the decision for the organization as a whole. At less than full capacity, marginal-costs consist of the variable costs of producing and shipping goods plus any costs directly associated with the transfer. At full capacity, however, incremental costs must reflect the opportunity lost by foregoing sales to outside customers. In this situation, incremental cost is equal to the market price.

3. Market prices: If there is an active competitive market for the goods or services transferred, the most logical pricing method to use is the market price.

4. Negotiated prices: In some instances profit centre managers may be allowed to negotiate transfer prices with each other on whatever basis they choose. Negotiation implies, of course, that each manager has a bargaining position to begin from. This situation arises only when there are alternative sources of supply and demand. When a selling division has a choice of customers, or when a buying division has a choice of suppliers, prices can be negotiated.

Determining Transfer Prices Two conditions most significantly affect the way transfer prices should be established. These are the presence of outside competition and slack resources in productive capacity.

Availability of outside competition: The presence of legitimate outside competition determines whether an objective value can be placed on the good or service transferred. Using market prices guarantees the optimal allocation of resources within the firm. Under competitive conditions, efficiency is assured if internal prices are no higher than external ones. Each seller is forced to meet competition and each buyer has alternative sources of supply. In fact, an internal buyer may even insist on a price below market because, in dealing intracorporately, the seller saves selling, collection, and bad debt expenses. Thus, when legitimate outside competition exists, establishing transfer prices is not difficult.

When outside sources of supply are potentially available but are not currently being used, one means of testing the efficiency of transfer prices is by securing competitive bids. However, although theoretically all internal prices should be tested by competitive bids, there are practical problems in doing so. First, it is well-known that a competitor will only bid on a job if he or she has a substantial chance of getting it. Suppliers differentiate between bids requested for information only and those for which there is a possibility of securing an order. A second problem is that competitive bids may be deceptive. A supplier who wants to change the sourcing of a product from inside to outside may bid substantially lower than he otherwise would, even below his cost. He may prefer to take a short-term loss in the hope of building up dependence so that he may eventually slowly increase the price to achieve long-term profitability. Thus, when market bids are used as measures of market prices the validity of each bid must be considered individually.

In the absence of competitive market prices, economically meaningful transfer prices cannot be established. In these situations, it is better for a responsibility unit to operate as a service centre transferring goods at cost, rather than as a profit centre.

Level of productive capacity: The existence of slack in an organizationÊs productive capacity influences transfer pricing because failing to make use of this additional capacity costs the organization as a whole. For example, assume that a buyer has the choice between an outside supplier and a division of his or her own firm. If the buying division pays an outsider anything above the marginal cost of the product to the firm, some contribution to profit and overhead will be going to the outsider. Therefore, any transfer price greater than marginal costs may lead to buying decisions


Notes


which are not in the best interest of the corporation as a whole, although this transfer price provides the selling division with some profit. If the marginal cost of a part to the organization is $10 and an outsider is offering to sell it at $15, accepting this offer means the sacrifice of a $5 contribution to profit and overhead. Yet if the selling divisionÊs fixed costs exceed $5, it may establish a transfer price greater than $15 so as not to incur a loss on the transaction. In this situation, the decision to source outside may be best from the standpoint of the buying division but not for the organization as a whole. Therefore, when a seller is operating at less than full capacity, transfer pricing at anything other than marginal cost may lead to decisions which do not maximize overall profits.

When outside competition exists, these two rules coincide. In a competitive situation, market prices and marginal costs are identical. In order to maximize profits each seller establishes his prices at the point where marginal cost equals marginal revenue. Therefore, at any output less than full capacity, pricing goods exchanged internally at market value both maximizes the profits of the selling division and also ensures goal congruence and consistent decision-making throughout the organization.

In some instances, when a selling division is operating at full capacity and an alternative source of supply exists, prices can be set at an amount greater than marginal cost of production. In this situation, the manager of a profit centre operating at full capacity may feel that he can allocate some of his productive capacity to earn revenue greater than he is now earning; and so he may want to recover the opportunity loss he believes that he is incurring. If the profit centre operation is truly decentralized, he should be free to price at whatever level he chooses, and the buyer should go to an outside supplier for his requirements.

The Significance of Transfer Pricing The transfer pricing problem has received a great deal of attention by economists, accountants, and management scientists over the last two decades. Transfer pricing systems are of great theoretical significance and considerable practical interest, but from the standpoint of organizational planning and control systems this emphasis is largely misplaced. In the absence of market-determined prices, the establishment of transfer prices is either arbitrary or requires quantities of information far in excess of what is normally available to the manager of a profit centre. Even if transfer prices are established by sophisticated analytical techniques such as linear programming, the shadow price solutions produced are still only single-period static solutions which require frequent revisions to be operational. Thus in all non-market situations, transfer prices must either be established by negotiation or by the directives of central staff. So perhaps skill in bargaining for favorable transfer prices may be a far more important managerial asset than the ability to allocate resources efficiently. After extensively reviewing the transfer price literature from the perspectives of the theory of the firm, mathematical programming, and other analytical techniques, Abdell-Khalik and Lusk (1974) came to a similar conclusion.

Student Activity There are cases in which cost plus pricing is not preferred to other methods of transfer pricing. Discuss the situations in which cost plus pricing will not be helpful for an organisation.

Summary Transfer prices must be established for the goods and services exchanged by interdependent organizational units operating as profit centres. Transfer prices can be based on historical costs, market prices, marginal costs, or negotiation. From the

Transfer Pricing

Notes


standpoint of the firm as a whole, any price paid to an outsider that exceeds the marginal cost of production for a good available from an internal source allows a contribution to fixed overhead and profit to leave the firm. Hence, to ensure the optimal allocation of economic resources within the firm, marginal costs should be used as the transfer price. When transfer prices do not equal marginal costs, one should be aware of the potential dysfunctional consequences to the corporation as a whole.

Keywords Transfer Pricing: The pricing of contributions (assets, tangible and intangible, services and funds) transferred within an organisation.

Full Cost: It is the material, labour and overhead costs required to produce and ship the product to the buying unit.

Cost Plus Pricing: Under this method, the price is set to cover costs and pre-determined percentage of profit.

Marginal Cost Pricing: In this method, fixed costs are ignored and prices are determined on the basis of marginal cost.

Review Questions 1. Explain the concept of transfer pricing.

2. Discuss the objectives and significance of transfer pricing.

3. Explain the different methods of transfer pricing. How can one determine the transfer price?





Budgeting

Notes


Unit 4 Budgeting Unit Structure • Introduction

• Process of Budget Preparation

• Classification of Budget • Sales Budget

• Sales Overhead Budget • Cash Budget

• Factory Overheads Budget

• Flexible Budget • Zero-base Budgeting

• Behavioural Aspects of Budgeting • Summary

• Keywords

• Review Questions • Further Readings

Learning Objectives At the conclusion of this unit you should be able to: • Understand the basics of budgeting • Classify budgets in different categories

• Identify the causes and means of deviations in between the actual and standard

Introduction Budget is an estimate prepared for definite future period either in terms of financial or non-financial terms. Budget is prepared for any course of action or business or state or nation as a whole. The budget is usually expressed in terms of total volume.

According to ICMA, England, a budget is „a financial and/or quantitative statement prepared and approved prior to a defined period of time, of the policy to be pursued during the period for the purpose of attaining a given objective.‰

It is in other words, „a detailed plan of action of the business for a definite period of time.‰

Process of Budget Preparation The Financial Service Department prepares worksheets to assist the department head in preparation of department budget estimates. The Administrator calls a meeting of managers and they present and discuss plans for the following yearÊs projected level of activity. The managers can work with the Financial Services, or work alone to prepare an estimate for the departments coming year. The completed budgets are presented by the managers to their Executive Officers for review and approval. Justification of the budget request may be required in writing. In most cases, the manager talks with their administrative officers about budget requirements.


Notes


Adjustments to the budget submission may be required as a result of this phase in the process.

The process of preparing a meaningful and useful budget is best undertaken as an organised and structured group exercise. The budget process involves asking a number of questions. These start with plans and goals, not numbers. These questions can only be answered by programme and finance staff working together:

What are the objectives of the project?

What activities will be involved in achieving these objectives?

What resources will be needed to perform these activities?

What will these resources cost?

Where will the funds come from?

Is the result realistic?

Once the budget has been agreed and the activity implemented, the process is completed by comparing the plan (budget) with the eventual outcome (ÂactualÊ), to see if there is anything we have learnt or could do differently next time.

Preparation of the Budget for definite future

Actual performance has to be recorded

Comparison between the actual and budget figures

Corrective steps – Deviations in between actual and budget

Revision of the budget

Budgeting

Notes


Classification of Budget On functional basis

The budgets can be classified into three categories: Functions, Flexibility and Time.

Production Budget The preparation of the production budget is mainly dependent on the sales budget. The production budget is a statement of goods, stating how much should be produced. It may be in terms of quantities, kgs, in monetary terms and so on.

Purpose of the Production Budget

The ultimate aim of the production budget is to find out the volume of production to be made during the year based on the sale volume. The production and sales volume should go hand in hand with each other, otherwise the firm would have to face the acute problem on holding unnecessary excessive stock or inadequate stock to meet the needs of the buyers on time, which will bring disruptions in the supply of goods on time as already agreed upon.

Units to be produced = Budgeted Sales + Closing Stock – Opening Stock

Methodology of the production budget: The methodology of production budget includes three different components viz. sales, closing stock and opening stock.

Sales have to be added with the stock of the year at the end and deducted from the opening stock.

Why must sales be given paramount importance in the preparation of production budget?

Major sales of a business enterprise regularly accrue only out of the current year of production.

Why does the closing stock have to be added?

The purpose of adding the closing stock is that it is a stock at end of the year end out of the current year production.

Budgets

Functions Flexibility Time

Sales Budget

Production Budget

Material Budget

Labour Budget

Manufacturing overhead b d t

Selling overheads budget

Cash budget

Fixed Budget

Flexible Budget

Long Term

Medium Term

Short Term


Notes


Why must the opening stock be deducted?

The aim of deducting the opening stock is that the stock at the beginning is the stock out of the yester or previous year production.

If sales are normally equivalent to the entire year of production, the firm need not concentrate on the volume of opening stock and closing stock. It means that whatever produced during the year is equivalent to current year sales. If the entire production is sold out, there wonÊt be a closing stock at the end of the year and opening stock i.e. subsequent years.

If current yearÊs production is equivalent to current yearÊs sales

=

Result: No closing stock and opening stock for the subsequent years. This situation may not be possible always.

Why is it not possible always?

The production volume is connected to the internal environment of the firm, which can be maintained through a systematic approach. But the sales cannot be easily administered by the firm which is being highly influenced by the demand and supply factors of the goods.

If the current yearÊs production is not equivalent to the current yearÊs sales:

Flow of goods from production of one period to another

Why does the closing stock arise in the business?

The closing stock is stock due to the excessive production over the sales volume.

The reasons for excessive production are as follows:

Ineffective study of market potential through market research leading to the expression of excessive demand from the market, which signals the production department to produce to the tune of MR conducted.

Due to price fluctuations in the market volume of sales may be affected.

Due to need of meeting the future demands.

The excessive production due to the cheaper availability of raw materials which leads to greater amount of closing stock. If the storage cost is more, then a hike takes place on the cost of raw materials leading to abnormal storage of the stock.

Current year production Current year sales

Internal environment Demand and Supply

Yester year production (units) Current year production (units)

Current year Sales Opening Stock Closing Stock

Budgeting

Notes


The above diagram clearly illustrates the emergence of the opening stock and closing stock during the year out of sales and production volume of the enterprise.

Illustration 1:

Prepare a production budget for three months ending March 31, 1996, for a factory manufacturing four different articles on the basis of the following information:

Type of the Product

Estimated Stock on Jan 1, 1996

Units

Estimated sales duringJan-Mar, 1996

Units

Desired Closing Stock on Mar 31,1996

Units AA 2000 10,000 5,000 BB 3000 15,000 4,000 CC 4000 13,000 3,000 DD 5000 12,000 2,000

Solution:

Production budget for three months ending March 31,1996

Particulars AA Units

BB Units

CC Units

DD Units

Estimated Sales 10,000 15,000 13,000 12,000 Add: Desired closing stock 5,000 4,000 3,000 2,000 15,000 19,000 16,000 14,000 Less: Opening Stock 2,000 3,000 4,000 5,000 Estimated Production 13,000 16,000 12,000 9,000

Illustration 2:

Mr. X Co. Ltd. manufactures two different products X and Y. X forecasts of the number of units to be sold in first seven months of the year is given below:

Months Product X Product Y Jan 1,000 2,800 Feb 1,200 2,800 Mar 1,600 2,400 Apr 2,000 2,000 May 2,400 1,600 June 2,400 1,600 July 2,000 1,800

It is expected that (a) there will be no work in progress at the end of every month (b) finished units equal to half the sales for the next month will be in stock at the end of each month (including the previous December).

Budgeted production and production costs for the whole year are as follows:

Product X Product Y Production in Units

22,000 24,000

Direct Material 10.00 15.00Per unit Rs.

Direct Labour 5.00 10.00

Total factory overhead apportioned 88,000 72,000

Prepare for the six months ending 30th June, a production budget for each month and summarized production cost budget.


Notes


Solution:

The first step is to calculate the production budget for the products X and Y.

Highlights of the Problem

Closing stock is equivalent to half of the sales of next month · given in the problem

Opening stock is equivalent to half of the sales of the current month – half of the sales of the current month is equated to the closing stock of the previous month.

Particulars Jan Feb Mar Apr May June

Product X

Sales

1,000 1,200 1,600 2,000 2,400 2,400

Add: Closing stock 600 800 1,000 1,200 1,200 1,000

1,600 2,000 2,600 3,200 3,600 3,400

Less: Opening Stock 500 600 800 1,000 1,200 1,200

Budgeted Production 1,100 1,400 1,800 2,200 2,400 2,200

In the next step, Total Budgeted Production for six months has to be calculated.

Every month budgeted production derived from the Table, pertaining to the duration in Jan and June should be added together to derive the total volume of the budgeted production of the early mentioned.

1100 + 1,400 + 1,800 + 2,200 + 2,400 + 2,200 = 11,100 units.

Particulars Jan Feb Mar Apr May June

Product Y Sales

2,800 2,800 2,400 2,000 1,600 1,600

Add: Closing stock 1,400 1,200 1,000 800 800 900 4,200 4,000 3,400 2,800 2,400 2,500 Less: Opening Stock 1,400 1,400 1,200 1,000 800 800 Budgeted Production 2,800 2,600 2,200 1,800 1,600 1,700

Total Budgeted Production of Y = 2,800 + 2,600 + 2,200 + 1,800 + 1,600 + 1,700 = 12,700 units

The next step is to find out the factory overheads per unit.

Factory overheads per unit Annual Factory Overheads

=Total output of the year

For Product (X) = Rs. 88, 000

= Rs. 422,000

For Product (Y) = Rs. 72,000

Rs. 324,000

Factory Overhead for 11,100 units of X = Rs.4 per unit 11,100 = Rs.44, 400

Factory Overhead for 12,700 units of Y= Rs.3 per unit × 12,700 = Rs.38,100

Budgeting

Notes


Production Cost Budget

Product X Output 11,100 Units

Product Y Output 12,700 Units

Particulars

Per Unit Rs.

AmountRs.

Per Unit Rs.

Amount Rs.

Total

Direct Material 10.00 1,11,000 15.00 1,90,500 3,01,000 Direct Labour 5.00 55,500 10.00 1,27,000 1,82,500 Prime Cost 15.00 166,500 25.00 3,17,500 4,84,000 Factory Overhead 4.00 44,400* 3.00 38,100** 82,500 19.00 2,10,900 28.00 3,55,000 5,66,500

Materials/Purchase Budget This budget takes place only after identifying the number of finished products expected to produce to the tune of production budget, in meeting the needs and demands of the customers and consumers during the season.

In order to produce to the tune of production budget to meet the market demands, the raw materials for the production should be maintained in sufficient quantity to supply them without any interruption. To have uninterrupted flow of production, the firm should go in for the immediate procurement of raw materials through the multiplication of raw material required to produce for a single product with number of units expected to produce.

Why is the stock of raw materials deducted from the expected volume of materials procured for production to the tune of production budget?

If there is any existing stock of raw materials i.e. opening stock of raw materials available from the yester seasons or years, the same be deducted from the volume of materials required for production to be ordered and placed. The remaining volume should be the volume to be ordered for production.

Illustration 3:

The sales manager of the MR Ltd. reports that next year he anticipates selling 50,000 units of a particular product.

The production manager consults the storekeeper and casts his figures as follows:

Two kinds of raw materials A and B are required for manufacturing the product. Each unit of the product requires 2 units of A and 3 units of B. The estimated opening balances at the commencement of the next year are;

Finished Product : 10,000 units

Raw materials A : 12,000 units

Raw materials B : 15,000 units

The desirable closing balances at the end of the next year are:

Finished products : 14,000 units

Raw materials A : 13,000 units

Raw materials B : 16,000 units

Prepare the production budget and materials purchase budget for the next year.

Solution:

The first step is to prepare the production budget. To identify the volume of materials required for production by considering the production budget and the closing stock of materials of A and B respectively.


Notes


Why must the closing stock of raw materials be added with estimated consumption?

The purpose of adding the closing stock of raw materials is to anticipate their future demand due to market influence; which warrants the firm to go in for placement of order not only taking into consideration of expected consumption of raw materials, but also the closing stock of raw materials to be maintained at the end of the season, in order to have an uninterrupted flow of production.

Why must the opening stock of raw materials be deducted?

The opening stock of raw materials that is available in the firm should be considered for the placement of order of raw materials. The materials to be ordered should be other than that of the materials available in the firm.

Production Budget (Units)

Estimated sales 50,000 Add: Desired Closing stock 14,000

64,000 Less :Opening Stock 10,000 Estimated Production 54,000

Materials Procurement or Purchase Budget (Units)

Material A Material B Estimated Consumption For A 2units x 54 ,000 For B 3units x 54,000

1,08,000

1,62,000Add : Closing Stock 13,000 16,000

1,21,000 1,78,000Less: Opening Stock 12,000 15,000Estimated Purchases 1,09,000 1,63,000

Illustration 4:

From the following figures extracted from the books of KPZ Ltd, prepare raw materials procurement budget on cost.

Particulars A B C D E F

Estimated stock on Jan 1 16,000 6,000 24,000 2,000 14,000 28,000

Estimated stock on Jan31 20,000 8,000 28,000 4,000 16,000 32,000

Estimated consumption 1,20,000 44,000 1,32,000 36,000 88,000 1,72,000

Standard price per unit 25 p 10p 50p 30p 40p 50p

Material Procurement Budget

Particulars A B C D E F Estimated consumption 1,20,000 44,000 1,32,000 36,000 88,000 1,72,000Add: Estimated stock on Jan 31

20,000 8,000 28,000 4,000 16,000 32,000

1,40,000 52,000 1,60,000 40,000 1,04,000 2,04,000Less: Estimated stock on Jan 1

16,000 6,000 24,000 2,000 14,000 28,000

Estimated Purchases (units)

1,24,000 46,000 1,36,000 38,000 90,000 1,76,000

Rate per unit 25 p .10p .50p .30p .40p .50p Estimated Purchase Cost 31,000 4,600 68,000 11,400 36,000 88,000

Budgeting

Notes


Sales Budget Sales budget is an estimate of anticipation of sales in the near future prepared by a responsible person for the sale of a product by considering the various factors of influence. Sales budget is usually prepared in terms of quantity and value. The following factors are normally considered for the preparation of sales budget of a firm.

Yester sales figures

Estimates of the salesmen who are frequently operating in the market, who know much better than anybody in the market

Capacity of the plant and machinery to produce

Funds availability

Availability of raw materials to the tune of demand in the respective time period

Changes in the taste and preferences of the customer or consumer

Changes in the competition structure- monopoly to perfect competition - Previously BSNL was known as DOT as a monopoly in the market in affording the services till early 2000. Then, changes took place in the market environment i.e. competition due to invasion of new entrants like Reliance, Hutch, Bharti televentures and so on. This warrants careful preparation of sales budget of number of telephone connection expected to sell.

Illustration 5:

Reynolds Pvt. Ltd., manufactures two brands of pen Light and Elite. The sales department of the company has three departments in different regions of the country.

The sales budgets for the year ending 31st December, 1996 are: Light department I 3,00,000; department II 5,62,500; department III 1,80,000: Elite – department I-4,00,000; department II-6,00,000; department III 20,000.

Sales prices are Rs.3 and Rs. 1.20 in all departments.

It is estimated that by forced sales promotion, the sales of Elite in department I will increase by 1,75,000. It is also expected that by increasing production and engaging in extensive advertising, department III will be enabled to increase the sale of Elite by 50,000.

It is recognized that the estimated sales by department II represent an unsatisfactory target. It is agreed to increase both estimates by 20%.

Prepare a sales budget for the year 1996.

Solution:

The sales budget should be prepared to the tune of various influences of the forthcoming seasonsÊ sales. The expected increase or decrease in the sales volume should be incorporated at the time of preparing the sales budget from the yester periods of sale figures.

There is no change in the volume of existing sales of the department of I Light; the existing sales of the department I of the Light brand should be retained as it is for the computation of the budgeted figures, but there is a change expected to occur in the existing volume of sales of the department I of the Elite brand. The change expected is amounted to increase of 1,75,000 units in addition to the volume of existing sales i.e. the total volume of sales is equivalent to 4,00,000 units of existing volume of sales + 1,75,000 units expectation of increase = 5,75,000 units for Elite Department I.


Notes


In the II department both Light & Elite are expected to gain an increase on the volume of existing sales amounting to 20% i.e. 20% increase in Department II of the Light brandÊs 5,62,500 units, amounting to 6,75,000 units. Similarly, in the case of Department II of the Elite brand, a 20% in 6,00,000 units amount to 7,20,000 units.

In the III department the Light brand does not have any change in the volume of existing sales. It means that 1,80,000 units have to be retained as they are in the computation of the budgeted figure but in the case of Elite, department III expects an increase in the volume of sales which amount to 20,000 units i.e. 70,000 units.

Sales Budget for the year 1996

Light Rs.3 Elite Rs.1.20 Total Selling Price

Quantity Rs. Quantity Rs. Rs. Department I 3,00,000 9,00,000 5,75,000 6,90,000 15,90,000 Department II 6,75,000 20,25,000 7,20,000 8,64,000 28,89,000 Department III 1,80,000 5,40,000 70,000 84,000 6,24,000 11,55,000 4,65,000 13,65,000 16,38,000 51,03,000

Illustration 6:

Sankaran Bros. sell two products A and B which are manufactured in one plant. During the year 1986, the firm plans to sell the following quantities of each product.

Product April-June July-September October- December January- March

Product A 90,000 2,50,000 3,00,000 80,000 Product B 80,000 75,000 60,000 90,000

Each of these two products is sold on a seasonal basis. Sankaran Bros. plan to sell product A throughout the year at price of Rs. 10 per unit and product B at a price of Rs. 20 per unit.

A study of the past experiences reveals that Sankaran Bros. have lost about 3% of its billed revenue each year because of returns constituting 2% of loss if revenue allowances and bad debts 1% loss.

Prepare a sales budget incorporating the above information.

Solution:

The first step to compute is the total sales volume of the firm; this will be found out through the addition of the sales volume in rupees of the two different products, A and B. To find out the individual sales volume, the quantities under each category should be multiplied with the selling price of the respective product.

Sales volume in Rupees = Sales in Quantities x Selling price per unit

The second step is to calculate the volume of revenue losses in terms of percentage of sales, which comprises two different divisions of revenue loss and loss due to bad debts of the customers.

The amount of the expected losses during the various quarters will be correspondingly deducted to identify the volume of net sale budgeted figures.

Net Sales = Gross sales of every product – Revenue losses

Budgeting

Notes


Sankaran Bros

Sales Budget for the year 1986

Particulars April-

June

July-September

October- December

January- March

Total

Product A 9,00,000 25,00,000 30,00,000 8,00,000 72,00,000

Product B 16,00,000 15,00,000 12,00,000 18,00,000 61,00,000

Total Billed Revenue

25,00,000 40,00,000 42,00,000 26,00,000 1,33,00,000

Return loss 2% 50,000 80,000 84,000 52,000 2,66,000

Allowance & bad debts loss 1%

25,000 40,000 42,000 26,000 1,33,000

Total amount to be deducted

75,000 1,20,000 1,26,000 78,000 3,99,000

Net sales after deduction

24,25,000 38,80,000 40,74,000 25,22,000 1,29,01,000

Illustration 7:

Gopi & Co Ltd. produces two products, Alpha and Beta. There are two sales divisions, North and South. Budgeted sales of the year ended 31st December 1980 were as follows:

Division Products Units Price per unit

Alpha 25,000 Rs.10 North

Beta 15,000 Rs.5

Alpha 24,000 Rs.10 South

Beta 30,000 Rs.5

Actual sales for the period were

Product North South Alpha 28,000 units @ Rs.10 each 25,000 units @ Rs.10 each Beta 18,000 units @ Rs.5 each 33,000 units @ Rs.5 each

On the basis of assessments of the salesmen, the following are the observations of sales division for the year ending 31st December, 1981.

North Alpha budgeted increase of 40% on 1980 budget

Beta budgeted increase of 10% on 1980 budget

South Alpha budgeted increase of 12% on 1980 budget

Beta budgeted increase of 15% on 1980 budget

It was further decided that because of the increased sales campaign in North, an additional sales of 5,000 units of product would result.

Solution:

The first step is to find out total volume of sales expected, by considering the yester year budget 1980 as a base for the preparation of the budget of 1981. The budget of the North zone should be prepared by taking into consideration the 5000 units of increase in sales from the previous budget 1980.

In the South zone, there are no additional sales unlike in the North.


Notes


The most important step involved in the process of apportioning the total 5000 units expected to increase is on the basis of total budgeted units of 1980 with reference to Alpha and Beta.

Work Notes:

Before computing the expected sales, the 5,000 units have to be apportioned on the following basis:

For North zone, additional sales expected is 5,000 out of 40,000 units of sales of the previous year budget. i.e. (25,000 units of Alpha and 15,000 units of Beta)

For Alpha of North Zone = 25000

5000 3,125 units40,000

For Beta of North Zone = 15, 000

5, 000 1, 875 units40,000

The above apportioned additional sales are expected to occur during the year 1981 on the basis of the year 1980 and should be added with the sales volume of the base year 1980 in order to get the budgeted sales value of the North and South Zones.

Calculation of the expected sales for the year 1981 in units

Alpha 25,000 Units 40% increase on 5,000 Units 3,125 Units 38,125 Units North

Beta 15,000 Units 10% increase on 15,000 Units 1,875 Units 18375 Units

Alpha 24,000 Units 12% increase on 24,000 Units ---------- 26,880 Units South

Beta 30,000 Units 15% increase on 30,000 Units ---------- 34,500 Units

Sales Budget for the year 1981(Zone Wise)

Zones Products Units Price per unit

Rs.

Expected Sales

Rs.

Total

Rs.

Alpha 38,125 10 3,81,250 North

Beta 18,375 5 91,875

4,73,125

Alpha 26,880 10 2,68,800 South

Beta 34,500 5 1,72,500

4,41,300

9,14,425

Sales Budget for the year 1981(Product Wise)

Products Zones Expected Sales Rs. Total Rs. North 3,81,250 Alpha South 2,68,800

6,50,050

North 91,875 Beta South 1,72,500

2,64,375

Sales Overhead Budget It is one of the important sub-functional budgets, prepared by the sales manager who is responsible for the increase in sales volume of the enterprise through various devices/tools of sales promotion.

The sales overhead can be classified into two categories viz. fixed sales overhead and variable sales overhead.

Budgeting

Notes


What is meant by Fixed Sales Overhead?

Fixed sales overhead is the expense incurred for promoting the sales which remains the same or fixed, irrespective of the volume of the sales.

For example, salaries to Sales Dept. Administrative Staff, Salary to Salesmen, Advertisement and so on.

What is meant by Variable Sales overhead?

Variable sales overhead is the expense incurred for the promotion of the sales, which varies along with the volume of firmÊs sales etc.

For example, sales commission, Agents commission, Carriage outward expenses.

The sales overhead budget is the statement of estimates of the various sales promotional expenses not only based on the early/yester period sales promotional expenses, but also on the sales of previous years.

Illustration 8:

The following expenses were extracted from the books of M/s Sudhir & Sons. to prepare the sales overhead budget for the year 1996.

Rs. Advertisement on Radio: 2,000 Television 12,000 Salary to Sales Administrative Staff 20,000 Sales force 15,000 Expenses of the sales department Rent of the building 5,000 Carriage outward 5% on sales Commission at sales 2% AgentsÊ commission 6.5 %

The sales during the period were estimated as follows:

Rs.80,000 including Agents Sales Rs.8,000

Rs.1,00,000 including Agents Sales Rs. 10,500

Solution:

The most important step is to find out the variable portion of the sales overhead of M/s Sudhir & Sons.

The calculation of salesmenÊs commission is on the basis of the sales volume generated by the sales force. The total sales volume consists of two different parts viz. sales contributed by the sales force and another one is contribution of the agents. To find out the sales volume of the salesmen, the portion of the agentsÊ sales volume should be deducted from the total sales volume.

Sales ForceÊs/MenÊs Volume = Total Sales Volume – AgentÊs Sales Volume

Similarly, the agentsÊ sales volume can be computed:

From the previous step, the amount of commission is to be computed from the volume of sales.

Carriage outward should be computed on the volume of sales.


Notes


Sales overhead budget for the year 1996

Estimated Sales Rs.80,000 Level

Rs.1,00,000 Level

Fixed Overhead Advertisement on Radio

2,000 2,000

Advertisement on TV 12,000 12,000 Salary to Sales Admin. Staff 20,000 20,000 Salary to Sales force 15,000 15,000 Expenses of the sales dept- Rent 5,000 5,000 Total Sales Fixed Overhead (A) 54,000 54,000 Variable Overhead Salesmen’s commission 2%

1,440

10,290

Agents’ commission 6.5% 520 682.5 Carriage outward 5% 4,000 5,000 Total Variable Overhead (B) 5,960 5682.5 Total Sales overhead (A+B) 59,960 59682.5

Cash Budget Cash budget is nothing but an estimation of cash receipts and cash payments for specified period. It is prepared by the head of the accounts department i.e. the chief accounts officer.

The utility of the cash budget is:

To meet the revenue and capital expenditures with adequate funds.

It should highlight the additional requirement cash whenever the need arises.

Keeping of excessive funds available in the business firm wonÊt fetch any return to the enterprise but this estimate of future cash needs and resources will guide the firm to plan for an effective investment out of the surplus funds estimated; enhances the wealth of the investors through proper investment planning out of the future funds available.

Cash budget can be prepared in three different ways:

1. Receipts and payments method

2. Adjusted profit and loss account

3. Balance Sheet Method

Cash receipts can be classified into various categories:

Cash Receipt

Sale Debtors Bills receivable Dividends Sale of Investments

Other Incomes

Budgeting

Notes


Cash payments are as follows:

Illustration 9:

From the following information, prepare a cash budget for the months of June and July:

Month Credit sales Rs.

Credit purchase Rs.

Manufacturing overheads Rs.

Selling overheads Rs.

April 80,000 60,000 2,000 3,000 May 84,000 64,000 2,400 2,800 June 90,000 66,000 2,600 2,800 July 84,000 64,000 2,000 2,600

Additional Information:

1. Advance tax of Rs. 4,000 payable in June and in December 1994

2. Credit period allowed to debtors is two months

3. Credit period allowed by the vendors or suppliers – one month

4. Delay in the payment of other expenses one month

5. Opening balance of cash on 1st June is estimated as Rs.20,000

Solution:

The first step in the preparation of a cash budget is to open the statement with the opening cash balance available.

Secondly, if any cash receipts are available they should be added one after another. In this problem, sales can be bifurcated into two classifications, the first one is cash sales. If the cash sales are given, the amount of cash receipt due to cash sales should have to be immediately brought under the respective period i.e. during the same month or week.

The next is the credit sales of the firm. The volume of sales should be affected only at the amount of realization of sales or collection of credit sales from the consumers and customers. If the cash sales are not given, and the credit sales are the only component given that should be added in the list of cash receipts, by registering the credit period involved for the customers and consumers. Being credit sales, the amount of sales realization should only relevantly be considered during the specified period.

The first step is to list out the various items of cash expenses expected to incur during the specified period. The text of the problem deals with the delay of making the payment of expenses is one month in all cases. It means the expenses like manufacturing overheads, selling overheads are expected to be paid one month later. It means that the expenses due in May are paid only in the month of June and during the month of June, monthly expenses are met.

Cash payments

Purchase of Assets Materials bought Salary paid

Rent paid Other payments


Notes


The purchases require the same kind of treatment in the case of sales. Normally, the purchases are classified into two divisions, cash purchases and credit purchases.

The cash purchases should be given effect only at the moment the cash payment is paid on the volume of purchase, but if the credit purchases are made by the firm, the credit allowed by the vendor/supplier to make the payments should be relatively considered for the expected outflow of cash i.e. payment of purchase one month later or two months later.

The expected time period occurrence of either cash receipt or cash payment should be considered for the preparation of the cash budget.

The cash budget should be prepared separately in the statement to derive the closing balance of the specified year/month. The closing balance of the yester period or previous period has to be carried forward to the next period as opening balance of the preparation of a budget. The closing balance of the month of June will be the opening balance of the month of July. Once the statement has been completed, the preparation of budget of respective periods should be consolidated for the specified periods.

Cash Budget for the months of June and July 1998

Particulars June Rs. July Rs. Opening balance 20,000 26,800 Receipts: Sales

80,000 84,000

Total Cash Receipts I 1,00,000 1,10,800 Payments: Purchases 64,000 66,000 Manufacturing Overheads 2,400 2,600 Selling Overheads 2,800 2,800 Tax payable 4,000 ……….. Total Payments II 73,200 71,400 Balance I-II 26,800 39,400

Illustration 10:

From the estimates of income and expenditure, prepare cash budget for the months from April to June.

Month Sales

Rs. Purchases

Rs. Wages

Rs. Office Exe

Rs. Selling Exp

Rs. Feb 1,20,000 80,000 8,000 5,000 3,600 Mar 1,24,000 76,000 8,400 5,600 4,000 Apr 1,30,000 78,000 8,800 5,400 4,400 May 1,22,000 72,000 9,000 5,600 4,200 June 1,20,000 76,000 9,000 5,200 3,800

(i) Plant worth Rs.20,000 purchased in June 25% payable immediately and the remaining in two equal installments in the subsequent months.

(ii) Advance payment of tax payable in Jan and April Rs 6,000

(iii) Period of credit allowed:

(a) By suppliers 2 months

(b) To customers 1 month

(iv) Dividend payable Rs.10,000 in the month of June

(v) Delay in payment of wages and office expenses 1 month and selling expenses ½ month. Expected cash balance on 1st April is Rs.40,000.

Budgeting

Notes


Solution:

(a) Plant worth Rs. 20,000 purchased, payable immediately is 25% i.e. Rs.5,000 should be paid in the month of June. The remaining cost of the machine has to be paid in the subsequent months, after June. Whatever payments are expected to be made after June are not relevant as far as preparation of the budget is concerned.

(b) Delay in the payment of wages and office expenses is only one month. It means wages and office expenses of the month of February are paid in the next month i.e. March.

Selling expenses: From the above boxes, it is obviously understood that during the months of April, May and June, the following will be stream of payment of selling expenses.

April = Rs.2,000 of Mar (Previous Month) and Rs.2,200 of April (Current month)= Rs.4,200

May = Rs.2,200 of April (Previous Month) and Rs.2,100 of May (Current month)=Rs.4,300

June = Rs.2,100 of May (Previous Month) and Rs.1,900 of June (Current month)=Rs.4,000

(c) Selling expenses have a delay of ½ month, which means 50% of the selling expenses are paid only in the current month and the remaining 50% are paid in the next month.

Particulars Feb Mar April May June Selling Expenses 3,600 4,000 4,400 4,200 3,800 Payment 50% in the current month 1,800 2,000 2,200 2,100 1,900 Delay 50% will be paid in the subsequent month

1,800 2,000 2,200 2,100 1,900

Every month 50% of the selling expenses of the current month and 50% of the previous month selling expenses are paid together; the above boxes depict the payment of 50% of the current selling expenses along with 50% expenses of previous month.

Cash Budget for the periods (April and June)

Particulars April Rs.

May Rs.

June Rs.

Opening Cash Balance 40,000 59,800 95,300 Cash Receipts Sales

1,24,000

1,30,000

1,22,000

Total Receipts (A) 1,64,000 1,89,800 2,17,300 Payments Plant Purchased

………..

………..

5,000

Tax payable 6,000 ……….. ……….. Purchases 80,000 76,000 78,000 Dividend payable ……….. ……….. 10,000 Wages 8,400 8,800 9,000 Office expenses 5,600 5,400 5,600 Selling expenses 4,200 4,300 4,000 Total Payments (B) 1,04,200 94,500 1,11,600 Balance (A-B) 59,800 95,300 1,05,700


Notes


Factory Overheads Budget Factory overheads budget is an estimate of the factory overheads expected to incur during the budget period. The expenses taken into consideration for the preparation of the budget are classified into three categories viz. fixed, semi-variable and variable.

Fixed expenses are forecasted on the basis of yesteryear figures but the variable expenses should be estimated on the basis of the output desired to manufacture during the period. The variable and semi-variable expenses are to be estimated on the basis of indirect materials, indirect labour and indirect expenses required to manufacture the targeted output.

Administrative Expenses Budget The budget is an estimate of the office and administrative expenses expected to incur during the specified period. This budget normally has greater volume of fixed expenses rather than variable expenses. The share of variable expenses is minimum when compared with fixed expenses.

The fixed expenses are salary to the office people & manager, rent of the office, insurance and so on.

The variable and semi-variable expenses are telephone charges, postage & telegram charges and so on; these expenses are incurred with the volume of the transactions of the office administration.

Fixed Budget

It is a budget known as constant budget. It never registers the changes in the preparation of a budget, being prepared irrespective of the level of output or production. This budget is mainly meant for the fixed overheads of the firm which are constant in volume irrespective of the level of production. The ultimate utility of the budget is to control the cost as a cost controlling measure, but the fixed budget is meaningless when compared to the actual performance.

Flexible Budget Flexible budget is prepared for any level of production as an estimate of statement of all expenses which are classified into three categories viz. variable, semi –variable and fixed expenses. The structure of the budget for any output is only to the tune of the actual performance achieved. This budget facilitates not only a comparison between various levels of production but also identifies the level of lowest production cost.

Utilities of the flexible budget:

This budget is the most useful tool of analysis in studying the sales when the circumstances do not warrant a prediction.

It is mostly suited to seasonal business, where the sales volume differs from one period to another due to changes that have taken place in the taste and preferences of the buyers.

The production is being done on the basis of demand of the products in the market. The demand of the products is studied only through demand forecasting. The flexible budget is more applicable in the case of products, in which it is difficult to forecast the demand.

The budget is prepared only during the time of acute shortage of resources of production viz. men, material and so on.

Budgeting

Notes


Illustration 11:

Draft a flexible budget for overhead expenses on the basis of following information and determine the overhead rates at 70%, 80% and 90% plant capacity.

Particulars 70% capacity 80% capacity Rs. 90% capacity

Variable Overheads Indirect Labour

-----------------

24,000

----------------

Stores including spares ----------------- 8,000 ---------------- Semi-variable overheads Power( 30% fixed ,70%)

----------------- 40,000 ----------------

Repairs and maintenance 80% fixed and 20% variable

----------------- 4,000 ----------------

Fixed Overheads Depreciation

----------------- 22,000 -----------------

Insurance ----------------- 6,000 ----------------- Salaries ----------------- 20,000 ----------------- Total overheads ----------------- 1,24,000 -----------------

Flexible budget for the period

Particulars 70% capacity 80% capacity 90% capacity Variable overheads Indirect labour

21,000

24,000

27,000

Stores including spares 7,000 8,000 9,000

8,000

8,000

8,000 Semi-Variable Expenses - Power* Fixed 30% Variable 70% 28,000 32,000 36,000

3,200

3,200

3,200

Repairs and maintenance Fixed 80% Variable 20% 700 800 900 Fixed Overheads Depreciation

22,000

22,000

22,000

Insurance 6,000 6,000 6,000 Salaries 20,000 20,000 20,000 Total Overheads 1,15,900 1,24,000 1,32,100

Illustration 12:

The expenses for budgeted production of 10,000 units in a factory are furnished below:

Particulars Per unit

Material 70 Labour 25 Variable overheads 20 Fixed overheads (1,00,000) 10 Variable expenses (Direct) 5 Selling expenses (10% fixed) 13 Distribution expenses(20% fixed) 7 Administration expenses(Rs.50,000) 5 Total cost per unit 155


Notes


Prepare a budget for production of:

(i) 8,000 units

(ii) 60,000 units

(iii) Calculate the cost per unit at both levels

Assume that administration expenses are fixed for all level of production.

(B.Com, Bharathidasan, April 1984)

Solution:

The first important step is to compute the total cost at the level of 10,000 units by way of adding the total variable cost and fixed cost.

What is the total variable cost of the production at the level of 10,000 units?

The variable cost of any level of production should be computed through an addition of two different components viz. variable cost of variable portion and the semi–variable cost.

The fixed cost of any level of production could be calculated by way of adding the fixed cost component as well as fixed portion of the semi-variable cost.

After finding the variable and fixed cost of every activity, as well as fixed and variable portion of every activity, should be added separately under the name of every activity together to identify the total value of the budgeted cost of overall expenses at any level of the production.

In this problem, the cent per cent variable and fixed costs of the level of production are to be initially considered under the name of separate heads. The variable cost at the level of 10,000 units to be calculated by way of multiplying the 10,000 units with the variable cost per unit of materials, labour, overheads and direct variable expenses.

For example, material cost at the level of 10,000 units is as follows:

Material Cost = Material cost per unit x Number of Units

= Rs. 70 x 10,000 units = Rs. 7,00,000

Likewise, the variable cost of other categories are to be found out and grouped under the head of cent percent of variable cost of the activity.

The fixed overheads given in this problem are fixed in volume, irrespective of the various levels of productions.

For example, the fixed overheads and administration overheads are amounted to Rs. 1,00,000 and Rs. 50,000 respectively; remain constant in volume irrespective of the level of production.

The second segment is the semi–variable cost, which comprises two different portions viz. variable and fixed. For example, selling expenses are 10 % fixed on Rs. 13 per unit, at the level of 10,000 units of production.

Out of total volume of selling expenses, the variable portion is 90% of the cost per unit which varies along with the volume of production and the remaining 10% on the cost per unit remains fixed at all levels of output.

Fixed cost = 10% on cost per unit = 10% on Rs.13= Rs.1.3 is the cost per unit to be multiplied with the total number of units i.e. 10,000, to find out the fixed cost volume.

The fixed cost volume is Rs. 13,000 which remains fixed/constant irrespective of the volume, means not only fixed cost for 10,000 units but also 8,000 units and 6,000 units.

The variable cost 90% on Rs. 13 is the cost per unit, to be multiplied with the number of units i.e. 10,000 units 8,000 units and 6,000 units.

Budgeting

Notes


The variable cost at 10,000 units = Rs.11.7 per unit x 10,000 units = Rs. 1,17,000

The variable cost at 8,000 units = Rs.11.7 per unit x 8,000 units = Rs. 93,600.

Flexible Budget

10,000 units 8,000 units 6,000 units Per Unit

Rs. Amount

Rs. Per Unit

Rs. Amount

Rs. Per Unit

Rs. Amount

Rs. Production Expenses:

Material

70.00 7,00,000 70.00 5,60,000 70.00 4,20,000

Labour 25 2,50,000 25.00 2,00,000 25.00 1,50,000

Overheads 20 2,00,000 20.00 1,60,000 20.00 1,20,000

Direct Variable expenses

5 50,000 5 40,000 5 30,000

Fixed Overheads Rs.1,00,000

10 1,00,000 12.5 1,00,000 16.667 1,00,000

Selling Expenses

Fixed

1.3

13,000 1.625 13,000 2.167 13,000

Variable 11.7 1,17,000 11.7 93,600 11.7 70,200

Distribution Expenses

Fixed

1.4

14,000 1.75 14,000 2.334 14,000

Variable 5.6 56,000 5.6 5.6 30,600

Administration Expenses 5.0 50,000 6.25 50,000 8.333 50,000

Total Cost 155.00 15,50,000 159.425 12,75,400 166.801 10,00,800

Illustration 13:

From the following information relating to 1963 and conditions expected to prevail in 1964, prepare a budget for 1964:

State the assumption you have made, 1963 actual

Sales 1,00,000 (40,000 units)

Raw materials 53,000

Wages 11,000

Variable overheads 16,000

Fixed overheads 10,000

1964 prospects

Sales 1,50,000(60,000 units)

Raw Materials 5 per cent price increase

Wages 10 per cent increase in wage rates

5 percent increase in productivity Additional plant One lathe Rs.25,000

One drill Rs. 12,000

(I.C.W.A, Inter)

Solution:

The most important step is the computation of the variable costs which have been proportionally adjusted in the lights of two different dimensions viz. percentage


Notes


change in the level of production i.e. either increase or decrease in production and expected level of changes in the cost.

With reference to this problem, the budgeted profit is being computed as follows:

Budgeted Profit = Budgeted Sales Volume – Budgeted Cost

Budgeted sales volume is the sales volume expected to generate at certain level of sales in units.

Budgeted cost is the volume of cost expected or anticipated to incur at the certain/specified level of output.

Raw materials cost during the year 1964 is expected to rise by 5% in price from the year 1963. It means that the price quantum rise expected to be on the price of the raw materials Rs.53,000.

Raw materials cost of the year 1964.

= Raw materials cost of the year 1963 + 5% increase on the price of raw materials

= 53,000 + 2,650

= Rs.55,650

The 5% increase amounted Rs.55,650 is only for 40,000 units but 60,000 units are expected to have during the year 1964. To be more specific, what should be the volume of 5% increase on the price recorded for 60,000 units ?

For 60,000 units = Rs. 55,650

60, 000 = Rs. 83, 47540, 000

Cost of the wages should be similarly calculated for the level of 60,000 units.

The wages during the year 1963 are given as Rs.11,000 considered as a base for the computation of the volume of wages expected to be prevalent during the year 1964.

= Wages of the year 1963 + 10% increase on the wages of the labour

= 11,000 + 1,100

= Rs. 12,100

The above found volume of wages is the expected volume of wages during the year 1964 for the volume of production 40,000 units.

The next step is to find out the wage rate per unit at the level of 40,000 units.

Rs. 12,100= = Re. 0.3025

40, 000

In order to register the productivity increase amounting to 5% during the same period horizon, the following adjustment has to be incorporated to affect the productivity in terms of the cost of labour per unit. The ultimate aim of the step is to identify the productivity of the labour, which means the effectiveness of the labour, through the cost per unit of the labour.

105 units are expected to produce during the same period at the cost per unit of the labour Rs. 3025. What would be the cost of the labour per unit for 100 numbers of units of normal capacity.

0.3025 x 100= = Re. 0.2881

105

Budgeting

Notes


Rs. 2881 is cost per unit of the labour registered. The productivity of 5% increase during the same period should be used to identify the value of wages expected to be incurred. Also, this should be the volume of wages at the level of 60,000 units.

= Re. 0.2881 x 60,000 units= Rs.17,286

The next step in the text of the problem is to determine the volume of the variable overheads for the level of 60,000 units. The variable overheads at the level of 60,000 units will be computed on the basis of the variable overheads of the firm incurred during the year 1963 at level of production amounted Rs.16,000.

For 60,000 units 16,000

= ×x 60,000 = Rs.24,00040,000

The most important step is to calculate the fixed overheads of the firm. While determining the fixed overheads for the year 1964, two points are to be considered, as follows:

The existing volume of the fixed overheads should have to be considered as a base for the computation of the fixed overheads of the year 1964. The volume of fixed overheads should be retained as the volume from the year 1963 as one of the components of fixed overheads for the year 1964.

The aim of retaining the yester year fixed overhead is the volume which remains the same irrespective of the level of production, which is posed to be included as one of the components of the fixed overhead of the forthcoming year.

If any changes on the assetsÊ structure occurred during the year, the same will directly have an impact on the volume of depreciation. The volume of depreciation is considered to be a fixed charge as a component of the fixed overhead computation for the year 1964. The most important point to be presumed is that the depreciation charge on the new arrival of assets are calculated only through straight line method. The straight line method is the only method that charges the depreciation as a fixed charge on the book value of the asset on every year, irrespective of the opening balance of the asset.

The fixed overhead of Rs. 10,000 during the year 1963 will be taken for consideration as one of the components of fixed overhead for the year 1964. In addition to the existing volume of fixed overhead, the depreciation charge through straight line has to be calculated and added with the existing fixed volume of overheads.

The expected volume of depreciation due to new arrivals during the year 1964 amounted to 10% on the original value of the assets. During the year 1964, the firm is expected to procure the following assets viz. lathe and drill machines whose costs are as follows: Rs. 25,000 and Rs. 12,000 respectively.

= 10% on Rs. 25,000 and Rs. 12,000 = Rs. 3,700

The latter amount of depreciation should be added with the existing volume of fixed overheads Rs.10,000

The total volume of fixed overheads= Rs. 13,700(Rs.10,000 + Rs.3,700)

Budget for the year 1964 Rs. Rs.Sales for 60,000 units @ Rs.2.50 1,50,000

Less: Cost production Raw Materials 83,475 Wages 17,286 Variable overhead 24,000 Fixed Overheads 13,700

1,38,461Estimated Profit 11,539


Notes


Master Budget Master Budget: Immediately after the completion of functional or departmental level budgets, the major responsibility of the budget officer is to consolidate the various budgets together, which is a detailed report of all operations of the firm for a definite period.

Zero-base Budgeting The most frequent budgeting approach to the planning, resource allocation, and control of unstructured processes can best be described as incremental, budgeting. It establishes expectations by adjusting the last periodÊs allocations and expenditures in light of coming events. It is expedient, inexpensive, and frustration minimizing, and it is assumed to be a sufficiently accurate method. This is not to say that incremental budgets rely on intuition or judgment alone; ratios such as sales dollars to sales support personnel or dollars, or administrative cost to the number of transactions, may be used in the adjustment of last yearÊs budget. However, incremental budgets rely on the last period as the frame of reference, rather than on overall analysis and synthesis. Incremental budgeting does not investigate the base amount, only the increments to it.

Zero-base budgeting is an attempt to overcome the limitations of the incremental approach. Since incremental budgeting looks at only a small fraction of the total budget, it may leave many significant questions unanswered, such as: how efficient and effective are the activities that were not evaluated? Or, should current operations be reduced or reallocated to fund new or higher priority items? The zero-base approach reviews, evaluates, and allocates all resources by asking two basic questions: where and how can money be spent most effectively; and how much should be spent?

How Does Zero-base Budgeting Work?

One approach to zero-base budgeting originated at Texas Instruments Ltd., and is now being promoted commercially by its developer, Peter Pyhrr (1973). This approach requires an organization to analyze all appropriation requests in detail, for current activities. It is a two-step process. The first step is to prepare „decision packages‰ for each activity or operation, and the second is to rank these decision packages in order of their importance.

A decision package is a document that identifies a discrete activity, function, or operation in a definitive manner so that management can evaluate and rank it against other activities and decide whether to approve or reject it (Pyhrr, 1973, p. 6). A key to the zero-base approach is the mandatory identification and evaluation of alternatives to each activity, and the development of a package for each alternative. In general, two types of alternatives are considered: (1) different ways of performing the same function or activity, such as centralizing or decentralizing an operation, employing one among others of technologies, or purchasing an activity outside versus performing it in house; and (2) different levels of effort for each activity. In this way managers can identify alternative actions at one level of expenditure and can also consider the benefits and drawbacks of additional levels of spending. Decision packages thus allow senior management to eliminate, reduce, or increase the level of spending for each activity and so reduce or shift funds.

Decision packages are usually described on a standard form which asks for following information:

1. The name or title of the package.

2. The problem or service to which the package relates.

Budgeting

Notes


3. The actions to be taken.

4. The benefits received if it is accepted.

5. The consequences if it is not accepted.

6. Quantitative measures of performance, such as cost/effectiveness ratios.

7. The resources required to implement the package.

8. A cross-reference to other related packages; e.g., those reflecting different levels of effort or alternative ways of performing the same function.

9. Detailed costing information.

10. Any special analysis or additional explanation needed.

The generation and evaluation of alternatives for an activity have several advantages. For example, in times of limited resources, complete elimination of some functions may be the only possible decision if only one alternative is considered. But elimination may not be desirable or practical. Senior management may prefer to reduce the current level of effort instead of eliminating an entire function, and zero-base budgeting makes this option clear. Because the managers who develop decision packages are those who are best equipped to identify and evaluate different levels of effort, it should be their responsibility to advise senior management of these possibilities.

Developing Decision Packages: Three considerations that determine the organizational level at which decision packages should be developed are the availability of alternatives, the level at which meaningful decisions can be made, and the time constraints on the analysis.

Generally, decision packages are developed for discrete activities. Managers might logically begin by describing the current yearÊs activities and operations. They can identify the current level of each activity and the methods by which it is being carried out. After they have broken their current operations down into activities, the managers can then start looking at the requirements for the coming year. It is extremely helpful, of course, if senior management issues a formal set of planning assumptions to aid each manager in determining his or her future requirements.

The preparation of decision packages usually begins with the generation of alternatives to business-as-usual activities and levels of effort. The manager may also consider new activities or programs. He or she then groups these proposed activities into one of three categories of decision packages: (1) different ways and/or different levels of effort for performing a current activity; (2) business-as-usual activities where there are no logical alternatives to the present method and level of effort; and (3) new activities and programmes. Then the ranking process can begin.

Ranking Packages: Management decides how much should be spent and where it should be spent by ranking all decision packages in order of decreasing benefit. It can then evaluate each cutoff level of expenditure and can study the consequences of not approving additional packages ranked below the expenditure level. Initial rankings should occur at the organizational level at which the packages are developed, so that each manager can evaluate the importance of his or her own activities. The manager at the next level up then reviews the rankings and uses them as guides to produce a single consolidated ranking for all packages presented to him or her. In this way, theoretically all packages for an entire company could be ranked. But while this single list would completely identify priorities, ranking such a large volume of packages would impose a ponderous, if not impossible, burden on top management. Terminating the ranking at the level that generated the decision packages is also unsatisfactory, because relevant trade-offs will not be identified for top management. At what level decision packages ought to be ranked depend, therefore, on a number


Notes


of factors, including: (1) the number of packages to be ranked and the time and effort required to do so; (2) managementÊs ability and willingness to rank unfamiliar activities; (3) natural groupings that provide a logical sphere of analysis, such as product or profit centres; and (4) the need for extensive review across organizational boundaries to determine trade-offs and expense levels.

Benefits of Zero-base Budgeting Proponents of zero-base budgeting suggest that it will produce several benefits. It spotlights redundancy and duplication of efforts; it focuses on programmes and expectations rather than on percentage increases or decreases from previous yearsÊ activities; it establishes priorities within and among responsibility units and allows comparisons to be made across organizational lines so that overall priorities can be established; and it aids performance evaluation by providing a data base which shows whether or not each activity or operation has yielded the benefits and used the costs expected.

If zero-base budgeting is used, changes in expenditure levels do not require a recycling of inputs when the budget is revised. The ranked list of decision packages already identifies those activities or programmes to be added or deleted if there are changes in expenditure levels. The list of ranked decision packages can also be used during the operating year to identify activities to be reduced or expanded if expenditure levels change suddenly or if actual costs vary from expectation.

Implementation of the Procedure Should zero-base budgeting be carried out for all activities every year? Arguments against yearly repetition point out that the benefits of evaluating all activities are usually completely realized in the first year, and that little benefit will result in subsequent years because the same packages will be proposed. Programmes do not change enough to warrant yearly reviews. And even if they did, the budget process is not the only way programs are reviewed. Hence, it can be argued that the extra effort required to practice zero-base as opposed to incremental budgeting is not worth repeating yearly.

The originator of the Texas Instruments zero-base budgeting method argues that if an organization uses an annual budget, the following two criteria should be met before annual zero-base budgeting is discontinued. First, management must be satisfied that operations are effective and efficient; second, the work environment must be reasonably stable, with no major changes in work loads, problems, needs, and so on (Pyhrr, 1973, p. 138). If these conditions are met, zero-base budgeting need be carried out only every third or fourth year.

Decision packages from earlier years can be reviewed temporarily, with changes on an exception basis and with an allowance for built-in cost increases such as wages and salaries. Decision packages can be developed for new activities, and zero-base budgeting can be applied to departments with special problems or changes. Management can then establish priorities and funding levels after reviewing the prior yearÊs packages and rankings (with appropriate modifications) and considering the newly developed packages. This procedure allows new programmes to be funded by reductions in current activities, since it is possible to evaluate new packages against last yearÊs expenditures and rankings. Thus management is continually reviewing all its resources and allocations, and not merely considering requested increases.

Budgeting

Notes


Behavioural aspects of Budgeting In sum, the proponents of zero-base budgeting believe it is a practical way to describe expenditures, integrate planning and budgeting, identify relevant trade-offs, redirect effort and funds from lower priority to higher priority programmes, and improve the overall efficiency and effectiveness of an organization.

Behavioural Budgeting A comprehensive budget usually involves all segments of a business. As a result, representatives from each unit are typically included throughout the process. The process is likely to be spearheaded by a budget committee consisting of senior level personnel. Such individuals bring valuable insights about all aspects of sales, production, and other phases of operations. Not only are these individuals ideally positioned to provide the best possible information relative to their respective units, they also need to be present to effectively advocate for the opportunities and resource needs within their unit.

Budget process with general budget guidelines, but it is the lower-level units that drive the development of budgets for their units. These individual budgets are then grouped and regrouped to form a divisional budget with mid-level executives adding their input along the way. Eventually top management and the budget committee will receive the overall plan. As you might suspect, the budget committee must then review the budget components for consistency and coordination. This may require several iterations of passing the budget back down the ladder for revision by lower units. Ultimately, a final budget is reached.

Behavioural budgeting is concerned with testing the effects of human psychological behaviour on budgeting, control, financial reporting, and decision-making in organisations. For example, a budget (and hence control and performance evaluation systems) has behavioural implications on everyone in an organisation: those who participate in preparing it, those who use it to assist in the decision-making process, and those who are evaluated using the budget. In addition, the quality of corporate financial reporting, particularly the quality of publicly reported earnings numbers, is influenced by the behaviour of managers who intentionally try to manipulate earnings for their own benefits, and in order to influences investorsÊ psychological behaviours, which can also be affected by analystsÊ self-interests. AuditorÊs independence can also be weakened by auditorsÊ self-interests and over-confidence, and so as managers. System enabling key employees in a department to provide input into the budgetary process. Thus the accountant receives useful budgeting information from those affected by the budget. Participative budgeting is a good motivational tool because the people participating may work harder to accomplish the budgeting goals, cooperation is facilitated, and more realistic budgeting figures are obtained.

The participative budget approach is viewed as self-imposed. As a result, it is argued that it improves employee morale and job satisfaction. It fosters the "team-based" management philosophy that has proven to be very effective for modern organizations. Furthermore, the budget is prepared by those who have the best knowledge of their own specific areas of operation. This should allow for a more accurate budget; in any event, it certainly removes one of the primary excuses that is used to explain why a particular budget was not met!

On the negative side of the equation, a bottom-up approach is generally more time consuming and expensive to develop and administer. This occurs because of the iterative process needed for its development and coordination. Another potential shortcoming has to do with the fact that some managers may try to "pad" their


Notes


budget, giving them more room for mistakes and inefficiency. More will be said about this problem shortly, but it is particularly problematic with a highly participative approach.

Impact of Behavioural Budgeting on Business

A. Participative budgeting empowers: Participative budgeting involves employee participation in the budget-preparation process at various levels of the organizational hierarchy. Although final decision-making responsibility remains at the top of an organization, the inclusion of more employees (and their input) increases the sense of ownership over the budget document and the motivation to meet it. Too much participation, though, can delay the process and raise costs.

B. Tendency to pad: When budget information comes from many employees, upper management should be aware of the tendency to "pad the budget." For example if asked to submit a sales budget, the sales manager may give a lower figure than he or she really expects. This "padding" is done so if sales come in higher than the given number, the sales force will look especially productive. Underestimating sales and overestimating expenses are examples of padding, and the difference between the padded amount and the realistic amount is called budgetary slack.

C. Decreasing uncertainty reduces padding: To avoid padding, upper management should educate employees to the fact that budgets will not be used for "witch hunts" when figures are not met. Decreasing employee uncertainty over how budgets will be used decreases the tendency to build in a buffer or pad. Also, employees should be rewarded for accurate budgets, not just meeting the budgets, for predicting sale too low may result in high-cost production to meet the "surprise" increase in orders.

D. Participative budgeting can create ethical conflicts: Participative budgeting can give rise to ethical considerations, especially when padding has been built in and a manager receives a bonus for "beating the budget."

Long before the papers on participative budgeting to be discussed later were written researchers started concentrating on the influence budgetary systems have on behaviour and action. In his book, Hopwood (1974) emphasises the need to see the process of standard setting and budgeting in its entirety and respond to it as a complex human and technical problem rather than one standing in technical isolation. "Budgets are used to motivate members of the organisation by serving as targets and mechanisms for gaining involvement and commitment" (Hopwood 1974, p. 44). Hopwood (1974) realises that budgeting is concerned with human action and the significance of its behavioural, political and social dimensions. He went on to express his amazement at the dominance of a purely technical approach and called for a merger of both technical and behavioural aspects.

In 1955, Argyris looked at the problems organisations faced when introducing participative management by drawing on prior research for a concept of organisation and human personality. In Argyris� (1955) invented scenario, employees were dependent on a leader. This lead him to question how much participation and democracy this allowed criticising that previous studies had failed to address that question. He concluded that participative management implied a different set of organisational principles and that executive training should thus focus on understanding the effects of basic dependency relationship on employees and how it conflicts with their normal personality needs. This dependency could be reduced by the introduction of participative management.

Budgeting

Notes


Summary Budgeting is the process of stating, in quantitative terms, planned organisational activities for a given period of time. On functional basis, budget is classified as : production budget, material budget, labour budget, manufacturing overhead budget, selling overhead budget, and cash budget. On the basis of flexibility, budget is classified as fixed budget and flexible budget. On the basis of time, budget is classified as long-term budget, medium-term budget and short-term budget.

Keywords Budget: A statement of planned allocation of resources expressed in financial or numerical terms.

Budgetary Control: It is the establishment of budgets relating to the responsibilities of executives to the requirements of a policy and the continuous comparison of actual with budgeted results, either to secure by individual action, the objective of that policy or to provide a basis for its revision.

Production Budget: It is a forecast of the production for the budget period. It may be expressed in units or standard hours.

Zero-based Budgeting: The system of budgeting that requires managers to justify their entire budget request rather than simply to refer to budget amounts established in previous years.

Sales Budget: A forecast of total sales expressed in terms of money and quantity.

Materials Budget: It shows the detail of raw materials to be consumed in the process of production.

Labour Budget: It shows the details of labour requirements in quantity, with estimated costs.

Manufacturing Overhead Budget: It shows the estimated costs of indirect materials, indirect labour and indirect manufacturing expenses during the budget period.

Fixed Budget: A budget designed to remain unchanged irrespective of the level of activity actually attained.

Flexible Budget: A budget designed to change in accordance with level of activity actually attained.

Review Questions 1. Define budget.

2. Define budgetary control.

3. Highlight the various types of budgets.

4. Elucidate the process of production budget.

5. Illustrate the methodology of purchase budget.

6. Draw the process of preparing the cash budget.


Notes






Unit 5

Variance Analysis and Reporting

Unit 6

Modern Control Methods

SECTION-III


Notes


Unit 5 Variance Analysis and Reporting

Unit Structure • Introduction • Variance Analysis • Material Cost Variance (MCV) • Material Price Variance • Overhead Variance • Sales Variance • Reporting • The Budget • Summary • Keywords • Review Questions • Further Readings

Learning Objectives At the conclusion of this unit you should be able to: • Appreciate the role of variance analysis and reporting in management control system. • Describe the tools of performance analysis and measurement and its impact on

management compensation

Introduction The purpose of variance analysis is to identify problems early so that prompt corrective action can be taken to minimize cost and schedule impacts, cost overruns, and schedule delays to the project. Variance analysis quantifies the deviations from the timed-phased budget based on the work accomplished and cost data collected. Variance within earned value management can be described by two metrics: Cost Variance and Schedule Variance. Other project performance measurements can be obtained from these two expressions.

Variances can be calculated for individual Cost Accounts and summarized at higher WBS and organizational levels including the total project.

Variance Analysis Meaning: The term „variance‰ means deviation, difference and so on. Variance in accordance with standard costing is meant as the difference/deviation in between two different costs viz. standard cost and actual cost. ICWA, London defines variance as „deviation in between the standard cost and comparable actual cost incurred during the period.‰


Notes


The variance of the specific element of cost should be periodically checked. Variance is classified into two categories.

Variance

Favourable VarianceStandard Cost> Actual Cost

Unfavourable/ Adverse VarianceActual Cost > Standard Cost

Planned costs are greater than the incurred actual cost during the period

Planned costs are less than the actual costs incurred during the period

Actual cost is well within the anticipated cost – cost effectiveness

Actual cost incurred is more than the anticipated cost – ineffective cost control

The variance can be classified into two categories, based on controllability viz. controllable and uncontrollable variance.

Controllable variance The difference between standard

cost and actual cost can be controlled-Excessive use of raw

materials By foreman

Uncontrollable variance The difference in between standard cost and actual

cost cannot be controlled - Price Increase

Increased Demand

Defective supply of raw materials

Wrong ascertainment of cost

Responsibility of Purchase Department

Responsibility of Cost Accounting Dept

Decreased Supply

No one is specifically responsible for price increase

Variance

Objective: The purpose of standard costing is to correct the variance, which is in between standard cost and actual cost.

Types of Variances There are two types of variances viz. cost variance and revenue variance.

Cost Variance: Cost variance can be further classified into three categories:

(a) Material Cost Variance

(b) Labour Cost Variance

(c) Overhead Variance


Notes


Revenue Variance

(a) Sales Variance

From the above classified types, let us discuss every variance in detail in the remaining.

Material Cost Variance (MCV) The name of the variance is self explanatory, denoting the difference between the standard cost of materials and actual cost of materials. The material cost variance is between the standard material cost for actual production in units and actual cost.

Reasons for Cost Variance The total cost is usually determined by two different factors of influence viz. quantity of materials utilized/ required and price of the materials. The fluctuations in the material cost are only due to the fluctuations in the utility of materials due to many factors.

This material cost variance, which is due to either change in the price of the materials or change in the consumption of materials.

Material cost variance can be computed into two different ways:

• Direct Method

• Indirect Method

Direct Method: It is a method that simply studies the deviation between the two different costs of materials without giving any emphasis on other factors of influence viz. the quantity of materials and their price. Under the direct method, the comparison is between the standard cost of materials, which is the planned cost of materials before commencement, scientifically developed by considering the all other factors of influence and the actual cost of materials, which is actually incurred during the production.

Why is the standard cost to be tuned to the level of actual cost?

The main aim of computing the standard cost for actual output is that the standard cost developed is not to the tune of actual production in units. Instead, it is available in terms of per unit of a product/for overall production, say, for a year. To have leveled comparison between the standard costs, they have to be designed to the tune of actual cost.

Material cost variance = Standard cost of materials for actual output – Actual cost of raw materials

= (S Q AO × SP) – (AQ × AP)

Indirect method: It is a method which computes the material cost variance by considering two important variances viz. material price variance and material usage variance. Under this method, material cost variance is calculated through the summation of the variances viz. price and usage of materials.

Material cost variance=Material Price Variance (MPV) +Material Usage Variance


Notes


Material Price Variance It is very simple to understand that the name of the variance is self-explanatory in explaining the meaning of the variance. It is a variance between two different prices viz. the standard price and actual price of raw materials. The difference should be expressed only in terms of the actual usage of materials. The ultimate aim of expressing this variance in the lights of actual usage of materials is to identify the deviation of the price changes in line with the purchase of raw materials.

Reasons for the cause of variance:

It is due to impact/changes in the price of materials.

Fluctuations in the cost of transport of materials, tax rates and so on

The price fluctuation is due to the market forces viz. demand and supply of raw materials.

Another varying factor is the quality of raw materials.

Price fluctuation without considering the economic order quantity of raw materials at the time of purchase.

The price variance may be due to failure in the consideration of various discounts during the moment of purchase.

Purchase during the boom season may lead to uneconomic for the firm due to heavy demand of materials.

Responsibility of Price Variance

The responsibility lies on the purchase department which procures the raw materials for the firm to produce the goods. This responsibility can be classified into two different categories viz. internal and external factors based on the controllability, the influence of the variance can be classified into two categories i.e. controllable and uncontrollable.

Material Price Variance = (SP – AP) AQ

Example: the material price variance is as follows

Standard price = Rs.2 per unit

Actual price = Rs.1.80 per unit

Actual quantity of materials consumed = 850 kg

Solution:

Material price variance = 850 kg (2.00 – 1.80)

= Rs.170 (F)

Decision criterion: If the resultant is positive, it means that the planned price which was scientifically developed is more than the actual price. In precise terms, the price fluctuations in the market are well within the planned price. If it is within the standard, it is quantified as favourable for a firm. If not, the excessive/exorbitant cost of purchase of raw material more than the standard is unfavourable/adverse for the firm. The reason is the firm has paid more on the cost towards the purchase of materials than the planned one.

Material usage or Quantity Variance

The variance/deviation is between the standard quantity of materials and the actual quantity of materials consumed. The found variance in kg of raw materials should be


Notes


expressed in monetary values i.e. in terms of rupees, through the multiplication with the standard price. The ultimate aim of expressing the variance in terms of standard price that is the price which is totally free from market fluctuations i.e. supply and demand factors of the market.

The reasons for the quantity variance are as follows:

Unstructured/careless usage of materials

Enormous usage of inferior quality of materials

Ineffective mechanical system in production

More usage of materials due to inefficient worker

Change in the product design leads to more usage of materials

Materials Usage Variance = Standard Price × (Standard quantity of materials for actual output – Actual quantity of materials used)

Material Mix Variance This kind of variance arises only due to the mixture of various raw materials to produce and obtain an output. Normally the process of production involves more than two materials to obtain the output. For example, the firm mixes the raw materials of A& B at the ratio of 3:2. The mixture is called Material Mix.

The above mentioned ratio is being changed by the firm for actual production in producing a unit of product as 4:1.

The change in the material mix occurs due to various reasons, among which are the following:

Inadequate supply of raw materials

Price factor of a material

Introduction of a new system of production due to expansion

Substitution of a material due to better quality and cheaper price than the existing material in current system of procurement

This material mix variance is highly applicable in industries of chemicals, fertilizers, pharmaceuticals, consumables etc.

How can this variance be computed?

The variance should be computed between two different materials viz. standard quantity of materials and actual quantity of materials.

Actual quantity of materials is the volume of materials that have registered the change in the usage of raw materials mixture but the standard quantity of raw materials is totally free from the change of mixture in the raw materials.

While studying the variance, the factors of comparison should be weighed equally with each other. For instance, the standard quantity of material should not be a rational factor of comparison with the actual quantity. In order to have an appropriate comparison, the standard has to be revised.

Why must the standard quantity of raw materials be revised?

The early estimated standard is the measure not considered the reality during the production process due to changes occurred in the procurement of raw materials. While comparing the standard with actual, the former is not at par with the latter in terms of realities. To incorporate the realities, the standards are tuned towards the actual. This makes the comparison meaningful in studying the variance among both.


Notes


When the total standard quantity of materials is equivalent to actual quantity of materials:

From the example, the ultimate aim of revising the standard is explained as:

Before the commencement of production process, the standard mix of materials for the production of one unit of output included two different mixtures of quantities of material viz. A & B amounting to 70 tonnes and 30 tonnes respectively; which formed 70% and 30% in the production of a unit of output with the current system of material procurement.

Due to shortage of material A, the firm is required to redesign the material procurement system to have an uninterrupted flow of production of one unit of product. In order to meet the shortage of raw material A, the firm should replace the shortage only against the adequate supply of material B from the market. The firm should restructure the procurement system of material as follows: 60% of material A and 40% material B. The restructuring is done only on the actual and not on the standard. While studying the variance analysis between the quantity of materials, standard of 70% of A and 30% of B should be tuned towards the actual 60% of A and 40% of B procured during the process.

Standard Quantity of Materials Actual Quantity of Materials

Material A 70 tonnes Material A 60 tonnes

Material B 30 tonnes Material B 40 tonnes

Revised Standard Quantity of Material

Standard quantity of material A/B= Total quantity of actual material

Total quantity of standard material

For A = 70

100 × 100 = 70 tonnes

For B = 30

100 × 100 = 30 tonnes

Revised Quantity of Material

Revised quantity of Material A = 70 tonnes

Revised quantity of Material B =30 tonnes

From the above, if the total quantity of standard materials is equivalent to the actual quantity of materials, the revised quantity of materials will be as same as the standard quantity of materials.

When the total standard quantity of materials is not equivalent to total actual quantity of materials consumed:

Supposing the standard quantity of materials of X and Y is 60 tonnes and 40 tonnes respectively. The actual quantity of materials is 90 tonnes and 60 tonnes. The total standard quantity of materials and actual quantity of materials amount to 100 tonnes and 150 tonnes respectively.

The revised standard mix of materials of X and Y are as follows:

X = 60 150

100 = 90 tonnes


Notes


Y = 40 150

100 = 60 tonnes

Material Mix Variance = Standard Price (Revised Standard Quantity – Actual Quantity)

From the earlier discussions, it is clearly understood that the revised standard mix of materials will be the same only during the moment at which the total actual and standard quantity of materials are equivalent to each other and vice versa.

Material Sub-usage Variance This is the variance between standard quantity and revised standard quantity of materials denominated in terms of standard price. The purpose of studying the difference between these two is to analyse the amount of deviation of the standard against the revised standard, in line with the actual fluctuation in the quantity of materials consumption during the production process. It is the only variance highlights the difference between the previously set standard and the redesigned standard in terms of actual quantity of materials for meaningful comparison.

Material sub-usage variance

= Standard cost per unit (Standard quantity – Revised Standard quantity).

If the total actual quantity of materials consumption in units is equivalent to the total standard quantity of materials, it nullifies the material sub-usage variance between the standard quantity of materials and revised standard quantity of materials. It means that the standard quantity of materials of the mix will be the revised standard quantity of materials. If both are equivalent to each other, the variance is equivalent to zero in terms of standard price/ cost per unit.

In light of the above explanation, find out the material sub-usage variance from the following:

Materials Standard Materials Actuals

A 60 Kgs @ Rs.10 A 70Kgs @Rs.10

B 40 [email protected] B [email protected]

100 120

Revised Standard quantity of Materials:

60KgsA : 120 kgs = 72 kgs

100 kgs

40 kgsB : 120 kgs = 48 kgs

100 kgs

Material Sub-usage Variance

= Standard price/cost per unit (Standard production for Actual output – Revised Standard quantity)

Material A = Rs.10 (60Kgs – 72Kgs) = Rs.120 (Adverse)

Material B = Rs.12 (40Kgs – 48Kgs) =Rs.96 (Adverse)

Material sub-usage variance = Rs.216 (Adverse)

From the above example, it is clearly understood that the previously set standard is less than the revised standard quantity of materials due to change in the materials mix consumption i.e. the unexpected replacement of one material with another due to


Notes


shortage of any one of the materials in the mix. The greater revised standard quantity of materials means greater the volatility in the actual consumption of materials. If the variance is adverse, it means that the standard which was initially set for comparison has not incorporated the fluctuations in the actual, being less than the revised standard which is an index of the actual.

This material sub-usage variance is one of the components of the materials usage variance.

Material Usage variance = Material Sub-usage variance+ Material Mix Variance

Material Yield Variance It is one of the components of the material usage variance which arises only due to the deviation between the standard yield determined and the actual yield accrued. This variance highlights either the abnormal loss of materials or saving of materials. This variance plays a most important role in the process industries, to assess the loss/wastage of materials. If the actual loss of materials is different from the standard loss of materials it will result the variance in two different situations.

When the standard and actual do not differ from each other:

In this case, the yield variance is calculated as follows:

Yield Variance = Standard Rate/Cost per unit (Actual Yield – Standard Yield)

Standard Rate has to be calculated from the following:

Standard Rate Standard Cost of Standard Mix

=Net Standard Output (Gross Standard Output - Standard Loss)

When the Actual Mix differs from the Standard Mix

In the second case, standard mix has to be tuned to the requirement of actual mix, which is revised standard mix, realistic in sense for a meaningful comparison, to highlight the deviation between two different yields viz. actual yield and revised standard yield. The standard rate has to be calculated only for the revised standard mix of materials.

Standard Rate Standard cost of Revised standard mix

=Net Standard Mix/Output (Gross Standard Output - Standard Loss)

Labour Variance Labour Variance is known in other words as Labour Cost Variance. The cost of the labour is usually denominated by the wages paid/incurred during the production. Labour Variance Analysis is the study of the deviation in between the actual cost of the labour incurred and standard/budgeted cost of the labour. This is another most important cost variance, next to material cost variance, which considers the rate of the wage per hour for the computation of the total standard cost of labour and actual cost of labour like price of the materials per kg.

Labour Cost Variance Labour cost variance is the tool that studies the deviation in between the total standard cost of the labour and actual cost of labour. The actual labour cost may vary due to many reasons from the planned.


Notes


Causes for the variance

The hourly rate of the labour may vary due to demand and supply of the labour force.

The hourly rate of the labour may vary due to nature of the labour required i.e. Skilled/Semi-Skilled/Unskilled. The rate differs from one category to another due to efficiency of the labourers.

The labour cost variance is in relevance to the time component of the job. The time required to complete the job may vary due to too many reasons; more specifically time wastage results in low production.

The following is the structure of the labour cost variance, which will illustrate the various components of the labour variance:

Labour Cost Variance = Standard Cost of the Labour *- Actual Cost of Labour**

*Standard Cost of the Labour = Standard Hours for Actual Output × Standard Hour Wage Rate

**Actual Cost of the Labour = Actual Hours taken for production × Actual Hour Wage Rate

Labour Rate or Wage Pay Variance This is the variance that results due to the change in the wage rate. The labour rate variance is the difference between standard wage rate, which already determined and the actual wage rate incurred during the production. The variance should be denominated in terms of the actual hours of production.

Why is the expression in terms of the actual hours?

The actual hours are taken into consideration only for reality, that is the time moments consumed by the production process. This expression helps to understand the excessive /lesser amount spent on the labour, which depicts, how much was over/under spent by the firm for the payment of wages than the planned during the production.

Labour Cost Variance

Labour Rate Variance Labour Efficiency Variance

Labour Mix Variance

Labour Idle Time Variance Labour Yield Variance


Notes


The causes of labour wage rate or pay variance:

It is due to changes that have occurred in the structure of basic wages.

The ratio of the labour mix is varied due to the nature of the order, undertaken by the firm to meet the needs. The special order from the buyer may require the goldsmith to take more special care in the design of an ornament than the regular or routine design. This leads to involvement of more amount of skilled labour, which finally escalates/increases the cost of the labour.

To fulfill the immediate and excessive orders of the consumers which are to be supplied to their requirements, leads to greater payment of wages through overtime charges, which is normally greater than the regular wage rate.

This variance mainly occurs in that industry which is connected with seasonal business. This variance plays a pivotal role in the industries like soft drinks, fans, refrigerator, fertilizer, crackers and so on.

The Labour Rate Variance (LRV) = Actual hours taken (Standard Rate- Actual Rate)

Labour Efficiency Variance The efficiency of the labour is denominated only in actual hours for actual output which should be less than the standard hours expected to perform during the job. The labour efficiency variance is the deviation between two i.e. standard hours for actual output and actual hours taken for actual output. The expression of variance in terms of hours should be expressed in terms of wage rate i.e. standard wage rate.

Why should the expression be in the standard wage rate?

The aim of expressing efficiency variance in terms of standard wage is to express them in monetary units and should be free from the demand and supply forces of the labour force which directly has an impact on the basic labour wage rate.

Labour efficiency variance = Standard rate (Standard hours for actual output – Actual hours for actual output)

What are causes of this variance?

Due to poor working conditions, the efficiency of the working force to complete the job may come down

Quality of maintenance of the machinery helps the working force to maintain its efficiency

Frequent change in the quality of materials may lead to change in the hours required to complete the work.

Poor personnel relations with the workers

Idle Time Variance

What is idle time?

The wages which are paid for unproductive hours to the labourers are known as idle time.

The idle time may be classified into two categories:

Normal idle time

Abnormal idle time


Notes


What is normal idle time?

This idle time is known as authorised idle time which can be understood in other words as unavoidable idle time. Normally, the worker is paid for that time during which he does not produce anything.

Time taken by the employees to change their dress, time taken by the employees to ease themselves during the hours of production i.e. going to the toilet for easing and for going to the canteen.

The employees are paid during the above enlisted occasions when they do not produce anything.

In between two different shifts, the production of finished goods does not normally take place due to change over the control from one employee to another.

What is meant by abnormal idle time?

This is known as avoidable idle time; during which the workers are paid for nil production. This type of idle time could be slashed down or downsized through effective planning. This idle time is the result of too many ineffective schedules e.g. inadequate supply of raw materials, power shortage/failure, breakdown of machinery and so on. The aforementioned could be easily sorted out through proper planning and scheduling; which will automatically reduce the unproductive time of labour force. Whatever payment of wages made to the working force during the idle time is to be considered as adverse. It means that the firm makes the payment of wages to the labourers/working force without any production/productivity.

Idle Time Variance = Idle hours × Standard Rate (Always „A‰)

Labour Mix Variance This variance arises due to deviations between the actual mixture of labour force for the job and standard mixture of labour force planned to complete the job. The mixture of work-force is considered to be most important for completion. Normally, the mixture is in a triad viz. Skilled, Semi-skilled and Unskilled. The standards are prepared by considering the requirements of the job to be completed. For completing the job, 5 skilled, 3 semi-skilled and 2 unskilled employees are required. Due to non-availability of skilled labour force, the firm is required to carry out the operations without any lacuna through the induction of more semi-skilled labour force. The actual composition of the labour force is 2 skilled, 6 semi-skilled and 2 unskilled which finally led to labour mix variance.

Reasons for the labour mix variance:

Absenteeism

Labour turnover

Non-availability of required labour force from the business environment

The above critical factors directly influence the efficiency of the labour force.

Labour Mix Variance = Standard Rate (Revised Standard Hours – Actual Hours)

Standard hours for the job are determined for the standard mixture of labour force but these hours are not denominated to the tune of actual hours taken by the actual mixture of labour force. To study the variance between them, the standard hours should be in line with the actual. The standard hours which are converted to the tune of actual hours are known as revised standard hours considered to be the level platform for an effective comparison.

Labour Mix Variance = Standard Rate (Revised Standard Hours – Actual Hours)


Notes


Labour Sub-efficiency Variance It is one of the components of the labour efficiency variance.

Labour Sub Efficiency Variance = Standard Rate (Standard Hours for Actual Output – Revised Standard Hours)

Labour Yield Variance It is considered to be one of the components of labour efficiency variance. This is a variance between two different outputs of the enterprise viz. standard output for actual hours and actual output.

This variance helps to study the deviation between two different levels i.e. how many number of standard outputs would be produced during the actual hours and how many number of actual outputs were produced during the actual hours.

Labour yield variance = Standard cost per unit (Actual output – Standard output in actual hours)

OR

= Standard cost per unit (Actual yield in units – Standard yield in actual hours)

If actual output or actual yield in units is greater than the standard yield in actual hours, it means that the firmÊs actual production in units is greater than the standard estimates. This is favourable to the business enterprise.

Standard hours for actual output for Women 600 Hrs

= 1,600 Units = 480 Hrs2,000 units

Standard hours for actual output for Boys 400 Hrs

= 1,600 Units = 320 Hrs2,000

From the above, labour efficiency variance should be found out.

Men =. 80(960 Hrs-1,600 Hrs) = Rs.512 (Adverse)

Women =. 60(480 Hrs-400 Hrs) = Rs.48(Favourable)

Boys =. 40(320 Hrs-200 Hrs) = Rs.48(Favourable)

Total labour efficiency variance = Rs.416(Adverse)

Total labour efficiency variance = Rs.416 (Adverse)

The next most important variance is Idle time variance

Idle time variance = Idle Hours × Standard Rate

First total idle hours of each category should be separately found out, then the obtained idle hours should be multiplied with the standard rate of labour.

Men = 40 Men x 4 Hours = 160 Man Hours x. 80 = Rs. 128 (Adverse)

Women = 10Women x 4 Hours = 40Man Hours x. 60 = Rs. 24(Adverse)

Boys = 5 Boys x 4 Hours = 20 Man Hours x. 40 = Rs. 8(Adverse)

Total idle time variance = Rs. 160(Adverse)

Total idle time variance = 160(Adverse)

The idle time variance is part and parcel of the labour efficiency variance.


Notes


While checking the equation through verification process, idle time variance should not be added once again along with the labour rate variance and labour efficiency variance.

The actual wages have included the wages for the idle hours. Idle hours are not taking into consideration for the computation of labour efficiency variance.

Verification

Labour cost variance= Labour rate variance+Labour efficiency variance

Men Rs.352 (Adverse) = Rs.160 (Favourable)+512(Adverse)

Women Rs.28 (Favourable) = Rs.20 (Adverse)+Rs.48(Favourable)

Boys Rs.68 (Favourable) = Rs.20 (Favourable)+48(Favourable)

Rs.256 (Adverse)

Labour Mix Variance = (Revised Standard Hours – Effective Actual Hours) × Standard Rate

For computing the revised standard hours, total standard hours should be computed by way summing up the individual standard hours.

Overhead Variance In general, the overhead variance is defined as the variance between standard cost of overhead estimated for the actual output and actual cost of overhead actually incurred.

With reference to absorption of overheads, the variance occurs only during either over or under-absorption of overheads.

Under-absorption overheads means that the standard cost of the overhead is more than that of the incurred actual overhead. In brief, it is a favourable situation as far as the firm is concerned and vice versa in the case of over-absorption of overheads.

Variable Overhead Cost Variance It is the variance or deviation in between the standard variable overhead for actual production of units and actual overheads incurred.

= Standard variable overhead rate per unit × Actual output – Actual variable overheads incurred

Variable Overhead Expenditure Variance This is the variance in between the two different rates of variable overheads viz. standard rate and actual rate; denominated in terms of actual hours taken consumed by the firm.

= Actual Hours (Standard Rate – Actual Rate)

Variable Overhead Efficiency Variance It is another variance which is between the standard hours for actual output and actual hours consumed during the production, denominated in terms of standard rate.

= Standard Rate (Standard hours for actual output –Actual hours)


Notes


Fixed Overhead Cost Variance The most important variance is overhead cost variance

= Standard overhead cost for actual output – Actual overheads

The second important variance is Budgeted or Expenditure variance

= Budgeted overheads – Actual overheads

What is the difference between the budgeted figures and standards?

Budgeted figures are not adjusted to the actual but the standards could be adjusted or tuned towards the actual.

The next important variance is overhead volume variance.

(a) If the standard overhead rate per unit is given

= Standard rate per unit (Actual production – Budgeted production)

(b) If the standard overhead rate per hour is given

= Standard rate per hour (Standard hours for actual production – Budgeted production)

The next important variance is overhead efficiency variance.

(a) If the standard rate per unit is given ·

Standard overhead rate per unit (Actual production – Standard production in Actual hours)

(b) If the standard rate per hour is given ·

Standard overhead rate per hour (Actual hours –Standard hours for actual production)

Sales Variance Sales variance is the only component accompanying the profit volume variance of the business transaction. The sales variances are computed and analysed in order to study the effect of sales value and facilitates the sales manager to easily understand the various sales efforts taken by the team.

The sales variance can be classified into various categories. They are as follows:

Sales Value Variance The name of the variance is self-explanatory in explaining the meaning of the variance, that is difference between the actual value of sales and standard value of sales.

The causes/influences of sales value variance are many more and some of them are highlighted for easy understanding about the overall picture.

The fluctuation in the selling price may lead to variance with the standard selling price- Selling Price Variance

Sales Variance

Sales value variance Sales Price Variance

Sales Volume Variance

Sales Mix Variance Sales Sub-usage

Variance


Notes


The fluctuation in the actual volume of sales may be due to various factors, mainly the preference of the buyers over the standard/budgeted volume of sales-Sales Volume Variance

Actual mix of material varieties may differ from the standard mix, which leads - Sales mix variance

Revised standard sales quantity may be varied from the budgeted sales quantity - Sales quantity/sub-usage variance

Sales value variance = Actual value of sales- standard value of sales

The decision criterion is that more the actual sales volume leads to greater and better the position of the firm than the budgeted sales volume, which leads to favourable position for the firm and vice versa.

Sales Price Variance It is one of the components as well as influences of the sales variance. It is the variance in between two different prices viz. actual price and standard price of the products.

The variance can be computed as follows:

Sales Price Variance = Actual quantity sold (Actual Price-Standard Price)

The price variance should be finally expressed in terms of the actual number of goods sold. The main aim of expressing them in actual quantity of goods sold is to express the variance in terms of actual performance in units.

The price variation may be due to many reasons:

The price variance may be due to changes taken place in the structure of competition. The nature of competition changes due to market potential for e.g. monopoly to duopoly; duopoly to perfect competition and so on; leads to change in the structure of pricing in order to retain the consumer base in line with the business.

The price variance may be due to two courses of action, which are as follows

Cost effectiveness strategy and Distinctiveness Strategy.

Sales Volume Variance It is one of the elements of sales variance, which is between the actual sales quantity and budgeted sales quantity. The variance is normally expressed in terms of price i.e. standard price. The purpose of expressing the variance in terms of standard price is that price which is free from market forces.

= Standard price (Actual quantity of Sales- Standard quantity of Sales)

The sales volume variance can be divided into two different streams · the sales mix variance and sales quantity variance/sub-usage variance.

(a) Sales Mix Variance: It is the difference between the actual sales and standard sales mix. This variance will arise only due to change in the proportion of goods sold. This is a most important variance usually computed/calculated, at the moment, the firm which deals more than one commodity.

If both the standard and actual mixes are equivalent to each other, there will not be any mix variance between the above mentioned.

If the mixes are totally different from each other, the sales mix variance is to be computed through the development of revised standard mix of quantities with reference to actual quantities sold, only the comparison will be meaningful for studying the variances occurred in between above mentioned.


Notes


The sales mix variance is expressed between two different quantities and finally should be denominated in terms of standard price. The reason for the expression in terms of standard price is the price that is totally detached from the demand and supply forces of the market.

Sales Mix Variance = Standard Price(Actual Quantity- Revised Standard Quantity)

(b) Sale Sub-usage variance: It is another component of usage variance, which expresses the deviation between the revised standard quantity to the tune of actual quantities sold and the early set standard quantities expected to sell.

This variance also elucidates the differences of the above mentioned only in terms of standard price, which is the ideal indicator relatively free from the market forces i.e. free from fluctuation.

Sales Sub-usage Variance = Standard Price (Revised Standard Quantity- Standard Quantity).

Reporting This refers to recording of information in a suitable format for presentation of the same to others for information, decision or action. Earlier it was noted that problem solving methodology required recording of facts so that these could be critically examined for arriving at a solution. Necessarily, for decision making it is required that the pros and cons related to possible solutions are documented and presented to those who have the problem of selecting a course of action out of the alternatives proposed, or to find out one not yet proposed, and give instruction for implementation. The document, which contains such information is known as a report.

One of the best ways to depict the performance of a company would be in terms of its financial variables. Through the application of accounting practices, both domestic and global, some reports have developed which have been used to determine and communicate financial indicators of performance. Financial reports use the currency unit as a basis to measure the performance variables. This is advantageous to the users, as the message could then be communicated across any range of products, any nature of business, any currency of exchange and across any period of time.

Reports that cover past performance are used to determine future operations and strategic decision making. But not all reports dwell on past performance, alone. Some show an expected view of the company, and these reports are used for planning and control. The content, format and periodicity of the reports are determined by their ultimate user.

Types of Financial Reports The most common financial reports in use are:

The Budget

The Cost report

The Balance Sheet

The Profit & Loss Account

The Cash Flow Statement

The first two reports are meant for internal consumption and other three are meant for external users.


Notes


Additionally, the management of a unit or a company may produce a financial report or customise one of the common reports described to suit its own unique needs.

The Budget The budget helps management to plan and control the effective and efficient application of all the resources of the company. It is a one-year slice of the strategic plan, but the budgeting process involves more than simply cutting out such a slice. It is an important tool for short term planning and control by management. The budget is used to influence the managerÊs performance before the commencement of the period of activity and to measure and appraise his performance after the activity is over. The process of making a budget, or Budgeting is an indispensable process of any management control system.

A budget usually has these features:

It usually covers a year, but may cover shorter periods for seasonal businesses

It is stated in monetary units such as Rupees.

It estimates the performance potential of the responsibility center.

It is a commitment by the management to attain a level of performance.

An authority higher than the responsibility center that is covered by the budget approves it and any change after such approval.

The budget is an instrument to monitor the performance of the responsibility center. At pre-determined intervals, actual performances of the center are measured and compared to the budget and any departures from the budget variables are studied and explained.

Relationship of Budget with Strategic Planning and Forecasting Strategic planning is the process of deciding on the nature and size of several programmes to be undertaken in order to implement the companyÊs strategies. The process of strategic planning precedes budgeting and provides the framework for the development of the budget. The budget focuses on activities of a single year. A strategic plan is essentially structured along product lines and other programmes, while the budget is strongly rooted around the concept of responsibility centers.

Budget and Forecasting A Budget is not forecasting, which is merely a prediction, without the implication of the managerÊs responsibility to make the prediction happen. A forecast may also cover more than a year and need not be stated in monetary units. Unlike the budget, a forecast does not need the approval of higher authority, even for changes. No analysis for changes is made formally or regularly. The forecast is a planning tool, whereas the budget is a tool for both planning and control.

We will learn more about budgeting in a later chapter.

The Cost Report Cost reports focus on cost data that aids management in controlling costs and taking other related decisions. They can cover products, services, jobs, programmes, divisions, departments and projects. However, every form of cost data need not be useful for management. Most cost reports are based on historical data but rooted in


Notes


the present. But decision making is always futuristic and needs a different kind of cost data in the form of Cost sheets to support it.

Areas of Decision Making Relevant cost data assists management in decision situations such as:

Make (in-house) or buy (from outside, i.e. outsource)? Fresh investment into new line of business Replacement of asset Divestment and discontinuation of production Pricing strategies Promotion strategies

The Cost Sheet The cost sheet is a financial report that shows the total cost of a product decomposed in terms of some of its most important components. The process of determining and presenting cost data in the form of a report is called Costing. The illustrative cost sheet on the following page is a financial report of the total cost for the manufacture and sale of 12,000 units of the product. When this sheet is presented to the management after an activity, it is a report of expenses incurred.

When this report is made for expected costs, it becomes an opportunity for the management to focus on each cost component and to explore alternative choices for cost control. The cost sheet is an important initiating document for determining the unit cost of a product or service and be can also one of the focal point for pricing. It can be compared with cost sheets of similar completed activities and used as a basis for budgeting. The largest values of costs such as Direct Material and Direct Labour also offer the largest opportunity for cost control.

Illustrative Cost Sheet (For 12,000 units)

Head of cost Gross cost Unit cost Direct Material 220000 18.33 Direct Labour 136000 11.33 Other Direct expenses 14000 1.17 1. PRIME COST (A) 370000 30.83 Indirect material 6000 0.50 Indirect labour 18000 1.50 Rent, rates and taxes of factory 10000 0.83 Depreciation 16000 1.33 2. FACTORY OVERHEADS (B) 50000 4.17 WORKS COST OR FACTORY COST (A + B = C) 420000 35.00 Office rent and rates 4000 0.33 Stationery 3000 0.25 Directors’ fees 2000 0.17 3. OFFICE OVERHEADS (D)r 9000 0.75 COST OF PRODUCTION (C + D = E) 429000 35.75 Sales commissions 12000 1.00 Advertising 7000 0.58 Packaging 5000 0.42

Contd…


Notes


Carriage outwards 3000 0.25 4. MARKETING OVERHEADS (F) 27000 2.2 5. COST OF SALES OR TOTAL COST (E + F = G) 456000 38.00

We devote a whole section of this book to Cost accounting later.

Annual Report The governmentÊs desire is that a reliable set of financial statements, one that presents a „fair representation,‰ of what has occurred, is given to the users of financial statement information. These users include shareholders, bankers, suppliers, and other individuals. This set of financial statements is known as ÂAnnual ReportÊ is sent to all the shareholders and submitted to the government also.

Annual reports are frequently referred to as certified reports or certified statements because the statements have been audited by an external party. In fact it is the outside auditor who has been certified not the statements themselves because the auditor merely gives an expert opinion regarding the financial statements of a company. There is no certification of correctness of the financial statements. Assuming the financial statements to be correct because the CA has given his opinion on the same is taking the things too far.

The major financial reports like balance sheet, profit & loss account and cash flow statement form a part of the annual report, which also contains other items besides these three reports. The major constituents of an annual report include the following:

1. DirectorsÊ Report

2. AuditorsÊ Report

3. Balance Sheet

4. Profit & Loss Account

5. Schedules

6. Cash Flow

7. Balance Sheet Abstract

The annual Report of COSCO (India) Ltd. in Annexure 1 at the end of this chapter shows all these section. You can go through the sections, there also for better understanding of the same let us look at them one by one!

Directors’ Report Directors have to report on the performance of the company for the year for which the report is being submitted to the shareholders. Although the directorsÊ report is supposed to present the future expectation for the next year and provide a detailed analysis of the past performance, it is rarely so in Indian companies. Some of the good Indian companies and most of the foreign companies provide this information to the shareholders in the Annual Report. Most of the companies provide the bare necessary information so as not to anger the shareholders. This shows their apathy towards the shareholders and the shareholders then treat back the company in the same manner.

DirectorsÊ Report also provides information on the employees earning more than a particular level of remuneration from the company as also on conservation of energy. Whether any conservation of energy has been done or not is a different matter! The report also talks about technology absorption, important area if the company is using foreign technology and absorbing it is necessary for the future survival of the company. The last section usually talks about foreign exchange earnings and outgo,


Notes


useful for measuring the export or import performance and can be utilised to see the risk the company has to bear with respect to foreign exchange fluctuations.

Auditors Report This opinion letter (known as auditorÊs report) generally has three standard sections that are reproduced almost verbatim in most auditorsÊ reports.

The opening section serves to inform the users of the financial statements that the auditor performed an audit. In some cases auditors perform consulting or other services aside from audits. Also, by specifying the items that were audited (the specific financial statements), the auditor is implying that certain parts of the annual report were not audited.

The scope section describes the breadth or scope of work undertaken as a basis for forming an opinion on the financial statements. This paragraph explains the type of procedures auditors follow in carrying out an audit. Note that just as companies must follow generally accepted accounting principles in preparing their statements, Chartered Accountants must follow generally accepted auditing standards in auditing those statements.

The opinion paragraph describes whether the financial statements provide a fair representation of the financial position, results of operations and cash flows of the company, in the opinion of the auditor. A clean opinion, such as this one, indicates that in the opinion of the auditor, exercising due professional care, there is sufficient evidence of conformity to generally accepted accounting principles (GAAP) and there is no condition requiring further clarification. This paragraph does not contend that the financial statements are completely correct. It does not even certify that there are no material misstatements. The CA does not give a guarantee or certification. He merely gives an expert opinion.

Annexure to the AuditorsÊ Report talk about the auditorsÊ comments on the policies and practices followed by the company regarding various items and compliances that the company had to make for the same. Any discrepancies in the policies and procedures of the company are brought to light here. AuditorsÊ also qualify the statement with these notes in case of any material differences from GAAP as also any material differences that these reports present from the actual in their opinion.

This is a report which is must read for any analyst who wants to understand the companies finances. Here a little more information on the process of audit would be desirable for you to fully appreciate the value of the same as also the limitations.

Student Activity „Reporting is an integral part of the management control system.‰ Do you agree with this statement? Give suitable examples.

Performance Analysis and Impact on Management Compensation Performance appraisal could be taken either for evaluating the performance of employees or for developing them. The evaluation is of two types: telling the employee where he stands and using the data for personnel decisions concerning pay, promotions, etc. The developmental objectives focus on finding individual and organisational strengths and weaknesses; developing healthy superior-subordinate relations; and offering appropriate counselling/coaching to the employee with a view to develop his potential in future.


Notes


Appraisal of employees serves several useful purposes:

1. Compensation decisions: It can serve as a basis for pay raises. Managers need performance appraisal to identify employees who are performing at or above expected levels. This approach to compensation is at the heart of the idea that raises should be given for merit rather than for seniority. Under merit systems, employee receives raises based on performance.

2. Promotion decisions: It can serve as a useful basis for job change or promotion. When merit is the basis for reward, the person doing the best job receives the promotion. If relevant work aspects are measured properly, it helps in minimising feelings of frustration of those who are not promoted.

3. Training and development programmes: It can serve as a guide for formulating a suitable training and development programme. Performance appraisal can inform employees about their progress and tell them what skills they need to develop to become eligible for pay raises or promotions or both.

4. Feedback: Performance appraisal enables the employee to know how well he is doing on the job. It tells him what he can do to improve his present performance and go up the Âorganisational ladderÊ.

5. Personal development: Performance appraisal can help reveal the causes of good and poor employee performance. Through discussions with individual employees, a line manager can find out why they perform as they do and what steps can be initiated to improve their performance.

The Benefits of Performance Appraisal

Employer perspective [Administrative uses]

Despite imperfect measurement techniques, individual differences in performance can make a difference to company performance.

Documentation of performance appraisal and feedback may be required for legal defence.

Appraisal offers a rational basis for constructing a bonus or merit system.

Appraisal dimensions and standards can help to implement strategic goals and clarify performance expectations.

Employee perspective [developmental purposes]

Individual feedback helps people to rectify their mistakes and get ahead, focusing more on their unique strengths.

Assessment and reorganisation of performance levels can motivate employees to improve their performance.

Summary The purpose of variance analysis is to identify problems early so that prompt corrective action can be taken to minimize cost and schedule impacts, cost overruns, and schedule delays to the project.

The Schedule Management System will reveal the status of specific activities, milestones, and critical events. Ratio of the Budgeted Cost of Work performed to the Budgeted Cost of Work Scheduled and represents the schedule efficiency of the project. Ratio of the Budgeted Cost of Work Performed to the Actual Cost of Work Performed and represents the cost efficiency of the project. The next step in the analysis is to evaluate the earned value data and develop a projection for the future of the project based on the progress made to date. EAC (or IEAC) is used to determine the Variance at Completion (VAC) for the project. The VAC is calculated as follows:

VAC = BAC – (I) EAC


Notes


Reporting refers to recording of information in a suitable format for presentation of the same to others for information, decision or action. The reporting system for any project has to be a new one designed around the responsibility involvement pattern in existence for that particular project only. The methodology of designing an appropriate reporting system starts with identification of the key result areas. Key result areas, may be equated to some physical and functional attainments which an executive may be entrusted to accomplish over a period of time so that the overall objective of the project is achieved.

Keywords Variance Analysis: It quantifies the deviations from the time-phased budget based on the work accomplished and cost data collected.

Schedule Variance: Difference between the budgeted cost of work performed and the budgeted cost of work scheduled.

Cost Variance: Difference between the budgeted cost of work performed and the actual cost of work performed.

Schedule Performance Index: Ratio of the budgeted cost of work performed to the budgeted cost of work scheduled and represents the schedule efficiency of the project.

Cost Performance Index: It is the ratio of the budgeted cost of work performed to the actual cost of work performed and represents the cost efficiency of the project.

Reporting: This refers to recording of information in a suitable format for presentations of the same to others for information, decision or action.

Review Questions 1. What do you understand by variance analysis?

2. Discuss the various types of variance and performance indicators?

3. What is reporting? Describe different types of reporting.

4. Explain the role of performance analysis in management compensation.






Notes


Unit 6 Modern Control Methods

Unit Structure • Introduction

• JIT

• Total Quality Management • Decision Support System (DSS)

• Summary • Keywords

• Review Questions

• Further Readings

Learning Objectives At the conclusion of this unit you should be able to: • Know what are the modern control methods

• Describe the importance of JIT in management control system • Discuss various techniques of TQM

• Appreciate decision support system as a control technique.

Introduction The success of every business lies in effective management control. It is up to the management to remain focused and dedicated towards achieving business targets. This involves a lot of hard work, but is very fulfilling when viewing the growth graph. Management control involves effective quality control, operations management, delegation of work among the units and effective budget management.

Today, the business world is very challenging and complex. The management team of any business is required to ensure the smooth functioning of all operations and even the shelf or rack life of the product or service. The methods adopted are not with the intention to control rather the strategy is to guide the operations. This involves total co-ordination within all the operating units and individuals. In the absence of co-ordination, there can never be any organization, there will only be an experience. Modern management control methods include:

Setting business goals, long and short-term.

Proper planning.

Identifying workable strategies.

Effective communication.

Delegation of work.

Timely evaluation of the accomplished stages.

Budget management.


Notes


Performance evaluation.

Quality control.

Overall Operations.

JIT Just-in-time (JIT) is an inventory strategy implemented to improve the return on investment of a business by reducing in-process inventory and its associated carrying Just-in-time (JIT) is an inventory strategy implemented to improve the return on investment of a business by reducing in-process inventory and its associated carrying costs. In order to achieve JIT the process must have signals of what is going on elsewhere within the process. This means that the process is often driven by a series of signals, which can be Kanban that tell production processes when to make the next part. Kanban are usually 'tickets' but can be simple visual signals, such as the presence or absence of a part on a shelf. When implemented correctly, JIT can lead to dramatic improvements in a manufacturing organization's return on investment, quality, and efficiency. Some have suggested that "Just on Time" would be a more appropriate name since it emphasizes that production should create items that arrive when needed and neither earlier nor later.

Quick communication of the consumption of old stock which triggers new stock to be ordered is key to JIT and inventory reduction. This saves warehouse space and costs. However since stock levels are determined by historical demand any sudden demand rises above the historical average demand, the firm will deplete inventory faster than usual and cause customer service issues. Some have suggested that recycling Kanban faster can also help flex the system by as much as 10-30%. In recent years manufacturers have touted a trailing 13 weeks average as a better predictor for JIT planning than most forecasters could provide.

Waste results from any activity that adds cost without adding value, such as the unnecessary moving of materials, the accumulation of excess inventory, or the use of faulty production methods that create products requiring subsequent rework. JIT (also known as lean production or stockless production) should improve profits and return on investment by reducing inventory levels (increasing the inventory turnover rate), reducing variability, improving product quality, reducing production and delivery lead times, and reducing other costs (such as those associated with machine setup and equipment breakdown). In a JIT system, underutilized (excess) capacity is used instead of buffer inventories to hedge against problems that may arise.

JIT applies primarily to repetitive manufacturing processes in which the same products and components are produced over and over again. The general idea is to establish flow processes (even when the facility uses a jobbing or batch process layout) by linking work centers so that there is an even, balanced flow of materials throughout the entire production process, similar to that found in an assembly line. To accomplish this, an attempt is made to reach the goals of driving all inventory buffers toward zero and achieving the ideal lot size of one unit.

The basic elements of JIT were developed by Toyota in the 1950's, and became known as the Toyota Production System (TPS). JIT was well-established in many Japanese factories by the early 1970's. JIT began to be adopted in the U.S. in the 1980's (General Electric was an early adopter), and the JIT/lean concepts are now widely accepted and used.


Notes


Benefits As most companies use an inventory system best suited for their company, the Just-In-Time Inventory System (JIT) can have many benefits resulting from it. The main benefits of JIT are listed below:

1. Set up times are significantly reduced in the factory: Cutting down the set up time to be more productive will allow the company to improve their bottom line to look more efficient and focus time spent on other areas that may need improvement. This allows the reduction or elimination of the inventory held to cover the "changeover" time, the tool used here is SMED.

2. The flows of goods from warehouse to shelves are improved: Having employees focused on specific areas of the system will allow them to process goods faster instead of having them vulnerable to fatigue from doing too many jobs at once and simplifies the tasks at hand. Small or individual piece lot sizes reduce lot delay inventories which simplifies inventory flow and its management.

3. Employees who possess multiple skills are utilized more efficiently: Having employees trained to work on different parts of the inventory cycle system will allow companies to use workers in situations where they are needed when there is a shortage of workers and a high demand for a particular product.

4. Better consistency of scheduling and consistency of employee work hours: If there is no demand for a product at the time, workers donÊt have to be working. This can save the company money by not having to pay workers for a job not completed or could have them focus on other jobs around the warehouse that would not necessarily be done on a normal day.

5. Increased emphasis on supplier relationships: No company wants a break in their inventory system that would create a shortage of supplies while not having inventory sit on shelves. Having a trusting supplier relationship means that you can rely on goods being there when you need them in order to satisfy the company and keep the company name in good standing with the public.

6. Supplies continue around the clock keeping workers productive and businesses focused on turnover: Having management focused on meeting deadlines will make employees work hard to meet the company goals to see benefits in terms of job satisfaction, promotion or even higher pay.

Problems The major problem with just-in-time operation is that it leaves the supplier and downstream consumers open to supply shocks and large supply or demand changes. For internal reasons, this was seen as a feature rather than a bug by Ohno, who used the analogy of lowering the level of water in a river in order to expose the rocks to explain how removing inventory showed where flow of production was interrupted. Once the barriers were exposed, they could be removed; since one of the main barriers was rework, lowering inventory forced each shop to improve its own quality or cause a holdup in the next downstream area. One of the other key tools to manage this weakness is production levelling to remove these variations. Just-in-time is a means to improving performance of the system, not an end.

With very low stock levels meaning that there are shipments of the same part coming in sometimes several times per day, Toyota is especially susceptible to an interruption in the flow. For that reason, Toyota is careful to use two suppliers for most


Notes


assemblies. As noted in Liker (2003), there was an exception to this rule that put the entire company at risk by the 1997 Aisin fire. However, since Toyota also makes a point of maintaining high quality relations with its entire supplier network, several other suppliers immediately took up production of the Aisin-built parts by using existing capability and documentation. Thus, a strong, long-term relationship with a few suppliers is preferred to short-term, price-based relationships with competing suppliers. This long-term relationship has also been used by Toyota to send Toyota staff into their suppliers to improve their suppliers' processes. These interventions have now been going on for twenty years and result in improved margins for Toyota and the supplier as well as lower final customer costs and a more reliable supply chain. Toyota encourages their suppliers to duplicate this work with their own suppliers.

Total Quality Management Until a few years ago, Indian industry was roundly criticised for paying insufficient attention to the quality of goods and services. Today, things have come full circle and the quality movement is at a feverish pitch. Companies such as BPL, Wipro, Carrier Aircon, Maruti, Thermax, Bata, Philips, Titan, etc., trumpet their steadfast devotion to quality in their advertisements. Quality has become the most important word in the corporate lexicon and companies have realised the importance of investing in processes that contribute to better quality and customer relationships. The term 'quality' refers to a sense of appreciation that something is better than something else. It means doing things right the first time, rather than making and correcting mistakes. According to Edward Deming, TQM is a way of creating an organisational culture, committed to the continuous improvement of skills, teamwork, processes, product and service quality and customer satisfaction. TQM is anchored to organisational culture because successful TQM is deeply embedded in virtually every aspect of organisational life.

TQM: The Main Ideas TQM is built around four main ideas: Do it right the first time, Be customer centered, Make continuous improvement a way of life, and Build teamwork and empowerment. Let's examine these in detail:

a. Do it right the first time: Managers have been interested in the quality of their products, at least as an afterthought, since the Industrial Revolution. Thanks to the sustained efforts of quality gurus like Deming and Kaoru Ishikawa, product/service quality has become both a forethought and a driving force in effective organisations of all kinds these days. Today's hospitals, universities and public sector organisations are as interested in improving product/service quality as are manufacturing organisations, mines, airlines and railways. In its most basic form, the emphasis on quality has come through four distinct phases since World War II - from 'fix it in' to 'inspect it in' to 'build it in' to 'design it in'. Present-day managers are moving away from the first two approaches towards the 'build it in' and 'design it in' approaches. Let's look into the differences in these approaches:

The fix it in approach to quality: Rework any defective products identified by quality inspectors at the end of the production process.

The inspect it in approach to quality: Here, quality inspectors sample work in process and prescribe machine adjustments to avoid substandard output.


Notes


The build it in approach to quality: Make everyone who touches the product, responsible for spotting and correcting defects. Emphasis is on identifying and eliminating causes of quality problems.

The design it in approach to quality: Intense customer and employee involvement drives the entire design production cycle. Emphasis is on continuous improvement of personnel, processes and product.

Each stage of this evolution has broadened the responsibility for quality, literally turning quality improvement into a true team effort. Also, the focus has shifted from reactively fixing product defects to proactively working to prevent them and to satisfy the customer completely. Just having 'zero things gone wrong' is not sufficient now, to offer something of value to customer and buy his loyalty. Today's quality leaders strive to exceed, not just meet the customerÊs expectations. Putting quality first is the new slogan.

b. Be customer-centered: Organisations have to meet the expectations of both the internal and external customers. Internal customers are other members of the organisation who depend on your work to get their job done. For example, a corporate lawyer employed by Maurya hotel does not directly serve the hotel chains' customers by changing beds, serving meals or carrying luggage. But that lawyer has an internal customer when a Maurya manager needs to be defended in court. As far as external customers are concerned, TQM demands all employees who deal directly with outsiders to be customer-centered. Being customer-centered means:

Anticipating the customer's needs;

Listening to the customer;

Learning how to satisfy the customer; and

Responding appropriately to the customer.

c. Make continuous improvement a way of life: The Japanese word for continuous improvement is Kaizen, which means improving the overall system by constantly improving the little details. Kaizen practitioners look at quality as an endless journey, not a final destination. In order to improve things, they experiment, measure, adjust continuously. Rather than naively assuming that zero defects means perfection, they try to put the finger on the problem causing trouble. There are four ways to achieving improvements:

(i) Improved and more consistent product and service quality.

(ii) Faster cycle times (in cycles ranging from product development to order processing to payroll processing).

(iii) Greater flexibility (for example, faster response to changing customer demands and new technology). Sensing trouble from competing automobile giants-Daewoo Motors, Hyundai, Mitsubishi and Telco, Maruti Udyog Ltd. has joined hands with Countrywide Financial Services, with a view to offer attractive financing schemes for prospective buyers. The additional duties imposed by the Government in 1998 Budget have also been included in the price of different models at the lower and middle end of the market. The Maruti Zen VX model hit the market in 1998 without carrying the cost of additional accessories and excise duty running to over Rs. 30.000. To exhaust the demand during the intervening period, the Zen model came with the 100 percent financing option. Such agile and smart moves have kept the company far ahead of its competitors in the past and there is no evidence of the company taking rest on its past laurels


Notes


as yet-despite having a good market share of over 70 per cent in India!

(iv) Lower costs and less waste (for example, eliminating needless steps, scrap rework and non-value adding activities).

TQM advocates emphasis on the importance of achieving greater quality, speed and flexibility at lower cost and waste. You need not sacrifice something in order to give another thing. All things are possible, provided you work with a clear-cut focus, i.e., improving things.

d. Build Teamwork and Empowerment: TQM is built around employees, their needs, aspirations and expectations. It is employee-driven. It allows employees to exploit their full potential. Empowerment takes place when employees are properly trained, provided with all relevant information and the best possible tools, fully involved in key decisions and fairly rewarded for results. In order to carry out work effectively and efficiently, teams have to be created, drawing talent from various departments in a cooperative way.

TQM Tools/Techniques The implementation of TQM involves the use of the following techniques.

1. Benchmarking: Competitive benchmarking is the first requirement for effective TQM. It is comparatively new to Indian companies. The essence of benchmarking is the striving to be the best in one's area of operations (dontootsu). It is a continuous process of measuring products, services and practices against the toughest competitors or industry leaders with the aim of mutual improvement.

Benchmarking is a continuous process. It is not an one-shot deal because industry practices change constantly. Complacency may be suicidal.

Benchmarking implies measurement of the gap between the practices of two companies, so as to uncover significant differences.

Benchmarking can be applied to products, services, practices, processes and methods.

Thus, benchmarking is a systematic investigation, a fruitful learning experience which ensures that the best of industry practices are uncovered, analysed, adopted and implemented. Companies such as Modi Xerox, HDFC, IFB, Infosys, Indal, SRF, TELCO, Thermax, Bombay Dyeing have successfully applied competitive benchmarking to meet the rising expectations of customers in their respective areas.

The benchmarking process involves twelve steps: identifying benchmarking candidates, identifying best competitor, collecting data, finding the gap, projecting the future performance, communicating benchmark findings, establishing functional goals, developing action plans, implementing plans, recalibrating benchmark's attaining leadership position and integrating into processes.

2. Quality Circles: One approach to implementing the decentralised approach of TQM is to use quality circles. A quality circle is a small group of employees who meet periodically to identify, analyse and solve quality and other work-related problems in their area. Generally speaking, members of a particular circle should be from the same work area, or who perform similar work so that the problems they select will be familiar to all of them. The ideal size of the group is six to eight members. The size should not be too big so as to


Notes


prevent members from interacting actively and contribute meaningfully in each meeting. The main features of a quality circle are as follows:

(a) Voluntary group: It is a voluntary group of employees. Members join the circle on their own. There is no pressure from management.

(b) Manageable size: Size of a quality circle varies between six to ten. Members generally hail from a particular work area.

(c) Regular meetings: Members meet at periodic intervals to discuss quality-related problems. They assemble during normal working hours usually at the end of the working day. The time for the meetings is usually fixed in advance, in consultation with the manager. As a rule of thumb, meetings occur once a week and each meeting lasts for about an hour.

(d) Own agenda: Each circle has its own agenda. It has its own terms of reference, selects its own problems and offers recommendations for solving them.

(e) Exclusive focus on quality: The quality circle, by its very nature, exists to identify, analyse and solve quality-related problems. The ultimate purpose is to improve organisational functioning and thereby, the quality of working life.

3. Empowerment: TQM relies on the empowerment of employees as well as the contributions of suppliers and customers in the decision-making process. Inputs from all these groups are necessary to achieve continuous improvements.

Empowerment is the authority to take decisions within one's area of operations without having to get approval from anyone else. Here, the operatives are encouraged to use their initiative to do things the way they like. To this end, the employees are given not just authority but resources as well so that they not only take decisions but implement them quickly. Thus, empowerment means giving the employees the authority to make decisions and providing them with financial resources to implement these decisions.

4. Outsourcing: The contracting out of a company's in-house function, to a preferred vendor with a high-quality level in a particular task area, is known as outsourcing. By farming out activities in which they may not specialise or do not have expertise (e.g., HRM, inventory management, warehousing, designing, etc.), organisations can save costs on employee benefits and free existing personnel for other duties.

5. Reduced Cycle Time: Cycle time refers to the steps taken to complete a company process such as designing a new car, publishing a new title etc. It involves removal of unnecessary steps in the process and acceleration of activities into a shorter time frame. Reduction in cycle time helps a company improve its overall performance as well as quality.

Student Activity „TQM is built around four main ideas: Do it right the first time, be customer centred, make continuous improvement a way of life, and build teamwork and empowerment.‰ Give your opinion.

Decision Support System (DSS) Decision support systems are a class of computer-based information systems including knowledge based systems that support decision making activities.


Notes


Because there are many approaches to decision-making and because of the wide range of domains in which decisions are made, the concept of decision support system (DSS) is very broad. A DSS can take many different forms. In general, we can say that a DSS is a computerized system used for supporting rather than automating decisions. A decision is a choice between alternatives based on estimates of the values of those alternatives. Supporting a decision means helping people working alone or in a group gather intelligence, generate alternatives and make choices. Supporting the choice making process involves supporting the estimation, the evaluation and/or the comparison of alternatives. In practice, references to DSS are usually references to computer applications that perform such a supporting role.

The term decision support system has been used in many different ways (Alter 1980, Power, 2002) and has been defined in various ways depending upon the author's point of view and others define a DSS rather broadly as "a computer-based system that aids the process of decision making." Turban defines it more specifically as "an interactive, flexible, and adaptable computer-based information system, especially developed for supporting the solution of a non-structured management problem for improved decision making. It utilizes data, provides an easy-to-use interface, and allows for the decision maker's own insights."

Other definitions fall between these two extremes. For Little, a DSS is a "model-based set of procedures for processing data and judgments to assist a manager in his decision-making." For Keen, a DSS couples the intellectual resources of individuals with the capabilities of the computer to improve the quality of decisions ("DSS are computer-based support for management decision makers who are dealing with semi-structured problems"). Moore and Chang define DSS as extendible systems capable of supporting ad hoc data analysis and decision modeling, oriented toward future planning, and used at irregular, unplanned intervals. For Sprague and Carlson, DSS are "interactive computer-based systems that help decision makers utilize data and models to solve unstructured problems." In contrast, Keen claims that it is impossible to give a precise definition including all the facets of the DSS ("there can be no definition of decision support systems, only of decision support"). Nevertheless, according to Power, the term decision support system remains a useful and inclusive term for many types of information systems that support decision making. He humorously adds that every time a computerized system is not an on-line transaction processing system (OLTP), someone will be tempted to call it a DSS. As you can see, there is no universally accepted definition of DSS.

Features of DSS 1. Support for decision makers in semi-structured and unstructured problems.

2. Support managers at all levels.

3. Support individuals and groups.

4. Support for interdependent or sequential decisions.

5. Support intelligence, design, choice, and implementation.

6. Support variety of decision processes and styles.

7. DSS should be adaptable and flexible.

8. DSS should be interactive and provide ease of use.

9. Effectiveness balanced with efficiency (benefit must exceed cost).

10. Complete control by decision-makers.

11. Ease of development by (modification to suit needs and changing environment) end users.


Notes


12. Support modeling and analysis.

13. Data access.

14. Standalone, integration and Web-based.

Benefits of DSS 1. Improving Personal Efficiency

2. Expediting Problem Solving

3. Facilitating Interpersonal Communication

4. Promoting Learning or Training

5. Increasing Organizational Control

Control in Service Organization An internal control mechanism forms the backbone of the exercise of business management. When its models are consistently designed and implemented to produce more conducive environment it tends to enhance attainment.

Management control has been defined as 'the process by which management assures that an organization carries out its strategies effectively and efficiently'. Rapidly rising costs evidenced over the past decade have resulted in increased emphasis on these qualities in all organizations, particularly those in the public sector or similar nonprofit, service-oriented organizations where management controls have historically been lacking.

Normative aspects of organization culture, the distribution and total amount of control, employee performance and perceived quality of service were investigated in a cross-sectional study (n = 823) involving subjects from 159 organizations. A model integrating these constructs is presented, followed by an empirical investigation of hypothesized linkages. Significant relationships were found between organization culture and control distribution, culture and total amount of control, culture and service quality, culture and employee performance, and total control and service quality. Contemporary organizations are making substantial financial and human resource investments in training in problem analysis and problem solving techniques, within the context of Total Quality Management (TQM) programs and, in some cases, culture change efforts (Beer, Eisenstat, & Spector, 1990). These investments are being made in the belief, rooted partly in the "human relations management" movement (Fayol, 1946; Likert, 1961; McGregor, 1960), that the participation and involvement of all hierarchical levels will result in higher product/service quality and, subsequently, improved organization performance.

The requirements for dynamic virtual organization management have been derived from an analysis of the state-of-the-art in service-oriented enterprise management systems and its preparedness for handling more complex, long-term business interactions with multilateral agreements. It was found that these forms of business interactions are currently not well supported with respect to dynamic configuration of membership and business interactions based on trust, security and contract parameters.

Improving Processes Establishing a quality management system is not rocket science. The intent of any quality management service is simply to provide a system for developing or improving processes through a structured approach, effective deployment and better control.


Notes


The response must be that in service industries, especially in a high-attrition environment like business process outsourcing (BPO), it is all the more imperative to have documented processes.

Documented processes help in the following ways:

Processes are optimized when best practices are documented.

Processes do not become person-dependent – any new employee knows how to do the work.

Key activities run smoothly when responsibilities and accountability is clearly assigned.

Defects are easier to capture and eliminate at the earliest stage.

Prescribed corrective actions can be taken as soon as defects occur.

Written changes in procedures and policies reduce ambiguity and increase change control in the environment.

Consistent process measures help gauge if everything is going well.

Better understanding of processes ensures compliance in service delivery.

The quality management system not only provides a structure and framework, it also ensures the rigor of an audit mechanism that enforces corrective action. Continuous improvement happens within all processes in a systematic manner.

Importance of organization chart: An organization chart outlines the support structure for every individual process and also gives the roles and responsibilities required for each of the blocks on the organization chart. The benefits are:

An organization chart allows clients to see the support structure for products or services.

The roles and responsibilities give a clear understanding of the job for the person who is new to the system.

The documentation of roles and responsibilities does not leave anything to interpretation that might vary from person to person.

The roles and responsibilities define the skills that are required to do a particular job.

Once the skill has been defined, then it can be verified to see if it is resulting in a high-performing individual.

Clearly, something as small as having an organization chart can bring a great deal of value and clarity to the system.

The Basis of MCS in Service Organization Many times companies embark on a methodology like Six Sigma, Lean Six Sigma or others to solve problems without realizing that these methodologies center on process improvement. For any improvement methodology to be successful, it is important to first have a process management and process measurement system. This helps in identifying defects and then, once a process is improved, a quality management system provides better control for sustaining outstanding performance.

Contract Management in Service Organization Microsoft Dynamics CRM 4.0 is powerful and at the same time very intuitive, plus it is web based, meaning that you can run nationwide company in MS CRM. LetÊs review the example on how to create, budget and log time against CRM contracts. All


Notes


the functionality, we are describing here is available out of the box, no custom logic required:

1. Leads. Everything should be originated from the lead object: somebody called or emailed you with question about your services. You enter this call into CRM as the lead, assign to relevant sales person and follow up with her/him on what happened with this lead

2. Lead as Account or Opportunity. When your sales person classifies lead to become the customer, lead is transferred to account, or alternatively you can have intermediate step to classify lead as the opportunity

3. Contract. When you have account in CRM (more likely customer), you can create contract for this account. Contract Budgeting is realized in so-called contract lines. In the case of service organization we recommend you to consider allotment in minutes (which you will have to translate into hours via reporting)

4. Case against contract line. Then when you would like to open service ticket – you simply create the case against contract line. When case is created, it is ready for accepting your consultants time logs in the form of tasks

5. Contract Invoicing status nuances. Microsoft Dynamics CRM has several phases for the contract, and you need to release contract for becoming active via Invoice Contract procedure

6. Closing the case. When you close the case, you virtually update contract line budget and real time spent. In the case closing form you see the time spent and you need to accept or adjust billable time

7. At this step the case is ready to be exported from MS CRM to your accounting billing system to invoice your customer

Total Quality in Service Organisation Despite services being a large segment of the economy, the concepts of service quality are not as well developed as those of manufacturing quality (Ghobadian, Speller, & Jones, 1994). This may be because the manufacturing and service literatures currently treat quality management differently (Harvey, 1998; Sousa & Voss, 2002). Most service quality research uses the gap model to examine service quality (Harvey, 1998). The gap model, which was first proposed by Parasuraman, Zeithaml, and Berry (1985), considers five gaps between service performance and customer expectations, but it does not directly consider many of the elements of total quality.

There is mixed support in the service quality literature for the visionary leadership construct. While Harvey's (1998) review of service quality does not consider the role of leadership, Chase (1996) reports evidence that superior leadership leads to superior results in services. In addition, Foster, Howard, and Shannon (2002) found that leadership was related to process improvement, teamwork, and employee satisfaction in their analysis of government services.

Finally, the importance of leadership in successfully implementing total quality in health care is recognized in the MBNQA's health care criteria for performance excellence (NIST, 2003). The first award criterion listed is "visionary leadership" and it outlines the key role of senior administrators in successfully implementing total quality in health care. Therefore, while the concept of visionary leadership may be difficult to implement in hospitals due to their organizational structure, it remains an important element of total quality management.

Both the service quality literature and the health care literature support the applicability of the internal and external cooperation construct to the service industry.


Notes


The internal cooperation construct is similar to the concept of human resource focus as used in service research. Typical items included in human resource focus are communications, training, recognition of support for quality objectives, and employee satisfaction.

Summary Modern management control methods include:

Setting business goals, long and short term.

Proper planning.

Identifying workable strategies.

Effective communication.

Delegation of work.

Timely evaluation of the accomplished stages.

Budget management.

Just-in-time (JIT) is an inventory strategy implemented to improve the return on investment of a business by reducing in-process inventory and its associated carrying Just-in-time (JIT) is an inventory strategy implemented to improve the return on investment of a business by reducing in-process inventory and its associated carrying costs.

Quick communication of the consumption of old stock which triggers new stock to be ordered is key to JIT and inventory reduction. This saves warehouse space and costs.

JIT (also known as lean production or stockless production) should improve profits and return on investment by reducing inventory levels (increasing the inventory turnover rate), reducing variability, improving product quality, reducing production and delivery lead times, and reducing other costs (such as those associated with machine setup and equipment breakdown).

JIT applies primarily to repetitive manufacturing processes in which the same products and components are produced over and over again. The major problem with just-in-time operation is that it leaves the supplier and downstream consumers open to supply shocks and large supply or demand changes. TQM is a way of creating an organisational culture, committed to the continuous improvement of skills, teamwork, processes, product and service quality and customer satisfaction. TQM is built around four main ideas: Do it right the first time, Be customer centered, Make continuous improvement a way of life, and Build teamwork and empowerment.

The implementation of TQM involves the use of the following techniques.

1. Benchmarking

2. Quality Circles

3. Empowerment

4. Outsourcing

5. Reduced Cycle Time

Decision support systems are a class of computer-based information systems including knowledge based systems that support decision making activities. A DSS can take many different forms. In general, we can say that a DSS is a computerized system used for supporting rather than automating decisions.


Notes


Keywords TQM (Total Quality Management): Organisational philosophy and strategy that makes quality a responsibility of all employees.

Kaizen: Continuous and never ending improvement involving everyone in the organisation.

Benchmarking: The continuous process of comparing an organisationÊs strategies, products or processes with those of best-in-class organisations.

Quality Circles: A group of 6 to 12 volunteer employees who meet regularly to discuss and solve problems affecting the quality of their work.

JIT (Just-in-time): An inventory strategy implemented to improve the return on investment of a business by reducing in process inventory and its carrying costs.

Decision Support System (DSS): Decision support systems are a class of computer based information systems including knowledge based systems that support decision making activities.

Review Questions 1. Briefly explain the various techniques of total quality management.

2. What do you understand by the term ÂJITÊ? What are the advantages and disadvantages of JIT?

3. Write a brief note on Decision Support System (DSS).





PUNJAB TECHNICAL UNIVERSITY LADOWALI ROAD, JALANDHAR

INTERNAL ASSIGNMENT

TOTAL MARKS: 25

NOTE: Attempt any 5 questions All questions carry 5 Marks. Q 1. “Control is a fundamental management function that ensures work accomplishment according

to plans.” Analyse the statement describing the importance of control and the steps involved in the control function.

Q 2. What are the elements of an adequate or effective control system? Q 3. Explain the process of setting up of responsibility centre. Q 4. Explain the different methods of transfer pricing. How can one determine the transfer price? Q 5. Elucidate the process of production budget. Q 6. Illustrate the methodology of purchase budget. Q 7. Draw the process of preparing the cash budget. Q 8. Explain the role of performance analysis in management compensation. Q 9. Briefly explain the various techniques of total quality management. Q10. Discuss the various types of variance and performance indicators.

PUNJAB TECHNICAL UNIVERSITY LADOWALI ROAD, JALANDHAR

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Mba 518

Economy & Finance

Transcript of Mba 518