Ms-43 Combined Minus Case Study 6

UNIT 1Objectives MANAGEMENTCONTROL SYSTEMS: AN INTRODUCTION Management Control Systems: An Introduction The objectives of this unit are to: • • • • familiarize you with the management-control systems in general explain the various concepts of control contrast management control with strategic thinking and planning, and other control concepts provide an overview of new management techniques for management control and implications of new dimensions such as ethics dimension for management control. Structure 1.1 1:2 1.3 1.4 Introduction Basic Concepts Nature and Purpose of Management Control Components / Elements of Control Systems 1.4.1 1.4.2 1.4.3 1.4.4 1.4.5 1.4.6 1.4.7 1.5 Planning, Measurement and Reporting Systems Hierarchy of Control (Strategy, Management Control and Operational / Task Control) Organization Structure and Control Process Corporate Culture Rewards / Compensation Communication and Integration Informal Management Controls New Management Techniques for Management Control 1.5.1 1.5.2 1.5.3 1.5.4 1.5.5 Integrating TQM and MCS JIT and MCS Benchmarking and MCS Activity Based Costing (ABC) and Management Control Speed, Quality and Cost (SQC): Management Controls in Service Industry 1.6 1.7 1.8 1.9 1.10 1.11 1.12 JT, ERP, TKM and Management Control Systems Ethics and Management Control Systems General Considerations in Designing Management Control System Summary Key Words Self Assessment Questions Further Readings 5 Management Control: Concepts and Context 1.0 INTRODUCTION In this unit, we will acquaint you with various conceptual foundations and framework of Management Control Systems (MCS). The main focus of this unit is on the nature and purpose of management control systems, elements of management control systems, interlinkages between strategic the inking, management control and operational controls. During the recent years, a number of new management techniques have emerged. These include Total Quality Management (TQM), Activity Based Costing (ABC), Enterprise Resource Planning (ERP), Total Knowledge Management (TKM), etc. In this unit we provide a brief outline on linkages of these management techniques with Management Control Systems. We close this unit by highlighting the implications of ethical dimension in signing and operating the Management Control Systems 1.2 BASIC CONCEPTS The concept of control can be explained by some of the well-known metaphors. These metaphors are as follows: • • • • • Thermostat 98.6 Human Body Temperature Driving System of Automobile Traffic Control Black Box These five metaphors of control provide us interesting insights into control process. In thermostat a pre-decided level of temperature is set and the device is designed in a way to get turn on or turn off when actual temperature deviates from the set standard. Thus, it is an automatic control system. While thermostat is a man made control system, nature has designed an elaborate control system for human beings viz. homeostatic. The body temperature is maintained at 98.6 F through a self-regulating mechanism. In a healthy body, this control process is automatic because system corrects the deviations through selfregulation. Only when the deviations are very high e.g. high fever, an external intervention in the form of medicine is required to bring the temperature back to normal. In terms of complexity of control mechanism, the control system of the body temperature is more complex as compared to the thermostat. The driving system of the automobile provides us the ABC of man-machine control mechanism wherein ABC implies, Accelerator, Brake and the Clutch. It is the control over these three components that gives the driver control over the vehicle. Changing gears according to the road conditions is the essence of this control system. This metaphor of control has interesting lessons for management control in organizations because organizations are man-machine systems. The traffic control systems is another interesting metaphor of control. It is a go, nogo system. Red, Yellow and Green represent the three colours of control. Red representing no-go, Yellow representing the permission to go and Green representing the go situation. In organizational contexts also, rules and procedures are designed around the concept of go and no-go. Black-box is another metaphor of control. A black box is a device with input terminal and output terminal and electrical circuitry within the box wherein the nature of the circuit by looking from outside is not known. This idea has been extended to all those operations and systems whose "exact nature cannot be observed 6 A summary of the above five metaphors of control is given in Table 1.1. Management Control Systems: An Introduction Table 1.1: Metaphors of Control Systems Metaphor of Control Thermostat Body Temperature Driving System Traffic Black Box Key Idea Engineering Model of Control Nature's Model of Control, Homeostasis Man Machine Control Model Yes-No Control Model Input-Output Model All the five metaphors of control have lessons for not only understanding the control process in organizations but also in designing the control systems. In addition to the above metaphors we also need to understand the idea of open loop control systems and the closed loop closed systems. In `"Control System Engineering", control system is defined as a "group of components functioning together in coordination to perform a function. This function may be control of a physical variable such as speed, voltage, temperature, pressure, position etc." In the open loop system, also known as non-feedback system, there is no provision within the system for the supervision of the output and no mechanism is provided to correct the system behaviour for any lack of proper performance of system components. Such systems are represented by the following diagram: Input variable Transfer function Output variable Illustrations of open loop system include automatic city traffic system, alarm clock, washing machine etc. In all these situations there is no feedback mechanism. Automatic traffic system does not take into consideration the intensity of traffic on the road etc. In sharp contrast to the open loop system, closed loop systems are the feedback systems. Such systems are driven by two signals viz. the input signal and the feedback signal. Feedback signal is derived from the output of the system. The advantage of the feedback signal lies in giving the system the capability to act as selfcorrecting mechanism. Given the above understanding about controls and control systems, we can now provide a conceptual framework for controls in organizations. In the context of an organization of men and machines, control has four elements: • • One, a measuring device which detects the actual state of the variable under control, sometimes called detector. Two, an assessing device which, usually by comparing, show the difference or gap between the actual state and the desired state of variable under control, sometimes called selector. Three, an altering or correcting device which carries out the necessary alteration or correction in the actual state of the variable to achieve the desired state, sometimes called effector. Besides these three elements namely, detector, selector and effector, the control system also includes the means for communicating information such as directives, guidelines, feedback, etc., among these elements. These elements of control system are shown by a diagram in Figure 1.1. • • 7 Management Control: Concepts and Context 1.3 NATURE AND PURPOSE OF MANAGEMENT CONTROL At one point in time the concept of management was captured by the catch phrase "POSDCORB" indicating the role of manager in terms of "Planning, Organizing, Staffing, Directing, Controlling, Reporting and Budgeting". While this fundamental definition also sums up the essence of the nature and purpose of management control, the concept of management control has evolved from this generic approach to a more specific definition. Anthony and Dearden (1981) provided the following definition: "Management control is the process by which managers assure that resources are obtained and used effectively and efficiently in the accomplishment of organization's goals". Subsequently this definition was been modified and refined by Anthony and Govindrajan (1994). The modified and refined definition is as follows: "Management control is the process by which managers influence other members of the organization to implement the organization's strategies". They further state: "Management control involves a variety of activities. These include: • • • • • • planning what organization should do, coordinating the activities of several parts of organization communicating information evaluating information deciding what, if any, action should be taken influencing people to change behaviour" The echoes of the POSDCORB mantra can be heard in this amplification of the nature and purpose of management control as articulated by Anthony and Govindrajan. 8 These definitions are summarized in Table 1.2. Management Control Systems: An Introduction Table 1.2: Elements of Management Control Process What the organization should do Communicating information, Evaluating information, Deciding what action should be taken Influencing people to change their behaviour Visioning Decision-making Leading Merchant (1998) argues that there are many definitions of management, "all of which relate to process of organizing resources and directing activities for the purpose of achieving organization's objectives". He uses the framework of Functions, Resources and Processes as elements of management. His framework is presented in Table 1.3. Table 1.3: Elements of Broad Areas of Management Functions Product (or service) development Operations Marketing / Sales Finance Resources People Money Machines Information Processes Objective setting Strategy formulation Control Source: Modem Management Control Systems: Texts & Cases, Kenneth A Merchant, Prentice Hall, Inc., 1998, p.3 It may be observed that in this classification, the focus is on 1) Functions of basic management such as product (or service) development, operations, marketing, finance etc; 2) Resources viz. people, money, machines and information; and 3) Processes viz, objective setting, strategy formulation and control. Merchant further states that in this framework, "the term control separates the management functions along a process continuum involving objective setting, strategy formulation and control". Merchant further develops his Management Control Systems framework in terms of three types of controls viz. Action Controls, Results Controls and Personnel and Cultural Controls. Figure 1.2 provides this framework. Action controls "involve ensuring that employees perform (or do not perform) certain actions known to be beneficial (or harmful) to the organization". Results controls focus on results and involve "rewarding individuals (and sometimes groups of individuals) for generating good results or punishing for poor results". Personnel and Cultural controls on taking steps that ensure "that employees control their own behaviour or control each others' behaviours". Such controls aim at helping employees do a good job and are based on employees' natural tendencies to control 9 Management Control: Concepts and Context themselves. These controls imply self-monitoring that could include self-control, intrinsic motivation, ethics, trust, transparency etc. It may be indicated that Management Control Systems can also be viewed from functional perspective. In functional approach to Management Control Systems, the managerial functions of Marketing, Finance, Human Resource Development (HRD), Manufacturing, Research & Development, etc., constitute the primary basis for design of the management controls within each function. Figure 1.3 presents the conceptual framework of functional approach to control systems. Activity 1 a) List at least three metaphors of control, with their key ideas and explain them briefly. …………………………………………………………………………………… …………………………………………………………………………………… …………………………………………………………………………………… …………………………………………………………………………………… …………………………………………………………………………………… b) Explain the meaning of POSDCORB and relate it to management control. …………………………………………………………………………………… …………………………………………………………………………………… …………………………………………………………………………………… …………………………………………………………………………………… …………………………………………………………………………………… c) Explain Functional approach to Management Control Systems. …………………………………………………………………………………… …………………………………………………………………………………… …………………………………………………………………………………… …………………………………………………………………………………… …………………………………………………………………………………… 10 …………………………………………………………………………………… 1.4 1.4.1 COMPONENTS ELEMENTS OF CONTROL SYSTEMS Planning, Measurement and Reporting Systems Management Control Systems: An Introduction The Planning, Measurement and Reporting (PMR) cycle is at the heart of designing a management control system. Planning includes the projects, ideas, programmes and activities that organization intends to take up over its planning horizon. It articulates the "strategic intent" (Prahalad and Hamel) in an environment of "strategic uncertainties" created by the changes in the technology, consumer preferences, competitors' strategies etc. Strategic inputs from the top management are incorporated in the budgeting exercise in planning the activities for the year. Measurement process involves measurement of the actual performance against the targets. Reporting involves "achievement reporting" by comparing the actual achievement with the desired achievement as reflected by the targets and the budgets. The above PMR cycle is repeated every year. The cycle can also be repeated over shorter periods of time, say six monthly and quarterly to ensure corrective action on the part of the managers and also to ensure that the "drivers are reaching at the destination point in correct time", Figure 1.4 presents the PMR cycle, Planning Reporting Figure 1.4: Planning, Measurement and Reporting (PMR) Cycle 1.4.2 Hierarchy of Control (Strategy, Management Control and Operational / Task Control) Anthony and Dearden provided a conceptual framework of control systems in terms of three leave, processes viz. Strategic Planning, Management Control and Operational Control. This terminology has now been sharpened through the idea of an "interactive hierarchy" of control represented by strategy, management control and the task control. In Table 1.4 below we provide the "old" and the "new" frameworks: 11 Management Control: Concepts and Context Table 1.4: The Old and New Framework of Management Control Systems Old Framework New Framework (Anthony & Dearden) (Anthony & Govindrajan) Strategic Planning Operation Control Strategy Formulation Task Control Management Control Management Control In the discussion below we interchangeably use the old and new frameworks as the underlying foundations of these frameworks are the same. Management Control and Strategic Planning and Control A quick comparison between strategic planning and control, and management control throws up the following points of distinction: • Strategic planning focuses on a single aspect of the corporate life at a time whereas management control focuses on all the operations of different subdivisions or units of an organization. The acquisition and deposition of major facilities, creation of division or subsidiaries, research and development of new products, and sources of new permanent capital belong to the domain of strategic planning. The focus of management control extends to the total operations of divisions, plants, etc. The domain of strategic planning comprises unstructured or unprogrammed decisions whereas management control is predominantly rhythmic and regular. The nature of information required for strategic planning tends to be tailor-made for the problem, largely external, futuristic and less accurate whereas management control requires integrated, largely internal, historical and accurate information. Strategic planning often uses techniques like SWOT analysis (Strength, Weaknesses, Opportunities and Threats analysis) whereas management control relies on budgeting. Strategic planning is a creative and anlytical activity whereas management control is largely administrative and persuasive in nature. The time frame of strategic plans tends to be long, say beyond one year, whereas the management control operates by an year, quarter or even smaller time frames. The appraisal of strategic plain is extremely difficult compared to management control which is relatively easy to evaluate. • • • • • • Management Control and Operational Control Operational control is yet another category of control, which operates in organizations. In simple words, it ensures that the specific operations or tasks are carried out efficiently and effectively. Some of the ways in which management control differs from operational control are highlighted here under: • Management control focuses on all the operations of a sub-division or unit of an organization whereas the focus of operational control is limited to a single task or transaction. Examples of activities for which management control is applicable are the total operations of most manufacturing plants, marketing function and the work of staff units of all types. Examples of tasks susceptible to operational control are the direct production operations of most manufacturing plants, production scheduling, inventory control, the order taking type of selling activity, and order processing, premium billing, pay-roll accounting and cheque handling. 12 Management Control Systems: An Introduction • The domain of operational control involves little judgment and greater reliance on rules whereas in management control there is greater degree of judgment and subjective decision making. The information needed for operational control is often tailor-made to the operation, non-financial, precise and in real time whereas management control often uses integrated, financial. futuristic and historical information, even approximations sometimes. The time horizon of operational planning and control tends to be day-to-day whereas management control works with weekly, monthly or yearly time frames. The techniques of Operations Research (OR) find wide applications in the area of operational control as the activities are programmable but management control has to work with diverse information generated through Management Information System (MIS), Decision Support System (DSS) and Knowledge Based System (KBS). • • • 1.4.3 Organization Structure and Control Process Organization structure is essentially the arrangement of various sub-units, departments and responsibility centers with defined authority and responsibilities. For a proper understanding of the control process, it is important to understand the nature of organization structure. The following are the broad forms of organization structure: • • • • Functional Structure Divisional Structure Matrix Structure Network Structure In functional structure, an organization is structured on the basis of critical. functions such as production, marketing, finance, HRD etc., with each manager having responsibility for the respective function. Integration across functions is ensured by the top management through formal and informal meetings and controls. In divisional strucutre, an organization is structured on the basis of a product line or group of product lines that constitutes the division; the divisional manager is responsibile for all functions related to the division. Integration across divisions is ensured by the top management by initiating divisional performance control systems. In matrix organizations, organization is structured along two dimensions viz, according to functions and according to projects / products. Such strucutres are quite common in case of project management organizations / R & D institution's wherein a person is simultaneously responsible to two bosses e.g. the project manager and the functional manager. In such organizations, integration is achieved through task forces and project teams. In network structures, organization is structured on the basis of network requirements. Organization is like a fishnet wherein various parts are interwoven and are highly interdependent. Such structures are "horizontal" in nature, in contrast to bureaucratic structures, which are "vertical" in nature. With the advent of Information Technology, the network structures have emerged as a new form of organization structure. Most Information Technology firms are organized around network 13 Management Control: Concepts and Context structures. Quick information transmission ensures integration between the various nodes of the network structure. Closely related to the concept of organization structure, is the concept of responsibility centre. In fact, organization structure and control systems are linked through the idea of .responsibility centre. Broadly speaking, "a responsibility centre is simply an organizational unit headed by a responsible manager". In control systems, a responsibility centre is usually built around financial responsibility say, for cost, revenue, profit and - vestment but also uses non-financial measures based on key or critical variables. The principal types of financial responsibility centres are as follows: • • • • Cost Centres Revenue Centres Profit Centres Investment Centres Standard Cost Centres can be exemplified by foremen in a factory whose responsibility is specified in standard quantities of direct labour and material required for each unit of output. He is also usually responsible for a flexible overhead expense budget, and his objective is to minimize the variance between the standard / budgeted cost and actual cost. Discretionary Cost Centres include most administrative departments viz. accounting department, legal department, labour relations department, factory office, and corporate office. There is no practical way to establish input-output relationship in an engineering sense for these departments. The management, therefore, makes use of their best judgment (discretion), to sot up cost budget for these departments. Revenue Centres can be best illustrated by the sales departments whose managers do not have authority to lower price but are judged by the sales revenue. Profit Centres are units such as a product division, where the manager is responsible for maximizing the profit i.e. revenue minus cost. Investment Centres are units where the manager is responsible for maximizing the profitability i.e. profits in relation to the magnitude of investment employed. 1.4.4 Corporate Culture "Corporate culture consists of shared values, common perception and common decision premises applied by organization particularly to the activities and problem of organization" (Maciariello & Kerby, 1997, p. 13). In essence, corporate culture is an integrating mechanism for integrating vision, mission and action aspects of managerial process. Vision and mission are based on shared values and common perceptions. Actions are based on common decision premises applied to the activities and problems of the organization. Because corporate culture is rooted in shared values, it facilitates control through "self-control". The members of the organization exercise self-control because they have imbibed the shared values. Maciariello & Kerby (1997, p.13) consider corporate culture as a coordination and control mechanism. According to them, "Common beliefs and values about the activities and problem of a business greatly facilitate control by: 14 • Internalizing in individuals key decision premises and directions • • Developing a sense of group loyalty Reducing dissonance and friction" Management Control Systems: An Introduction An important aspect of corporate culture is trust and transparency. It ensures that values are shared by every one and there is fairness in performance evaluation, rewards and punishments. This reinforces the trust and transparency, leading to strengthening of the corporate culture. 1.4.5 Rewards/Compensation Efficacy of control systems depends upon the nature of the reward and the incentive systems. Rewards could be monetary and non-monetary in nature. Monetary rewards include salary increase and ESOPs (Employee Stock Options Plans). Non-monetary rewards include recognition, enhanced status, increased autonomy, appreciation etc. There are several theories of motivation. These theories provide us insights as to what motivates individuals. At the root of most of these theories is the idea of rewards and positive reinforcements. There has been a shift from the punishment oriented approaches to control to reward-oriented approaches as a basis to motivate people. It is now widely recognized that though money is an important motivator, there are several non-monetary incentives that motivate individuals to perform at peak levels. The ambience and salience of the corporate culture provides basis for such non-monetary incentives. Work-culture in itself could be a motivating factor. It may be indicated that rewards could be based on both individual and group performance. Team building and team approaches are essential for success of any organization. Hence, the rewards should also be team based, while at the same time recognizing the individual's contribution to the success of the organization. 1.4.6 Communication and Integration Communication is at the root of the efficacy of the control systems. Communication helps in proper coordination of activities across functions, divisions and the networks. It ensures that organization members move in the direction of shared values and goals of the organization. It ensures "goal convergence" between the individual's goals and organization goals. There are several "management communication vehicles" such as formal Conferences, Workshops, Official Newsletter, Monthly Reports, Inter Office Memos, Office Notes, E-mails, Intranet, Internet etc. In addition, informal communication is also very much prevalent. In fact, informal communication is at times more effective than formal communication. Because of importance of communication, "corporate communications" has emerged as a function in itself. Integration of various activities and processes is not only achieved through "communication circles" but also through other formal mechanism such as committees. To address issues at different levels, committees are constituted to achieve integration across the organization. Strategy and operating management committee aims at achieving a synergy between strategy and its implementation. The idea of `quality circles' has also emerged as an important idea to achieve integration between the strategy and operations. 1.4.7 Informal Management Control 15 Besides the formal management control system, which has been the focus of our discussion so far, much of the management control involves informal communication and interactions. Informal management control occurs through meetings, conversation, site visits, etc. Structure meetings with unstructured agenda which Management Control: Concepts and Context means that the time and venue of the meeting is fixed, say every Monday at 11.00 am, in the chief's office, but not the agenda - the matters to be considered and decided, has been a common mode of control in professional groups, research teams, university schools and banks. Staff retreat and informal dinner also serve in a limited way the purposes of management control. Indeed, the role of informal management control has been considered so critical that managements like to keep `loyal employees' who are essentially `informers', in key -positions. In a Marwari organization, the finance man is often from the family/caste/ village. Informal control is not visible in the form of responsibility centres, programmes, budgets and reports yet it exerts strong, pressure. Informal management control is not amenable to systematic description but it does operate in every organization whether it has a formal management control system or not. Activity 2 a) List four points of distinction between management control and strategic planning. …………………………………………………………………………………… …………………………………………………………………………………… …………………………………………………………………………………… …………………………………………………………………………………… …………………………………………………………………………………… …………………………………………………………………………………… b) List four points of distinction between management control and operational control. …………………………………………………………………………………… …………………………………………………………………………………… …………………………………………………………………………………… …………………………………………………………………………………… …………………………………………………………………………………… …………………………………………………………………………………… c) Identify broad forms of organizational structure. …………………………………………………………………………………… …………………………………………………………………………………… …………………………………………………………………………………… …………………………………………………………………………………… …………………………………………………………………………………… …………………………………………………………………………………… d) Define “responsibility centre” and identify various types of responsibility centres built around financial responsibility. …………………………………………………………………………………… …………………………………………………………………………………… …………………………………………………………………………………… …………………………………………………………………………………… …………………………………………………………………………………… …………………………………………………………………………………… e) What do you understand by Corporate Culture? How does it influence the management control system? …………………………………………………………………………………… …………………………………………………………………………………… …………………………………………………………………………………… …………………………………………………………………………………… …………………………………………………………………………………… …………………………………………………………………………………… 1.5 16 NEW MANAGEMENT TECHNIQUES FOR MANAGEMENT CONTROL During the recent years a number of new management techniques have been conceptualized and tested in the organizational context. They have now become part of the standard management literature. Further, these techniques have now been integrated with the literature on management control systems. In the discussion below, we provide a brief on these techniques and their integration with the management control systems. In particular we will discuss Total Quality Management (TQM), Just In Time (JIT), Benchmarking, Activity Based Costing (ABC) and SQC (Speed, Quality, Cost) model for service industry. 1.5.1 Integrating TQM and MCS Management Control Systems: An Introduction Fundamental idea in TQM is the PDCA cycle. PDCA stands for Plan, DO, Check and Act. This idea has been extensively applied to the field of quality improvement. The focus of this idea was on Total Quality and to gain competitive advantage through the Total Quality approach. PDCA cycle provided foundation for the Total Quality Control (TQC). Subsequently, TQC was given a new name viz. Total Quality Management (TQM). Within the broad umbrella of TQM, a number of tools and techniques have been developed. They largely relate to improvement in Operational controls/Task control. The customer focus has been brought in sharply and the concept of quality has been redefined from the viewpoint of customer. TQM approach has helped in strengthening the feedback mechanism between the customer and the producer. It has also strengthened the coordination between the marketing and the manufacturing divisions with the organizations. Quality circles evolved as important instruments at the shop floor level to improve the task performance. The concept of Kaizen i.e. continuous improvement provided the foundation for search for ways to improve performance in relation to various tasks being performed by the work force. Thus, task control is facilitated through various techniques of TQM such as kaizen and quality circles. It may be indicated that the PDCA cycle for all practical purposes is a modification of the control system concepts. It has been earlier indicated that idea of control systems has been articulated in terms of, Planning-Coordinating-Communicating information - Evaluation of information - Deciding the action - Influencing people to change behaviour. It can be seen that the PDCA cycle and the concept of control system have close equivalences and similarities. In the literature on TQM, three "managerial" functions have been clearly identified viz. innovation, kaizen (continuous improvement) and maintenance. Top management should focus on the innovation, middle management on kaizen and supervisors and workers on maintenance. Interestingly these three functions correspond to the "hierarchy of control" framework discussed earlier viz. strategy formulation, management control and the task control. An equivalence between TQM and MCS ideas is presented in Table 1.5. Also presented is an integral view emerging from the two approaches. Table 1.5: An integrative View of TQM and MCS Level of Management Top management Middle management TQM Innovation Kaizen MCS Strategy Formulation Management Control Task Control Integral View Visioning Decision-Action Task Performance Supervisors and Workers Maintenance Thus, in the integral view of management control systems, TQM is a supporting tool for the management control systems. It may be indicated that though the concept of TQM is presented as a philosophy of quality and a tool for gaining competitive advantage through the route of quality, 17 Management Control: Concepts and Context most of its tools and techniques are focussed at the operational/task control. Statistical control charts, fishbone technique for root cause analysis, error prevention, zero defect, waste elmination etc are aimed at task performance and operations management. Thus, TQM is essentially an operations management technique and largely belongs to the third level of control hierarchy viz. the task control. 1.5.2 JIT and MCS Just-In-Time entered the lexicon of management both as a philosophy as well as a technique. More comonly known as JIT, Just in time philosophy aims at "eliminating waste by reducing the time products spend in the productive process and eliminating the time products spend on activities that don't add value". Since holding inventory is a non-value-added activity, in the JIT production systems, aim is to have zero inventory. The essence of JIT philosophy and JIT production system is to eliminate waste and improve quality. In JIT system, an organization "purchases materials and parts and produces components just when they are, needed in the production process". In JIT oriented organizations the customer's orders move the production process. Hence there is no need to unnessarily carry the inventories. There are two approaches to business: 1) Produce, hold inventories and wait for customer orders. 2) Get the customer orders, then produce. For example, in case of book publishing the first approach may still be valid and a publisher may have to necessarily carry inventory, particularly in those cases where a market is to be created for the book. In several other manufacturing situations, production process can be triggered on the basis of orders on hand. For example, a transformer manufacturing unit can design its production system on the basis of JIT approach, when it is in a comfortable order book position. Manufacturing of perishable commodities can't wait for the customer orders. However, they have to ensure Just-In-time delivery. For this they must carry inventories to fulfill the customers demands. In JIT system, the following are considered important: • Reduction in production cycle time: Since, JIT focuses on waste elimination, it aims at reduction in production cycle time, by reducing the "wasted time" in the manufacturing process. Reduction in production cycle time not only helps in a better response to customer orders but also in reduction of monitoring levels. Prodction flow smoothening: JIT also helps in smoothening the production flow. If there are fluctuations in production rates, the deliveries to customer are affected. Further organizations have to carry the excess inventory. Hence in JIT, factories are so organized as to ensure reduction in work-in-progress as well as reduction in idle time of machinery. In addition, a flexibility is required in production operations. Flexibility in production operation is facilitated through flexibility in facilities and employee. The facilities should be usable for producing a variety of components and products and employees should be multiskilled to take up a variety of jobs. Quality Focus: JIT focuses on quality improvement through employee involvement. Once employees are involved in achieving zero defect, there is a reduction in non-value added activities. There is an emphasis on Total Quality Control and continuous improvement in quality. • • 18 An important aspect of JIT is "the practice of establishing relationship with customers for automatic ordering". When there is an advance booking of an order, the JIT could work very well. For advance booking, the relationship between the organization and its Management Control Systems: An Introduction customers should be one of trust and confidence. For all practical purposes, customers become insiders and part of the administrative process. This in a way is an essential condition for JIT system to be effective. JIT can be considered an important operational control mechanism, with a focus on cycle time reduction thereby leading to better efficiency and productivity. The goal of the JIT is to have zero inventory wherein the optimum lot size is one - i.e. goods are produced or ordered only when they are needed. In reality this happens rarely. Anthony and Govindrajan (1994) observe that "the term is a catchy way of stating the direction in which lot size should be headed". It indeed is a catchy phrase even though it doesn't capture the reality. Perhaps a better phrase would be "Minimum Inventory Driven System" (MIDS), but catch phrases have their own appeal. 1.5.3 Benchmarking and MCS The idea of benchmarking was initially developed by Xerox to achieve "Leadership Through Quality". The word benchmarking is derived from the word benchmark used by surveyors to indicate "a mark in the stone or metal, or other durable material firmly fixed in the ground, from which differences of level are measured as in surveys or tidal observations". Thus, the "level difference" is the hall mark of benchmarking. The level of difference can be identified by comparing the performance with others. This can provide us strategic information of significant importance. In fact, because of such benefits of benchmarking, it has become a "significant strategic tool". Benchmarking is "the process of continuously comparing and measuring an organization against business leaders anywhere in the world to gain information which will help the organization take action to improve its performance". In essence benchmarking is a "learning model" wherein we learn from others and use the learning to improve competitive edge. Accordingly, benchmarking has also been defined as "the identification and implementation of best practices to achieve customer results and business performance". The mission of benchmarking is to be "best-in-class". The idea of benchmarking is to provide a road map for being Numero uno (number 1 or the best-in-class). It has been observed that "Benchmarking itself is a process. You do not use it to prove you are best at something, but to learn how to become the best. Benchmarking, by itself, does not improve performance; it provides information you can use to improve. It is a discovery process aimed at exceeding customer expectation" (George and Weirmerskirch, 1999, p.207). Benchmarking is broadly classified in following three categories: 1) 2) 3) Competitive benchmarking Process benchmarking Strategic benchmarking Competitive benchnmarking, "attempts to determine what competition is doing with respect to product design". It is an effort to determine product characteristics that would provide a competitive edge. Competitive benchmarking also focuses on benchmarking product costs, so that costs can be compared with others. Through this secrets of cost controls can be learnt. However, there are difficulties in product cost 19 Management Control: Concepts and Context benchmarking, because others may not easily share their costing data. Further, different companies use different types of classifications and terminologies while preparing product cost-sheets. In spite of such limitations benchmarking the product cost could provide some useful hints. In process benchmarking, the focus is on improving process. The fundamental questions that we have to ask in process benchmarking are as follows: • • • What is the scope of the process we are going to benchmark? How does that process work? How do we measure it? What do we want to learn about that process from benchmarking partners? In strategic benchmarking the idea is to create and implement a new strategy. "The key is to create a shift in strategy or the adoption of a new business practice, which management expects to result in a competitive advantage". Given the above brief discussion on benchmarking, we can relate it to the conceptual framework of MCS. It may be observed that three types of benchmarking are interconnected with hierarchy of control viz. strategy formulation, management control and task control. 1.5.4 Activity Based Costing (ABC) and Management Control Activity Based Costing (ABC) is yet another idea that has influenced the field of management control. While some consider Activity Based Costing as an old wine in new bottle, others consider it a necessity to arrive at the correct view of the product costs. It is essentially a system for allocation of overheads on the basis of "activity" caused by the product. In this new system, "the word activity is often used instead of cost centre, and cost driver instead of basis of allocation; and the cost system is called an activity based-cost system (ABC)", It has been pointed out that the need for using activity as a basis for allocation of cost has arisen because direct labour hours are no more considered as reliable basis for arriving at the correct picture of product costs. Since, labour cost as percentage of total cost has been declining, labour hours as a basis for overhead allocation are likely to provide a distorted picture. Similarly, in case of service industries, machine hours as a basis for overhead allocation could lead to distortions. Activity based costing corrects such distortions by using activity as a basis for overhead allocation. ABC has important implications for management control. It yields better picture of the product costs facilitating decision-making in relation to pricing, product mix, make or buy decisions etc. It has been pointed out that because of a large number of cost drivers and "activity cost pools", companies do not find it worthwhile to generate ABC information on routine basis. Instead of relying on a large number of cost drivers, it is preferable to focus on "critical drivers". Since ABC generates a more accurate picture of the product cost, it can provide critical insights to the cost basket of products that a company is producing. This information is useful for strategic purposes to realign the product basket. Hence, ABC is essentially a tool for strategic planning and strategic think. Herein lies its linkage with the control system hierarchy. The above discussion indicates that both TQM and ABC have relevance for management control. While ABC is more useful for strategic planning of the product portfolio of the organization, TQM has its usefulness for the operational controls. Though of different origin, the two together can be integrated with the management control systems. Figure 1.5 provides this integrated framework. 20 Management Control Systems: An Introduction Integration of Strategy and Operational Management Operational Management Figure 1.5: ABC and TQM as Supporting Tools for MCS 1.5.5 Speed, Quality and Cost (SQC): Management Controls in Service Industry The competitive advantage depends upon three factors, viz. Speed (S), Quality (Q) and Cost (C). Managing these "SQC" factors is critical to the success of business. Speed refers to speed with which product is delivered to the client. It also implies the “speed of business”. With Information Technology and other advances in manufacturing technology, the speed of doing business has been increasing. "Business at the Speed of Thought" has emerged as a new metaphor to emphasize the importance of speed and speed management. Thus, it is not just the Quality Management and Cost Management that are critical, but Speed Management is equally important and sometimes more critical. It may be indicated that speed management should be differentiated from Time Management. Speed management implies managing both space and timing factors in such a way as to ensure proper delivery of the product to the customer. Thus, it implies honouring the commitments and sticking to delivery schedules. Management Control Systems should be so designed as to facilitate better management of the Speed, Quality and Cost. It may be indicated that the SQC concept discussed here is particularly important for the service industry where, speed of delivery is critical to business success in addition to quality and cost. In service industry, delivery of products or services should be Perfectly - In - Time (PIT) like the astronaut landing on moon. Hence, the critical importance of Speed Management and the need for on-line monitoring and control systems. 1.6 IT, ERP, TOTAL KNOWLEDGE MANAGEMENT (TKM) AND MANAGEMENT CONTROL SYSTEMS The revolution in Information Technology has influenced the corporate world in many ways. With the availability of on-line information, the task of managers in performance monitoring has become both easy and difficult. While MIS (Management Information Systems) focussed on key variables and relevant information, the IT has thrown open the gates for information revolution through democratization of information. Every variety of information is now easily-accessible to managers and employees. This facilitates coordination across various departments, task and responsibility centres. IT revolution has also lead to emergence of E-commerce which has opened new opportunities for expanding business. Internet and Intranet are now widely being used by the managers. They have facilitated what can be known as "virtual control" on operations. Most organizations are now using "Virtual Control Systems" for online monitoring of its activities. 21 Management Control: Concepts and Context Earlier, information integration in organizations was achieved through MIS; now the same is achieved through ERP (Enterprise Resource Planning) systems. ERP systems are essentially software developed for achieving information integration through the latest technology. "ERP software is designed to model and automate many of the basic processes of a company, from finance to the shop floor with the goal of integrating information across the company and eliminating complex, expensive links between computer systems that were never meant to talk to each other" (Leon, Alexis, Enterprise Resource Planning, Tata McGraw Hill, 1999 p.5). It may be indicated that "Computers and IT are integral parts of an ERP system; but ERP is primarily an enterprise-wide system, which encompasses corporate mission objectives, attitudes, beliefs, values, style and people who make the organization" (Leon, 1999 p.4). Thus, it can be observed that ERP philosophy is close to the framework of Management Control Systems, In fact the essence of ERP can be viewed as a combination of IT and MCS (Management Control Systems). The evolution of the idea of ERP is linked with the sophistication in the use of information and the developments in IT. This sophistication is indicated by the evolutionary journey from the idea of MIS to the idea of KBS (Knowledge Based Systems) in use of information by managers. "The MIS system addressed to the operational information needs through effectiveness measures like exception reporting, insights into processes etc. 'DSS (Decision Support Systems) used extensive modeling tools such, as optimization simulation and statistical analysis to reveal patterns in the information generated by MIS systems to genuinely support tactical and even strategic decisions. KBS systems went beyond data, information and models to capture the knowledge of the decision maker and to use the captured knowledge to propose far superior solutions" (Sadagopan S, ERP: A Managerial Perspective, Tata McGraw Hill, 1999 p.5). During recent years, there has been a shift from data to information to knowledge. Hence, knowledge based systems are emerging as new tools to strengthen the information links between three levels of control hierarchy. Knowledge has been defined in many ways. In the enterprise context, it is the "full utilization of data, information and ideas" originating from various sections, departments and individuals as well as from customers, suppliers and other stakeholders. Knowledge Management implies leveraging the organizational knowledge for achieving competitive edge. This is achieved through Knowledge Function Deployment (KFD) which implies the following: • • • • Building and managing customer relationship through knowledge. Educating customer by providing additional information and knowledge about products, process and people in the organization. Building Knowledge sharing culture within the organization and with the stakeholders. Networking and developing knowledge alliances for enhancing the net worth. Making organization a learning organization. Using the Knowledge Function Deployment techniques such as knowledge mapping, mind scape maping, "participatory design", knowledge tree and knowledge software tools, etc., the Total Knowledge Management (TKM) is a new approach to create strategic advantage for organizations by managing its Total Knowledge that is available to it in explicit and tacit forms. Figure 1.6 provides an (integrated) framework of MCS integrating ABC, TQM and Total Knowledge Management. 22 Management Control Systems: An Introduction Activity 3 a) List the new management techniques that are influencing the design of management control systems in organizations. …………………………………………………………………………………… …………………………………………………………………………………… …………………………………………………………………………………… …………………………………………………………………………………… b) Explain how PDCA cycle of TQM and PMR (Planning, Measurement Reporting) cycle of Management Control System can be integrated together. …………………………………………………………………………………… …………………………………………………………………………………… …………………………………………………………………………………… …………………………………………………………………………………… c) Explain how JIT influences Management Controls. …………………………………………………………………………………… …………………………………………………………………………………… …………………………………………………………………………………… …………………………………………………………………………………… d) "Activity Based Costing (ABC) is essentially a strategic think tool". Explain. …………………………………………………………………………………… …………………………………………………………………………………… …………………………………………………………………………………… …………………………………………………………………………………… e) Highlight the importance of SQC (Speed, Quality and Cost) factors for management control. …………………………………………………………………………………… …………………………………………………………………………………… …………………………………………………………………………………… …………………………………………………………………………………… f) What is the impact of Information Technology (IT) on design of Management Control System. …………………………………………………………………………………… …………………………………………………………………………………… …………………………………………………………………………………… …………………………………………………………………………………… g) "Total Knowledge Management (TKM) can facilitate management control by strengthening links between three levels of control hierarchy". Explain. …………………………………………………………………………………… …………………………………………………………………………………… …………………………………………………………………………………… …………………………………………………………………………………… 23 Management Control: Concepts and Context 1.7 ETHICS AND MANAGEMENT CONTROL SYSTEMS During the recent time, the ethical dimension of corporate behaviour and conduct has received wide attention in the field of management. Several organizations have drawn up ethical codes of conduct. However, we need to answer the following questions: Why individuals in organizations indulge in unethical conduct and unethical practices? The answer to this could be sought in the following two explanations: The overall environment in the nation is one of corruption and moral decay, leading to legitimization of unethical behaviour on the part of citizens. This is a macro-level problem that should be tackled by the enlightened citizens of the nation through a collective voice and collective choice. At the organizational level, the ethical failures occur because norms are not properly designed. Ethical failure are essentially control failures. While internal auditing can check frauds and misappropriates the ethical misconduct can be checked only through properly designed norms and standards. Maciariello and Kirby (1997, pp. 648-654) provide a cybernetic model of instituting ethics program in organizations. This model in its simplified version is as follows: • • • Decide the desired state: Set the ethical goals in terms of compliance with all laws. Translate the ethical goals in terms of code of conduct and ethics policies. Measure the current state: Find the current state of compliance of laws, find the deviations from code of conduct. In essence, conduct an `ethical audit'. Initiate remedial action: Investigate the alleged violations and initiate a remedial action to ensure that the loose ends are tightened and to prevent reoccurrence of unethical practices, issue proper warning signals to prevent unethical behaviour, "It is better to foster ethical behaviour than to police, catch, and punish unethical behaviour". Those indulging in unethical behaviour may need `ethics counseling' for moral and ethical correction 24 Maciariello and Kirby (1997) provide us the following six step framework for controlling ethical beha' iour and preventing "ethical violations". Step 1: Goal setting: Achieve compliance with all law, ethical codes and policies of the organization. Step 2: Sensitizing: Sensitize all managers and employees as to what kind of behaviour constitutes unethical behaviour. Step 3: Ethical audit: Audit the behaviour of employees with respect to norms, standards and code of conduct. Step 4: Reporting: Report significant deviations from ethical conduct. Step 5: Investigation: Investigate alleged violations. Step 6: Remedial Action: Implement decisions to correct improper behaviour. In respect of ethics, there are two types of organizations viz., reactive and proactive. Reactive organizations tend to take the policing, witch-hunting and scape-goat approach. Proactive organizations ensure that managers and employees are properly sensitized to reduce the chances of ethical misconduct. They also do this by putting the expectations, norm and standards in writing in the form of a "rule book". This achieves two purposes. First, the alleged violations can be compared with the norms and standards and unnecessary witch-hunting is avoided. Second, ethical sensivity and ethical consciousness can be raised through a periodic reminder of the rule-book, as well as through ethical counselling. Many a time, the question of ethics in organizations relates to the proper design of control system, particularly the operational controls. By following the cybernetic ethics control model, many ethical failures can be avoided and ethical violations can be prevented. Activity 4 a) Provide an outline of cybernetic model of ethics in organizations. .................................................................................................................................. .................................................................................................................................. .................................................................................................................................. .................................................................................................................................. .................................................................................................................................. b) How proactive organizations check the unethical conduct of their employees. .................................................................................................................................. .................................................................................................................................. .................................................................................................................................. .................................................................................................................................. .................................................................................................................................. Management Control Systems: An Introduction 1.8 GENERAL CONSIDERATIONS IN MANAGEMENT CONTROL SYSTEM DESIGNING An effective management control is needed by every organization. But how to create it? In other words, what are the prerequisites of an effective management control system? These are questions of considerable interest and significance and have been subject of ceaseless debates. It is not that we intend to provide you cut and dried answers to these either. Here, we attempt to highlight some broad considerations which should be borne 25 Management Control: Concepts and Context in mind while designing and implementing a management control system in any organization. Top Management Responsibility: The responsibility for the design and implementation of a management control system rests inescapably with the top management or say the coordinating unit. The reason is simple. It is the top management that decides the goals, objectives, strategy and structure of an organization which indeed serve as the boundary constraints for management control system. Financial controller often provides critical assistance in designing management control system in an organization. Organization Specific: It must be remembered that management control system tends to be highly situational and organization specific. The designer of management control system must therefore clearly understand the relevant external and internal environment of an organization. He must fully understand the nature of business i.e. whether it is manufacturing, service, profit-oriented, non-profit, private or social project, and its size, scale, technology and diversity of operations, etc. Indeed, each organization would have its peculiar environments and mangement control systems must seek specific fit to these. Goal Congruence: Efficient and effective accomplishment of the goals of the organization is the aim of all management processes. Management control system is no exception. Each responsibility centre in the organization must then strive to put up best performance but not at the cost of overall peformance. The overriding consideration in designing and implementing a management control system should be individual good consistent with sum total good. Management Motivation: A prerequisite for goal congruence in an organization lies in the.acceptance of the goals and sub-goals of the organization by its unit managers and adequate effort and motivation on their part to achieve them. Thus, motivation of managers deserve special consideration in designing and implementing a management control system. Fairness or Objectivity: It is sometimes said that managerial effort and motivation, among other things, depend largely on the degree of fairness or objectivity build into the performance measurement and evaluation. Experience shows that people resent evaluation, which they consider unfair or subjective or vague rather than evaluation per se. Thus, reasonably objective measures of performance should merit special attention of the management control system designers. 1.9 SUMMARY This unit discussed the concept and nature of management control rooted in various metaphors of control systems. The unit discussed the nature of "interactive hierarchy" of management control, in terms of strategy, management control and task control. It also stated that, in general, management control system comprises a structure of financial responsibility centres viz. standard cost centre, discretionary cost centre, revenue centre, profit centre, investment centre, and a process of Planning, Measurement and Reporting. The unit provided an overview of inter-linkages between various new management techniques such as TQM, JIT, ABC, ERP, TKM, etc., with management control systems. It also provided a discussion on ethical dimension in management control systems to prevent ethical failures in organizations. Broad considerations, such as goal congruence, managerial motivation, objective performance measure, among others, should be borne in mind by the designers of management control system in any organization. 26 1.10 KEY WORDS Detector: The device that detects, observes and measures the activities or phenomenon being controlled. Goal Congruence: Harmony between or matching of goals of the individual and the goals of the organization, or goals of a part of an organization and goals of the total organization. Effector: A device that modifies or effects changes in the performance to achieve the desired state. Management Control: A process of control by which a management attempts to carry out its strategies by motivating people to perform their activities and making necessary corrections. Operational Control: A type of control which ensures that specific operations or tasks are carried out efficiently. It requires certain techniques and methods for various tasks. Responsibility Accounting: A system of accounting which recognizes various responsibility centres within the organization. Depending upon the goals, a responsibility centre may be a cost centre, a revenue centre, a profit centre or an investment centre. Selector: A device that assesses or evaluates the performance of an activity in relation to a pre-determined standard and identifies deviations. Strategic Planning: The process of developing strategies and policies for the organization so that the organization and its parts function as a unified whole. Management Control Systems: An Introduction 1.11 SELF-ASSESSMENT QUESTIONS 1) 2) 3) 4) Define the purpose of management control, distinguishing it from Strategic Planning, Strategic Formulation and Operational Controls. Identify various critical components of management control and indicate how they influence the behaviour in organizations. "The ultimate purpose of management control is to achieve goal congruence" Comment? New Management techniques such as Total Quality Management (TQM), JIT (Just-In-Time) are in tune with the conceptual foundations of Management Control Systems. Explain. Ethical control systems, when designed on the basis of cybernetic framework, can prevent many ethical failures in the organizations. Explain. 5) 1.12 FURTHER READINGS Anthony, R.N. and John Dearden, 1977, Management Control Systems-Text and Cases, Taraporevala: Bombay (Chap.l). Anthony R.N. and Govindrajan V, 1994, Management Control Systems, Tata McGraw Hill (Chap.l). Horngren C.T, Gary Sundem W.O. Stratton, 1999, Introduction to Management Accounting, Prentice Hall. 27 Management Control: Concepts and Context Maciariello Joseph A, & Calvin Kirby, 1997, Management Control Systems: Using Adaptive Systems to Attain Control, Prentice Hall (Chap. 1 & 19). Merchant, Kenneth A, Modern Management Control Systems: Text & Cases, Prentice Hall (Chap.l ). Shank John K. and Govindrajan V, 1993, Strategic Cost Management: The New Tool for Competitive Advantage, The Free Press. Sharma Subhash, 1988, Management Control Systems-Text and Cases, Tata McGraw (Chap. 1). Stephen George and Arnold Weimerskirch, 1994, Total Quality Management: Strategies and Techniques Proven at Today's Most Successful Companies, John Wiley & Sons Inc. Tiwana, Amrit 2000, The Knowledge Management Toolkit: Practical Techniques for Building a Knowledge Management Systems, Prentice Hall (Chap. 3). 28 UNIT 2 STRATEGIES AND MANAGEMENT CONTROL Objectives After studying this unit, you should be able to understand the: • • • 2.1 2.2 2.3 2.4 2.5 2.6 2.7 2.8 2.9 2.10 2.11 2.12 Concept of strategy Nature of corporate and business unit strategies Inter-linkages and interface between strategies and management control Introduction Mission and Objectives Concept of Strategy Strategies and Core Competencies Corporate Level Strategies Business Unit Strategies Strategies and Management Control: Interface Radical Performance Improvement and Management Controls Summary Key Words Self Assessment Questions Further Readings Strategic and Management Control Structure 2.1 INTRODUCTION In the control hierarchy, the focus is on strategy formulation, management control and task control. Strategies indicate the general direction in which an organization is moving to fulfill its mission, goals and objectives, Hence, understanding the nature of competitive strategies is very important. There are a variety of models and frameworks which help us in understanding the concept of strategy. They also help us in formulation of strategies. In this unit we will deal with these models and frameworks. Since you will be studying about the concept of strategy in greater depth in the course on Strategic Management, in this unit, therefore, we limit ourselves to a general introduction of the concept of strategy and various models of strategy formulation. The basic idea in this unit is to understand the linkage between strategy and management control. 2.2 MISSION AND OBJECTIVES Goals are defined as "broad statements of what the organization wants to achieve in the long run on a permanent basis" and objectives are defined as "specific statement of ends, the achievement of which is contemplated within a specified time". Many times these terms are also used interchangeably. However; both are subsumed under the term mission, which is indicative of the `strategic intent' and `strategic direction' of the organization. Mission is articulated on the basis of the vision of the founders or the chief executive. Mission is achieved through a properly formulated strategy and 29 Management Control: Concepts and Context action plan with appropriately in-built mid-course correction system. Mission, vision and action indicate the interactive relationship between strategy and management control. In the case of business organizations, an important goal is the Return-on-Investment (ROI). The concept of ROI is defined as follows: Thus, ROI is a product of two factors viz. Profit margin in % terms and investment turnover. ROI can be improved either by increasing the profit margin or by increasing the productivity of capital by improving the turnover ratio or by improving both. As an illustration, consider the case of ABC with revenues as Rs. 50,000, expenses as Rs. 48,000 and investment as Rs. 10,000. Its ROI is as follows: 30 ROI can be improved either by increasing profit margin from the current level of 4% or by improving efficiency of usage of assets i.e. by increasing turnover ratio from existing level of 5 or by improving both. But there will be other constraints such as business factors, managerial factors and environmental factors that would restrict the profit margin and turnover ratio. Strategic and Management Control 2.3 CONCEPT OF STRATEGY The idea of strategy can be traced to the Greek word `strategies' meaning "the general's art". Stanford Research Institute defines strategy as "a way in which a firm reacts to its environment, deploys its principal resources and marshals its main efforts in pursuit of its purpose". It may be observed that "Pursuit of Purpose" is a key word in this definition. Therefore, for strategies to be meaningful, a firm should articulate its Purpose. The concept of corporate strategy was initially formulated by Kenneth R. Andrews: Strategy formulation is a process that senior executives use to evaluate a company's strengths and weaknesses in the light of the opportunities and threats present in the environment and then decide on strategies that would fit the company's competencies with environmental opportunities. In this concept, SWOT analysis is at the heart of strategy formulation. In SWOT analysis focus is on company's strengths and weaknesses and on the opportunities and threats coming from environment/ competition. SWOT analysis is an exercise in `internal analysis' i.e. identifying strengths and weaknesses and `environmental analysis' i.e. identifying opportunities and threats. Once this is done, appropriate strategies are formulated to achieve a fit between the organization and environment. Thus, strategy formulation is essentially a "fitting" process to find appropriate fit between organization and environment. There are four "fitting" responses. Figure 2.1 presents these responses. A discussion on these responses is as follows: Response I Matching strengths with environmental opportunities: This calls for an aggressive approach to strategy because the company has many strengths and many opportunities. If these opportunities are not tapped, they would become missed opportunities. Response II Coping with threats from the position of strength: When the company has several strengths but it faces a number of threats, the response strategy is one of diversification. Through diversification it can minimize the adverse impact of threats Response III Market offers opportunities but the company has several weaknesses: In such a situation, company should be put into a turnaround gear. It should focus on overcoming its weaknesses so that it can tap the opportunities to its advantages. Response IV There are many threats and the company has several weaknesses: This is the case of losing battle. Company can focus an protecting its territory through a defensive approach. Unless a `strategic surgery' is done, company will have to divert and say quits to the business. 31 Management Control: Concepts and Context SWOT analysis is a useful tool for positioning the company with respect to the environmental conditions. This analysis can also be applied to the product-market strategies. Products have their strengths and weaknesses, markets offer opportunities and threats. There are four positioning strategies: 1) 2) 3) 4) Product has many strengths and Market offers opportunities: Skim the market, increase the market share. Product has strengths but Market is full of threats: Highlight the product's strengths to maintain the market share. Product has weaknesses but Market offers opportunities: Improve the product to the requirements of the market. Product has weaknesses and Market has threats: This is an ICU (Intensive Care Unit) syndrome. Be prepared to say quits both to the product and to the market. 2.4 STRATEGIES AND CORE COMPETENCIES The idea of core competence was formulated by Prahald and Hammer in their article, "Core Competence of the Corporation". "A core competence is what a firm excels at and what adds significant value for customers". From this definition of corecompetence, it may be observed that core competence essentially means strengths of the company. Thus, the concept of core competence draws our attention to the first factor of SWOT analysis i.e. the strengths factor. "Strategy should be based on strength", is an ancient quote, used in the context of war between two kingdoms. In competency-based strategy, we find an echo of this ancient wisdom. The idea of core competence when matched with the opportunities and threat analysis, provides a contour for strategic directions for the organization. Herein lies the importance and usefulness of the idea of core competence. Since different organizations possess different core competencies, each organization must identify its core competencies and build them further for matching with market opportunities and overcoming the market threats. Activity 1 a) Explain the concept of ROI. 32 ………………………………………………………………………………………..... ………………………………………………………………………………………..... ………………………………………………………………………………………..... ………………………………………………………………………………………..... ………………………………………………………………………………………..... ………………………………………………………………………………………..... b) Define the meaning of the word strategy? ………………………………………………………………………………………..... ………………………………………………………………………………………..... ………………………………………………………………………………………..... ………………………………………………………………………………………..... ………………………………………………………………………………………..... ………………………………………………………………………………………..... c) Explain, what is SWOT analysis? ………………………………………………………………………………………..... ………………………………………………………………………………………..... .……………………………………………………………………………………….... ………………………………………………………………………………………..... ………………………………………………………………………………………..... ………………………………………………………………………………………..... d) Define "core competence". In what ways is it linked with SWOT analysis? ………………………………………………………………………………………..... ………………………………………………………………………………………..... ………………………………………………………………………………………..... ………………………………………………………………………………………..... ………………………………………………………………………………………..... ………………………………………………………………………………………..... Strategic and Management Control 2.5 CORPORATE LEVEL STRATEGIES It has been said that, "A new strategy sometimes succeeds and may sometimes fail. Unless we try it out we will not know about its success or failure". This wiS'dom of the practitioners is important in formulating strageties. Strategies help us in identifying the "general direction in which an organization plans to move to achieve its mission, goals and objectives". The general direction is indicated by the portfoliomix of the businesses. Why the current portfolio mix should change? What should be the new portfolio mix? These are the questions of importance in formulating Corporate Level Strategy. In the case of army, strategy implies "deployment of resources". Similarly, in corporate level strategy, the key idea is about the "deployment of resources" and the choice of "right mix of businesses" including the right choice of the "basket of products" At the corporate level, the strategy issues involve the following decisions: • • • Remain a single industry firm Diversify in related businesses Diversify in unrelated businesses A single industry firm operates in one line of business. Many IT industry firms are single industry firms, for example, Infosys. A related diversified firm has business units in related businesses, while in unrelated diversified context, firm operates in very diverse businesses. Tata and Birla are often cited as business houses (conglomerates) that have in their portfolio mix, a number of unrelated businesses. All the three types of firms can be observed in real life. Each has its own advantages and disadvantages. Research has yet to conclusively prove the efficacy of one type over the other, in terms of value to shareholders and “value to stakeholders”. The advantage of related diversification lies in firm's ability to transfer its core competencies from one set of business to another. In conglomerates, such flexibility in transfer of core competencies is not easily available because the businesses and their core competencies are not inter-related. Complete autonomy to businesses is an 33 Management Control: Concepts and Context effective way of running such businesses. In Birla organizations, such an autonomy is ensured through a "Padta system", wherein only cash flows are monitored and complete autonomy is given for decision making to the chief executive of the respective . businesses. It may be indicated that core competencies can be classified in following two categories: • • Transferable core competencies Non-transferable core competencies In case of single industry firm, core competencies are easily transferable from one business unit to another, from one location to another. In case of related diversified firm, core competencies can also be transferred from one business unit to another. However, in case of non-related diversified firms, it becomes difficult to transfer core competencies across the entire business spectrum. Transferability of the core competencies provides flexibility to corporate management to respond well to the opportunities and threats. 2.6 BUSINESS UNTT STRATEGIES While strategies are formulated at the headquarters, battles are fought at the field. This metaphor has implications for the business organizations. Corporate level strategies determine the overall strategic direction of the organization, the battle for survival and market shares takes place at the level of the business units. Therefore, business unit mission and business unit strategy assume significance in the overall scheme of things. Business units of an organization have to face the "competition heat" at the market place. In case of single industry firm, the heat of competition is felt both at the corporate level and the business unit level. In case of diversified firms intensity of competition heat is felt more at the business unit level. In both situations, business units must gear itself to face the competition. In essence, it should focus on creating a competitive advantage for itself. The following models help us in formulating business unit strategies: The BCG Model BCG (Boston Consulting Group) model is an important analytical tool for anlyzing the business unit strategies. The model provides a 2 x 2 matrix based on market share and market growth as a criteria to classify various businesses. The model not only classifies the business but also identifies the strategies for each category. Figure 2.2 presents the BCG model. 34 The following are the metaphors used in BCG matrix to classify various businesses: 1) 2) 3) 4) High market share, high market growth – Star High market share, low market growth - Cash cow Low market share, high market growth - Question mark Low market share, low market growth – Dog Strategic and Management Control It may be indicated that BCG matrix is essentially an extension / application of SWOT analysis to product and markets. High market share and low market share are indicative of the strengths and weakness of the company and high market growth and low market growth are indicative of the opportunities and threats. BCG matrix suggests that if a company/business unit is in "star" position, the strategy should be to hold on to this position. This is referred to as "hold" strategy. If company is in a "cash cow" position, it should milk the cash cow. This is referred to as "harvest" strategy. If company is in "question mark" position, it should try to increase the market share. This is referred to as "build strategy". If the company is in "dog" situation, it should think of getting out of such a business. This is referred to as "divest strategy". General Electric (GE) Planning Model The General Electric Planning model considers business strength and industry attractiveness as criteria for categorizing businesses. This model uses a 3 x 3 matrix for classifying businesses in terms of categories such as winners, question marks, average businesses, profit producers and losers. The model is presented in Figure 2.3. When we compare the GE model with BCG model, we can observe that market share is indicative of the competitive position or business strength and market growth rate is indicative of the attractiveness of the industry. In fact, we can reduce 3 x 3 matrix of GE model into a 2 x 2 matrix and refer It as modified GE model. The model is presented in Figure 2.4. 35 Management Control: Concepts and Context Improving Competitive Advantage An important aspect of business unit strategy relates to improving competitive advantage. For this Porter's five force model is useful to get an understanding of the industry structure. The five forces identified by Porter are as follows: 1) "The intensity of rivalry among existing competitors. Factors affecting direct rivalry are industry growth, product differentiability, number and diversity of competitors, level of fixed costs, intermittent over capacity, and exit barriers. The bargaining power of customers. Factors affecting buyer power are: number of buyers, buyer's switching costs, buyer's ability to integrate backward, impact of the business unit's product on buyer's total costs, impact of the business unit's product on buyer's product quality/performance, and significance of the business unit's volume td buyers. The bargaining power of suppliers. Factors affecting suppler power are number of suppliers, supplier's ability to integrate forward, presence of substitute inputs, and importance of the business unit's volume to suppliers. Threat from substitutes. Factors affecting substitute threat are relative price/ performance of substitutes, buyer's switching costs, and buyer's propensity to substitute. The threat of new entry. Factors affecting entry barriers are capital requirements, access to distribution channels, economies of scale, product differentiation, technological complexity of product or process, expected retaliation from existing firms and government policy". 2) 3) 4) 5) Porter's five force model is presented in Figure 2.5. 36 Figure 2.5: Porter's Five Force Model The intensity of these forces is indicative of the attractiveness of the industry and competitive pressures within the industry. The five force analysis helps us in focusing our attention on the opportunities and threats in the external environment. Porter suggests two strategies for responding to the opportunities and threats, viz., cost leadership and differentiation. In cost leadership route to competitive advantage, the focus is on gaining competitive advantage through cost advantage. If per unit costs are low because of the economies of scale, cost control, experience, curve advantage, etc., then the firm gains a cost advantage at the market place. In product differentiation route to competitive advantage, the focus is on differentiating the product in terms of product features, product design and product identity. The idea is to "create something that is perceived by customers as being unique". In the third route to competitive advantage, both the cost leadership and product differentiation are combined together. This route to competitive advantage is referred to as cost-dum-differentiation because it combines both the cost advantage and the product differentiation advantage. Hence, it represents the most attractive competitive position. Activity 2 a) Explain the basic idea behind BCG matrix. …………………………………………………………………………………… …………………………………………………………………………………… …………………………………………………………………………………… …………………………………………………………………………………… …………………………………………………………………………………… b) What is the difference between GE Planning model and BCG matrix? …………………………………………………………………………………… …………………………………………………………………………………… …………………………………………………………………………………… …………………………………………………………………………………… …………………………………………………………………………………… c) Identify the forces of Porter's five force analysis of an industry and offer your comments. …………………………………………………………………………………… …………………………………………………………………………………… …………………………………………………………………………………… …………………………………………………………………………………… …………………………………………………………………………………… Strategic and Management Control 2.7 STRATEGIES AND MANAGEMENT CONTROL: INTERFACE There is a close interface between strategies and management control. This interface is indicated by the concept of "interactive control" formulated by Simons (1995). Control system is essentially a strategy implementation tool. When viewed from this perspective, strategy and control systems are coupled with each other. Information generated from the control system is useful in formulating new strategies. When control system generates meaningful and useful information for thinking about new strategies, such a control system is referred to as "interactive control". The information from such a control system has a learning value for the managers and the organization as a whole. 37 Management Control: Concepts and Context Because of "strategic uncertainties" such as changes in technologies, competiton, lifestyles, Customer preferences etc., it is important that control system should throw up information relating to indicators of strategic uncertainties and indicators of troubles. Then such a control system has learning value for all the employees leading to a proper "learnign environment". Such a control system also makes the organization a "learning centre". Thus a strong interface between the strategy and control system makes the organizations learning organization. The learning loop between strategy and control system is depicted in Figure 2.6. Activity 3 a) Explain the idea of "interactive control" given by Simons. …………………………………………………………………………………… …………………………………………………………………………………… …………………………………………………………………………………… …………………………………………………………………………………… d) How control systems can make an organization a "learning organization". …………………………………………………………………………………… …………………………………………………………………………………… …………………………………………………………………………………… …………………………………………………………………………………… 2.8 RADICAL PERFORMANCE IMPROVEMENT AND MANAGEMENT CONTROLS The idea of Radical Performance Improvement (RPI) has been suggested by Sumantra Ghoshal et. al., in their book, Managing Radical Change. They consider managerial function as "learning to cook sweet and sour". For achieving radical improvements in performance, managers should effectively manage the sour task of improving resource productivity and the sweet task of creating and exploiting new opportunities. In a way, this approach is similar to Simons "interactive controls" wherein strategy and control systems are coupled to generate the synergy. While control systems could represent the sour side, strategy represents the sweet side, as it involves looking for opportunities. However, at times, strategy could also go sour. If both control system and strategy go sour, there will be catastrophic under-p rformance leading to sickness. In the RPI framework, three stages of competition have been identified, viz. Competition for dreams, Competition for the resources and competencies and Competition for markets. Competition for dreams involves articulating vision for future markets, indicating the corporate ambition and providing an overall sense of purpose to the business. Competition for resources and competencies includes competition for technology, quality people, brands etc. Competition for markets implies articulation of competitive strategy through industry analysis, segmentation and positioning, cost leadership and product differentiation, etc. Figure 2.7 presents this framework. 38 Strategic and Management Control For translating the framework of Radical Performance Improvement into an action plan, resources and competencies should be matched with business and opportunities. This is similar to the SWOT analysis, wherein strengths and opportunities are matched. Strengths are indicative of the resources and competencies, while opportunities implies "baskets of businesses". Existing resources and competencies could be expanded by adding new resources and competencies. Similarly, an organization could look for new businesses and new opportunities. RPI framework suggests that managers should leverage the existing and new resources and competencies by exploiting the existing and new markets and opportunities. Figure 2.8 presents this approach. Source: Ghoshal et.al., Managing Radical Change, 2000, Penguin Books, p.87 Through the case studies of Indian companies, Ghoshal et.al., suggest many innovative ways of "cooking sour and sweet" to achieve a breakthrough in performance. They also suggest a fundamental shift in management thought from 3Ss to 3Ps, wherein 3Ss stand for Strategy, Structure and Systems and 3Ps stand for Purpose, Process and People. In fact, we need an integrative approach wherein 3Ss and 3Ps play a complementary role. They should not be in contradiction to each other but should mutually support each other. We•present this integrative approach in Figure 2.9. 39 Management Control: Concepts and Context In effective organizations, interaction between three Ss and three Ps is managed to achieve a synergy between them, thereby ensuring radical performance Management Control Systems should be designed to facilitate this interaction. Herein lies the linkage between Radical Performance Improvement (RPI) and the Management Control Systems (MCS). Activity 4 a) Which are the three stages of competition suggested by Ghoshal et. al.? …………………………………………………………………………………… …………………………………………………………………………………… …………………………………………………………………………………… ………………………………………………………………………………….... b) Identify the three Ss and three Ps in the RPI model and highlight their importance for radical performance improvement. …………………………………………………………………………………… …………………………………………………………………………………… …………………………………………………………………………………… ………………………………………………………………………………….... 2.9 SUMMARY Concept of strategy is fundamental to survival and growth of an organization. Strategies should be well articulated in consonance with Purpose, Mission, Goals and Objectives. SWOT analysis is an important analytical tool that managers use in formulating strategies. BCG matrix and GE planning model, are analytical models for deciding about the "basket of businesses" or "basket of products" that a business entity should carry in its portfolio. Porter's five force model is alse helpful in analyzing the attractiveness of an industry. These models help managers in concretizing their business strategies. Interface between strategies and management control can be strengthened through "interactive controls". This in turn can make an organization as a "learning organization". The unit concluded with the concept of Radical Performance Improvement and role of control systems in facilitating Radical Performance Improvement. 2.10 KEY WORDS Goals: Broad statements of what the organization wants to achieve in the long run Strategy: A way in which a firm reacts to its environment deploys its resources and marshals its main efforts in pursuit of its purpose. SWOT Analysis: An analytical tool for strategy formulation indicating Strengths, Weaknesses, Opportunities and Threats. 40 Core Competence: A core competence is what a firm excels at and what adds significant value for customers. BCG Matrix: A 2 x 2 matrix based on market growth and market share. It classifies business in terms of "stars", "cashcows", "question marks" and "dogs" GE Planning Model: A 3 x 3 matrix based on industry attractiveness and business strength for classifying businesses in various categories. Interactive Control: When control system generates meaningful and useful information for thinking about new strategies such a control system is referred to as "interactive control". Three Stages of Competition: Competition for Dreams, Competition for Resources and Competencies and Competition for Markets and Opportunities. Strategic and Management Control 2.11 SELF ASSESSMENT QUESTIONS 1) 2) 3) 4) 5) Define the concept of strategy. Show how SWOT analysis is used in formulating strategies. Explain the BCG model, highlighting its usefulness in formulating business unit level strategies. Explain Porter's five force model and its importance for strategy formulation. How can interface between strategies and management controls be strengthened? Explain the concept of Radical Performance Improvement (RPI) and the role of Management Control Systems in facilitating RPI. 2.12 FURTHER READINGS Andrews, Kenneth R, 1980, The Concept of Corporate Strategy, Richard D.Irwin. Anthony, R.N. and Govindrajan V, 1994, Management Control Systems, Tata McGraw Hill (Chap.2). Ghoshal, Sumantra Gita Piramal and Christopher A Bartlett, 2000, Managing Radical Change: What Indian Companies Must Do To Become World-Class, Penguin Books (Chap. 4&14). Merchant, Kenneth A 1998, Modern Management Control Systems: Text and Cases, Prentice Hall. Porter Michael, 1985, Competitive Advantage, The Free Press. Sharma, Subhash 1988, Management Control Systems, Text and Cases; Tata McGraw Hill (Chap.2). 41 Management Control: Concepts and Context UNIT 3 Objectives DESIGNING MANAGEMENT CONTROL SYSTEMS The objective of this unit are to: • • • familiarize you with the attributes of Management Control Systems explain the concept of Management Information System (MIS) and identify the important design considerations in designing MIS highlight the importance of behavioural aspects in creating conditions within the organizations for goal congruence. Structure 3.1 3.2 3.3 3.4 3.5 3.6 3.7 3.8 3.9 3.10 3.11 3.12 Introduction Attributes of MCS Centralization Vs Decentralization Cybernetic Paradigm or The Feedback Factor Meaning and Implications of MIS Design Considerations in Designing MIS MIS and Total Knowledge Management (TKM) Behavioural Aspects Summary Key Words Self Assessment Questions Further Readings 3.1 INTRODUCTION In this unit, we will acquaint you with the various attributes of Management Control Systems (MCS). The unit presents the cybernetic paradigm of the control systems, highlighting the importance of the feedback factor. The essential aspects of MIS (Management Information System) have been presented and key design considerations in designing MIS have been highlighted. Importance of key variables or critical success factors has also been discussed. We close this unit by pointing out. the relevance and importance of the behavioural dimension in achieving goal congruence between individual goals and organizational goals. 3.2 ATTRIBUTES OF MCS Control systems can be broadly classified in the following two categories: 1) Reactive Control Systems 2) Proactive Control Systems In reactive control systems, the corrective action is initiated after the happening of the event or a control failure. In proactive control systems, the signals from the environment are anticipated and control system is built to incorporate the impact of such signals for taking the corrective action. Proactive control systems are similar to 42 what Newman calls "steering controls". According the Newman, in steering controls, results are predicted and corrective action is taken to ensure successful completion of operation e.g. astronauts landing on the moon right on target and on time. In proactive control systems, failure anticipation and contingency planning are the critical attributes. The strategic thinking and planning process should take care of these two important aspects of the control systems. The other attributes of the control system include the performance measurement and comparison with the standards. In performance measurement, we need to identify the indicators of performance. The indicators could be financial as well as non-financial in nature. Performance Measurement System (PMS) aims at measuring the performance of a responsibility unit in consonance with orgazational strategy. The concept of Balanced Scorecard has been proposed as a Performance Measurement System. Balanced Scorecard links the strategy and the performance by developing appropriate measures of performance and measures of strategic success. Thus, balanced scorecards represent the proactive control system or the steering control systems. It may also be indicated that Simons (1995) has suggested the idea of "interactive control". When control system throws up information which is useful for identifying new strategies, there is a greater interaction between the processes of strategic thinking and management control. Since, in such situations, control system becomes a strategy formulation tool, Simons refers to such control as "interactive control". The concept of Balanced Scorecard helps not only in seeking a linkage between the strategic measures and the performance measures but also acts as a tool for providing information that is useful for strategic thinking and strategic direction of the organization. Thus, it not only acts as a proactive control system but also as an interactive control. Hence, balanced scorecard can be viewed as a "steering" of the steering control systems. The above discussion indicated that the essential attributes of management control system are as follows: 1) 2) 3) 4) Proactive orientation Performance Measurement System (PMS) Strategy - Control System Linkage throught Interactive Control Failure Anticipation and Contingency Planning Designing Management Control Systems 3.3 CENTRALIZATION VS DECENTRALIZATION Centralization Vs. decentralization has been an important point of debate in the control system literature. It is primarily a concern of the large bureaucratic and hierarchical structures wherein decentralization becomes a necessity. Decentralization ensures freedom and autonomy in decision making with accountability and responsibility as the prerequisite. It may be indicated that with the advent of the Information Technology and new type of organization structures such as network structures, the issue of centralization vs. decentralization has to some extent lost its original relevance. It is generally recognized that "on-line control systems" could create greater centralization, however, as "learning organizations", the organizations are discovering that Information Technology leads to greater decentralization because of "democratic access" to information and knowledge within the organizations. Indeed, because of 43 Management Control: Concepts and Context democratization of information, centralization decentralization in decision-making and control. is giving way to 3.4 CYBERNETIC PARADIGM OR THE FEEDBACK FACTOR Cybernetic paradigm has its origin in cybernetics. Cybernetics is essentially the `science of communication and control'. The fundamental idea in cybernetics is the concept of the "negative feedback" and its role in purposive and adaptive behaviour of systems. Cybernetic paradigm finds its application in various organizational contexts, particularly in designing the management control systems and the information systems. According to Mason (1981), "The basic cybernetic model commences with some norm or target being set by decision making information system. Then action is taken pursuant to this goal. Subsequently observations are made to measure the effect that action has on the source and the resulting `feedback' is recorded in a databank". The essential aspect of this paradigm is the feedback factor in ensuring the "goal convergence" of the system. In using cybernetic paradigm for designing control system, the following aspects should be considered: 1) Target setting: Proper targets should be set. Past data could be useful in arriving at the standards of performance and achievement. In situations where business is entirely new, based on new ideas, target setting could be based on intuitive judgement. In `knowledge economy' where businesses are based on ideas and knowledge, the traditional target setting concepts may not be relevant. 2) 3) 4) 5) Achievement / Performance measurement: Measure the performance against the targets to assess the achievement. Identify deviations: Identify deviations between targets and achievements. Measure the degree/intensity of variations. Identifying the Causes / Reasons for variations. Use the Feedback Information from the Cause - Effect analysis of variations, to take corrective action. Thus, cybernetic paradigm provides us a five step framework for designing the control system in organizations. Activity 1 a) Differentiate between Reactive Control Systems and Proactive Control Systems. ………………………………………………………………………………… ………………………………………………………………………………… ………………………………………………………………………………… ………………………………………………………………………………… ………………………………………………………………………………… b) "In view of the advances in Information Technology, the issue of centralization and decentralization has lost its original relevance". Discuss. ………………………………………………………………………………… ……….……………………………………………………………………… ……….……………………………………………………………………… ………………….…………………………………………………………… …………………………….………………………………………………… 44 c) What is the role of feedback factor in Management Control Systems? ………………………………………………………………………………… ……….……………………………………………………………………… ………………….…………………………………………………………… ………………….…………………………………………………………… …………………………….………………………………………………… ……………………………………….……………………………………… ………………………………………………….…………………………… …………………………………………………………….………………… Designing Management Control Systems 3.5 MEANING AND IMPLICATIONS OF MIS Management Information System (MIS) has three components, Management, Information and System. Management essentially means planning and controlling operations, but such planning and controlling. Information has to be distinguished from data. For example, customer's invoices are data only, while the inventory analysis, sales analysis etc, are information (after the same data are converted). System essentially implies a systems approach to turn data into information and integrate all systems of a business. Thus, MIS may be defined as a set of integrated, well-knit and scientifically designed system whereby raw data get converted into decision-based and control-oriented information and flow continuously regularly from one end to another. A sound MIS ensures inter cilia the following: • • • • Right information at right time to right person and in right manner; Regularity in the periodicity of information flow; Information geared toward aiding managerial decisions for planning and control; Screening of all information at the point of transmission to select the relevant and reject all irrelevant details, keeping an eye on the diverse steeds of management at different levels; and A built-in system of link-up and follow-up. • There are three key elements in any information-flow, namely timing, degree of accuracy and nature of defects. Timing of information is perhaps of the greatest importance in any MIS, since it is an accepted fact that information delayed is information denied. Closely linked with timing is the degree of accuracy which should be determined with reference to the purpose of the proposed information and the decision that might emanate from it. Nature of details or the volume of,information is also an important factor in MIS. Inadequate information and more than adequate information may both be worse than no information. What is information (finished product) to one may be data (raw materials) to another. It all depends upon the levels and functional areas of management. For example, a detailed customer-wise outstandings analysis is an information to the line management but only data to the top management. From these data may be prepared division-wise working capital locked up in respect of oustandings and this may become an information to the top management. It may be mentioned that, MIS should be more future-oriented than just an extrapolation of past data. Taking decisions based on past data alone is the same as driving a vehicle with eyes fixed on the rear view mirror - the vehicle will not achieve even reasonable speed and reach the destination in time. When MIS is future oriented, it becomes a strategy tool, otherwise it remains merely a `control tool'. 45 Management Control: Concepts and Context 3.6 DESIGN CONSIDERATIONS IN DESIGNING MIS In the above discussion, it has been mentioned that Management Information System (MIS) is an important tool of Management Control Systems. With the advent of information technology, it has become possible to generate Online Management Information System. While information technology has made it easier to generate relevant information, the conceptual and essential aspects of MIS and MRS (Management Reporting Systems) remain valid. In designing MIS, important design considerations are as follows: 1) 2) 3) 4) MIS should be linked to responsibility centre MIS should highlight critical indicators MIS should report both financial and physical information MIS should highlight variations in actual and planned performance MIS is essentially &decision making and performance monitoring tool. Since it helps in decision making, it should be linked to the various responsibility centres and various levels of management. Top management should get relevant information on performance of responsibility centres and the responsibility centre incharge should also get critical information on various activities and operations of the responsibility centre. Required reports should be generated to bring to the attention of the top management, the problems being faced by the responsibility centres. Top management, in turn, could provide the required support in terms of resources and policy clarity to improve the performance of responsibility centres. MIS is also a diagnostic tool. As a diagnostic tool, it should highlight the critical indicators. Accordingly, it should focus on key performance variables or critical success factors. Key success factors are "crucial to attainment of strategy, goals and objectives". Maciariello and Kirby (1994, p.78) indicate that, "it is necessary to establish them (key variables or key success factors) for each responsibility centre; they are instrumental for achieving the goals and objectives of the responsibility centre. They in turn become the basis for the establishment of appropriate performance measures, responsibility centre designations, reward structures and resource allocation procedures. Once the key success variables are identified, the control system is given focus". It may be indicated that a critical indicator could be financial or non-financial in nature. For example, in case of hotel industry, occupancy rate is a critical indicator. MIS should throw up information on such critical indicators to help managers in taking corrective actions to improve performance of their responsibility units. Thus, MIS can be used as a tool for Performance Improvement. For example, if occupancy rate of a hotel is constantly low, it indicates that there is a need for a "radical performance improvement" through certain strategic decisions. Thus, MIS is not just a management control tool but also has a strategic relevance. MIS is useful for performance evaluation. It is a supportive tool for the Performance Measurement Systems (PMS). As a supportive tool, it should report both financial and physical information to inform managers' about the achievements of the responsibility centres / departments. In a holistic view of performance evaluation, both financial and physical parameters are important, hence, MIS should provide the information on both aspects viz., the financial and physical. The ultimate aim of MIS is to motivate managers to improve the performance of their responsibility units. Hence, MIS should highlight variations in actual and planned performance. This helps in drawing managers, attention to. areas where action is 46 required. Further it also helps in drawing up an action plan for performance improvement. The above discussion indicates that MIS is essentially a managerial tool for decision making, performance review and performance measurement. With the advent of information technology, it has become easier to generate the required information for performance improvement. Hence, MIS has now become not only a tool for management control but also a tool for strategy. Designing Management Control Systems 3.7 MIS AND TOTAL KNOWLEDGE MANAGEMENT (TKM) Knowledge Management has emerged as a new managerial tool. At the conceptual level, MIS still retains its attractiveness because it draws our attantion to the critical success factors and helps us in taking corrective actions. With the arrival of `learning systems' paradigm, we need to go beyond the MIS, while retaining it as an important tool in our managerial kit. Learning systems paradigm aims at making `cybernetic organizations' which are control driven into `learning organizations' which are `learning' driven. While MIS is rooted in the cybernetic paradigm, Knowledge Management is rooted in the `learning system' paradigm. When two ideas are combined together, we arrive at the `cybernetic learning organizations'. In such organizations, MIS is used as a learning tgol and a strategy tool rather than merely a control system tool. Thus, MIS gets integrated with Knowledge Management. Nonaka and Takeuchi in their book, The Knowledge Creating Company (1995), provide us the basic framework for knowledge management. They identified knowledge in terms of `explicit knowledge' and `tacit knowledge'. Explicit knowledge is codified knowledge, available in the form of formula, tested hypothesis, laws, theories etc. Tacit knowledge is the knowledge embedded in individual experience. It is knowledge `residing in the heads' of specialists and workers. Explicit and tacit knowledge can al,o be referred tows structured and intuitional knowledge. At the strategic planning and strategy formulation level, intuitional knowledge is extremely useful. At the operational control level, structured knowledge has greater relevance. At the management control level, both structured knowledge and intuitional knowledge have role to play. While MIS may largely be based on structured knowledge, in designing KBS (Knowledge Based Systems) for management control, an effort is made to integrate the tacit knowledge with explicit knowledge. The concept of Total Knowledge Management (TKM) has been emerging as a new concept. It implies using the explicit and tacit knowledge to gain competitive advantage. MIS is useful as a tool for integrating the explicit and tacit knowledge. Therein lies its importance as a Total Knowledge Management (TKM) tool. Activity 2 a) Define MIS. …………………………………………………………………………… …………………………………………………………………………… …………………………………………………………………………… …………………………………………………………………………… ……………………………………………..……………………………... b) List important design considerations in designing MIS. …………………………………………………………………………… …………………………………………………………………………… …………………………………………………………………………… …………………………………………………………………………… ……………………………………………..……………………………... 47 Management Control: Concepts and Context c) Explain the difference between explicit xnowieage ana tacit knowledge. …………………………………………………………………………… …………………………………………………………………………… …………………………………………………………………………… …………………………………………………………………………… …………………………………………………………………………… …………………………………………………………………………… …………………………………………………………………………… d) What is the meaning of Total Knowledge Management (TKM)? How MIS is a useful tool for Total Knowledge Management (TKM)? …………………………………………………………………………… …………………………………………………………………………… …………………………………………………………………………… …………………………………………………………………………… …………………………………………………………………………… …………………………………………………………………………… …………………………………………………………………………… ……………………………………………..……………………………... 3.8 BEHAVIOURAL ASPECTS Behavioural dimensions are critical in mangernent control systems. Wiener defines cybernetics as "study of the entire field of control and communication theory, whether in machine or animal". Organizations are run by human beings and not by machines or animals. While Weiner may have considered human beings as animals, in reality human beings are not mere animals as some may think. Because organizations are managed and run by human beings, the behavioural dimension becomes a critical factor in the efficacy of the control systems in achieving the pupose for which they are designed. The basic idea of studying behavioural aspects in the context of management control systems is to create conditions for ensuring "goal congruence" between individuals' goals and organizational goals. Individuals working in organizations look foward to fulfilling their personal goals. Top management is interested in ensuring achievement of organizational goals. Integrating individual goals and organizational goals is critical to the success of an organization. The primary objective of management control systems is to achieve this integration and thereby ensure "goal congruence". While money is considered as an important motivator, there are several non-monitory factors that help in achieving the goal convergence. Hence, it is important to look at the behavioural processes at the work place to create a work culture that is conducive to goal congruence. Hersey et.al., (1998) observe that "the extent to which individuals and groups perceive their own goals as being satisfied by the accomplishment of organizational goals is the degree of integration of goals". The idea of goal integration is presented in Figure 3.1, wherein the directions of goals of Management, Employee and Organization are indicated by arrows. The diagram is self explanatory and indicates three situations: 1) There is an opposition between the goals of management, employees and organization leading to no positive organizational accomplishment. 2) There is a wide gulf (divergence) between the goals of management, employee and organization, leading to little organizational accomplishment. 3) There is convergence between the goals of management, employees and organ izationa leading to high organizational accomplishment. 48 Designing Management Control Systems Behavioural sciences and in the recent years spiritual sciences, including Indian Ethos, have contributed considerably to our understanding of the behavioural dimension in managing organizations. The behavioural dimension deals with the following issues: 1) 2) 3) 4) 5) 6) 7) 8) 9) Leadership Communication Motivation Managerial Styles Conflict and Cooperation Organization Culture & Empowerment Ethics Creativity & Self Development Socio-cultural Influences A detailed discussion on these themes is usually available in OB / HRD / Indian Ethos books. Our concern is primarily from the viewpoint of management control systems, because there is a close linkage between the behavioural dimension and control system design. The interaction between people and the control system design could have two consequences viz., the positive impact or the negative impact. Though the primary idea of control systems is to achieve the "goal convergence" between an individual's goals and the organizational goals, this may not always happen because the way the information provided by the control system is used by the managers. The positive impact of control systems leads to synergy between the individuals and the organization and the negative impact leads to attempts to beat the control system through a sabotaging behaviour. Hence, it is essential that control systems are used in a positive manner to achieve the needed goal congruence between the employees and the organization. Broadly speaking there are three styles of management, referred to as theories X, Y and Z which are used for ensuring goal congruence. They are based on different 49 Management Control: Concepts and Context assumptions about nature of human beings. Reddin (1987) has summed up the differences between the three theories. These are presented in Figure 3.2. Theory X Man is a beast Evil is man' inherent nature Biology drives man Force motivates man Competition is man's basic mode of interaction Individual is man's social unit of importance Pessimism best describes man's view of man Theory Y Man is a self-actualizing being Good is man's inherent nature Humanism drives man Voluntary cooperation motivates man Cooperation is man's basic mode of interaction Group is man's social unit of importance Optimism best describes man's view of man Theory Z People have wills People are open to good and evil Situations drive people Reason motivates people Interdependence is people's basic mode of interaction Interaction is people's social unit of importance Objective best describes people's view of mankind Figure 3.2: Three Styles of Management Source: Effective Management, Reddin W J, Tata McGraw Hill, 1987, p.91 Theories X, Y, Z can help us in understanding several issues related to behavioural aspects in organizations. Conflict and cooperation in organizations can be viewed through the prism of these theories. While theory X tends to be dis-empowering in nature, theories Y and Z tend to empower people because these theories are participative and team nurturing in their orientation. When organization culture emphasizes Y and Z it is conducive for expression of creativity at the work place. This has been demonstrated through the Japanese Quality Circle approach. During recent years, another theory has been proposed viz., Theory'K (Sharma, 1996). Essence of this theory lies in relating the theories X, Y and Z to situational requirements. Accordingly it is a combination approach expressed in the form of an equation K = X + Y + Z, wherein "+" indicative of the situational requirement. In practical situations most managers tend to use combination approach rather than only one of the theories. Through experience they sharpen their skills in using Theory K to ensure goal convergence or goal congruence. Socio-cultural influences also impact on the work place and work culture. In Indian context, there is a considerable diversity at the work place, because employees come from varying backgrounds, from different regions and with different language base, reflecting varying multiplicity at work place. When the cultural ethos-are leveraged in a positive manner, there is an improvement in performance. Japanese demonstrated it during the last thirty years. In Indian context, Indian ethos of `unity in diversity' should be harnessed to create synergy at work place. Indian mind set is also characterized by "flexibility in rigidity". This helps in developing an approach to effectively handling contradictions and polarities. This should also be harnessed positively to achieve success in business. With the arrival of Information Technology, knowledge - seeking ethos of the Indian society have provided competitive advantage to Indian Information Technology firms. India's knowledge seeking ethos are rooted in its open and integrative culture, based on integrative synthesis of ideas from various locations across space and time. It may be indicated that, earlier the competitive advantage was based on co: `, followed by Japanese competitive advantage based on :.iality. Now, the competitive advantage is based on `knowledge' factor. Knowledge seeking ethos of Indian society provide it a 50 strategic advantage to leverage its strengths for improving competitive advantage. Indeed, all the three factors viz. Cost (C), Quality (Q) and Knowledge (K) have critical role to play in achieving competitive advantage. Importance of these have been highlighted in the emergence of Total Cost Management (TCM), Total Quality Management (TQM) and Total Knowledge Management (TKM) as tools for improving performance with a view to gain competitive advantage. However, behavioural dimensions are at the root of ensuring that people in organizations pay attention to these three factors and ensure goal congruence. Designing Management Control Systems 3.9 SUMMARY This unit discussed the attributes of Management Control Systems rooted in the "steering" approach to control systems. The importance of the feedback factor was highlighted. The unit provided the concept of Management Information System (MIS) as an important management tool with focus on key success factors. MIS helps management not only in management planning and control but also in strategic gearing by focussing on the key variables of performance. With the arrival of the concept of knowledge management, the importance of tacit knowledge has been recognized. MIS is also useful as a tool for integrating explicit and tacit knowledge to arrive at better decision making. The unit concluded by highlighting the importance of behavioural aspects in ensuring goal congruence between individual goals and organizational goals. 3.10 KEY WORDS Steering Controls: When results are predicted and corrective action is taken to ensure successful completion of operation, then such controls are referred to as steering controls. For example, astronauts landing on moon right on target and on time. Interactive Control: When control systems throw up information which is useful in identifying new strategies, then control system becomes a strategy formulation tool, Simons refers to such controls as interactive control. Cybernetics: Study of the entire field of control and communication theory, whether iii machine or animal. MIS: Management Information System. A tool for better decision-making and performance monitoring. It can also be useful in integrating explicit and tacit knowledge. Key Variables: Critical success factors that are instrumental in achieving goals and objectives of the responsibility centre. Explicit Knowledge: Codified knowledge available in the form of formula, principles tested hypothesis etc. Tacit Knowledge: Knowledge residing in the heads of specialists and workers. Total Knowledge Management (TKM): When organizations use both explicit and tacit knowledge to improve their competitive advantage, they are operating in Total Knowledge Management (TKM) mode. Theories X, Y, Z & K: Theories of management styles reflecting the authoritarian (Theory X), participative (Theory Y), team oriented (Theory Z) and a combination approach (Theory K, wherein K = X + Y + Z). 51 Management Control: Concepts and Context 3.11 SELF ASSESSMENT QUESTIONS 1) 2) 3) 4) Provide a brief account of the important attributes of Management Control Systems (MCS). Explain the cybernetic paradigm of designing control systems. Explain the concept of MIS. What are the important consideration in designing MIS? Explain the meaning of "key variables". Pick up an industry of your choice e.g. Information Technology, Dairy, Pharmaceutical, Tea, Fast food etc. and identify various key variables for an enterprise in this industry. Why behavioural dimensions important in Management Control Systems? Which styles of management and under what conditions are they critical in understanding the behavioural dimensions in relation to MCS. 5) 3.12 FURTHER READINGS Anthony, R N and Govindrajan V, 1994, Management Control Systems, Tata McGraw Hill (Chap.3) Hersey Paul, Kenneth Blanchard and Dewey Johnson, 1998, Management of Organizational Behaviour: Utilizing Human Resources, Prentice Hall (Chap.6). Maciariello, Joseph A & Calvin Kirby, 1997, Management Control Systems; Using Adaptive Systems to Attain Control, Prentice Hall (Chap.3) Merchant Kenneth A, 1998, Modern Management Control Systems: Text Cases, Prentice Hall (Chap.4). Sharma Subhash, 1988, Management Control Systems - Text and Cases, Tata McGraw Hill (Chap.4 & 5). Sharma Subhash, 1996, Management in New Age: Western Windows Eastern Doors, New Age International Publishers (Chap.5). Tiwana Amrit, 2000, The Knowledge Management Toolkit: Practical Techniques for Building a Knowledge Management Systems, Prentice Hall (Chap.6). 52 UNIT 4 Objectives RESPONSIBILITY CENTRES Responsibility Centres After you have studied this unit, you should be able to: • • • • understand and explain the concept of responsibility centres in the context of an organization; should be able to integrate the organization structure and responsibility centres; identify the major problem areas to be tackled for the successful introduction of responsibility centres; and understand the basic requirements for the design of a simple system for the evaluation of responsibility centres. Introduction Delegation and Responsibility Centres The Concept of Responsibility Centres Organization Structure and Responsibility Centres Types of Responsibility Centres Establishing Responsibility Centres Performance Evaluation of Responsibility Centres The Concept of Responsibility Accounting 4.9 Summary Key Words Self Assessment Questions Further Readings Structure 4.1 4.2 4.3 4.4 4.5 4.6 4.7 4.8 4.9 4.10 4.11 4.12 4.1 INTRODUCTION In small organization, decision-making and management of business are often done by a single individual. However, as the organization grows and becomes larger, the business cornplexities arise and it becomes rather unmanageable by one person alone. He,-then, is forced to take help of many persons to achieve the objectives of the organization. As he is not in a position to take all the decisions himself, he has to seek help from others in this respect. Thus, he has to share the authority of decisionmaking and responsibility with others. Sharing of the authority and responsibility may be taken as delegation, which goes alongwith the divisionalization and segmentation. When the decision-making authority is delegated to person in charge of a division or a segment, known as ma lagers, they have to be held responsible for the consequences of their decision and making. This necessitates evaluation of the managers, who have taken decision and, thus, making them duly accountable for what they have done. This process requires establishment of responsibility centres in the organization. A responsibility centre may be defined as an area of responsibility which is controlled by an individual. The responsibility centres require establishment system of accumulation., absorption and allocation of costs to identifiable responsibility centres. Robert N. Anthony and Vijay Govindarajan has defined responsibility centre is an organization unit that is headed by a responsible manager. A company is a collection of responsibility centre. At the lowest level of hierarchy in a company sections or work shits are responsibility centres. At the 5 Management Control Structure higher levels are departments or strategic business units which consists of the smaller units, staff and management. At the level of senior management and Board of Directors whole of the company is a responsibility centre. 4.2 DELEGATION AND RESPONSIBILITY CENTRES Determining the responsibility centres in an organization depends upon the philosophy, strategy followed by an organization or company concerned. However, no set pattern, can be followed in this respect by all the companies. It will depend upon nature, size, and area of operation of the company concerned. Even the environmental factors have to be considered for it. There are several ways of delegating the authority and associated responsibility. The company management would have to consider and identify key factors for it. They may undertake delegation on the basis of functional responsibilities, such as production, marketing and finance. They may consider product lines and geographical location of the business also as the key factors. Functional Delegation In many organizations authority and responsibility is delegated on the functional basis of production, marketing and finance. One individual will be given the decision making authority and the responsibility for all the production activities, another for all the marketing activities and yet another for all finance activities. This pattern of delegation is illustrated in Exhibit 4.1 Exhibit 4.1: Functional Organization Chief Executive Officer Production Officer Product Lines Some organizations delegate authority based on product lines of the company. A single manager will be responsible for the different functions of production, marketing and finance for the particular production lines. This type of delegation is followed normally by companies who choose to organize themselves into strategic business groups. These product line managers may in turn delegate their decision making authority and responsibility to various subordinate functional managers, namely, production manager, marketing manager and finance manager. Exhibit 4.2 illustrates delegation based on product lines. Exhibit 42: Product Line Organization Chief Executive Officer Product X Product Y Production Marketing Finance Product Z Marketing Officer Finance Officer 6 Geographical Regions Geographical delegation of authority and responsibility is normally resorted to for the simple reason that customs and characteristics of the people, market and the -business environment may vary considerably from area to area. This is even more so' in the case of multinational companies operating worldwide. It is a common practice to segregate the organizations on the basis of domestic and foreign operations. In India, it is a common practice for companies operating throughout the country to divide their operations into four or more geographical regions of the country. Exhibit 4.3 illustrates patterns of delegation based on geographical division of the operations. The pattern of delegation followed by different companies will be determined more by the philosophy and leadership style followed by the top management. Apart from management style and philosophy the complexity of operations of the organization is another important factor. In most cases when organizations become multitechnology, the sheer need for specialized knowledge compels delegation. Another major criterion for delegation is the economic consideration. When the cost or benefit arising out of wrong or right decisions is large then the decisions may probably not be delegated. Hence, you will find decisions involving long term impact on the company and large financial implication are seldom delegated. However, most decisions involving day-to-day operations are delegated in most cases. In some cases, the delegation of authority may not be helpful or followed in practice. When the cost or benefit arising out of wrong or right decision is large, it will not be very useful to undertake delegation. Similarly, decisions involving long-term impact, on the company and which involves huge funds need not be delegated and such decisions have to be undertaken by the top management only. However, the decisions involving day to day operations may be delegated, without any difficulty, Exhibit 4.3: Geographical Organization Responsibility Centres 7 Management Control Structure Activity 1 Please answer by completing the blanks: a) Some of the key factors considered by companies in delegation authority in the organization are: ……………………………………………………………………………………… ……………………………………………………………………………………… ……………………………………………………………………………………… ……………………………………………………………………………………… ……………………………………………………………………………………… ……………………………………………………………………………………… ……………………………………………………………………………………… b) Functional delegation involves delegation of authority on …………………............ ………………………………… of the business namely ……………………...….. and………………………………………………………………………………… Activity 2 Briefly answer the following questions: a) Why do firms delegate? ......................................................................................................................................................... ......................................................................................................................................................... ......................................................................................................................................................... ......................................................................................................................................................... ......................................................................................................................................................... ......................................................................................................................................................... ......................................................................................................................................................... b) What factors usually determine delegation? ......................................................................................................................................................... ......................................................................................................................................................... ......................................................................................................................................................... ......................................................................................................................................................... ......................................................................................................................................................... ......................................................................................................................................................... ......................................................................................................................................................... ......................................................................................................................................................... c) Can you recall the common forms of delegation? ......................................................................................................................................................... ......................................................................................................................................................... ......................................................................................................................................................... ......................................................................................................................................................... ......................................................................................................................................................... ......................................................................................................................................................... ......................................................................................................................................................... ......................................................................................................................................................... d) How do the different forms of delegation differ? ......................................................................................................................................................... ......................................................................................................................................................... ......................................................................................................................................................... ......................................................................................................................................................... ......................................................................................................................................................... ......................................................................................................................................................... ......................................................................................................................................................... 8 4.3 THE CONCEPT OF RESPONSIBILIT CENTRES Responsibility Centres The establishment of responsibility centres have become quite essential in a large organization. As the complexity of the organization grows, it becomes quite imperative. Today, the companies are facing a lot of challenges due to increasing competition, as we arc moving towards more and more liberalization and globalization. It has necessitated effective control and management of various operations of the company concerned. This challenge of the competition can be met by recognizing three key principles. They are: (1) delegation of responsibility for specific to successive lower levels of the organizations (2) motivation of the level of management to which a certain task has been delegated and (3) measurement of achievement of the specified objectives. The organization structure followed in this framework is mostly pyramidical. Under it, the lower level managers report upward towards their superior as the superiors delegate their authority to lower levels. In this process of delegation of authority to different levels or segments of the organization, there is a need for proper and adequate delegation of authority and responsibility so that there is neither overlapping nor gaps. It is quite necessary and important to decide about the nature and level of delegated authority at the time of establishing responsibility centres. The key factor or consideration for determining the responsibility centres is its ability to control cost or revenue. As effective control implies controlling cost and revenue. It fact, the effective planning and control system are structured around the implicit or explicit centres of responsibility within the organization. The managers at different levels should have a clearly defined area of responsibility if their proper evaluation is to be undertaken. The responsibility centres too have to be evaluated on the basis of set criteria which may be as follows; i) ii) iii) iv) Comparison with budgets and targets; Comparison among different division within the company; Comparison with historical results; Comparison with industry averages. 4.4 ORGANIZATION STRUCTURE AND RESPONSIBILITY CENTRES At the time of establishing responsibility centres, the existing organization structure should be properly reviewed often, in practice, it requires a change in the existing organization structure. In view of that, following changes may be quite necessary in it: 1) 2) The responsibility for all the revenues and expenses must be assigned to identified competent individuals in the organization. The accounting system should be modified as to accumulate and report expenses and revenues on the lines of assigned responsibilities within the organization. A system of evaluation based on comparison of revenues and expenses of different responsibility centres with pre-assigned targets should be established: If the suitable and necessary changes are not undertaken in the existing organization, the purpose will not be responsive to the needs, equired in this connection. 3) The responsibility centre has to be kept under the control of competent persons. In practice, there may be difficulty in identifying such persons. It is also found that several expenses are controllable not by one such centre but by different centre. Similarly, expenses may also be controlled at different levels. Reallocation of expenses from one units, to another may often become quite necessary. 9 Management Control Structure Any desired change in the organization should not to be taken in isolation. It should be taken as a part of integrated change otherwise several practical problems may arise later. In fact, the responsibility structure should be on the lines of integrated organization structure and there should be clear definition of responsibility at different levels. Activity 3 a) What are the essential changes to be effected for a responsibility centre system to meet the needs of a decentralized organization? .............................................................................................................................. .............................................................................................................................. .............................................................................................................................. .............................................................................................................................. .............................................................................................................................. b) Can you describe the relationship between organization structure and responsibility centre? .............................................................................................................................. .............................................................................................................................. .............................................................................................................................. .............................................................................................................................. .............................................................................................................................. 4.5 TYPES OF RESPONSIBILITY CENTRES The responsibility centres can be classified keeping in mind two important factors. They are; (a) the scope of responsibility assigned and (b) the decision making authority given to individual managers. These are four types of responsibility centres. They are given as follows: 1) Expense Centre It is also known as cost centre. A cost or expense centre is a segment and division of an organization in which the managers are held responsible for the cost incurred in that segment. They may not be responsible for revenue. The expense centre managers have control over some or all of the costs in their segment of business but not over revenues. In a manufacturing organization, the production and service departments are classified as expense centres. In a marketing department, a sales region or a single sales representative may be taken as expense centre. The expense centre managers are responsible for the costs that are controllable by them and their subordinates. There are two general type of expense centres l) Engineered expense centers 2) Discretionary expense centers they correspond to two type of costs. Engineered cost are those elements of costs which can be predicted with fair degree of accuracy e.g. cost of raw material, direct labour, water and electricity etc. Discretionary cost (also called managed costs) are costs for which output can't be measured in monetary terms, e.g. are administrative and support units like accounts department, legal department, public relations department, research and development department, most of the marketing activities etc. 2) Revenues Centre 10 Revenue centre is a segment of the organization which is primarily responsible for generating sales revenue. The revenue centre manager has control over expenses of the marketing department but he has no control over cost, or the investment in assets. The performance of revenue centre managers is evaluated by comparing actual revenues with the budgeted revenue and actual marketing expenses with budgeted marketing expenses. 3) Profit Centre Profit Centre is a segment of business often called a division that is responsible both for revenue and expenses. In a non-profit organization, the revenue centre may be used instead of profit centre, as profit is not the primary objectives of such organization. The main purpose of profit centre is to earn the targeted profit. In fact, the profit centre managers are more concerned with finding ways to increase centre's revenue by increasing production or improving distribution methods. The performance of the profit centre is evaluated in term of whether the centre has achieved its budgeted or target profit or not. 4) Investment Centre An investment centre is responsible for the profits and investment. If a manager controls investment, that area of responsibility can be called as investment centre. He is responsible for the returns on the investment. He is required to control the amounts invested is the centre's assets. The manager of investment centre has more authority and responsibility than the manager of either cost centre or profit centre. Exhibit 4.4 shows different type of responsibility centres and relationship between inputs and output. Table 4.1 shows some of the items of a financial statement and the responsibility of the managers of revenue centre, cost centre, pofit centre and investment centre regarding these items. Table 4.1: Examples of various type of Responsibility Centres Financial Statement Items Statement Trading and Profit & Loss Statement Revenue Cost of goods sold Gross profit Advertising Research & Development Other expenditure Corporate income tax Profit before tax Balance Sheet Fixed Assets Current Assets Current Liabilities Long term debt Cost Centre Profit centre Investment Centre Responsibility Centres X X X X X X X X X X X X X X X X X X X X X X X X X (X indicates that responsibility centre manager is accountable for some elements included in the financial statement) Source: Kenneth A. Merchant "Financial Responsibility Centres". Modern Management Control systems: Text & Cases, Pearson Education Inc. 1998. 11 Management Control Structure (Adapted from Robert N. Anthony and Vijay Govindarajan. "Responsibility Centres: Reve and expense centres" Managment Control Systems, Irwin 1995 pp 110. Relationship between different Responsibility Centres When the whole company is treated as a profit centre it may have one or more expense responsibility centres. If a company has more than one profit centre, each profit centre will have one or more expense responsibility centres. It may also have a corporate 12 expense responsibility centre to which all expenses, which are not incurred specially for profit centre, may be charged. For example, general administration expense of corporate office may be charged to appropriate corporate expense responsibility centre. Characteristics of a Responsibility Centre An effective responsibility centre should have the following characteristics: 1) 2) It is a cleared defined segment of an organization. A designated individual is responsible for its performance; namely, the output produced by the segment as well as inputs consumed by the segment. The designated individual has the necessary authority to discharge the assigned responsibilities. Responsibility Centres 3) The usual forms of responsibility-centres in different organization vary widely. It can be the entire company, business units, product divisions, sales branches, sales regions, Functional departments such as production, marketing, personnel and finance or their subdivisions. Illustration Ibis Apparels is organized with clear delegation of responsibilities. The production manager is responsible for all the activities relating to production. Similarly, the marketing manager is responsible for all activities relating to the marketing of products, Vice-President; Apparel Division is responsible for the profits of the division. However, only the president is responsible for the investment decisions for the different divisions of the company. The management control structure of Ibis Apparels is presented in Exhibit 4.5. As presented in Exhibit 4.5 the management control structure of Ibis Apparels is structured into responsibility centres as follows: Designation President Responsibility Centre Investment Centre: Responsible for all investment decisions and hence to be evaluated on the basis of performance of Return on Investment (ROl) Profit Centre :Responsibility for all the revenues and expenses Apparels Division of the division and hence responsible for the profits of the division; to be evaluated on the basis of profit performance either in terms of achievement of budgeted performance or in terms of margin on sales Vice-President 13 Management Control Structure Production Manager (Apparels) Expense Centre: Responsible for production and hence responsible for all the expenses to be incurred for production; to be evaluated on the basis of achievement of budgeted targets of production and control of expenses within budgets and or a certain inputs-output relationship. Revenue Centre: Responsible for all the revenues of the decision; to be evaluated on the basis of achievement of the budgeted targets Marketing Manager (Apparels) Activity 4 a) Try to draw the organization chart of Ibis Apparels based on the above information relating to responsibility centres. ............................................................................................................................................. ............................................................................................................................................. ............................................................................................................................................. ............................................................................................................................................. ............................................................................................................................................. ............................................................................................................................................. b) Can you identify the four major elements to be controlled in any organization? ............................................................................................................................................. ............................................................................................................................................. ............................................................................................................................................. ............................................................................................................................................. ............................................................................................................................................. ............................................................................................................................................. c) Can you describe different responsibility centres in terms of the major elements to be controlled in any organization? ............................................................................................................................................. ............................................................................................................................................. ............................................................................................................................................. ............................................................................................................................................. ............................................................................................................................................. ............................................................................................................................................. It should be noted that the responsibility of the expense centre and profit centre may be further delegated to subordinate responsibility centres. From the above we can visualize the hierarchy of responsibility centre in case of Ibis Apparels as Exhibit 4.6: Ibis Apparels-Hierarchy of Responsibility Centre 14 4.6 ESTABLISHMENT RESPONSIBILITY CENTRES Responsibility Centres Establishment responsibility centres in an orgnisation is not an easy task. It must be carefully planned and executed. Some of the major steps involved in the process can be described as follows: l) Study the organization structure, authority-responsibility relationships or job descriptions, layout of the factory and office, various activities, production process and structure of the production flows, and the interrelationships among these different activities. Based on this study, list all the different operations and activities, functions and tasks in the terms. Define each activity in descriptive terms, Evaluate the need for any reorganization required in the context of establishment of responsibility centres and develop an organization structure on the lines of desired responsibility centres. Delineate the organization into various responsibility centres. Ensure that the centres so established satisfy the three characteristics of a good responsibility centre. 2) 3) 4) The establishment of centres can be considered a tentative starting point for evaluation against the following factors: • The objectives of the system which will govern the number and type of responsibility centres, the need for cost information relating to a particular activity; The need for flexibility for supplying cost information for occasional requirements; Ease in allocation of costs, measurement of performance and evaluation of variances; Future needs of the organization at least to the extent known from corporate or strategic plans; The volume of information and paperwork to be contended with; Segregation of production departments and service departments; Comparison of the planned responsibility centres with those of a similar company; and A system of coding of the responsibility centres for easy recording and retrieval of information. This can also integrated with account numbers. • • • • • • • Activity 5 Draw up a flow chart of activities for establishing responsibility centres in an organization with which you are familiar. ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ....................................................................................................................................... 15 Management Control Structure 4.7 PERFORMANCE EVALUATION OF RESPONSIBILITY CENTRES After assigning the necessary authority and responsibility to individuals at different centres, it becomes quite necessary to undertake evaluation of their performance. Any performance evaluation has to be done taking into account the objectives set as well as the predetermined criteria set for them. The objectives may be different for different responsibility centres. For example, for expense centre, it would be minimizing cost, for revenue centre, it would be maximizing sales revenue, for the profit centre, it would be maximizing profits and for investment centre, it would be maximizing return on investment. The overall performance evaluation concept applied to various responsibility centres is given in the following Table 4.2 Table 4.2: Various Centres and their Performance Evaluation Types of Centres Control Variable of Variable the Centre Predetermined by Top Management Objective Expense Centre Revenue Centre Profit Centre Investment Centre Prices and quantities Prices and quantities Minimize cost of inputs of input/budget Prices and quantities Quantities to be of inputs sold/budget Prices and quantities Investment of inputs and outputs Price and quantities None of inputs and outputs and investment Maximize sales revenue Maximize profit Maximize return on investment Activity 6 Can you enumerate major consideration in performance evaluation of responsibility centres? ...................................................................................................... ...................................................................................................... ...................................................................................................... ...................................................................................................... ...................................................................................................... ...................................................................................................... ...................................................................................................... 4.8 THE CONCEPT OF RESPONSIBILITY ACCOUNTING The responsibility accounting refers to the accounting process that reports how well various divisional managers, responsible for the various centres, have fulfilled their responsibility. It implies, in fact, information system that personalized control reports by compiling and reporting cost and revenue information according to responsibility areas within an organization. The responsibility accounting, according to Chonles T, Horngren, assigns particular revenues and costs to the individuals in the organization who has greatest potential dayto-day influence over them. However, its purpose is not to place blame. Rather, it is to evaluate performance and provide feedback so that future operations can be improved. 16 The responsibility accounting implies that an individual should responsible for those items or activities which they can control. They should not be responsible for those items or activities over which they do not have any control. Under the framework of responsibility accounting an expense centre, viz., becomes an accounting centre for accumulating allocation or absorption of expenses, such accumulation helps in generating necessary information required for the top management to effect control over the activities of the responsibility centre. In fact, the responsibility accounting is the information processing system used in consonance with the responsibility centre. Activity 7 What is responsibility accounting? How does it differ from responsibility centres? ....................................................................................................... ..................................................................................................... .................................................................................................... .................................................................................................... .................................................................................................... .................................................................................................... Responsibility Centres 4.9 SUMMARY Increasing complexity of business demands more effective management control systems. One of the major steps in this direction the delegation of authority and the assignment of responsibility for the achievement of specified results. Responsibility centres form an important tool in this effort. The very objective of responsibility centre is that a certain individual in an organization is held responsible for the operations under his control in terms of inputs and outputs. The responsibility centres are evaluated for their performance. Responsibility accounting provides the necessary support for such a system by accumulating and reporting relevant information relating to activities of different responsibility centres. 4.10 KEY WORDS Delegation: Process of assigning the authority for taking decision and the associated responsibility to a designated individual in an organization. Expense Centre: A segment of the organization where the managers' sphere of control is over expenses. Investment Centre: A segment of the organization where the manager is responsible for exercising control over the investments made and hence responsible for the return in relating to the investments. Profit Centre: A segment of the organization where the manager is responsible for both revenue and expenses and hence expected to exercise control over profits to be earned by the segment. Responsibility :Centre: A segment of the organization in charge of a designated individual responsible for the achievement of specific objectives set for that segment. Responsibility: Accounting: Responsibility accounting is the structuring of the information processing system through which information is identified and reported for different responsibility centres. Revenue Centre: A segment of the organization where the manager is responsible for the revenues earned by that segment. 17 Management Control Structure 4.11 SELF ASSESSMENT QUESTIONS 1) 2) 3) 4) 5) Why do organizations delegate authority and responsibility? What are the commonly used basis of delegation in organizations? How do they differ? Explain responsibility accounting. What are the essential requirements of effective responsibility accounting? Choose the right answer from the given alternatives fo: the following questions. An investment centre will have: a) Authority to make decisions affecting major factors determinants of profits including choice of markets, prices, sources of supply and nature of customers. b) Authority to make decision over all costs of operations including choice of suppliers. c) Authority to make decisions effecting the major determining profits such as choice of markets, sources of supply and significant control over imvestment in assets used by the segment, d) Responsibility for developing markets and vendors for the organization. 6) A profit centre will have authority and responsibility to make decision relating to: a) Major factors affecting profits including choice of suppliers and markets for sale of products. b) All investments in the division, choice of suppliers and markets and setting prices. c) All aspects of costs of operations of the organization. d) All the element of input going into the final output. 7) An expense centre has: a) b) c) d) 8) Responsibility for putting together material and labour to produce the final output. Responsibility over all expenses incurred in the organization. Responsibility for developing markets for selling output. Authority to make decisions over siginificant aspects of costs including the power to choose sources of supply. Suburban Nursing Home is situated on the outskirts of Calcutta. The nursing home caters to the middle class population in the suburbs. It is found that the number of patients at the nursing home increases during the monsoon months of June to August. An MBA from one of the leading Institutes in the country was hired to improve the management of the nursing home which was all along managed by its medical staff. The new general manager introduced a system of management control for the nursing home including responsibility accounting. The changes envisaged provision of quarterly cost reports to department heads.Earlier, there was no system of regular cost reporting to the department leads. 18 The General Manager wrote to all the departmental heads about the introduction of management control system. Highlights of the communication from the GM were as follows: We have introduced responsibility accounting system for the nursing home. All the departmental heads will be provided with quarterly reports showing the budgeted and actual expenses for the period. The report will show the variations from the budget. The essence of the control system is that you are responsible for the expenses in yours department and for controlling the same within the budget. The variations are highlighted to enable you to identify which items of expenses are out of control and the size of variation will indicate the ones, which are crucial. You can concentrate your effort towards control on such variations or exceptions. We call this management by exception,.we are providing below the last quarter reports: The General Manager wrote to all the department heads about the budget. The essence of the control system is that, you are responsible. Suburban Nursing Home Performance Report-Catering Department June-August 19X1 Budget Actual Variance (Rs.) (Rs.) (Rs.) Patient days costs 12,000 15,000 (3,000) Catering labour Supplies and provision Water Fuel Maintenance & other services Catering-Manager’s Salary Depreciation Allocated Administrative cost Responsibility Centres % Variance (25%) 7,500 10,000 (2,500) (3 3.33%) 60,000 70,000 (10,000) (16.67%) 1,000 1,200 (200) (20%) 3,500 4,200 (700) (20%) 2,000 2,700 (700) (35%) 9,000 9,300 (300) (3.33%) 10,000 12,000 (2000) (20%) 3,000 3,750 (750) (25%) 1,08 000 1,28,150 (20,150) (17.86%) The above report shows that most expenses are substantially above their budgeted levels and departmental heads should pay particular attention to cases where the volume of such expenses is large. The annual budget for the year 19X 1 prepared by the GM in consultation with the departmental heads was approved at the budget meeting. Quarterly budgets were prepared based on one-fourth of the annual budget. It was also observed that the price increases which were considered at the time of preparation of the budget were underestimated by about 3%. Required 1) Comment on the budget of the responsibility centre manager. 2) Comment on the variances and explain what part of it, if any, can be assigned to the responsibility centre. 4.12 FURTHER READINGS Anthony, Robert N. John. Dearden, and Richard F., Vancil, 1965. Nlanagenaent.Control systems-Cases and Readings, Richard D. Irwin; Homewood, Fremgen, J.M. 1975. Accounting for Managerial Analysis, Richard, D. Irwin; Homewood, 1976. Fremgen, J. M. 1975. Accounting for Managerial Analysis, Richard D. Irwin; Homewood, 1976 19 Management Control Structure Raymond L. Larson, `Decentralization in Real Life', Mc mageinent Accounting, 55, March 1974. Solomons, Devid; 1965. Divisional Performance; Measurement and Control, Richard D. Irwin; Homewood, 1965. Solution Question No. 7 1) The idea of controllability of expenses is of significant importance to the design of a responsibility accounting system. The quarter's budget fails to appreciate the fact that the catering manager has no control over the number of patients to be catered to. It should also be noted that some items of expenses, included in the responsibility report, are beyond the control of the catering manager. Items such as manager's salary, allocation administrative expenses, depreciation are outside the control of the catering manager. Regarding the increase in cost, they have to be seen in the light of the seasonality of patient arrival. This can be taken care of by opting for a flexible budget. The GM had made a mistake by dividing the fixed budget into quarters without considering the volume changes during the quarters. 2) The variation should be identified in terms of expenses needing the manager's attention. In doing so, proper adjustments should be made for the change in volume of activity. The variances should be analysed to find out the causes of variances such as volume change, change in prices, excess use of resources, unexpected increase in work demanding overtime payments and so on. The total variation from the budget, after taking the above factor into consideration and the pattern of variation over time, provide some of the necessary aspects for judging the efficiency and effectiveness of the manager. 20 UNIT5 PROFIT CENTRES Objectives After you have studied this unit, you should be able to: • • • • understand the concept of profit centers; integrate the concept of profit centers and the organization structure of an organization; identify the important factors to be considered in the establishment of a profit center; and understand and apply the basic requirement of a system of performance evaluation of a profit center. Profit Centres Structure 5.1 5.2 Introduction The Role of Profit Centres in an Organization 5.2.1 5.2.2 Advantages of Profit Centre Difficulties with Profit Centre 5.3 5.4 5.5 5.6 5.7 5.8 5.9 5.10 Boundary Conditions for Profit Centres Performance Measurement of Profit Centres Profit Centre as a Motivational Tool Performance Related Compensation Summary Key Words Self Assessment Questions Further Readings 5.1 INTRODUCTION A Profit Centre is a segment of a business, often called division that is responsible for both revenue and expenses. In a non-profit organization, the term `revenue centre' may be used instead of profit centre' as profit may not be the primary objective-of such an organization. In other words, a profit centre is a responsibility centre in which inputs are measured in terms of expenses and outputs are measured in terms of revenues. The expense centre, expense responsibility centre and profit centre are inter-related. The main objective of expense centre is to effect expense control. In case of profit centre, expense control is only one of the several considerations. The scope of a profit centre is broader than that of expense centre. In a profit centre the measures of performance is boarder than that of an expense centre as in expense centre, we measure only one element, i.e., cost whereas in profit centre we measure both cost as well as revenue. Similarly, the scope of activities of profit centre is much broader than that of revenue centre because of the responsibility to produce the product more efficiently. In a profit centre, manager has the responsibility air' authority to make decisions that affect both costs and revenues for the department or division. In fact, the main objective of a profit centre is to earn profit. Thus, a profit centre manager aims at 21 Management Control Structure both the production and marketing of a product. Such a manager decides about the production policies, the price and marketing strategies. He is concerned with increasing the centre's revenues by increasing production and/or improving distribution methods. However, such a manager does not take decision or has control over the investment in the centre's assets. He may make proposals for the investment in the division but the decisions about it are normally taken by the top management. A typical example of a profit centre is a division of the company that produces and undertakes marketing of different products. Thus, it is concerned both with formation of production strategy as well as marketing strategy. The main objective being to earn higher profits by pursuing such policies. Financial performance of a profit centre manager is measured in terms of achievement of budgeted profits that way, a comparison has to be done between the profit centre and budgeted profit. However, a problem arises in measuring its performance in terms of profits, when products and services are provided to another unit within the organization. Determination of profit is easier when products and services are sold outside the organizations. For example, repairs and maintenance department in a company can be treated as a profit centre if it is allowed to bill other production departments for the services provided to them, 5.2 THE ROLE OF PROFIT CENTRES IN AN ORGANIZATION In most of the organizations, it is found that there is more concentration on profit centre as an important unit for the purpose of control. In case of profit centre, it is possible to have an effective system of evaluation of performance which is quite necessary to impose effective control. Such effective control, from this point, is not possible neither in case of expense centre nor revenue centre. The profit centre focuses its attention on the most crucial element of an organization, i.e., profit. The profit is a combined measure of both effectiveness and efficiency. It provides a powerful tool for measuring how well the profit centre and its manager has performed. It motivates the profit centre manager to take decision about inputs and outputs in such a way that the profit of a profit centre is maximized. The profit centre becomes a good training ground for general management responsibility. It enables the top management to focus its attention and give advice to those segments which require them the moss. It also gives a sense of satisfaction to the manager concerned as the result is directly linked to the activities. The profit centre used as a means of basing the compensation structure. The profit centre is also closely related to the organizational principle of decentralisation. 5.2.1 Advantages of Profit Centres • • The operating decisions can be taken quickly without refering to the headquarters. Quality of the decisions is improved because the managers taking these decisions are aware of the ground realities and also closest to the point of decision. Higher management can focus on macro issues leaving the micro issues to be tackled by operational managers. Profit consciousness is enhanced in profit centre managers due to the fact that profit is going to be the criteria for assesment and as a result the managers would be sensitive to the impact of their action on both the expenses and revenue. • • 22 • • • • Managers are free of micro restraints and can use their creativity and initiative. Profit centres are incubators for future business managers at higher level as they are excellent training ground for general management. Profit centres creates a reservior of managerial talent which a company can use during diversification. Use of profit centres helps the company to locate and diagnose the problem areas quite easily, because profit centres provide information on the profitability of the components of the company. Profit Centres 5.2.2 • • • Difficulties with Profit Centres Top management may loose some control as the control reports prepared by the profit centres are not as effective as personal knowledge of an operation. Managers may be lacking competence in general management operations. There may be unhealthy competition among the various profit centres, which may manifest itself in form of undesirable behaviour of managers. These type of undesirable behaviour may include, hiding of information, hoarding of equipment etc. There may be disagreement among different profit centres regarding transfer, price, sharing of common cost, sharing of revenues generated by joint efforts. Profit centre managers may lay emphasis on short term profits at the expense of long term profits by neglecting crucial area like manpower training and development, maintenance and research and development activities. High profits of the profit centre may not always optimize the profits of the company. Setting up of profit centres may entail extra cost to the company in the form of additional management, staff and record keeping and additional ancillary infrastructure which may lead to redundant tasks at each profit centre. • • • • Activity 1 Try to define a profit centre? In what way a profit centre is different from an expense centre? ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... 5.3 BOUNDARY CONDITIONS FOR PROFIT CENTRES In companies where each of the principal function of manufacturing and marketing is performed by seperate organizational units, these type of compnies (organizations) are known as functional organizations.As the companies expand and mature over a period of time offering diverse products and services, it becomes difficult for top management to pay equal attention to all products and services. In this scenario one of the option available is to divisionalize the company which implies that each major organizational unit in the company is responsible for both the manufacturing and the marketing of the product, implication of this move is that there is greater amount of delegation of authority and responsibility to the operating managers. An organization with several divisions is a complex as a whole. Tile divisions, however, are not separate entities in their own right. The design of profit centres in 23 Management Control Structure organizations will have to contend with the question of service functions centrally located in the headquarter which do not directly contribute towards performance of profit centres. We also have to consider the domain of the profit centre. Thus, defining the boundary conditions for the profit centres is an important aspect of the design of profit centres. The major problem associated with the service functions is that there is no direct measures of profit which can satisfactorily evaluate the performance of the function. Even though the service functions are very important in the profit performance of the company as a whole, it is very difficult to isolate and measure their contribution. It may be possible to organize many service centres into profit centres and their services could be sold, but in most organizations they are intended to provide their services only to the organization. Their services may not be used in sufficiently large volume if they are organized as profit centres. The examples of service functions are management information service, legal services, corporate planning department etc. A plausible solution is to distribute the cost of service functions among various profit centre where such activity can be economically justified. The major problem is to define the boundary conditions for the profit centre where by we can balance the costs and revenues of the division. The major objective of the exercise is to ensure that we maximize certain revenues and minimize certain costs. Therefore, measurement of profits as the outcome becomes the major criteria in decision making within the division. This leads us to the most logical choice of accepting profit performance measurement as the major factor guiding the determination of profit boundaries. However, we should not lose sight of the fact that what is good performance of the division need not always be the good performance of the company as a whole. Further, the profit centres should not result in conflict with other divisions within the organization. These conflicts to occur in organizations when the divisional managers in their eagerness to achieves profit in their division lose track of the interest of other divisions. Appropriate boundaries for profit centres thus would ensure a more meaningful profit performance of the profit centre managers and act as better incentive. Economic basis of the profit centre boundary revolves around factors such as market for the product, cost and revenues structure and the separability of their cost and revenues from the rest of the organization, management objectives and above all the extent of operational freedom that is available. Access to the market is very important with respect to profit centre performance in that the choice of market, adaptation of the product to market are necessary for maximization of revenues. Cost and revenues are separate from the rest of the organization and the ability to influence them by the decisions of the division is a necessary condition for influencing profit. A manager should be evaluated only on the basis of items over which he has control. If most costs and revenues are not separable and controllable part of this is too small, profit centre may not be of much use. Management must be willing to accept the profit performance of the division and be prepared to guide the decisions of the profit centres without curtailing their freedom. It should be borne in mind that profit alone could never be the sole criteria for evaluation of the performance of a profit centre. All aspects considered, however, rightly demarcated boundaries of profit centres will not produce any tangible to the organizational unless the divisions have a reasonable measure of operational autonomy. The autonomy will have to be clearly understood within the context of overall rules of the game established by the top management. 24 Autonomy is crucial in decision areas such as buying, production and its scheduling; inventory policies, choice of market, product mix and pricing Activity 2 1) 2) Try to prepare a check list of the boundary conditions for the establishment of profit centres in an organization. List down the organization requirements for the establishment of profit centres. Profit Centres ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... 5.4 PERFORMANCE MEASUREMENT OF PROFIT CENTRES Having demarcated the boundaries for profit centres; it becomes important and necessary to measure their performance. However, with boundaries so set, performance measurement becomes easier and convenient. But still the measurement of profit is not a simple task. It poses problem as the concept of profit may not be very clear, the problem of transfer pricing has to be tackled and the decision has to be taken regarding compensation based on evaluation. Basic of Measurement of Performance It is not quite easy or simple to decide the basis of measurement of performance. However, the profit contribution by the profit centre may be taken as basis for it. However, if current profit is taken as the basis it may be in tune with goals of the organization which may be short-term as well as long-term. In fact, the short term profit goals may be in consonance with the long-term profit goals. In this connection, one problem arises regarding question of current profitability as compared to future growth. If we confine to current profit only, it would be at the cost of future growth.' Similarly, the concern for future growth can be achieved at the expense of the current profit performance. Another problem may arise when we devote our attention to R&D. Any additional cost incurrent for R&D would certainty affect the current profit performance. Similarly, the cost for current training and development which is quite necessary for the development of the organization ultimately has the adverse impact on current profit performance. The Concept of Profit There are different concepts used related to profit, hence, that would also pose a problem in this connection. This term may have different connotations, such as book profit, real profit, and profit contribution. The easiest and most acceptable concept of profit is the book profit, which is shown by the books of account. However, when we take into account the book profit, the problem of allocation of organizational expenses arises. It is not easy to solve it as no method of such allocation seems to be scientific one and that may be questionable. The real profit may be a better basis of evaluation of performance, as the real profit takes into account economic value of the resources consumed. For this, valuation of resources consumed should be taken, taking into account depreciation. In this case, also the question of allocation of common expenses remains untackled. 25 Management Control Structure This leads to choosing the third concept of profit, i.e., the profit contribution. It implies profit contributed directly by the division. It may also be described as `incremental profit' or the `additional profit' earned solely as a result of operations of the division. The Question of Expression of Profit Another related problem is how do we express the profit in the context of profit centres. Is it to be expressed as an absolute amount? Or as a margin on sales? Or as a rate of return on investment? Whichever way express profit, it has its own significance. And all the questions relating to measurement of profit will be applicable in whatever way we express profit. . Transfer Price and Profit Centres The measurement of profit in a profit centre is also complicated by the problem of transfer prices. A transfer price is a price used to measure the value of goods/ services furnished by a profit centre to other responsibility centres within a company. In other words, when internal exchange of goods and services takes place between the different divisions of the firm that requires their valuation in terms of money. It becomes quite necessary to deal with transfer price as the profit centres as buyers and sellers should be able to negotiate prices of such transfer independently. Activity 3 1) What difficulties are to be sorted out before designing an evaluation system for profit centres? ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... 2) Can you try to enumerate the problems associated with ‘profit' and its measurement for a division? …………………………………………………………………………………………. ......................................................................................................................................... ......................................................................................................................................... ........................................................................................................................................ ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… Problem of Analysis of Profit Centre Results Apart from the profit measurement and associated problems, there is also the problem of understanding the performance itself. Usually profit performance problem of understanding the performance itself. Usually profit centre performance will have to be evaluated against some standards and the most common practice is to evaluate the same against the budgets. The variances occur as a result of the combined influence of a host of factors. Unless these influences can be segregated and understood the major objective of control would not be achieved. Further, reliance on the total deviation without isolating the controllable and non-controllable aspects of the variations may have demotivating impact on the managers. 26 The problem will also be different when the division is a single product or a multi product division. However, in the case of a multi-product division the problem may be more complex. We shall try to analyse the variances of net income before tax for profit centre. We use the data of Ibid Apparel presented in Table 5.1 and 5.2 for this purpose. For the sake of simplicity, we have grouped the products into major groups and we will use the average data for each group as the per unit information Table 5.1 : Ibis Apparels Master Budget Sales and Expense Data for Period 1 (in 000) Undergarments Per Unit Sales in Units Sales Revenue Variable expenses Manufacturing Marketing Total Variable expenses Contribution margin Fixed expenses Manufacturing Marketing Administration Total Net profit before taxes Table 5.2: Ibis Apparels Actual Sales and Expense Data for Period 1 Products Undergarments Outer-garments Per Unit Total Per Unit Total 10.000 5,000 Rs.9.00 Rs.90,000 Rs.50.00 Rs.2,50,000 3,50 1.50 5.00 4.00 35,000 15,000 50,000 40,000 30.00 10.00 30.00 20.00 1,00,000 50,000 1,50,000 1,00,000 Actual Total 15,000 Rs.3,40,000 1,35,000 65,000 2,00,000 1,40,000 50,000 65,000 15,000 1,30,000 10,000 Rs.10.00 4,00 2.00 Rs.6.00 Rs.4.00 Products Outergarments Total 7,000 Rs.70,000 Rs.40.00 Per Unit Total 8,000 Rs.3,20,000 1,20,000 64,000 Rs.1,84,000 Rs.I,36,000 Master Budget 15,000 Rs.3,90,000 1,48,000 78,000 Rs.2,26,00 Rs.1,64,00 Rs.60,000 Rs.75,000 14,000 Rs. 1,49,000 15,000 Profit Centres 28,000 15.00 14,000 8.00 Rs.42,000 Rs.23.00 Rs.28.000 Rs. 17,00 Sales in Units Sales Revenue Variable expenses Manufacturing Marketing Total Variable expenses Contribution margin Fixed expenses Manufacturing Marketing Administration Total Net profit before taxes On comparing the budget and actuals presented in Table 5.1 & 5.2 we find that the profit before tax is down by Rs. 5,000 from the budgeted figure. Let us disaggregate the information and see the actual influences so as to understand the performance of the profit center. As a first step towards this we try to construct the flexible budget for the division. Table 5.3 presents the flexible budget calculations. 27 Management Control Structure Table 5.3: Ibis Apparels Calculation of Flexible Budget for Period Sales Revenue Undergarments Undergarments Total Variable expenses Undergarments Manufacturing Marketing Total Outergarments Manufacturing Marketing Total Total Manufacturing Variable expenses Total Marketing variabl Expenses Total Rs. 60,000 Rs. 1,75,000 5,000 5,000 15,000 x x Rs. 15.00 8,00 = = Rs. 75,000 40.000 Rs. 1,15,000 Rs. 1,15,000 5,000 15,000 (actual units sold x budgeted selling price) 10,000 x x Rs. 10.00 40,00 = = Rs. 1,00,000 2,00,000 3,00,000 (actual units sold x budgeted variable expense) 10,000 10,000 x x Rs. 4.00 Rs. 2,00 = = Rs. 40,000 20,000 Rs. 60,000 Table 5.4: Ibis Apparels Calculation of Volume-mix and Expense-price Variances for period I 1 2 3 Actual 15,000 0 340 135 65 200 140 50 65 I 130 10 90 U 33 F 18 F 51 F 39 U 0 0 (1-2) Volume & Mix (2-3) Expense & price 0 40F 20 U 5U 25 U 15 F 10 F 10 F 1U 19 F 34 F Master Flexible Budget Budget Sales units 15,000 Sales Revenues (Rs. `000) 390 Variable Expenses (Rs. `000) Manufacturing 148 Marketing 78 Total Variable Expenses Contribution Margin Fixed Expenses (Rs. `000) Manufacturing Marketing Administration Total fixed expenses Profit before taxes ('000) 226 164 60 75 14 149 15 15,000 300 115 60 175 125 60 75 lit. 149 (24) 39 U 28 Notes 1) Sales Volume Variance = Master budget average contribution margin per unit x (Actual sales units - Master budget sales units) =(Rs. 1,64,000/15,000) x (15,000 - 15,000) = 0, 2) Sales mix variance = (Flexible budget average contribution per unit - Master budget average contribution per unit) x Actual sales unit = [ (Rs.1,25,000/ 15,000) - (1;64,000/15,000) ] x 15,000 = Rs. 39,000 U. Sales volume and Mix Variances From Table 5.4 it is easy to understand the actual performance and see how the decline in profit after tax of Rs. 5,000 has resulted. We can see that the total sales volume of 15,000 has not change and hence no loss is attributable to volume variance. However, the sales mix does change and the drop in sales of high contribution outergarments results in a combined loss of Rs. 39,000, despite an increasing in sales of low contribution undergarments. That is, the company has lost a contribution of Rs. 51,000 on outergarments and gained a contribution of Rs. 12,000 on undergarments, thus incurring a loss of Rs. 39,000 on account of sale mix change . Master budget contribution Margin per unit Budgeted sales units Sales mix % Actual sales Actual sales mix % Price and Expense Variances The Rs. 40,000 favourable price variance in Table 5.4 arises from the fact that the average actual sales price exceeded the average flexible budget sales price. This can be disaggregated by products as follows: Undergarments (Rs. 9.00 - 10,000 Outergarments (Rs. 50.00 - 40,000 = Rs. 10,000 U = Rs. 50,000 F Undergarments Rs. 4.00 7,000 46.67 10,000 66.67 Outergarments Rs. 17.00 8,000 53.33 5,000 33.33 Profit Centres Rs. 40,000 F The total expense variance is Rs. 34,000 favourable which can be disaggregated as follows: Manufacturing variable Rs. 20,000 U Manufacturing fixed Marketing variable Marketing fixed Administration Total 10,000 F Rs. 5,000 U 10,000 F Rs. 5,000 F 1,000 U, Rs. 14,000 F Rs. 10,000 F Now we have a clear idea as to which segments of the business have contributed towards gains and which segments contributed towards losses. This information will help the profit center management and the top management to tackle the situation better. Summary of Variances Sales Mix variance Sales Price variance Expenses variances Total Rs. 39,000 U 40,000 F 14,000 F Rs. 5,000 F This analysis explains the actual performance of the profit center. 29 Management Control Structure 5.5 PROFIT CENTER AS MOTIVATIONAL TOOL The behaviour of the divisional managers is often heavily influence by how their performance is measured. Thus, profit centres act as a tool for motivating such managers. However, it is quite debatable as to what extent, profit centres motivate them. Sometimes, it may demotivate them. The different arguments supporting the value of profit centre as motivational tool can be summarized as follows: 1) A profit centre manager is perceived to have a higher status in the organization and hence provides a psychological benefit to the division manager. It is argued that this perceived importance motivates him to perform better. By making the managers responsible for the profit performance of their divisions it tried to blend their objectives with the profit objectives of the company. Profit centers tend to enhance the profit consciousness of the managers and subordinates within the division and hence they all strive for maximizing the profits of the division. This leads them to become conscious about the expenses in the division. They constantly try to evaluate every expense decision in the context of its relationship to profits. The position of being a profit centre, manager in an organization brings in a sense of pride and belongingness, which in psychological terms provides sustenance for the needs of self actualisation and self-esteem. Most of the organization theorists argue on these lines. The freedom and authority given managers imbibe a sense of independence and responsibility in the profit centre managers enabling them to strive for better performance. 2) 3) 4) All these arguments are essential or inter-related and may at least partially contribute towards better performance when combined with a realistic system of rewards and punishments. Several studies have been conducted in India in this regard and they have concluded that there has been enhancement of the profit consciousness amongst the managers as the greatest motivational contribution of profit centers. Thus, profit centers do serve as a motivational' tool. 5.6 PERFORMANCE RELATED COMPENSATION If compensation is related to performance of the divisional managers, that certainly motivates them to put in their best. The compensation linked with performance should provide sufficient incentives to such managers so that they may be duly motivated to maximum contribution to the overall profits. It is also necessary that the measurement of profit of the centres should be undertaken objectively. Any objective measurement, linked with the effective system of adequate compensation, would be an important motivational factor. The amount of and nature of compensation should be in the overall context of the organization. For that it is essential that the evaluation is undertaken at collective level and the incentives, through compensation, are quite realistic so as to motivate the divisional managers. 30 5.7 SUMMARY Profit Centres Profit centres aim to focus attention of the managers on control by making them responsible for both' revenues and expenses of the centres. Establishing and operating control system based on profit centres poses many practical difficulties such as deciding on the basis of profit measurement, allocation of expenses, and inter-divisional transfer prices. A major problem to be confronted in establishing profit centres is the very question of the boundaries of the profit centres within the organization. Profit centres may be an important motivational tool in organizations. There is evidence to show that they imbibe a sense of profit consciousness among division managers. The establishment of profit centres and the evaluation of performance using profit measures s pose several ticklish questions arising from combined influence of a host of factors. Profit centres, in order to be effective and enduring in an organization, would also require a performance related compensation system which may again pose several practical difficulties in the implementation of the idea. 5.8 KEY WORDS Book profit: Profit measured by matching revenues and expenses of an accounting period according to generally accepted accounting principles. Boundary conditions of profit centres: The boundaries of divisions in an organization should be so determined that overlapping is avoided. Where certain revenues and expenses are attributable to a particular division, they should be assigned only to that division. Performance evaluation: The process of assessment of the result of operations of the division by comparing against predetermined standards. The basis of such evaluation need not be restricted to any one variable. Profit centre: A division of an organization which is responsible for both revenue earned and. the expenses incurred by it. Such a division is usually evaluated on the basis of profit or a variant of it. As a general principle the measurement is restricted to revenues and expenses over which the division has control and hence the profit so measured may be different from the profit in the accounting sense. Profit contribution: This is actually the contribution made by a division towards the profits of an organization without setting off all those costs incurred by the. organization over which the division has no control. Real profit: The profit determined by valuing tale resources consumed by the division at their economic value to the business and not their historical cost. Variance: Deviation of actual of various elements of costs and revenue from the planned levels. 5.9 1) SELF ASSESSMENT QUESTIONS Evaluate the purpose of comparing actual net income planned net income of profit centres. What problems, if any, may be confronted in this case? 31 Management Control Structure 2) 3) 4) 5) How do the boundary conditions influence the measurement of the performance of profit centres? n what ways does the idea of profit and the difference in measuring profit affect the evaluation of profit centres? How does profit centre motivate divisional managers? What is performance related compensation? What are its advantages? What are the pitfalls against which we must guard ourselves before introducing the same. 5.10 FURTHER READINGS Bhatia, Manohar L., 1986, `Reorganising for a Decentralised Structure', Economic Times, January 4. ,198,1, `Profit Centres in Large Indian Industries', The Management Accountant, December. , 1983, `Motivational Value of Profit Centres', Myth and Reality `Cost and Management', November-December. , 1985, `Integrating Management by Objectives (MBO) and Responsibility Accounting', The CharteredAccountant, Volume XXXIII. Dean, Joel, 1957, `Profit Performance Measurement of Divisional Managers', The Controller, 25 September. Dearden, John, 1968, `Appraising Profit-Centre Managers', Harvard Business Review, 46, May-June. Dearden, John, 1960, `Problems in Decentralised Profit Responsibility', Harvard Business Review, 38, May-June. Parker, Lee D., 1979, `Divisional Performance Measurement: Beyond an Exclusive Profit Test', Accounting and Business Research, 9 Autumn. Solomons, David, 1965, Divisional Performance: Measurement and Control, Homewood: Richard D. Irwin. 32 UNIT 6 TRANSFER PRICING Objectives After studying this unit, you should be able to: • • • • understand and differentiate transfer pricing from external pricing; appreciate the need for transfer prices in a situation where two or more divisions exchange goods or services; evaluate the different problems of fixing transfer prices in the context of a divisionalised organization; and appreciate the importance of transfer pricing in taking correct production and selling decisions. Transfer Pricing Structure 6.1 6.2 6.3 6.4 6.5 6.6 6.7 6.8 6.9 6.10 Introduction Transfer Pricing and Corporate Policy Criteria for Determining Transfer Pricing Methods of Transfer Pricing Decentralisation and Performance Evaluation Transfer Pricing Practices Summary Key Words Self Assessment Questions Further Readings 6.1 INTRODUCTION Large companies, in practice, are divisionalised companies. In other words, they are organized into different divisions for having effective control over them. In such a divisionalised company, where profit or investment center is created, there is likely to be transfer of goods or services from one division to another. Such internal transfers create the problem of pricing the product or service. Thus, if one division supplies its finished output as input to another division the question of transfer pricing arises. Transfer price is the price at which the supplying division prices its transfer of output to the user division. As it is only internal transfer and not a sale, transfer price is different from normal price. The price charged to the inter-divisional transfer of goods and services is the revenue to selling division and cost to the buying division. Thus, the price charged will affect the profit of both the divisions. In fact, the benefit (revenue) to one division can be created at the expense of the other division. The transfer pricing does affect the financial performance of different divisions. Therefore, the transfer price should be free from all the biases. It has to be as equitable as possible to the different divisions in the company concerned. 33 Management Control Structure Activity 1 a) b) Note down the conditions which make transfer prices necessary. Can you try to construct a set of objectives for establishing a transfer price system. .............................................................................................................................................. .............................................................................................................................................. .............................................................................................................................................. .............................................................................................................................................. .............................................................................................................................................. 6.2 TRANSFER PRICING AND CORPORATE POLICY Introduction and operation of an effective system of transfer pricing in an organizations is entangled with at least major aspects of corporate policy. They are (1) divisional autonomy, (2) transfer pricing, and (3) performance evaluation. The first two aspects are specific ingredients of general areas of corporate control. Most large organizations may be divisionalised. The divisional managers' freedom of action is not complete. Divisional managers are to make periodic reports to the headquarters. The corporate policy on this may include: a) b) c) the level of details in these reports, the accountability of decisions and actions, the frequency of over-ruling of the divisional manager's decisions, and so on. The headquarters closely controls those aspects which affect the operations of other divisions. This includes quantities of output transferred among the divisions as also the price at which the transfer takes place (the transfer price). Apart from control considerations the headquarters must also be concerned with policy regarding evaluation of performance of the divisions. The evaluation of performance of the division is necessary for the `rewards' and 'punishments' to be decided for the divisional managers. The rewards and punishments of the divisional managers have to be based on some observable objective measures such as sales, profits, cost reductions, innovation, improvements and growth. The corporate policy determination in the context of divisionalised firms involves two decision-making levels. First the headquarters which sets overall performance evaluation and the corporate control policies and secondly by which set the enterprise level policies relating to discretionary controls such as physical outputs, prices and the like. The divisional managers who control enterprise level variable would like to maximize their benefits. The benefits depend on the evaluation criteria set by the headquarters. The outcomes depend on the corporate control policies and environment factors. The environment factors such as market condition competition price, taxation and so on are exogenous or given for any enterprises. Most of this environmental variable may be uncertain and will force the divisional manager to take decisions under uncertainty. It is in this context of setting corporate policies relating to evaluation and control that we have to look at transfer pricing and its implications for performance evaluation and corporate control. 34 Activity 2 Map the relationship of corporate policy issues involved in establishing transfer price system? ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... .......................................................................................................................................: Transfer Pricing 6.3 CRITERIA FOR DETERMINING TRANSFER PRICING It will be advisable to formulate certain criteria before determining the transfer price. Those criteria may be as follows: 1) 2) Transfer price should help in accurate measurement of divisional performance. Transfer price should motivate the divisional managers into maximizing the profitability of their divisions and making decisions which are in the best interest of the organization as a whole. The transfer price should ensure that divisional autonomy and authority is preserved. The transfer price should allow goal congruence to take place. It implies that the objectives of the divisional managers are compatible with the objectives of overall company. A transfer pricing system should check the international groups which may try to manipulate transfer prices between countries with a view to minimize the overall tax burden. 3) 4) 5) 6.4 METHODS OF TRANSFER PRICING In practice, several methods are used for transfer pricing. However, there are two basic approaches to determination of transfer price. They are: (i) Market based; (ii) Cost based. Let us discuss them briefly, as follows: Market Price The most popular method of determining transfer pricing is the market price, as it is quite reasonable for supplying division as well buying division. It is not difficult, as the price is easily available in the open market. When there is a well-established market for the goods or services to be transferred. The transfer price can be easily determined on the market price basis. However, such market price should be taken as ceiling limit for transfer price. When divisions have the alternative to buy or sell from the open market, they would transfer to buy or sell from sister division. When transferred goods are recorded at market price, the divisional performances are more likely to represent the real economic contribution of the division to total company profits. Under certain conditions, there may be deviations from market-based transfer price. Some instances, for such deviations, are as follows: 35 Management Control Structure • • • • Where the products involved are highly specialized and a ready market does not exist, market-price determination will be more difficult. Where it is necessary to take advantage of economies of the scale in the production of some goods or services. When it is necessary to shift resources from low priority to high priority divisions. Where considerations of taxation are applicable. Market-based transfer pricing is more commonly used, as it offers following advantages: • • • • They are one of the most simple and easily understood method. They minimize the complications for performance evaluation. They reduce points of conflict between various divisions. They are usually consistent with the environment outside. Cost-based Prices When external markets do not exist or are not available to the company or when correct information about external market prices is not available, the cost based transfer price may be used. The cost-based prices methods may be as follows: a) b) c) d) e) a) Variable Cost Actual Cost Cost plus a normal mark-up Standard Cost Opportunity Cost Variable Cost Under this method, only variable production cost is taken into account. In variable cost, the cost of direct material, direct labour and variable factory overhead are included. In other words, fixed cost is not included in it. Variable cost method for transfer price may be useful when the selling division is operating below capacity. However, the selling division manager would not like it as a basis for transfer price, as it does not provide the profit to that division. b) Actual Cost If transfer prices based on actual cost, it would include total or full cost of production per unit. It is a simple and convenient method, as the required information is available in the accounting records. However, the selling division would not earn any profit on goods or services transferred to the buying division. The buying division would stand to gain, as it would be lower than the market price. However, it is quite inappropriate for profit center analysis. c) Cost Plus Normal Mark-up 36 Under this method, the transfer price include cost per unit plus some profit margin or normal mark-up. This mark-up price may be determined in two ways. Either the management of the company may set a target profit or it may be equal to the profit Margin that competing firm might reasonable be expected to realize. However , the decision about the ‘percentage’ of mark-up may be arbitrary and questionable. d) Standard Cost Transfer Pricing Standard Cost is pre-determined cost and is also called `engineered cost'. In practice, it may appear to be more practical and useful and may be taken to be a good choice for transfer price. Standard cost based transfer price encourages efficiency in the selling division as inefficiencies are not transferred on to the buying division. Use of standard cost reduces the risk to the buyer. e) Opportunity Cost Often in practice, the determination of transfer price on market price or cost may be difficult. Under those circumstances, the transfer price may be based on opportunity cost. Such pricing may also be required where the supplier division is a monopoly producer or the user division is a monopoly consumer. The transfer price may be fixed at a level which equal the opportunity cost of the supplier division and the user division. It also identifies the minimum price that a selling division will be willing to accept and the buying division will be willing to pay. The opportunity costs based on transfer prices for each division are as follows: Selling Division: For the selling division, the opportunity cost of transferring is the greater of: a) b) The outside sales value of the transferred product; Differential production cost for the transferred product. Buying Division: For the buying division, the opportunity cost of acquiring by transfer is the lesser of: a) b) The price that would be required to purchase from the outside; The profit that would be lost for producing the final product if the transferred unit could not be obtained at economic price. In the economic interest of the company, it would be better if the opportunity cost for the selling division is less than the opportunity cost for the buying division. The practical difficulty may arise when the divisions will tend to overstate or understate their opportunity cost so as to influence the transfer price to their advantage. Under such condition, the central management may examine it and bring the necessary changes by obtaining necessary information in this regard. There are two other methods of determining the transfer price. They have been; described briefly as follows: 1) Negotiated Prices In practice, the transfer price is determined on the basis of negotiations between the selling and buying division. It may be between the market prices and the cost-based price. While negotiating the price, the seller division manager and buying division manager act much the same as the managers of independent companies. If the transfer price is based on negotiated price, the company, as a whole, stands to benefit. Such price avoids mistrusts, bad feeling and undesirable bargaining interest among divisional managers. it provides an opportunity to achieve the objectives of goal congruence, autonomy and accurate performance evaluation. 37 Management Control Structure The negotiated price basis may have some limitations also. They are: • • • In the process of negotiation, a great deal of management effort, time and resources may be consumed. Such a price may also depend upon the skill and ability of managers concerned. One divisional manager may take advantage of having some private information which the other manager may not possess. With the result, the negotiated price may not be accurate. Dual Prices 2) It is also known as `two-way prices'. Under this method the selling division is credited with one price. That may be cost plus profit margin whereas the buying division is charged at different price, which may be equal to variable cost. The difference in the transfer prices for the two divisions could be accounted for by a centralized account. The dual pricing gives motivation and incentive to selling division as goods are transferred at cost plus some profit margin. On the other hand, for the buying division, it would be quite appropriate price. Often, the use of dual prices may lead to a divergence between the segment profits and those of company. However, this is not a serious issue and can be resolved in the interest of the divisions concerned. Activity 3 i) What conditions must exist for establishment transfer price based on the following? a) b) c) market price or modified market price different cost - based transfer prices negotiated transfer price d) opportunity-cost-based transfer price ...................................................................................................................................................................... ...................................................................................................................................................................... ...................................................................................................................................................................... ...................................................................................................................................................................... ii) Prepare a matrix showing different transfer pricing models, situations ideal for each case, and advantages and problems of using different transfer prices. ........................................................................................................................................... ........................................................................................................................................... ........................................................................................................................................... ........................................................................................................................................... 6.5 DECENTRALISATION AND PERFORMANCE EVALUATION 38 Every organization aims at achievement of some group-objectives. An important consideration in organizing activities is the congruity between the objectives of the individuals in the group and the group. Where such congruity exists the group goals would be achieved automatically with the achievement of personal goals. In reality, however is a natural contradiction between individual goals and the group goals. A basic contradiction which can be easily understood is the fact that the individual tends to want to put a small part of effort into achievement of the group's goals and at the same time like to share a larger part of the benefits of the group's activities. It is in the context of this natural tendency that the group must impose some performance evaluation of the individual. The share of the individual in group-achieved benefits (or results) should be proportional to some observable contributions of the individual to the group's objectives. The group activities are to be left to the individuals and what success criteria are to be considered in the evaluation of the contribution made by the individual towards the group. The activity of the group to be left to the individual's decision will determine the degree of individual autonomy. The success criteria to be used for evaluating the individual's contribution to the group will determine the method of performance evaluation. The set of observable success criteria may be taken to include absolute profit levels, profit rates, cost levels, revenues, market share, product improvements, increase in productivity and so on. Managers on the other hand base their controls on various variables such as quantities of inputs purchased and consumed, quantities of output produced, prices obtained on outputs, expense incurred on marketing, research and development, product improvements and so on. Please recall the overall performance evaluation given for various types of responsibility centers in Table 4.1 It is generally agreed that there are three major principles for developing and implementing performance evaluation system: 1) The criteria and procedure of performance evaluation should be clear and explicit and the superior and subordinate should have common understanding prior to the beginning of the evaluation period. The criteria of performance evaluation should be as accurate possible. It is ideal to use a multiple criteria of performance than any single criteria. Transfer Pricing 2) 3) If we look at the control variables used by responsibility centres in Table 4.2 (in unit 4) we notice that in case of all the centres in a multi divisional organization using or providing goods or services from or to another division --the performance measurement will be closely linked to the transfer pricing used by the organization. It is this central position of transfer pricing in the performance of evaluation of different divisions and the resultant organizational problems that makes it very crucial in the scheme of performance evaluation. Activity 4 What are the problems which come up in transfer pricing in the area of performance evaluation. ……………………………………………………………………………………… ……………………………………………………………………………………… ……………………………………………………………………………………… ……………………………………………………………………………………… ……………………………………………………………………………………… 6.6 TRANSFER PRICING PRACTICES There is a large amount of documented sources on the transfer pricing policies used by companies all over the world. These studies have documented various aspects of transfer pricing policies such as (a) its role as an overall component of reporting and control system in companies, (b) the effect of transfer pricing on intra-corporate conflicts, (c) variations in transfer pricing policies across the world, and (d) environment constraints on use of transfer prices. 39 Management Control Structure A brief summary of transfer pricing practices is as follows: 1) 2) Companies tend to look at transfer pricing not just as a mere accounting exercise, but also as an important tool in policy formulation towards achievement of corporate objectives. Transfer pricing acts as a major source of political conflict within the organization and this takes place irrespective of the method used for this purpose. Different methods may, however, increase or decrease the possibility of conflict. Companies tend to use a variety of transfer pricing methods. However, the dominant among them are the market prices or the methods based on modifications of the market prices. Even though many companies use transfer prices as a policy variable, it is not the major or principal policy variable. International companies use conscious manipulation of transfer prices as an instrument of maximizing achievement of corporate goals. An explicit example is the transfer of profits from subsidiaries to parent companies or other companies in the group through transfer pricing policies relation to supply of capital equipment or inputs by multinational companies. 3) 4) 5) 6.7 SUMMARY Large businesses are usually organized into divisions for effective management control. When the organizations get divisionalised, they face the problem of pricing the goods and services `purchased' by one division from another from within the organization. Transfer price is the price establishment for inter-divisional transfer of goods or services. The processes of setting transfer prices are closely related to the corporate policies on divisional autonomy and performance evaluation. There are various methods of transfer pricing that can be used by an organization. However, the choice will 'be determined by a host of factors such as nature of the product; policy of the company with respect to divisional autonomy, method of performance evaluation, and so on. The usual methods are based on cost of production, market prices, negotiated prices or opportunity cost supplier and user divisions. It is common practice to use any one of these methods as a basis and then to determine the actual transfer price by appropriate mutually agreed adjustments in the context of a particular company. Transfer pricing has a direct impact on the issue of performance evaluation to be used by the company and hence is closely related to the question of motivation of the executives. In actual practice companies use almost all the methods. The choice of methods is determined by the management policy and the particular situation of the company. Most commonly used methods are based on market prices. Companies consider transfer pricing important to the policy formulation for achieving the objectives of the company. The internal political structure of the organization also plays a part. Illustration The Apparels division of Ibis Apparels uses yarn from Ibis Yarns, the spinning division which is operating at full capacity. The yarns division sells part of its output to regular outside customers at Rs. 15.00 a unit. Apparels division has now offered Rs. 10.00 a unit for the yarn. It sells its products in the open market only. The cost structure of Apparel Division is estimated as follows: Selling price Rs. 100 Outside supplies 40 Ibis yarn supplies 10* Other variable costs 15 Fixed overheads Rs. 95 40 The Apparels Division is operating at about 50 per cent of its capacity and the divisional management believes that a saving of Rs. 5.00 per unit of yarn which is a major part of the Apparel Divisions' input, can give it a price advantage in the market and will be able to increase its capacity utilization. The company uses return on investment to measure the financial performance of divisional managers. 1) 2) 3) Assuming that you are the divisional manager of Ibis Yarns, will agree to selling yarn at Rs. 10,00 to Apparel Division? Why or Why not? Will it be the immediate economic advantage of Apparel Division if the yarn division supplied yarn at Rs. 10.0 per unit? Explain. Can you evaluate the management issue involved in this situation? What will be your stand if you were the President of Ibis Company? Transfer Pricing Suggested answer a) It is advisable to supply Apparel Division with yarn at the rate of Rs. 10.00 per unit. Yarn Division will lose Rs. 5.00 per unit on quantity sold to Apparel division. The performance of yarn division will be adversely affected as it is be evaluated on the basis of return on investment. The nature of Rs, 15,00 per unit fixed cost is the key to the question of deciding what is good for Apparel Division, These costs are to be incurred, irrespective of the volume of operations Thus, even if the yarn is purchased at Rs, 15.00 per unit and a price cut of Rs. 5.00 is effect to increase the sales the contribution will still be positive as shown below: Selling price Less: variable costs: Outside supplies Ibis yarn's supplies Other variable costs Contribution margin - 40 - 15 - 30 Rs. 10 Rs. 95 b) The Apparel Division has a positive contribution of Rs. 10 per unit even after obtaining the yarn at market price and effecting the required reduction in price to effect expansion in sales volume. Correct analysis will show that it is not necessary to obtain a price advantage of Rs. 5 per unit from yarn division to make the price reduction possible. There is no immediate advantage to be obtained by Yarn Division supplying the yarn at Rs. 10. c) The best interest of the Ibis company is served by the apparel division effecting the price cut to increase the volume and thereby reducing the per unit incidence of fixed costs. Forcing the Yarn Division to supply at Rs. 10 per unit is not a valid argument since there is no real advantage to the company as a whole. As the president of the company I would ask the Apparel Division to look elsewhere for maximizing the margins than by artificially increasing the same by temporary Vail out from another division. 41 Management Control Structure 6.8 KEY WORDS Cost Based Transfer Price: A price determined for inter-divisional transfer of goods or services which are based on cost of such goods or services with or without the additional of a margin on the cost. Either the whole or some predetermined components of the cost from the base of such transfer prices. Market Price Transfer Prices: A price determined for inter-divisional transfer of goods or services which are based on the market price of such goods or services, with or without any adjustment. Market price may be determined by the adjustment to be carried out. Negotiated Price: A price for inter-divisional transfer of goods or services which are determined by negotiations between supplying and divisions. A price established in an 'arms length negotiations between supplying and user divisions. A price established in an 'arms length negotiation' is a free and as if these divisions where two independent parties to the transaction. Transfer Price: An internal selling price established for goods or services transferred between divisions of a divisionalised company. 6.9 SELF ASSESSMENT .QUESTIONS Steel Industries Ltd. (SIL) was formed by merging three independent units, Mini Steels Ltd. (MSL), Steel Rolling Ltd. (SRL) and Steel Fabricators Ltd. (SFL). After the merger in 19XI the three units have operated as three divisions of SIL, as if they were independent units, having own sales force and production.facilities. Each division management is responsible for sales, costs of operations, financing and working capital management. SF division received a contract for structural fabrications. It uses rolled components from SR division. It also uses components from outside suppliers. SF used a cost figures of Rs. 3,800 per ton for the rolled products manufactured by SR in preparing the bid for the contract. This cost was based on the information relating to standard variable cost of manufacturing, selling and distribution supplies by SR. SR has an aggressive production and sales force catering to new rolled products according to the market demand. SR's average selling price for the rolled products to be supplied to SR is Rs. 6,500. Sales of these components are growing in the market. SR has offered to meet the demand of SR regularly at the current selling price less variable selling and distribution expenses. SR has offered to pay standard variable manufacturing cost plus 20%. The corporate management had so far never set a transfer price since the divisions had continued with their independence even after merger. Since the two divisions, now could not agree on the price, the corporate finance director intervened and suggested a price based on standard full manufacturing cost plus a mark up of 15%. Needless to say both the divisions rejected the compromise suggestion. The cost structure of SR division's rolled components to be supplied to SF division and the three suggested transfer price are given below: 42 Current market selling price Variable manufacturing cost Fixed manufacturing cost Variable selling and distribution cost Rs. 6,500 Rs. 3,200 1,200 600 Rs. 5,000 Transfer Pricing Transfer Price alternative: Current market price less variable selling and distribution expenses (Rs. 6,500 - 600) Variable manufacturing cost plus 20% (Rs. 3,00 x 1.2) Full manufacturing cost plus 15% (Rs. 4,400 x 1.15) Required 1) 2) Discuss the effect of each of the suggested transfer prices on the SR division. What would be the attitude of SR division towards intra company sales? Do you agree with the process of negotiation between SR and SR divisions as satisfactory method of resolving the transfer price question? Explain your position. What is the role of corporate management in the situation? Will you agrees to the suggestion of imposing a transfer price in this situation? Explain your answer. Rs. 5,900 Rs. 3,840 Rs. 5,060 3) 6.10 FURTHER READINGS Benke, Ralph L., and James D. Edwards, 1980, TransJ r Pricing: Techniques and Uses, National Association of Accountants: New York. Bhatia, Manohar L., Profit Centres: Concepts, Practices and Perspectives, Somaiya Publications, Bombay (Appendix I - Transfer Pricing, pp.259-272) Holstrum, Gary L., and Eugene H. Sauls, 1973, `The Opportunity Cost Transfer° Price', Management accounting, May. Milburn, J. Alex, 1976, 'International Transfer Transactions: What price? CA Magazine, 109, December. Solomons, David, 1965, Divisional Perfbrmance: Measurement and Control, John D. Irwin: 1-Iomewood. Verlage, 1-I.C., 1975, Transfer Pricing for Multinational Enterprises: Some Remarks on its Fiscal, and Organization Aspects, Rotterdam University Press: Rotterdam. Wells, M.C., 'Profit Centre, Transfer Prices and Mysticism', Abacus, 4, December. 43 Management Control Structure UNIT 7 INVESTMENT CENTRES Objectives After studying this unit, you should be able to: • • • • design an investment centre for an organization; define the investment base for an investment centre; and design appropriate measures for measuring investment centre performance; and suggest an appropriate financial control system which can eliminate investments, over which divisional managers have no control. Structure 7.1 7.2 7.3 7.4 7.5 7.6 7.7 7.8 7.9 Introduction Investment Base Measuring Investment Centre Performance Measuring the Investment Base Problems of Financial Control of Investment Centre Summary Key Words Self Assessment Questions/Exercises Further Readings 7.1 INTRODUCTION Investment centre is a responsibility centre in which inputs are measured in terms of cost/expenses and outputs are measured in term of revenues and in which assets employed are also measured. Thus, the investment centre is responsible for the assets under its disposal alongwith the profit. It involves questions related to as to what assets and liabilities should be included for determining the investment base of the investment centre. An investment centre manager is responsible for the production, marketing and investment in the assets employed on that division or segment of the organization. He has to take decisions related to credit policy, inventory policy as well as investment in equipments to be used for production and marketing. That way it may be taken as extension of profit centre that it covers all the elements relevant to the measurement of performance of division. As a responsibility centre, the performance of the division concerned would be measured in relation to the profits and assets employed in the division concerned. 7.2. INVESTMENT BASE Investment on asset responsibility implies the authority to buy, sell and use assets. This involves taking decisions related to identification of the assets and liabilities for determining, the investment base of the investment centre. It is not a simple problem, as the accounting theory does not help us in this regard. However, they should be included in such a manner that would motivate the managers concerned to take the best possible decision related to buying, selling and using the various assets. If it is not done, the return on investment in those assets would not be reasonable or as desirable in the given circumstances. 44 The divisional manager has to be motivated to act in the best interest of the organization while taking such decisions. He is supposed to act, like top management in this respect. This would, however, depend upon the way the divisional manager is evaluated by the top management and also the extent of delegation of authority and resultant decentralisation. The top management shoo Id be quite careful while evaluating the divisional manager's performance. He may depend upon the traditional method of evaluation, i.e., relating income to assets in terms of return on investment. It may be taken as Segment Return on investment or SROI. Lf the return on investment under the control of division or segment is quite satisfactory or reasonable, the company's return on investment would also be reasonable and satisfactory. Activity 1 1) What is the importance of determining the right investment in the investment centres? Investment Centres ..................................................................................................................................................... ..................................................................................................................................................... ..................................................................................................................................................... ..................................................................................................................................................... 2) What are the problems in using different investment bases for an investment centre? .............................................................................................................................................. .............................................................................................................................................. .............................................................................................................................................. .............................................................................................................................................. .............................................................................................................................................. 7.3 MEASURING INVESTMENT CENTRE PERFORMANCE These are two important and popular methods of measuring investment centre performance. They are Return on Investment (ROI) and Residual Income (RI). Return on Investment (ROI) Return on investment is a popular and easier method of measuring investment centre performance. ROI is the relationship between return or profit and investment. It is usually expressed in terms of percentage. The profit here refers to profit before taxes and interest or operating profit. We take such profit as profit before taxes and interest is not influenced by extraneous factors such as financing or taxes over which the divisional manager does not have any control. Similarly, the investment here refers to operating assets which are available for use in the operations. Thus, ROI can be defined as ROI= Profit before Interest and Tax × 100 Net operating Investment Net operating investment may be in terms of written down value or the gross value of the fixed assets. The net value of the assets would depend upon the depreciation method used. It would be better to use, the average value of the fixed assets during their useful life. 45 Management Control Structure An example will explain the computation of ROI. Consider the cases of Ibis Company presented in Exhibit 7.1, which has a piece of equipment costing Rs. 1,00,000. The equipment has five year life and no salvege value. The equipment can generate a cash return of Rs. 50,000 per annum. The equipment is depreciated on a straight-line basis. The company has an expectation of minimum rate of return of 25% on investment. Exhibit 7.1: Ibis Company ROI Computation Using Net Book Value of Asset Year 1 Net Book Value at Beginning of Year (Rs. ‘000) Cash Return (Rs. ‘000) Less: Depreciation Profit Before Taxes Return on Investment% 50 20 30 30 50 20 30 37.5 50 20 30 50 50 20 30 75 50 20 100 2 80 3 60 4 40 5 20 ROI using gross book value of the assets will be 30% for all the five years since the profit before taxes is the same during all the years. (Profit Before Taxes/Gross Book Value) x 1 00 %. = (30,000/1, 00,000) x 100 = 3 0% If we take average investment as book value of the assets at the beginning of the period plus the book value of the asset at the end of the period divided by two i.e. (1,00,000 + 0) = 50,000, the ROI on average investment will be: For measuring divisional performance, ROI method appears to offer several advantages. They are: (i) this is generally accepted method;l (ii) it is a relative and not absolute measure; (iii) it is conceptually easy to understand and interpret; and (iv) it provides incentive for optimum utilization of the assets of the company concerned. However, there may be problems related to (a) determination of investment base, and (b) determination of net income. These problems, however, can be resolved without much difficulty. Residual Income An alternative measure of financial performance of an investment centre is residual income. It is an amount that remains after deducting an "implied" interest charge from operating income. In other words, the difference between the actual operating income of a division and the required/expected income is the residual income. The expected return on investment is capital charge. The idea is that the division bears a charge for the assets provided by the company concerned to the division for its use. The efficiency of the division, on this basis, is to be judged on the contribution beyond the expected return which may be based on the cost of capital or opportunity cost of the investment. Symbolically SRI=SPC - (SROI x S R) Where SRI = segment residual income SPC = segment profit contribution 46 SPC = segment profit contribution SROI = segment Expected RO1 SR = segment resources. Following the example given in Exhibit 7.1 we present the residual income calculation in Exhibit 7.2. Exhibit 7.2: Ibis Company Residual Income Computations Using Net Book Value Year 1 Net Book Value at Beginning of Year (Rs. '000) Profit Before Tax ( '000) Less: Capital Charge 25% of Investment Base (Rs. '000) Residual Income (Rs. '000) Other Performance Measure ROI and RI are the popular methods of measuring performance of investment centres. However, several firms use other methods or measures also. They are: growth in market share, sales growth (actual achieved vis-a-vis the planned or budgeted performance), and profit growth etc. Other factors, such as new product development and personnel development of the division concerned may also be considered for such measurement. Activity 2 Compare ROI and RI as the bases of evaluation of investment centre performance. Which of these measures will you prefer and why? ...................................................................................................... ...................................................................................................... ...................................................................................................... ..................................................................................................... 5 10 15 20 25 30 25 30 20 30 15 30 10 30 5 100 2 80 3 60 4 40 5 20 Investment Centres 7.4 MEASURING THE INVESTMENT BASE For the performance evaluation of a division as it has been seen, we take ROI, RI and a few other criteria but the return' or `investment base' can not be defined without any ambiguity. There are various concepts of returns as well as investment base. The variables to be included in either of them would depend upon the management policy. For measuring investment base, two methods are commonly used. Under one method, we take total assets and, in other, we take total assets minus current liabilities. A general condition, however, is that the investment base should include only those resources which (are used in producing profit for the decision) concerned. Those assets, which are under construction or which remain idle should not be included it the investment base. Total assets imply the fixed assets like, building, furniture and machinery and the current assets, like cash, receivable and inventory. For the valuation of either components of the current assets or fixed assets, no common methods are used in 47 Management Control Structure practice. It differs from company to company and the policies adopted by the management concerned. Cash may be controlled centrally or independently by the division concerned. in most of the companies, the cash is controlled centrally to avoid keeping idle cash. With the result the divisions normally hold smaller amount of cash. Often the required cash is computed on the basis of a certain percentage of turnover or payment requirement for pertain number of days. While taking amount of receivables, they may be taken at their net values, i.e. receivable minus provision for bad and doubtful debts. This commonly accepted method is proper as the divisional managers may influence the amount of receivable through the volume of sales, proportion of cash and credit sales, the period of credit allowed and the efficiency of collection policies. The amount of inventory and its methods of valuation posses more serious problem, while including it as investment base. A common practice, used by most of the division, is to include them at their carrying cost. It is necessary for carrying on smooth operation of the division concerned. However, the fluctuations in demand for its output or supply of inputs have to be duly considered. Some companies used LIFO method of taking inventory, but under the inflationary conditions, its value would be understated. It would be better to use standard or average cost for the valuation of inventories while including them in the investment base. A common practice for valuation of fixed assets is cost less depreciation. Thus, they are taken at historical cost rather than economic cost of the investment required in the fixed assets. If total assets are taken as investment base, it tends to overstate the investment base. Total assets minus current liabilities may be taken to be a better measure for the investment base. In case, the division has very little control over the current liabilities, they should not be deducted from the total assets for the computation of investment base. Valuation of Fixed Assets For the purpose of measuring investment base in the investment centre, valuation of fixed assets poses the greatest difficulty. Exhibits 7.1 and 7.2 illustrate the impact of net investment on ROI and RI using the net book value of the fixed assets. Exhibit 7.1 shows the ROI computations for each year based on the net book value of the assets at the beginning of the year. In the first year the ROI is 30% and increases over the five year Iife of the investment in each year or the accelerated depreciation. The picture is not different when we used the RI to measure the divisional performance and use the net book value of the assets as the investment base. The RI increased over the five year life of the assets from Rs. 5,000 in first year to Rs. 25,000 in the fifth year. To avoid this artificial increase in the ROI or RI, when profit taxes are constant, many organizations use the gross book value or the average investment over the life of the investment to compute the fixed portion of the investment base. We have seen that the ROI, using gross book value, is 30% in each year. Similarly the RI will be Rs. 5,000 in each year if we use grow book value of the assets is used as the investment base. The use of traditional reliance on historical cost and depreciation methods to calculate both income and the value of investment base is contributing towards this confusing picture. A more meaningful approach to solve the problems created by the gross and net book values of assets in measuring the investment base is to use the replacement cost of the fixed assets for all divisions and use the same for computation of RO1 or RI 48 we can obtain more meaningful and comparable ROI and RI figures across the divisions. Table 7.3, 7.4 and 7.5 shows result of two studies about industry practices in calculating the investment base in investment centres. These studies clearly show that majority of the companies include fixed assets in their investment base at their net book value. Table 7.3: Valuation of Plant and Equipment Percentage of Respondents Uning the Method Reece & Cool (1978) 459 Respondents Gross book value Net book value Replacement cost 14% 84 2 Govindarajan (1994) 500 Respondents 6% 93 1 Investment Centres 100% 100% Sources: Reece and Cool, "Measuring Investment Center Performance," p. 28-49. Govindrajan, "Profit Center Measurement," p.2 Table 7.4: Assets Included in Investment Base Percentage of Respondents Including the Asset in the Investment Base Reece & Cool (1978)Govindarajan (1994) 459 Respondents Current assets Cash owned by the profit center Corporate cash allocated to the profit center External receivables Intra company receivables Inventory Other current assets Fixed Assets Land & building used solely by this profit center Equipment used solely by this profit center A portion of land & building used by 2 or more profit centers A portion of equipment used by 2 or more profit centers An allocation of assets of headquarter central research or similar units Other Assets Investments Goodwill Note: n/a denotes "not asked" Sources: Reece and Cool, "Measuring Investment Center Performance," p.28-49 Govindarajan, "Profit Center Measurement,"p.2. 63% n/a 94 n/a 95 76 94 83 45 41 16 500 Respondents 47% 13 90 55 95 83 97 96 49 48 19 n/a n/a 53 55 49 Management Control Structure Table 7.5: Liabilities Deducted in Calculating Investment Base Percentage of Respondents Deducting the Liability from the Investment Base Reece & Cool (1978) 459 Respondents Current external payables Current intra company Other current liabilities Deferred taxes Other noncurrent liabilities Note: n/a denotes “not asked” Sources: Reece and Cool, "Measuring Investment Center Performance," p28-49 Govindarajan, "Profit Center Measurement,"p.2. Activity 3 Discuss the problem of measurement of investment base. What are the special problems faced with respect to different elements of the investment base? ....................................................................................................... .................................................................................................... .................................................................................................... .................................................................................................... 51% 30 45 n/a 20 Govindarajan (1994) 500 Respondents 73% 46 68 28 47 7.5 PROBLEMS Of FINANCIAL CONTROL OF INVESTMENT CENTRE As there are problems in computations of the investment base, similarly, there are problems in determining the financial control parameters in the divisionalised companies. Two most important parameters of financial control in the divisionalised companies are as follows: 1) 2) Congruity of objectives; and Ability of top management to evaluate performance of managers. The congruity of objective implies that the divisional manager would take the same decision which the top management would take the given situation. The top management should be duly satisfied that the divisional managers would act in the best interest of the company. With regard to the second parameter, it is necessary that the top management would evaluate the performance of the divisional managers keeping in mind the objectives of the organization. In fact, it is presumed that if the performance of the divisions is satisfactory, the company's overall performance is also going to be satisfactory. There are two issues involved with regard to the effective financial control of investment centres. Firstly, while imposing financial control, it should be kept in mind that such investments should not be include over which the divisional manager does not have any control. Secondly, such control should try to eliminate the possibility of fluctuation in the investments caused but by the divisional manager's action. The financial control should not be undertaken in such manner which many demotivate the manager of the division concerned. 50 7.6 SUMMARY Investment Centres In the extension of the idea of decentralization and divisionalised control, investment centre forms one of the higher forms of decentralization. An investment centre is responsible not only for the revenues and expenses under the control of the division but also for the investment under the division. In reality we can say that the investment centre will be almost like a separate organization for the purpose of control. The evaluation of financial performance of the investment centres is normally carried out by using the return on investment or the residual income measure. Return on investment is the ratio of-the measure of return obtained by the division to the investment used by the division for achieving the same. Residual income is the profit before taxes less the capital charge. It is also possible to use different capital charges for different types of assets thereby influencing the decision to use the assets. In a capital scare situation it will have the effect of setting priorities for the use of different type of assets. in evaluating the performance of managers, the assets or investment over which they have control alone should be considered in the investment base. The valuation of assets forms -an important problem in the profit evaluations of investment centres. Therefore, it is advisable that the measure used should preferably be one not influenced by the accounting valuations. One of the suggested modes of valuation can be the current cost of the assets. Divisional performance should not be evaluated exclusively by the profit measures but by evaluating the efficiency and effectiveness of the operations of the investment centres and therefore measures such as market share, sales growth, product improvements and so on should be taken into account in the evaluations. Illustration The average asset balances of the Apparel division's of Ibis for 19XI are given below: Cash Receiables Inventory Raw materials Works in process Finished goods Gross fixed assets Accumulated depreciation Total: Current liabilities Equity Total liabilities and equity Rs. 2,50,000 1;30,000 2,45,000 Rs. 2,500,000 10,00,000 15,00,000 27,50,000 Rs. 7,50,000 20,00,000 Rs. 27,500,000 6,25,000 Rs. 2,50,000 3,75,000 During I9XI the Apparel division earned a profit of Rs. 3, 00, 000 before taxes on total sale of Rs. 40, 00,000. 1) 2) Compute ROI using net total assets (that is total assets less current liabilities) as the investment base. Compute RI using a capital charge of 10% on net total assets. 51 Management Control Structure 3) If the corporate management desires, the division to increase its RO1 by 5% during19X2, what change in the profit margin on sales or asset turnover ratio would be required? Suggested Answer 1) Return on investment = (profit before tax/investment base) x 100% ROI = (Rs. 3,00,000/20,00,000) x 100 =15% 2) Residual Income: Profit before tax Capital charge (Rs. 20,00,000 x .10) Residual Income 3) Plan for increasing ROI Objective: ROI is to increased by 5% ROI Existing RO1 Desired ROI = (profit/sales) x (profit/investment) x 100% = (Rs. 32,00,000/40,00,000) x (40,00,000/20,00,000) x 100 = .075x2.0 = 15% = 20% Rs. 3,00,000 2,00,000 Rs. 1,00,000 Increase in ROI by increase in profit margin: 20 = (profit/sales) x 2.0 21 (profit/sale) = 20%/2 = 10% 22 Increase in investment turnover: 23 20% = 7.5% x (sales/investment) (sales/investment) = (20%/77.5%) = 2.67 times 7.7 KEY WORDS Asset turnover: The ratio of sales to the investment base. It means the sales rupee generated for every rupee of investment and will influence the return on investment. Capital charge: The charge made to the divisions for the use of assets provided by the organization and the residual income is computed by setting off this charge against the income Gross book value: The historical cost of fixed assets used as investment base by some organization. Investment base: The investment taken for the purpose of computing the return on investment or the residual income. In a ROI computation this is the denominator. Net book value: This represents the gross assets less accumulated depreciation. Profit margin: The ratio of profit to sales. It represents the portion of a rupee of sales which is available as a margin. It can be gross margin when the profit available after meeting the cost of goods sold is considered or operating profit margin when the cost of goods sold and all other operating costs of the period are considered. 52 Residual income: A measure of divisional performance computed as the difference between operating profit before taxes less the capital charges. Return on investment: A measure of the performance of a division calculated as a ratio of profit to investment base. Investment Centres 7.8 1) SELF ASSESSMENT QUESTIONS/EXERCISES Differentiate between a profit centre and an investment centre. Which one do you think is a better device from the management control point of view and why? 2) What are the alternative methods of determining investment base? Bring out their merits and demerits. 3) What problems are likely to be faced in evaluating the performance of investment centres? Are the performance of investment centre and the performance of its manager two different things? Discuss. 4) Do the margins in charge of investment centres, in your opinion, really have control on the investment in their divisions? What could be the possible explanations? 5) Ibis Commodities Group is a division of the Ibis Company dealing in food products. The division is responsible for procurement and distributing of food products handled by the company. Residual income is used to evaluate the divisional managers. The company expects a 25% capital charge on division's investment. The residual income is computed by deducting the capital charge from the division's contribution towards company's profit before taxes. The investment base of the division includes closing balance of receivables, inventories and net fixed assets. Divisional managers have full control over current assets and current liabilities. Company policy is to minimize the investment in these assets. Fixed assets are the joint responsibility of divisional managers and corporate management. The divisional manager was in the process of preparing the budget for 19X3. Therefore he wanted the divisional finance manager to review the results of 19X1 and the fist six months of 19X2. The information relating to performance of the Commodities Group is presented below: Ibis Commodities Group Annual Budget 19X2 2quarters Budget 1,000 350 100 40 50 25 565 435 150 285 75 10* (Rs. `000) 2 quarters:Annual 19X1 ActualBudget Actual Results 1,100 395 115 40 60 20 630 470 120 350 250 100* 1,700 600 175 75 90 40 980 720 270 450 400 50 1,680 590 210 100 80 40 1,020 660 260 400 375 25 Sales Expenses: Direct material Wages Administration Depreciation Other expenses Total expenses Division's margin Allocated Corporate expenses Division's Contribution to corporate profit 25% Capital charge on divisional investment Residual income 2,000 700 200 75 100 50 1,125 875 300 575 500 75 53 Management Control Structure Divisions Investment (Rs. ‘000) 19X2 19X1 Budgeted Actual Budgeted 31 Dec 300 400 1,300 2,000 500 Balance 30 June 260 450 1,490 2,200 275* Actual Balance 31 Dec 30 June 31 Dec 250 .200 225 500 350 375 1,250 2,000 250*, 1,050 400 900 375 1,600 1,500 Accounts receivable Inventories Net Fixed assets Total Capital Charge (25%) Note: Operations are more or less uniformly distributed throughout the years. * Proportionate capital charge for the period. Required: 1) 2) Evaluate the performance of the division for the six months ended 30 June 19X2. Critically examine the measurement, reporting and evaluation systems of Ibis Commodities Group and suggest what changes, if any, should be effected to reflect the division's responsibilities. 7.9 FURTHER READINGS Bhatia, Manohar L., Performance Measurement of Profit Centres: Practices and Perspectives, the Chartered Accountant, Vol. XXX, No. 9, March 1982, pp. 586-593 Mauriel, John J. and Robert N. Anthony, 1966, `Misevaluation of Investment Centre Performance', Harvard Business Review, 44, March-April. Parker, Lee D., 1979, `Divisional Performance Measurement: Beyond an Exclusive Profit Test', Accounting and Business Research, 9 Autumn. Tomkins, Cyril, 1973, Financial Planning in Divisionalised Companies, Haymarker: London. Vancil, Richard F., 1978, `Measuring Investment Centre Performance', Harvard Review. 56, May-June. 54 UNIT 8 Objectives BUDGETING AND REPORTING Budgeting and Reporting The objectives of this unit is to familiarise you with • • • • • • The significance of budgeting as a tool of management control Different types of budgets Budget setting process Operating an effective budgetary control system Variance reporting & corrective actions Behavioural dimension of budgetary control Structure 8.1 8.2 8.3 Introduction Classifications of Budgets for different purposes Building Blocks of Budgets/Budget Setting Process 8.3.1 8.3.2 8.3.3 8.3.4 Important Considerations Budget as a Part of Overall Business Plan Functional Budgets and their Inter-relationships Master Budgets 8.4 Flexible Budgeting 8.4.1 8.4.2 8.4.3 8.4.4 Fixed and Flexible Budgets Development of Flexible Budgets Flexible Budget in Marketing Limitations of Flexible Budgets 8.5 Budgetary Control System: 8.5.1 8.5.2 8.5.3 8.5.4 8.5.5 Introduction Budgetary Control and Standard Costing Administration of Budgetary Control System Performance Reporting Uses of Performance Reports 8.5.6 Limitations of Performance and Cost Controllability 8.6 8.7 Capital Budgeting and Control Behavioural and Ethical Aspects in Budgeting and Reporting 8.7.1 8.7.2 8.7.3 8.7.4 8.7.5 Introduction Behavioural Problems Budget Slacks Problems of Motivation Behavioural Aspects in Performance Improvement 8.8 8.9 Summary Self-Assessment Questions 5 8.10 Further Readings Management Control: Process 8.1 INTRODUCTION Budgeting and Budgetary control are perhaps the oldest and most popular instruments used in planning as well as monitoring the operations of an enterprise over a short and medium term time-frame. Budgeting and Budgetary Control seek to direct the activities of the enterprise in a certain logical sequence and addresses some basic issues which are essential to the planning and control process: Objective Diagnosis Prognosis Strategies Tactics Control : : : : : : Where do we want to go? Where are we? Where are we heading? How do we go? How do we implement the strategies? How do we make mid-course corrections? How do we monitor our course? When the same issues are addressed over a long term time-frame, the exercise is called corporate planning or strategic planning. According to Chartered Institute of Management Accountants, UK (CIMA) Budget is "A plan expressed in money. It is prepared and approved prior to the budget period and may show income, expenditure, and the capital to be employed..." Plan is the end result of the planning process. A detailed and well-knit plan has two axes: (a) physical and (b) financial. Translation of planned activities for a definite period of time i) ii) into physical terms results in programming into financial terms results in budgets However, a good budgeting should subsume programming (i.e. physical dimension) also, even while the focus in budgets is the financial aspect. 8.2 CLASSIFICATION OF BUDGETS FOR DIFFERENT PURPOSES Budgets may be classified into different types and looked at from different viewpoints: a) Functional or sectional: i) ii) iii) iv) v) vi) vii) viii) ix) b) Sales budget selling and distribution cost budget Production budget production cost budget purchase budget plant utilisation budget administration cost budget research and development cost budget personnel budget cash budget (to include capital items also) summary budgets Consolidated : 6 i) ii) iii) c) master budget (containing, inter alia, the budgeted revenue statement and balance sheet) Budgeting and Reporting Expense-behaviour wise : i) ii) d) fixed budget flexible or multiple budgets basic budget or long term budget current annual budget or annual business plan shorter period budgets (annual budget broken down into quarters or months). Cost Centre Budgets Profit Centre Budgets Revenue Centre Budgets Periodicity : i) ii) iii) e) Responsibility-wise : i) ii) iii) f) Emphasis or Approach : i) ii) production-oriented budgets (under sellers' market situation) market-oriented budgets (under buyers' market situation) principal budgets (primarily financial and partly quantitative) subsidiary or support budgets (primarily quantitative and partly financial) g) Building Block : i) ii) h) Management Style or level of participation : (This classification is of course not very relevant in actual practice) i) ii) authoritative Participative Very often a judicious blend of many of the above classifications is attempted to obtain the desired results. 8.3 8.3.1 BUILDING BLOCKS OF BUDGETS / BUDGET SETTING PROCESS Important Considerations There are certain important issues that need to be examined and sorted out before starting the detailed budget setting exercise. These are briefly discussed below: i) Corporate Objectives: Companies having systematic and organised long range planning (LRP) process will always have before them such long-term objectives, spelt out clearly and quantified. The companies which do not have a LRP system should also develop a broad outline about its objectives on a long-term basis, at least for two or three years. The objectives should be specially in two respects, growth and profitability. Preferably these should be broken up into present products and lines of activities on the one hand, and proposed new products and new lines of activities on the other. Corporate Profit Planning: Profit planning and budgeting are not two different things. They are rather interdependent and, more precisely, complementary to each ii) 7 Management Control: Process other; Profit planning should precede the detailed budgeting exercise. Basically, profit planning provides a general blue print of the expected profits and the broad elements through which these can be achieved during a particular budget period. By its very nature it is a summary plan, not backed up by a detailed action plan. From a practical point of view it is always convenient to develop a broad profit plan and get it approved by the top management before a detailed budgeting exercise is taken up. This will obviate confusion and back and forth referrals that are common in a budgeting exercise iii) Nature of Markets: By nature of markets we mean the buyers' market and sellers' market. Rarely it is found that a company is operating exclusively in the buyers' market or sellers' market. if that be so, then the budgeting exercise would be relatively a simple one. More often than not, a company will be found to operate under a combination of these two types of markets - some of its products being in the buyers' market and some others enjoying the privilege of being in the sellers' market. This combination has to be broadly determined since it has a bearing on the marketing budgets. Principal Budget Factor: CIMA defines this as "A factor which will limit the activities of an undertaking and which is taken into account in preparing budgets". This is also called key factor, limiting factor, critical factor or governing factor. it is actually the factor, the extent of whose influence must first be assessed to ensure that the functional budgets are reasonably capable of fulfillment. Limiting factors may be in any of the operational areas, namely sales activity (demand, sales efficiency, warehouse space); plant capacity (machine hour, space, bottlenecks in key process); raw materials (shortage, import restrictions); labour (general shortage, shortage of skilled labour); management (technical know how, efficient and effective executives) and capital (fixed capital, working capital). Limiting factor may be of an enduring nature or of a purely temporary nature (that is those which may be overcome by suitable management actions). But an adequate consideration of the magnitude or impact of such factors in existence during the budget year is a must in realistic budget-setting. v) Sales Forecasting: Since more often than not sales is the limiting factor, preparation of sales budget is generally the starting point in the budgeting exercise. Sales estimate or sales forecast, is the basis of sales budget. Here is a list of the various factors to be considered in arriving at sales estimate or sales forecast: Table 8.1: Sales Estimation Factors 1) 2) Analysis of the past sales to understand the trends of sales and also forecast the future trends. Demand analysis and market analysis to ascertain market potential, market growth, the company's share of the market, emergence of competition, competitors' strategy, product design, pricing trends, customers habits and preferences, etc. Analysis of reports by salesman as to expected sales - first hand and fresh from the field reports, Examination of general business conditions. Production capacity study (or availability study, in case of a pure trading concern). Profitability analysis through sales mix planning to ensure tat profit objective is; fulfilled by the proposed sales forecast. iv) 3) 4) 5) 6) 8 vi) Spending for the future: There could be quite a few items for spending for the future, in the budget year itself; for example, development of the people, industrial engineering, market research, new product development and launch, extraordinary promotional campaign, etc. Such expenses may not contribute directly to profits during the budget year and may often bring down the profitability, sometimes drastically. it is therefore, necessary to segregate all such expenses from pure operational expenses, at least for the purpose of understanding the budget year performance and profitability in the right perspective. The top management may still commit such expenses on long term considerations knowing fully well the extent to which these would reduce the profit for the budget year. Budgeting and Reporting After having thoroughly evaluated the above issues and prepared some basic inputs as a sequel, one might go about developing the detailed budgets. Effort should be made of course to direct the entire budget setting activities ?long a systematic and logical approach. In a large and diversified organisation, budget setting exercise needs to be decentralised. However, the summary budgets and master budgets have to be prepared through consolidation process at the corporate office. In order to ensure that a common wavelength is established among the people engaged in the budget setting exercise at different locations and units of the enterprise, it is advisable for the corporate office to issue what may be called a set of Corporate Policy Guidelines. This should be finalised, well in advance, by the budget committee at the corporate office and circulated among the concerned units so that they can adhere to these guidelines in framing their respective budgets and submit the same to the corporate office in time. It is imperative that the entire budgets are finalised and approved and the budget package circulated to all concerned, before the budget year starts. Progressive companies these days encourage very rightly a participative process of budget setting. Budgeting should essentially be based on a combination of top-down and bottom-up approaches. Budgets develop through the participative process would automatically have a much greater degree of involvement and commitment on the part of the people. This will also have a favourable motivational impact in the organisation. Activity 1 List and explain five purposes of budgeting systems. ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… …………………………………………………………………………………………. Apart from the important general considerations discussed above we need to mention some recent developments at the methodology plane that have a significant bearing on the process of budget setting. One of these is Productivity Controlled Budget (PCB). This is defined as a "budget the approval of which will not be forthcoming until or before the budget holder has been able to show a level of productivity improvement to his/her. Departmental Heads" PCB is therefore a combination of traditional budgeting system and productivity concept which is built into the same, even at the lower level of management. 9 Management Control: Process Another recent development is Budgeting under Activity Based Costing (ABC). ABC system recommends a more rational method of allocating overheads (based on activity) in contrast to the conventional method of volume-based allocation of overheads. The benefits and advantages of ABC system have been well appreciated in manufacturing as well as other areas. There may be some distinct advantages arising out of the application of ABC principles in budgeting overhead expenses. The procedure involves designing an Activity Matrix in which the resources are listed vertically and the major functions (activities) horizontally. The matrix will show cost per unit of activity which is more realistic than traditional method of overhead allocation and budgeting. Next is Rolling Budget (continuous budget). In a situation where forecasting economic trend, market conditions etc is extremely difficult, Rolling Budget may be a useful approach. A rolling budget is defined by CIMA as "A budget continuously updated by adding a further period, say a month or quarter and deducting the earliest period". This would be "beneficial where future cost and/or activities cannot be forecast reliably". The inherent advantage of rolling budget is the reduction of element of uncertainty in budgeting under fluctuating economic conditions. Zero Base Budgeting (ZBB) is yet another new development, Peter A Pyhrr, who introduced ZBB in Texas Instruments, defines it as : `An operating and budgeting process which requires each manager to justify his entire budget request in detail from scratch (hence zero-base) and shifts the burden of proof to each manger to justify why he should spend any money at all. This approach requiresi that all activities be identified in decision packages which will be evaluated by systematic analysis and ranked in order of importance'. ZBB therefore starts with a basic premise that the budget for the next period is zero and puts the onus on each manager to justify why the money should be spent at all and what would happen if the proposed activity is not carried out and no money is spent. ZBB presupposes that each manager has to undertake a cost benefit analysis for each of the activities under his jurisdiction that are proposed to be taken up in the budget year. Under conventional budgeting system, budgets are generally arrived at after adding some factors or percentages to the immediate past year's corresponding actual figures of costs and revenues. Sometimes for revenues a little more detailed exercise is carried out but as regards costs, extrapolation of the past figures tends to be the most commonly adopted method. Thus there is a lack of objectivity and perhaps a scope for perpetuating inefficiencies in matters of incurrence of costs that might already have been there in the past. It is in this context that ZBB is a marked departure from the conventional budgeting technique. ZBB is of course not an altogether new budgeting system. The approach is, by and large, adopted when an enterprise formulates its first budget or a set of budget immediately after a thorough reorganisation and regrouping of its activities. However, barring such experiences for brief periods only, most of the firms continue to frame their budgets on the conventional incremental budgeting method and ZBB cap provide some new insight to them. Activity 2 List out the differences between Zero Base Budgeting and Conventional Budgeting. .............................................................................................................................. ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………. 10 Next important area is "Budgeting Under Uncertainty". Budgets are prepared in advance in anticipation of market expectations and assumed economic environment that is likely to prevail in the budget period. The budget setting process will recognise the fact that future is uncertain. As such attempts should be made to measure the extent of uncertainty so as to take appropriate precaution to minimise the risks likely to emanate from uncertainty. The methods of analysing uncertainty are : a) b) c) d) Rolling budget Optimistic/pessimistic approach Sensitivity analysis Probability analysis Budgeting and Reporting Rolling budget has already been discussed above, Under optimistic/pessimistic approach budget is prepared in three different levels viz : • • • Best possible Most likely Worst possible These three levels of budgets will enable the management to formulate appropriate strategy for achieving the expected level of performance in terms of turnover, profitability, etc. Sensitivity Analysis: This method measure the responsiveness of profitability to changes of the variables in the budgets. The sensitivity analysis attempts to answer "what if" question by changing the key variables, mostly by using computer, Probability Analysis: Probabilistic budget model is desirable when there are a large number of variables which are subject to uncertainties of varying degrees. By applying the probability factors the outcome of each of these variables can be assessed and decision can be taken accordingly. Budgeting with more than one limiting factor: The starting point of budget formulation is the identification of key factor (limiting factor) and coordination of functional budgets based on this key factor. In case there is one limiting factor the contribution maximisation is possible by making the most profitable use of this key factor (say scarce materials) subject to market constraint. When more than one limiting factor exists the technique of linear programming is used for maximising contribution. Contribution (profit) maximisation, however, is not the only budget preparation criterion. Budget should be realistic, acceptable far the operating managers, and ensure satisfactory profit in relation to the resources used. 8.3.2 Budget as a Part of Overall Business Plan "Budgets are designed to carry out a variety of functions: planning, evaluating performances, coordinating activities, implementing plan, communicating, motivating and authorising actions, The last named role seems to predominate in government budgeting and not for profit budgeting, where budget appropriations serve as authorisations and ceilings for Management actions" (Horngren: Cost Accounting-A Managerial Emphasis). Many progressive organisations have introduced a Corporate Long Range Planning (CLRP) system with generally a time-horizon of five years. As a part of the system the CLRP document is revised and updated regularly by incorporating necessary changes from time to time. In this context the rolling plan concept has been found to be well-suited to CLRP's. By a suitable system the CLRP exercise, usually preceding the budgeting exercise, may be linked up with the annual budget. 11 Management Control: Process Usually the forecasts under CLRP in the Plan Year I would broadly serve the purpose of the annual budget. There may be even changes between the Plan Year 1 forecasts a the budget estimates. But the reasons for all such changes should be adequately explained, quantified and included in the budget narratives. This will ensure that implementation and monitoring of CLRP is not lost sight of. More precisely this will create a situation whereby a Long Range Corporate Plan gets broken down into Shor Range Operational Plans or Business Plans or Budgets, for effective implementation progressively. A systematic budgeting process makes the management forward looking. This forwar looking approach results in planning as well as setting targets and gives the organisation purpose and direction. Budgeting technique is of immense help in formulating strategies, both long and short term, and action plans for implementing th same. Budget formulates expected performance (targets) for key personnel to achieve the corporate objectives. The setting of such targets compel the managers to think ahead i the changing environment. This forced thinking is the most important contribution of budgeting to the enterprise performance. 8.3.3 Functional Budgets and their Inter-relationship Functional Budgets are budgets prepared independently by the functional heads. Then are several types of functional budgets depending on the size, nature and policy of the concern Classification of Functional Budgets of a typical concern vis-a-vis the managers responsible for preparing the same will be as under : Table 8.2: Functional Budgets and their Inter-relationship The relationship indicated above (Budget Controller vis-a-vis all others) are only functional in nature, not of administrative authority. 12 Activity 3 Discuss the role of assumptions and predictions in budgeting. ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… A brief discussion on the important functional budgets follows : Sales Budget The Sales Budget is a forecast of total sales expressed in monetary and quantitative terms. The preparation of this budget is generally the starting point in the operation of the Budgetary Control System. A sales budget may be prepared under the following classification: a) b) c) d) Product Groups and/or Products Areas, territories or zones Areas , territories or zones Salesmen or agents Types of customers National Government State Government Export Wholesalers Retailers Periods - week, month, quarters, etc. Budgeting and Reporting e) Sales budgets are influenced by a large number of factors, both internal and external, as given below : External Factors a) b) c) d) e) f) g) a) b) c) d) e) f) g) Change in population and in its sex and age group, (demographic factors) Government Policy and Regulations. Income distribution of the prospective buyers. Economic trends. National and international events. Extent and severity of competition. Seasonal and cyclical fluctuations. Internal Factors Analysis of past sales vis-à-vis- trend analysis. Demand analysis backed by market research. Analysis of reports by salesman. Review of general business condition. Production capacity - scope for improvement in short/long term. Profitability analysis through sales mix planning. Use of promotional aids. 13 Management Control: Process Methods of Sales Forecasting Basically forecasting the sales of a product depends on its total demand forecasting on the one hand and the present as well projected market share on the other. This exercise needs to be carried out for all major product offerings of the company. There is a plethora of methods and tools used for demand forecasting. These are summarised below, under logical groupings Financial and Semi-Financial Tools i) ii) Historical analogy method -e.g. demand for steel in India now may be related with that in USA in the 70's Corresponding period comparison -e.g. demand for textiles in Oct/Nov' 2001 may be equal to demand for the same in Oct/Nov' 2000 plus a suitable percentage or growth factor End-users'/buyers' expectation method-e.g. demand for water filtration chemicals in metro cities, particularly during the rainy seasons. Quantitative and Statistical Tools i) ii) iii) iv) v) vi) vii) viii) ix) x) Time series analysis including adjustments for seasonal and cyclical variations. Trend extension or regression analysis - i.e. trend line fitted into the date for a number of periods in the past. Multi-variate analysis Exponential Smoothing Probabilistic models Input-Output tables Functional models - i.e. establishing a relationship between one dependent variable with one or more independent variable(s) Linking factor-e.g. demand for spare parts may be linked with the population of the equipment, using an estimated "factor" or percentage. Establishing lead-lag relationship-e.g. heavy order bookings of capital goods is an advance indicator of economic prosperity Technology Forecasting (TF) - particularly for products highly susceptible to technological obsolescence. Qualitative Method i) ii) iii) iv) Opinions from experts Brain-storming Delphi Technique Scenarios building Field Survey (primary data) i) ii) Questionnaire-based survey of representative samples, established preferably by Stratified Random Sampling Technique Bridging factor used in (i) above for estimating universe/population from samples Test Marketing. 14 iii) Literature Survey (secondary sourced) : Through a judicious blend of some of the above-mentioned techniques sales forecasting exercise is to be completed first. Thereafter by applying the projected market share ratio the company's forecasted sales figures should be determined separately for each product or product-group. Selling and Distribution Budget This budget which is closely related to the Sales budget is the forecast of selling and distribution cost in the budget period. Advertising Cost Budget This budget is also dependent on the Sales Budget in as much as this has to take into account the likely increase in demand as a result of advertising or the advertising (promotional) cost needed for sustaining the budgeted sales. Production Budget The production budget is a forecast of production inyhe budget period analysed into production volume budget and in physical units and the production cost budget. Broad factors usually considered are : a) b) c) d) Production planning Capacity consideration Sales budget Inventory policy i.e. the extent to which inventory of finished goods is to be carried. Budgeting and Reporting Plant Utilisation Budget The budget covers the estimating plant facilities required to meet the budgeted production as set out in the production budget. The budget shows: a) b) c) budgeted machine load Bottleneck machinery Need for overtime work, sub-contracting and shift working in short term and addition of facilities in the long run. Repairs and Maintenance Budget Maintenance cost budget which is closely related to Plant Utilisation budget is prepared in three parts : a) b) c) Preventive maintenance Corrective maintenance Major overhauling Personnel Budget This budget shows in financial as well as in physical terms the type of labour required - skilled, semi-skilled, highly skilled, etc. to meet the programme set out in the production budget. Impact of Learning Curve should be given due weightage in formulating this budget. 15 Management Control: Process Purchase Budget The budget represents the purchases including capital items to be made during the budget period. The budget is usually based upon: a) b) c) d) e) f) g) Production budget Capital expenditure budget Research and development budget Policy of sub-contracting Stock levels in respect of "A" class items Finance available Storage space available Production Cost Budget Production Cost Budget This budget is analysed into three subsidiary budgets viz : a) b) c) Material cost budget Labour cost budget Factory overhead budget Administration Cost Budget This budget will show the total estimated cost of formulating the policy, directing and controlling the operations of the undertaking. The budget is almost of a fixed nature. Research and Development Cost Budget This budget is considered from both the long and short term view-points and provides and effective tool for planning and balancing the research and development programme. This budget is dependent on the R&D policy, Product Life Cycle and of course the permissible financial resources. Inter-relationship of Functional Budgets: Since the functional budgets are inter-related, change. in any of the functional budgets will generate chain reaction as evident from the following diagram : Table 8.3: Inter-relationship of Functional Budgets 16 Of course Cash Budget will be affected by a change in any functional budget. Activity 4 a) Describe a typical organization’s process of budget preparation. ………………………………………………………………………………… ………………………………………………………………………………… ………………………………………………………………………………… ………………………………………………………………………………… b) Explain the concept of activity based budgeting and the benefits it brings to the budgeting process: ………………………………………………………………………………… ………………………………………………………………………………… ………………………………………………………………………………… ………………………………………………………………………………… Illustration 1 : Functional Budgets Balance Sheet as on 31st December, 19X2 Liabilities Share capital Reserves & surplus Sundry creditors Provisions: Tax Dividend 23,000 12,000 Rs. 2, 74,000 Rs. 2, 74,000 Rs. 2, 00,000 19,000 20,000 Assets Fixed assets (written down) Stock of materials Sundry debtors Cash Rs. 2, 00,000 20,000 29,000 25,000 Budgeting and Reporting With the help of the following additional information, you are required to prepare a Forecast Profit and Loss Account for the year 19X3 and a Forecast Balance Sheet as on 31st December 19X3. i) Capacity utilised Units produced Sales price per unit Material Wages Manufacturing overheads (Variable + Fixed) Administration overheads Selling & distribution overheads (Variable + Fixed) Capital expenditure Depreciation Income Tax Dividend Rs. 60,000 Rs. 3,000 per year Rs. 50,000 Rs. 20,000 4,000 6,000 + 2,000 5% increase in costs expected 10% increase in costs expected Present (19X2) 60% 60,000 Rs. 2.10 36,000 12,000 4,200 + 3,000 Rs. 2.30 Price increase of 25% expected 10% increase in rates expected 10% increase in costs expected 80% Future (19X3) 17 Management Control: Process ii) Period allowed : To debtors - one month By creditors - two months Stock of raw materials maintained - 3 months' requirement Time lag in payment of wages and expenses being insignificant may be ignored. iii) There, is not stock of finished goods at the year end. Solution Sales budget: Units = 80/60x 60, 000 = 80, 000 at Rs.2.30 Sale value = Rs. 1, 84,000 Purchase budget (Materials) : Consumption during 19X2 Add 33⅓ % for increase in capacity Add 3 months stock to be held Less Opening Stock Price increase of 25% Total requirement Consumption during 19X3: Opening stock Add Purchase Less closing stock Rs. 125   12, 000 ×  100   Rs. 36,000 12,000 48,000 12,000 60,000 20,000 40,000 10,000 Rs. 50,000 20,000 50,000 15.000 55,000 Wages budget: Wages paid in 19X2 Add 33⅓% for capacity increase Add 10% for rate increase Rs 12,000 4,000 16,000 1,600 17,600 Overhead budget: Manufacturing Overheads: Variable expenses Add 33⅓% for volume increase 4,200 1,400 5,600 18 Add 10% for the cost increase Fixed expenses Add 10% for cost increase Depreciation Administration Overheads: Expenditure during 19X2 Add 5% for cost increase Selling and Distribution Overheads: Variable expenses Add 33) % for volume increase 560 6,160 3,000 300 3300 3,000 4,000 200 4,200 6,000 2,000 8,000 Budgeting and Reporting Add 10% for cost increase Fixed expenses . Add 10% for cost increase 800 Rs. 8,800 2,000 200 Rs. 2,200 19 Management Control: Process FORECAST PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDING 31ST DECEMBER, 19X3 Dr. Rs. To Materials consumed To Wages To Manufacturing overheads Variable expenses Fixed expenses Depreciation To Administration overheads 6,160 3,300 3,000 4,200 55,000 By Sales 17,600 Cr. Rs. 1,84,000 To Selling& Distribution overheads: Variable expenses Fixed expenses To Net Profit 8,800 2,200 83,740 1,84,000 To Income Tax To Dividend To Balance c/d 50,000 By Net Profit 20,000 13,740 83,740 FORECAST BALANCE SHEET AS ON 31ST DECEMBER, 19X3 Liabilities Rs Share Capital Reserves and Surplus Balance Profit this year Sundry Creditors Provisions: Tax Dividend 50,000 20,000 3,11,073 3,11,073 19,000 13.740 32,740 8,333 2,00,000 Fixed Assets Opening value less depreciation Addition Closing Stock (mat.) Sundry Debtor Cash 2,00,000 3,000 6,000 2,57,000 15,000 15,333 23,740 Assets Rs 83,740 1,84,000 83,740 20 Illusration 2 : Some Functional Budgets & Cash Budgets The following data relate to Product P Budgeted Data 1st October to 31st December 19X1 1st January to 31st March 19X2 Budgeting and Reporting Sales division Sales of P Rs. Stocks of P: Opening Unit Maximum units 1 54,000 90 150 2 3,42,000 320 500 3 2,28,000 260 350 1 60,000 100 150 2 3,60,000 350 500 3 2,40,000 250 350 Sales and production occur evenly each months during each budget quarter. Debtors pay for sales in the month following that when sales occur. Creditors are paid for materials in the second month following that when purchases occur. On an average, overhead incurred is paid for within the month following that in which incurred. Wages are paid in the same month as earned. Cash balance on 31st December, 19X1 Rs. (18,000). Corporation tax of Rs. 50,000 is payable in January 19X2. Special advertising campaign expenditure of Rs. 60,000 is due in March 19X2. Standard Cost Data Direct Materials Direct Wages DM1 DM2 DW1 DW2 10 kgs @ Rs. 3 per kg. 5 kgs @ Rs. 2 per kg. 5 hours @ Rs. 4 per hour 2 hours @ Rs. 5 per hour Production overhead is absorbed as a labour hour rate i.e. Rs. 12 in respect of DWI and Rs. 10 in respect of DW2. Administration and selling overhead is recovered at 20% of production cost. Profit is calculated at 10% of selling price. Direct Material Data Materials DM1 Maximum consumption per week (kg! Minimum consumption per week (kg) Reorder quantity (kg) Stock at 30th September, 19X1 (kg) Stock at 31st December, If XI (kg) Lead time from suppliers (weeks): Maximum Minimum 4 3 3,600 2,400 20,000 24,500 23,000 6 DM2 1,800 1,200 12,000 13,650 14,400 5 21 A major sales campaign is planned in the budget period beginning 1st April, 19X2. In Management Control: Process anticipation of an increase in sales, an advertising campaign will commence in the previous quarter. The production directors has requested that stocks of raw materials be increased to maximum level by 1st April, 19X2 and the sales director has requested that stocks of finished goods be increased to maximum level by 1st April, 19X2. You are required to prepare the following budgets for the three months ending 31st March, 19X2: a) production; b) purchases; c) production cost; d) cash (for each of the three months) Solution: Workings (i) Standard Cost and Price of Product Material: DM1 10 kg X Rs. 3 Rs. 30 Rs. DM2 Wages : DW1 DW2 Production overhead 1 Production overhead 2 Production Cost Administrative & selling overhead 20% of production cost 5 kg X Rs. 2 5 hrs. X Rs. 4 2 hrs. X Rs, 5 5 hrs. X 12, 2 hrs. X 10. Rs. 10 Rs, 20 Rs. 10 60 20 80 150 30 180 Profit (10% on selling price of 1 /9 of cost) 20 200 Selling price (ii) Sales Jan. Feb. Mar. 30 40 Rs. 60,000 Rs. 3,60,000 Rs. 2,40.000 Rs. 6,.60,000/Rs. 200 = 3300units a) Production Budget Sales + Closing stock +.Closing stock Division1 Division 2 Division3 150 500 350 100 350 250 700 3,600 units 1,000 4,300 -Opening stock Division] Division 2 Division 3 22 b) Purchases. Purchases will take into account maximum stock level. Maximum level = Reorder level + Reorder quantity - minimum consumption during the period. Reorder level = Maximum usage x Maximum reorder period For DM1 For DM2 = 3600x6 = 1800x5 = = 21,600 9,000 Budgeting and Reporting Minimum usage in reorder period is : For DM1 For DM2 = 2400x4 = 1200x3 = 9,600 = 3,600 Therefore, Maximum level based on the formula given above DMI DM2 Desired stock Production 3,600x 10 21,600 9,000 + 20,000 + 12,000 - 9,600 = 32,000 - 3,600 = 17,400 DM1 32,000 36.000 68,000 Less : Opening stock 23.000 45,000 kg. Price per kg Total Purchase Budget c) Production cost for 3,600 units Material DM1 3,600 x Rs.30 DM2 3,600 x Rs.10 Labour DWI 3,600 x Rs.20 DWI 3,600 x Rs.10 Overhead POI 3,600 X 60 P02 3,600 X 20 Rs. 1,08,000 36,000 72,000 36,000 2,16,000 72,000 Rs. 1,44,000 1,08,000 Rs. 1,77,000 Rs. 3 1,35,000 3600x5 DM2 17,400 18000 35,400, 14,400 21.000 kg,, Rs. 2 42,000 2,88,000 5,40,000 Cash for each of three months Jan. Feb. Opening Balance Received from Sales: 1 /3'rd of Rs. 6,24,000 1/3rd of Rs. 6,60,000 1 /3i•d of Rs. 6,60,000 1,90,000 Payments: Direct Material (Refer to Note 1) U. Direct wages 1/3(3,600x30) Production overhead 41,000 36,000 84,000 41,000 36,000 96,000 1,99,000 (18,000) 2,08,000 2,20,000 (21,000) Mar. (26,000) 2,20,000 2,46,000 59,000 36,000 23 96,000 Management Control: Process (Note 2) Corporate tax Special advertising 50,000 - - - 60,000 2,51,000 (5,000) 2,11,000 Balance carried forward Note 1.Production in Dec.quarter Sales in Division 1 Sales in Division 2 Sales in Division 3 54,000 3,42,000 2,28,000 6,24,000/200 = 3,120 Units Sales 3,120 Units Add:Closing Stock(100+350+250) 700 3,820 3820 Less:opening stock (90+320+260) Production 3,150 units*10 +closing stock -opening stock 670 3,150 31,500 23,000 (24,500) 30,000 *Rs 3 Rs.90,000 1,73,000 (26,000) (21,000) 3150*5 15,750 14,400 (13,650) 16,500 *Rs2 Rs.33,000 Rs :1,23,000 for quarter / 3 = Rs. 41,000 for Jan. and Feb. Purchase Budget for March quarter = Rs. 1,77,000 / 3 = Rs. 59,000 March Note 2 Production Overhead For first quarter ... 3,150 units x Rs. 80 Rs. 2,52,000 / 3 = Rs. 84,000 for Jan. Production overhead for second quarter = 3,600 X Rs. 80 = Rs. 2,88,000 / 3 = Rs. 96,000 for Feb. and March 24 Illustration 3 : Functional Budgets XYZ Ltd. manufactures two products B and T,,It is going, to prepare its budget for the year ending 31st December 19XX. Expectations for 19XX include the following : a) Opening Balances Rs. Rs. Fi dA Land 20,000 Buildings and plant Cumulative depreciation Current Assets : Stocks : Raw Materials Finished Goods : B T Debtors Cash/Bank Less : Current Liabilities Creditors 29,000 Taxation 28,000 57,000 Liabilities: Represented by Share Capital Retentions b). Finished Products . Budgeted Sales (units) Budgeted selling price (per unit) 11,600 1,21,,600 3,000.. 3,400 7,200 13,600 45,000 10,000 68,600 1,50,000 (60,000) 1,10,000 Budgeting and Reporting 71,600 50,000 B 5,000 Rs. 30 .1,21,600 T 1,000 Rs. 50 300 200 Q 3 kg. 4 kg.. 2000 kg. 1500 kg. Rs.1.00 Opening Stock of finished goods (in 200 units) Budgeted closing stock (in units) 1,200 i) Direct Materials Raw Material per unit of production B T Opening stock of Raw materials Budgeted closing stocks , Cost per kg. of material purchased ii) P 5 kg., 2. kg. 2000 kg. 2500 kg. Rs. 0.50 Direct Labour: Labour is paid at the rate of Rs. 2 per hour. 3 direct, IO, bour hours are required to product one unit of 3 and 5 Tabour hours are required for one unit of T. iii) Factory Overheads: It has been estimated that factory overheads will be Rs. 33,750,including,Rs. 11,750 for depreciation. Factory overheads are absorbed on a direct labour hour basis. iv) Work in progress: This is negligible and can be ignored (i.e. no opening or closing stocks) 25 Management Control: Process c) Administration Overheads These are estimated to be Rs. 11,625. They are charged to goods leaving work in progress and entering finished goods stocks and are absorbed as a percentage of factory cost. d) Selling and Distribution Overheads. These are estimated to be Rs. 20,000. They are charged to the cost of sales on the basis of a percentage of the selling price. e) Stock Pricing Goods are priced on a FIFO basis. Opening stock of raw materials are 2000 kg. of P at Rs. 0.50 (Rs. 1,000) and 2,000 kg. of Q at Rs. 1 (Rs. 2,000). f) Taxation in 19XX is estimated at Rs. 30,000. Overdraft Interest in 19XX is expected to be Rs. 595, Rs. 500 of which will be paid during the third quarter of the year. You are required to prepare the following budgets for 19XX for XYZ Ltd. using absorption costing methods. i) ii) iii) iv) v) vi) vii) viii) Sales budget; Production budget (quantities only); Direct Materials budget (usage and purchases); Direct Labour budget; Overhead absorption rate; Closing stock budget; Cost of goods sold budget; Budgeted Profit and Loss Account. Budgeted Sales Quantity 5,000 1,000 Production (Quantities) Sales (in Unit) Add: Closing Stock Less: Opening Stock Production required Selling price Rs. 30 Rs. 50 B 5,000 1,200 6,200 200 6,000 P Sales Rs. 1,50,000 Rs. 50,000 Rs. 2,00,000 T 1,000 200 1,200 300 900 Q Solution a) Products B T b) c) i) Direct Materials Budget Quantity required for Units produced (6,000 x 5 kg.) (900 x 2 kg.) (6,000 x 3 kg.) (900 x 4 kg.) 30,000 1,800 18,000 3,600 31,800 21,600 26 B u d g e t d S & D O v e r h a d R s . 2 0 ,0 0 a l e s B 5 R s . 3 0 = R s . 1 , 0 s 2 , 0 1 , 0 x 5 5 0 % o f S a l e s= T h e r f o r e , S & D o v e r h e a d i s 1 0 B 1 , 1 , R s . 1 5 , 0 R s . 5 0 0 S e l i n g O . H f o r T = 1 0 % o f R s . 2 0 , 0R g C l o s i n g S o c k B u d g e t i ) R a w M a t e r i a l P Q Add: Closing Stock 2500 34,300 Less: Opening Stock 2,000 Materials required (in kg.) 32,300 Cost per kg. Rs. 0.50 Total Rs. 16,150 Total Material Cost as per Budget = Rs. 37,250 (Rs. 16,150 + Rs. 21,100) d) Direct Labour Budget Product Production L. Hrs .Total hrs. in units B T 6,000 900 reqd. 3 5 reqd. 18,000 4,500 22,500 1500 23,100 2,000 21,100 Rs. 1.00 Rs. 21,100 Budgeting and Reporting Rate Labour cost Rs. 2 Rs. 2 Rs. 36,000 Rs. 9,000 45,000 e) i) Overhead Absorption Rate Budgeted Factory O.H. Budgeted Hours Budgeted Factory O. Rate = Rs. 1.5 per labour hour ii) Factory Cost of goods produced Direct Material B P,(6,000 x 5 kg. x 0.50) Q (6,000 x 3 kg. x 1.00) Direct Material Direct Labour Factory O.H. 18, 000 x 1.5 Factory cost of goods sold Rs. 15,000 Rs. 18,000 33,000 36,000 27,000 Rs. 96,000 Rs. 33,750 22,500 T Rs.900 Rs. 3600 4,500 9,000 6,750 Rs. 20,250 (900 x 2 x 0.50) Rs. (900 x 4 x 1.00) 4,500 x 1.5 iii) Administration Overhead Estimated Factory Cost (Rs. 96,000 + Rs. 20,250) Therefore, Adm. O.H. is 10% of factory cost Adm. O.H. for Product T(10% of Rs. 96,000) Adm. O.H. for Product T(10% of Rs. 20,250) iv) Selling and Distribution Overhead = Rs. 9,600 =.Rs. 2,025 Rs. 11,625 27 Management Control: Process Opening Stock (2,000 kg. x 0.50) = Rs. 1,000 (2,000 kg. x 1.00) Purchases (32,3000 x 0.50) Rs. 16,150 (21,100 x 1.00) 17,150 23,100 = = Rs. 2,000 23,100 = 21,600 1,500 = Rs 21,100 34,300 kg. Less : Consumption (31,800 x 0.50) 2,500 kg. ii) Finished Goods Factory cost of production Add: Adm. overhead Units Finished Cost per unit 15,900 (21,600 x 1.00) 1,250 B Rs. 96,000 Rs. 9,600 1,05,600 6,000 Rs. 17.60 1,500 kg. T Rs. 20,250 Rs. 2,025 22,275 900 Rs. 24.75 Statement showing Cost of Closing Stock of Finished Goods Products Amount Units. 200 Rs. 3,400 Opening Stock Addition Less Cost of finished goods sold, From Opening Stock 4,800 x Rs. 24.75 Closing Stock 6,000 6,200 (200) 1,05,600 1,09,000 (3,400) Amount Rs. 7,200 22,275 29,475 7,200) Fresh units introduced & completed (4,800)* 1,200 21,120 4,950 * Units Completed during the year - Opening stock (FIFO method is used) B Units Amount Units Amount From Opening Stock 200 Rs. 3,400 300 Rs. 7,200 Units introduced finished & sold Selling & Dist. Overhead Cost of Goods sold (i) Budgeted P and L A/c Sales Less: Cost of sales Profit before tax and interest Less: Interest Profit before tax Tax Profit after Tax (PAT) B Rs. 1,50,000 1,02,880 T Rs. 50,000 29,525 Total Rs. 2,00,000 1,21,405 67,595 595 67,000 30,000 37,000 4,800 84,480 87,8001000 15,000 1,02,880 700 24,525 5;000 29,525 17,328 Cost of finishing the goods sold 5,000 28 8.3.4 Master Budgets Introduction Once the functional budgets are prepares and an such budgets are available, the Budget Controller's office will have to engage itself in the next very important task which is preparation of the Master Budget. This comprises summarisation and consolidation of all functional budgets, preparation of the cash budget and developing the profit and loss budget and the budgeted balance sheet. The summary budgets thus prepared are again reviewed, reconsidered and readjusted until an overall satisfactory budget is drafted. This budget is then submitted to the top management for acceptance. Only after such acceptance this set of budgets will be called Master Budget. Master Budget essentially means a finally approved comprehensive set of document covering all budgeting activities with respect to the budget year. The said document is also termed `Budget Package'. It is in the fitness of things to obtain a good number of the Budget Package printed and circulate the same among all concerned departmental heads and other senior executives before the budget year starts. This will also serve the purpose of communication which is an essential requirement in the planning process. Cash Budget A cash budget is a forecast of cash position over a period of time, to reflect changes in the position within the same period. Conventionally, cash budget is considered to be an integral part of the total budgeting process and it is prepared only after all sectional or functional budgets are available. However, to install better control on cash flow, the scope of operation of cash budgets can be expanded to cover each function or sub-unit separately and to develop a rolling cash flow plan for each subunit as well as the company as a unit. A format for such rolling plan is included, vide Illustration 4. If a company adopts, say, a 12 month rolling plan, every month the figures in the format will be up-dated to cover the subsequent twelve months. For the purpose of effective control, budget-actual comparison pertaining to the immediate previous month has also been shown in the format. Illustration 4 : Cash Budget (Format) CASH BUDGET (FORMAT) (Under Rolling Period Basis) Period ............... Budget Actual Comparison Month - 1 Item Budget Actual A. Sales Receipts: 1) Cash sales and advances 2) Sundry debtors collected 3) Cash subsidies, rebates, etc. Month 1 Month 2 Month 3 Budgeting and Reporting Total of A 29 B. Operating Disbursements : Management Control: Process 1) 2) 3) 4) 5) 6) 7) Cash purchases and advances Sundry creditors paid Wages, salaries, PF, bonus etc. Rents, electricity, rates, insurance etc. Selling expenses0 Administration expenses Income tax Total of B C. D. Cash flow through operations (difference between A & B) Miscellaneous receipts (rents, dividends, royalties, etc.) Total of C&D E. Capital Receipts 1) Debenture issue 2) Terms loans 3) Issue of share capital 4) Sale of assets Total of E F. Non-operating Disbursements 1) Interest & Financial costs 2) Donations 3) Dividends 4) Capital expenditure 5) Debt Redemption Total of F G. Net Cash flow (C+D+E+F) H. Add. Cash balance: beginning of month I. J. Cash position Less: Minimum cash balance required (increase / decrease) L. Cumulative bank loan position Drawing power The above method is known as Receipts & Payments method of Cash Budgeting. K. Bank loan position 30 There are two other methods of preparing Cash Budget viz. a) b) a) Adjusted P/L Method Balance Sheet Method Adjusted Profit and Loss Method Budgeting and Reporting Under the Receipts and Payments Method (as given in Illustration 6.) all the transactions relating to receipts and payments of cash are taken into consideration, while this method is based mainly on non-cash transactions. The theory has an underlying assumption that profit will be equivalent to cash, or, i,n other words, the earning of profit brings equal amount of cash into the business, This also leads to another assumption that the business will remain static. That is, there will not be wearing out or expansion of assets: debtors, stock etc. balances will remain unchanged, so that total cash available for distribution would be equal to the profit earned. But, in practice, business does not remain stationary so that an adjustment will have to be made in respect of many items like fluctuations of stock, appropriation of profit, provisions, accruals, etc. Illustration 3 may now be referred to. b) Balance Sheet Method Under this method, a budgeted Balance Sheet for the budget period showing all items excluding cash is prepared. The balancing figure in the Balance Sheet is represented by cash. Therefore, if the liabilities side is larger than the asset side, this would represent a balance at the bank and if the asset side is larger than the liabilities side, this would mean that cash will be overdrawn or adjustments will have to be made before the Cash Budget is finalised. This has been shown in Illustration no. 5. Illustration 5 : Format of Cash Flow Analysis The mode of preparation of cash budgets under this method will be evident from the standard format given here : CASH FLOW STATEMENT (FORMAT) Period………………. Opening Cash Balance Add ('Generation' of cash) i) Adjusted net Profit: Net Profit for the period Add (less) • • • • ii) iii) iv) Depreciation written off Provisions Accrued expenses (accrued income), Write-offs ___________________________ Rs. Rs. Decrease in current assets Increase in current liabilities (including bank borrowings) Receipts from other sources • • • • • Issue of share capital Issue of debentures Term Loans Sale of Plan & Machinery Investment 31 Total of Cash (A) Management Control: Process Deduct (Consumption' of cash): i) ii) iii) iv) Increase in current assets Decrease in current liabilities Prepayments Other payments • • Capital expenditures Repayment of loans Payment of taxes • Payment of dividends ____________________________ _______________________________ Total Deduction CLOSING CASH BALANCE (A-B) Illustration 6 ; Cash Budget (Receipts & Payments Method) Required from the following Information a monthly cash budget for the fourth quarter ending 31st December: 1) Extracts from Sectional Budgets Month Sales Materials Rs. 36 40 48 45 46 50 52 Wages Rs, 13 15 15 15 16 18 20 (Figures in Rs. million) *Production Admn. & Selling overheads overheads Rs. Rs. 4.5 3.2 4.5 3.2 5.0 3.6 6.0 3.5 6.0 4.0 7.0 4.0 7.0 .4.5 Rs. June 60 July 65 August 70 September 75 October 80 November 85 December 90 2) Credit terms: Sales - three months to debtors; 10 per cent of sales are on cash. On an average 50 per cent of credit sales are paid on due dates and the balances in the following month Creditors (Materials) - two months 3) Lag in payment: Wages quarter month, Overheads - half month 4) 5) Cash and bank balance on 1st October is estimated to be Rs. 30 million. Other Information: i) Plant and machinery to be installed in August at a cost of Rs. 480 million will be paid for by monthly installments of Rs. '10 million from 1st October. Preference dividend @ 5 per cent on capital of Rs.' 100 million payable in December: ii) iii) Call on 50,000 equity shares @ Rs. 20 each receivable in November. 32 iv) Dividends (from investments) of Rs. 5 million receivable in December. v) Income-tax (advance) payable in December, Rs. 10 million. Solution: CASH BUDGET Period ending 31st December (Rs. in million) Details Balance b/d Receipts Sales Call on shares Dividends Total (X) Payments: Creditors (materials) Wages Overhead production Overhead - admin. and selling Preference dividend Income tax Plant and machinery Total (Y) Balance c/d (X-Y) Notes: i) The balance of Rs. 15.50 million at end-December indicates overdraft. ii) Closing balance of October becomes the opening balance of November, and so on. iii) Wages for October would be one-fourth of September wages plus threefourths of October wages. Similar would be the treatment for November and December. iv) Overheads for October would be half of September overheads plus half of October overheads. Similar would be the treatment for November and December. v) Receipts from sales are found out as under: COLLECTIONS (Rs. in million) Month June July August September October November. December Total Sales 60 65 70 75 80 85 90 64.25 69.25 8.00 8.50 9.00 74.25 October 27.00 29.25 29.25 31.50 31,50 33.75 November December 48.00 15.75 6.00 3.75 10.00 83.50 10.75 45.00 17.50 6.50 4.00 10.00 83.00 7.00 46.00 19.50 7.00 4.25 5.00 10.00 10.00 101.75 (15.50) 64.25 94.25 69.25 10.00 90.00 74.25 5.00 86.25 October 30.00 November 10.75 December 7.0 Budgeting and Reporting 33 Management Control: Process Summary Budgets The Master Budget has been defined as the Summary Budget which incorporates its component functional budgets and which is finally approved and adopted. A Summary Budget has been defined as a budget which is prepared from and summarises all the functional budgets. In short, when all the functional budgets are prepared, they can be summarised to produce: i) ii) Budgeted Revenue Statement or Profit and Loss Account Budgeted Balanced Sheet. A master budget is thus an overall business plan and is akin to familiar financial statements. The major technical difference is that here one is dealing with expected future data rather than with historical data. Budgeted Revenue Statement or Profit and Loss Account: The Profit and Loss Account is built up from the other budgets already set, and no fresh estimates are necessary. The budgeted cost of production is deducted from the budgeted sales revenue in order to arrive at the budgeted gross profit, The operating profit is obtained by deducting from the budgeted gross profit all budgeted nonproduction overheads that is, Administrative, Selling and Distribution overheads, Addition and subtraction of other budgeted non-operational income and expenditure items give the budgeted net profit: The advantages of a Budget Profit and Loss Account are as follows : a) b) c) d) It presents a projected profit. position - overall as well as stagewise - of the concern. It enables the planning and control of the profits of the unit, It facilitates investigation into the causes for variances in profit. It ensures and cross checks the consistency and matching between all the functional budgets. Budgeted Balance Sheet The preparation of Budgeted Balance Sheet also is simple. This is prepared on the basis of the last Balance Sheet, wherein all forecast changes of assets and liabilities are included. The advantages of the Budgeted Balance Sheet are as follows : i) It reveals the overall financial position of the concern so that management may take appropriate action in advance. The various ratios based on budgeted Balance Sheet would be of assistance to the management in assessing the financial position of the unit. It provides a mechanism of checks and balances with respect to other budgets. The budgeted return on capital employed may be determined. Necessary changes may be made if the return is not considered to be adequate. ii) iii) Revision of Budget Package The budgets are framed based on a series of assumptions likely to prevail in the budget period usually one year. The period being short it is unlikely that the variation between budget and actuals should exceed the permissible limit provided there is no unusual lapses in the budget preparation. Nevertheless, the change in external environment as well as unforeseen changes cannot be ruled out necessitating changes in the budget. 34 It is very often observed that budget revision is undertaken only to reduce budgetactual difference. This should not be the case since a budget will lose its value as a yardstick. Sometimes, however, a budget revision may be necessary due to the following reasons, provided that these will otherwise have significant impact on the operating performances during the budget period: i) ii) Correction of major errors which might have crept in while preparing the budget. Giving effect to extraordinary situations, not envisaged or considered at the time of budget formulations. (Examples of such situations are: price-cuts.and/or profit limits imposed by the government, important raw material becoming non-available, an important material being declared a banned item, strained political relations with a country affecting imports of materials and/or export of finished goods, rapid change in technology leading to changed method of production, etc.) Budgeting and Reporting Since the budget package is based on the details provided in the functional budgets, any significant change in the functional budgets requires revision of the entire budget package, on the same principles and routine followed in budget setting. However, this does not imply that the original budget is to be discarded; but in addition to normal variation there should be a revision variance which acts as a corrective factor for future reference. Where rolling budget is in operation the signals of change become apparent and revision process is simplified. 8.4 FLEXIBLE BUDGETING 8.4.1 Fixed and Flexible Budgets Basically the concept of flexible budget is that some sort of budgetary cost adjustments will have to be made for varying levels of output. The underlying principle of flexible budget is to flex the fixed budgets to correspond with the actual level of activity. The CIMA defines flexible budget as "a budget which is designed to change in accordance with the level of activity attained", as against a fixed budget, being defined as "a budget which is designed to remain unchanged irrespective of level of activity actually attained". The fixed budget though rigid in character is subject to revision when there is a significant change in the basic assumptions underlying the fixed budget. A fixed budget has only a limited application, e.g. budgeting of fixed expenses but is ineffective as a control medium, particularly when wide fluctuations in the level of activity could take place due to external factors like market conditions, raw materials availability, etc. As a sharp contrast to fixed budget, flexible budgetary system attempts to develop a series of budgets for different levels of activity under varying sets of assumptions. This is why flexible budgets are also known as multiple budgets. The need for flexible ' budgets arises when due to uncertainties or changes in the environment it becomes extremely difficult to prepare even a reasonably good sales forecast. An attempt is, therefore, made to develop several alternative sales forecasts necessarily leading to the corresponding alternative levels of production, capacity utilisation and therefore, development of multiple budgets accordingly. Sales forecast may at times be difficult due to some situations that might arise in the companies: i) ii) iii) iv) Which are subject to weather condition, e.g. soft drinks industry; Which frequent, change their product range or introduce new products; Which are affected by change in design e.g. ladies fashion garments; Where production is on made to order basis. 35 Management Control: Process Flexible budgets are of use in bringing the adjusted budget to prevailing working condition arising out of seasonal or calendar variations. A distinction may be made between a flexible budget and a flexed budget. While flexible budgets are prepared at the beginning of the budget period, a flexed budget is defined as a budget prepared at the end of the budget period; and an attempt is made to adjust the original budgeted amounts with respect to the actual output or sales achieved. 8.4.2 Developments of Flexible Budgets It is necessary to establish the budget centres based on the principle of cost centre. Considering the behavioural character of costs the expenses relating to budget centres are to be segregated into fixed, variable and mixed costs. The total amount of cost which a budget centre is expected to incur in relation to the budgeted activity of the centre is estimated in the form of "B udget Allowance". The budget allowance is set in respect of each cost centre as the incidence of costs is not the same and the fluctuations in variable costs vary from item to item due to activity variations. In certain cases costs are related to output and in others the costs are related to input e.g. direct labour hours, machine hours, etc. Training and management development costs are on the other hand related to number of new employees (and not output). Material handling cost fluctuates with the volume of materials handled. Even at the cost of repetition it is stressed that while fixing the budget allowance, the behaviour characteristics of each item of cost should be carefully analysed. Fixed cost (including labour cost) is `relatively' fixed and hence, proper allowance should be given for fluctuations in activity. Determination of capacity utilisation is invariably associated with the flexible budgeting technique. The capacity size is the natural outcome of capital. budgeting decision. The other relevant factors influencing capacity utilisation are, demand pattern (including seasonal and cyclical fluctuations), the cost of carrying inventory and inventory stock out, existence of bottleneck machine in production departments, sub-contracting policy, etc. Apart from machine capacity, the concept of capacity is equally applicable in other factors of production e.g. material, labour, etc. Illustrations 7, 8 and 9 exhibit the methods of developing Flexible Budgets under different situations. 8.4.3 Flexible Budget in Marketing While fixed budgets portray a more or less rigid plan based on one set of conditions and one level of activity, flexible budgeting system attempts to develop a series of budgets for various levels of activity and under varying sets of assumptions. Conventionally flexible’ budgeting system is associated with production budgets. But there is no reason why this concept should not apply to the marketing budgets also. In fact, marketing budgets could be framed on a more realistic basis and their control made more meaningful and effective with the help of this concept. The expense behaviour analysis suggested earlier should form the bed-rock of flexible budgeting in marketing, specially for marketing expenses budgets. We have give a summary of the marketing expenses broken down into four functions and indicating the behaviour of expenses in illustration No. 9. This also illustrates how the flexible budgeting concept can be applied with advantage in marketing operations. It may be noted in the said illustration no. 9 that during the first quarter the adverse expense variance is only Rs. 1 million under the fixed budgeting method. it will be easy for the marketing department to justify this increase on the ground of sales being higher 36 than budgeted. Similarly, in the second quarter the marketing department will be complemented for showing a favourable expense variance of Rs. 1.5 million! However, when we apply the flexible budgeting concept, the position changes dramatically. The adverse variance in the first quarter is Rs. 4 million and not Rs. 1 million. Similarly, during the second quarter there is again an adverse variance of Rs. 2.7 million and not a favourable variance of Rs. 1.5 million. To judge expense variance in the right perspective, the Flexible budgeting approach would obviously be the correct one. For more effective control o f expenses, the same approach of arriving at the revised budgeted expense figures -the expenses that should be allowed with reference to the actual activity - can be extended to each functional area. And for this purpose the budget should also be broken down department-wise. Further, to introduce more intensive control, the technique can be adopted on a monthly basis instead of quarterly. The mode of working will however remain the same. Finally, the model has tremendous flexibility in that it can be extended to product-groups or even product-level. Budgeting and Reporting 8.4.4 Limitations of Flexible Budgets There is some skepticism among the functional managers as to the applicability of flexible budgeting technique as a vehicle for cost control. With reasons they assert that the bulk of production costs. because of technical up gradation, is tending to assume the characteristics of fixed cost. The price of material is beyond control and labour component cannot be adjusted to the level of production, at least in the shortrun. The difficulties of predicting the behavioral aspects of costs, discussed earlier are equally applicable to flexible budgeting technique. The cost of operation of the system is another negative factor for its wide acceptance. in case the actual activity attained does not correspond to any of the predetermined levels, the budget allowance is set by statistical method of interpolation with associated risks. Despite the above-mentioned limitations, flexible budgeting could be useful under different types of situations and thus continues to remain a powerful tool in management accounting. Activity 5 List out the conditions under which flexible budgeting could be used ……….………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… 37 Management Control: Process Illustration 7 : Developing a Flexible Budget The, following particulars are relating to X Co. Period Normal: Capacity 80% Capacity Units Marginal cost @ Rs. 4 per units Fixed costs 60% 3,000 Rs. 12,000 8,000 80% 4000 Rs. 16,000 8,000 100% 5000 Rs. 20,000 8,000 Total 20,000 24,000 28,000 Now, if the number of units actually produced in a period is 4,500 units, then comparison of actual costs will have to be made with the flexible budget at this level of activity. Thus Rs. Marginal cost (4,500 units @ Rs, 4) Fixed costs 18,000 8000 Total 26,000(amount allowed) The difference between the amount incurred and that allowed would be reflected as a variance which requires further explanation. Illustration 8 : Developing Flexible Budgets A single-product manufacturing company is currently producing 12,000 units (at 60 percent capacity). The following particulars relating to its cost structure are available. Per unit Rs. Direct materials Direct labour (variable) Manufacturing overheads (60% fixed) Administrative overheads (fixed) Selling & distribution overheads (40% variable) Cost of sales Profit Selling Price 5 2 5 2 3 17 3 20 We have to prepare a flexible budget for 60 per cent, 80 per cent and 100 per cent activity levels taking into account the following further information: a) b) c) If activity exceeds 60 per cent, a 5 per cent quantity discount on raw materials on account of increase in the total quantity will be received. The present fixed cost structure will remain constant up to 90 per cent capacity, beyond which a 20 per cent increase in cost is expected. The present unit selling price will remain constant up to 75 per cent activity level, beyond which a 2% per cent reduction in original price for increase in activity by every 5 per cent is contemplated. 38 Particulars Activity level 60% (12,000 units) Rs. 80% (16,000 units) Rs. 100% (20,000 units) Rs. Budgeting and Reporting a) Prime cost: Direct materials Direct labour @ Rs.2 60,000 24,000 84,000 b) Variable overheads: Manufacturing @ Rs. 2 Selling& Distribution @ Rs. 1.20 38,400 c) Fixed overheads: 36,000 24,000 21,600 81,600 d) Cost of sales (a+b+c) e) Sales f) Profit (5-4) 2,04,000 2,40,060 36,000 36,000 24,000 21,600 81,600 2,49, 800 3,12,000 71,200 43,200 28,800 25,920 97,920 2,96,920 3,50,600 53,800 51,200 64,000 24,000 14,400 32,000 19,200 40,000 24,000 76,000 32,000 1,08,000 95,000 40,000 1,3 5,000 Manufacturing Administrative Selling & Distribution At 80 per cent, profit is the highest. Hence, of the three activity levels, 80 per cent is the most profitable one. Workings: a) Direct material cost: At 80%: 16,000 @ Rs. 5 less 5% - Rs. 76,000 At 100%: 20,000 @ Rs. 5 less 5% - Rs. 95,000 b) Fixed Costs: Manufacturing: Rs. 3 (60% of Rs. 5) arrived at the activity level of 12,000 units. Therefore, total fixed cost: 12,000 @ Rs. 3 = Rs. 36,000. Similarly, for administration and selling and distribution items. At 100% fixed cost increases by 20%. c) Sales: At 80%: 16,000 @ Rs. 20 less 2''4%0 = Rs. 3,12,000 At 100%: 20,000 @ Rs. 20 less 12''A% = Rs. 3,50,000 (Price reduction @ 21/2% for every 5% in activity level) 39 Management Control: Process Illustrotion 9: A case study on Flexible Budgeting The marketing expenses of P Ltd. have been budgeted at Rs. 100 millions for the current year and their functional allocation is shown below: Functional Allocation of Budgeted Expenses: (Rs. in millions) Fixed Direct selling Distribution Promotion Other marketing 10 15 5 10 40 Var.iable 30 20 10 60 Total 40 35 15 10 100 The sales were budgeted at R. 1000 million and the quarterly breakup of the budgeted sales is, Quarter I Quarter II Quarter III Quarter IV Rs. 160 million Rs. 240 million Rs. 280 million Rs. 320 million The actual sales during the 1 and 11 quarters were Rs. 200 million and Rs. 180 million respectively and the actual marketing expenses were Quarter I - Rs. 26 million and quarter II - Rs. 23.5 million. A. Fixed Budgeting Under fixed budgeting no distinction .will be made between fixed and variable marketing costs and the total budgeted marketing costs of Rs. 100 million would be assumed to be incurred uniformly throughout the year. So quarterly budgets for marketing costs would he Rs. 25 million for each quarter. The report on sales and marketing costs would be as given below: QUARTER I Budget Sales Marketing expenses 160 25 Actual 200 26 Variance 40(F) 1(A) Budget 240 25 QUARTERII Actual 180 23.5 Variance 60(A) 1.5(F) (F) Favorable and (A) Adverse B) Flexible Budgeting If a flexible budgeting were followed the fixed marketing costs of Rs. 40 million would be; assumed to be. incurred uniformly throughout the year. The variable marketing costs would vary with the sales value in each quarter. Since Rs. 60 million of variable costs represent 6% of budgeted sales the budgeted marketing costs would be as follows: (Rs. in million) Total Fixed expenses Variable expenses 40.00 60 0 100.00 , Qtr. I 10.00 9.60 19.60 Qtr.!! 10.00 14.40 24.40 Qtr.lll 10.00 16.80 26.80 Qtr.IV 10.00 19.20 29.20 40 When actual expenses are to be compared with the budget, the budgeted variable expenses will have to be flexed for the actual sales volume achieved to work out the variances. Marketing Expenses Allowed for Sales Achieved (Rs. in million) Quarter I Fixed expenses Variable expenses (6% of actual sales) Total 10 12 22, Quarter II 10 10.8 20.8 Budgeting and Reporting The control report under flexible budgeting would be as follows : QUARTER I Budget Sales Marketing expenses 160 25 Actual 200 26 Variance 40(F) 4(A) 240 20.8 QUARTER II BudgetActual 180 23.5 Variance 60(A) 2.7(F) 8.5 BUDGETARY CONTROL SYSTEM 8.5.1 Introduction CIMA Terminology defines Budgetary Control as "The establishment of budgets relating the responsibilities of executives to the requirements ofa policy, and the continuous comparison of actual with budgeted results, either to secure by individual action the objectives of that policy or to provide a basis for its revision". Budgetary Control System, like any other control system, comprises several important steps that need to be taken up in a logical sequence, as follows i) ii) Developing the budgets as well as breaking these up into departmental/sectional details and also for shorter periods; Continuous comparison at regular periodic intervals, say, monthly or quarterly, between the budgeted figures and the corresponding actuals„using suitably designed formats; As a sequel to (ii) above, location of divergences between the budgeted figures and actual figures and pinpointing those that are adverse in nature and higher in magnitude; analysing the reasons for the divergences so pinpointed; Initiating remedial measures, again through the active involvement of the operating people, in order to correct the adverse divergences in the immediate next time-period; and iii) iv) v) vi) if any major divergence, whether favourable or adverse, is found to be beyond control during the budget period, then working out a rational basis for revising the budget itself. 8.5.2 Budgetary Control and Standard Costing Budgets are usually based on historical costs adjusted for anticipated changes and generally broad in nature. Standard cost is an estimated cost of a ,product following a systematic and scientific study of each element of cost. According to C1MA it is "A standard expressed in money". And "It is built up from an assessment of the value of cost elements. 41 Management Control: Process Certain basic principles and steps are common to both Budgetary Control and Standard Costing. They are: a) b) c) d) e) Establishment of a predetermined standard, target or yardstick of performance; Measurement of actual performance vis-à-vis the yardstick; Location of variances between actual and standard performances; Disclosure of reasons of such variations; Suggestions as to corrective actions where necessary, In spite of these points of similarity in principles, steps, attitude, approach and aim, Standard Costing and Budgetary Control differ in scope, nature and technique of operation. Standard Costing i) ii) Applicable to only production operations and product costs More intensive in nature i) ii) Budgetary Control Applicable to all functional areas of an enterprise More extensive in nature iii) Projection of cost accounts iv) Variations revealed through accounts v) Cannot be operated in parts or elements vi) Technically a more improved system iii) Projection of financial accounts iv) Variations not normally revealed through accounts v)' Can be operated in parts, sections or departments vi) Elementary in nature It may be noted also that Budgetary Control System can be operated independently, but Standard Costing System would depend to some extent on budgeting. 8.5.3 Administration of Budgetary Control System It is important to note that a sound organisation, systematic budget development, proper budget maintenance and efficient budget administration are prerequisites for successful Budgetary Control System. Since Budgetary Control System involves team work it is to be ensured that proper co-ordination exists among the departments. Those who take part in the budget preparation and are responsible for execution and operation of the system must be taken into confidence and their concurrence in the final tape of the . budget preparation should be ensured. The organizational structure for this purpose should obviously comply with the basic principles underlying any organization structure design in general. The responsibilities and authority relationships should be clearly, spelt out in particular. Depending on the size and complexity of the organization it should be headed by a Budget Controller, Budget Manager or Budget Director. The selection of the head deserves special attention as he should be able to carry the whole team with him and discharge the responsibilities efficiently. The key person (e.g. Budget Controller) should frame a Budget Committee representing all the functional heads. In broad out line the responsibility of the Budget Committee should be : a) To obtain the functional budgets within the time-frame, review and approve the same. 42 b) To receive periodic budget reports and observe the actual trend c) d) To suggest corrective actions when necessary. To develop a rationale for budget revision, if necessary. Budgeting and Reporting In short, the budget committee should be in overall control of both budget preparation and budget administration. The Budget Manual is a document or rule book which sets relevant instructions governing the responsibilities of persons, and outlines the procedures, forms and records relating to the preparation of and use of budgets. The Manual avoids ambiguity, reduces staff training period and eliminates risk of overlapping of functions, which are common problems in Budget Administration. The planned activities of the organization are divided into Budget Centres indicating the areas which must be clearly definable and should be put in charge of respective defined persons so as to avoid overlapping of duties. The budget centres are also the basis of what is known as Departmental Budgets that are essential for operation of responsibility accounting system. The success of planning and control process is dependent on effective communication, coordination and performance evaluation. The concept of coordination implies that interests of the functional managers are to be subordinated for serving the greater interest of the corporate entity. The formulation and administration of budgets might reveal some weak links in the communication process vis-à-vis the organisation structure. Setting of individual targets in the backdrop of the corporate objectives compels the key personnel to think ahead and thus a corporate spirit is inculcated steadily. Budget acts as a framework for performance appraisal. The targets set of in the budget formulation act as a guide to the persons involved in operations and they become conscious about the expectation of management. This human involvement plays a significant role in achieving corporate objectives, existence of computer and automation notwithstanding. While on the subject of performance appraisal using budgets as the yardsticks we may underline the importance of using suitably designed formats for presentation of budget-actual comparison. A format for this purpose should preferably provide a multiple frame of comparison and the following column-heads may be suggested to this end: Budget TM (This month) Budget YTD (year-to-date) Variance TM Actual TM Actual YTD Variance YTD Actual YTD LY (year-to-date last year) Variance YTD LY 8.5.4 Performance Reporting From the point of view of performance reporting as well for Management Information System (MIS) there are three levels of management that would be relevant namely : Corporate level or top level Executive level or middle level Operating level or supervisory level The nature of reports meant for 'tese different levels of management will be different, so Will be the contents, structure of formats and frequency of the reports. We may give here a few examples of both special reports and routine reports applicable to the different levels of management. 43 Management Control: Process Special Reports Corporate level - Company's financial position-financial ratios Project feasibility study Report on sourcing of funds Executive level - Report on make or buy decision Product Profitability Studies Price Fixation Cost Reduction Measures Operating level Plant utilisation and idle capacity cost Slow and non-moving inventory Change in production methods/processes Routine Reports Corporate level Project Cost Reports Labour efficiency and productivity Inventory turnover ratio Debtors turnover ratio Periodic profit & loss account and balance sheet Executive level Inventory planning and control reports Variance analysis (summarised) Report on production achieved Report on sales achieved Product cost reports Maintenance cost reports Power & fuel consumption and cost Variance analysis (detailed) Sales and order booking analysis Marketing cost analysis Distribution cost analysis Credit control report Labour turnover and cost Welfare schemes and cost Incentive schemes and cost R & D cost reports Quality cost reports Administration overhead statement The above list is only indicative and is by no means exhaustive, Periodicity of Reports is another important aspect, in reporting. Frequency of reporting as well as periodicity should vary depending on the contents of the reports and the different levels of management who would be the recipients of the reports:.: Special reports by their very nature do not generally have any predetermined periodicity. Studies or analyses may be commissioned by any. level of management and at any time and reports will be prepared as a sequel and submitted to the persons who need the same within the deadline agreed to beforehand. As regards routine reports, however, the periodicity in general should as follows Corporate levelExecutive level Monthly/Quarterly Fortnightly/Monthly Daily/Weekly/Monthly Production Operating level - Sales&Marketing Personnel 44 Operating level - Closely related to the above is the structuring of the report formats. The general guidelines are as follows : Corporate levelExecutive level Operating level Lesser degree of structuring Mostly structured Fully structured Budgeting and Reporting 8.5.5 Uses of Performance Reports Very often it is found that Performance Reports serve only the purpose of providing information to the recipients and perhaps a psychological sense of security or a feeling that the business is as usual! While this aspect of utility of reports cannot be totally ruled out, it needs also to be kept in view that the primary purpose of a report is to trigger of decisions - decisions for better planning and more effective control. Coming to the planning part first, reports should contribute towards a continuous improvement in the planning process through more rational decisions. Generally special reports lead to decisions on special issues or one-off situations and planning process follows accordingly. The Routine Reports also improves planning process through improved decision making in a large and diverse number of operational matters. In passing it needs to be underlined that to aid the planning process the concerned report should be futuristic or feed-forward oriented rather than providing just feedback information. Next we come to the control dimension. Reports meant for control are essentially of the ex-poste or feedback type. These reports generally marshal actuals against the predetermined norms or performance yardsticks (e.g. budgets, standard costs, etc.) throw up the divergences (favourable / adverse and large / small) and thus draw the attention of the recipients to the areas that need managerial action. As a sequel certain decisions follow that are called corrective actions and these are, as the expression suggests, meant to correct the adverse divergences and bridge to the extent possible the emerging gap between what is happening (actuals) and what should be happening (norms). ' We have to sound a note of caution at this stage. Planning and control are really not two separate management functions - it is high time that the Walls of Jericho between planning and control crumbled down and managers realised that these are two sides of the same coin. A good manager therefore effectively uses a performance report both for the purpose of controlling the operations in the current period and planning the same for the immediate next period. 8.5.6 Limitations of Performance Reporting and Cost Controllability First and foremost one should remember that Performance Reports are not ends in themselves but only means -means to initiate decisions and actions. Reports would not automatically do the job; it is the human beings - the managers receiving such reports who will have to do it. This brings us to a very important dimension in the decision making process the human dimension or as it is called the Human Factor in Management. Human beings by, their very nature like tc follow the path of least t esistance and because of zerorisk taking attitude managers are wary of taking decisions or initiating actions even when performance reports would warrant them to do so. There are several other issues, that have been covered under Behavioural & Ethical Aspects in Budgeting and Reporting (8.7). We are not repeating here the observations made there we would nonetheless advise the reader to go through the same. 45 Management Control: Process The next intriguing aspect or limitations is that reports will generally contain figures: but facts lie hidden behind the figures and systematic efforts are needed to discover these facts. Otherwise it would not be possible to take right decisions based on the figures alone. Finally, reports are reports only - these can only be aids to decision making but cannot replace human judgements that are an integral part of the decision-making process. Sometimes using his own judgement a manager may have to take a decision that are at variance with the contents and recommendations in the relevant performance report and such decisions might be found to be in order. Last but not the least is the Cost Controllability aspect vis-à-vis performance reporting. There are certain myths about cost control. One of these is that costs can he classified as controllable and non-controllable and this is strongly advocated by the accountants. But the fact of the matter is that controllability of costs would depend on four factors: • • • • the person in charge the level of the concerned person in the organisation the situations prevailing at the moment the time-frame (for e.g. everything is controllable in the long run but uncontrollable in the very short run) This, the classification of costs into controllable and no controllable categories cannot be taken as rigid or fixed for all persons or situations or for all time to come. For different levels of management, different situations and different time-frames, the management accountant should work out totally different sets of controllable and uncontrollable costs. Only if such a flexible approach is adopted, can performance reports be used meaningfully and effectively as a tool for cost control, otherwise not. Activity 6 Describe a typical organization's process of budget administration .………………………………………………………………………………………… …………………………………………………………………………………………… …………………………………………………………………………………………… …………………………………………………………………………………………… …………………………………………………………………………………………… …………………………………………………………………………….. 8.6 CAPITAL BUDGETING AND CONTROL Capital Budgeting as against Revenue Budgeting discussed above assumes greater importance in view of substantial investment involved and any decision once taken is irreversible in this area. The mode of control of capital expenditure should be significantly different from that of normal revenue expenditure since any capital expenditure : a) b) involves immediate cash outflow, sometimes of a significant amount, with little possibility of immediate returns; and it brings in its train a series of extra revenue expenditures (e.g. depreciation, maintenance, operators wages or salaries, general overhead expenses, etc.) which are a drain on the revenue profits of the particular year and also of a few subsequent years. 46 Capital expenditures at the same time increase the profit earning capacity of the business. Hence the importance of prudent investment on capital items needs hardly be emphasised. While we are not going into a detailed and comprehensive control system for capital expenditures, we would like to mention here a few important considerations involved in it, i) All capital expenditures should be categorised as productive (say, plant and machinery) and service or support (office equipment, furniture, automobiles etc). It has been found that capital expenditures have a greater tendency to increase in the second category (service or support). A more stringent system of control is therefore called for in this area. Some multi-national corporations as well as progressive organisations are known to apply a thumb-'rule such as allocation of the total capital expenditure budget for •a year on a 50:50 basis between productive and support assets. The logic behind this may be that the additional contribution generated through the additional productive assets (consuming at least 50 per cent of the budget) should be able to take care of the full revenue backlash arising out of the entire capital expenditures pertaining to both productive and support assets ii) AII capital expenditure may be streamlined and centralised through a document, namely, Capital Expenditure Requisition (CAPEX) in a standard form, preferably printed. The CAPEX will contain in r alia, the details of the asset to be purchased and the financial and no financial justification for it. For each item of capital expenditure, a CAPEX should be initiated by the head of the department requiring the item. He should then pass it on to a responsible officer in the accounts department (say, the capital expenditure coordinator) for. necessary verification and calculation of DCF returns (in case of high value items). Before an item is purchased the relative CAPEX, duly verified, should be authorised by the appropriate approval authority. The levels of such approval authorities have to be decided in advance, depending on the amount of capital expenditure involved. For example, a departmental head may approve any CAPEX upto Rs. 1000, the general manager may approve upto Rs. 2500 and beyond that all CAPEX have to be authorised by the chief executive. Such limits should be determined with reference to the nature and volume of business and other pertinent factors. The CAPEX for every item must be included in the budget. For any unbudgeted item, special approval by the chief executive would be necessary, irrespective of the amount involved, The capital expenditure budget or capital budget of the company should be completed in every detail viz. details of items, departments requiring them, nature of requirement (replacement or new), purpose code (expansion, production support, employee welfare, pollution control, etc.) estimated amount in each case, the timing of the cash flow, etc. Budgeting and Reporting iii) iv) v) vi) There is another very important area with respect to Capital Budgeting. This is appraisal of capital projects and evaluation of financial attractiveness of at least the major capital expenditure projects. A plethora of tools and techniques, under both undiscounted and discounted cash flow bases, are available in literature on Managerial Economics, Financial Management etc. Details in this regard are outside the purview of our subject here. 47 Management Control: Process 8.7 BEHAVIOURAL AND ETHICAL ASPECTS IN BUDGETING AND REPORTING 8.7.1 Introduction Budgetary Control System or any management control system cannot be operated unless the human factor in management is given adequate consideration to. This aspect has long been neglected since the accent was on the quantitative aspect of budgeting, variance analysis etc. According to Kaplan and Champour "Management Accountants who limit their resources to technical procedures and who fail to make an effort to understand the organisational and behavioural roles of accounting are living in the past and doing less than half a job in the present", Behavioural issues are intimately linked with ethics. Perhaps the most important problem is a steady erosion of faith and confidence that results in behavioural problems. The top management's role, also contributes to the undesirable and sometimes unethical behaviour of managers. Performance appraisal system, which are extremely sensitive to adverse variances, can vitiate the tatmosphere within the organ organisation. Constant fear of getting a negative appraisal degenerates the organisation's climate and take a heavy toll of efficiency, productivity and creativity of managers, and of course their ethical behaviour. Sometimes a new manager, who inherits problems created by his predecessor, becomes a victim of the latters past errors of omissions and commissions. He could be made a scapegoat by his other colleagues in the division.This can lead to the new manager becoming demoralised and demotivated. 8.7.2 Behavioural Problems The major behavioural problems usually encountered in Budgetary Control System are summarised as under : a) b) c) d) e) Budgeting as well as target setting and efforts for achieving the targets are not generally by the same set of people, resulting in mutual mistrust. The corporate goals outlined in the budgets do not necessarily coincide with the individual goals, thus leading to a problem of goal incongruence. Excessive reliance on performance measurement through budget actual comparison encourages Slack Budgeting, as discussed later. The operating people get conditioned not to look beyond the target set. In course of preparation of departmental budgets particularly of the cost centre departments, an inter-departmental rivalry is created because of demand on resources in general and on scarce resources in particular. This leads to an untoward situation called `Budget Bargaining'. Operating management staff at the lower levels may be hesitant to meet the targets under the impression that, once a target is reached it will be immediately raised to a higher level. Non-management staff; feels they are remote from the goals of the company and as such, not only are they apathetic to the budgeting exercise but they also feel that the system is only an indirect means Of squeezing them. f) g) 8.7.3 Budget Slack 48 Excessive reliance on performance measurement through. budget actual comparison, encourages the operating managers to inflate their budgeted expenses and depress the budgetary revenue. Such `padding' and `sand bagging' practices result in slacks within the budget. The organisation's reward structure, by over reacting to under achievement of objectives, is one of the causes of managerial desire for slack. Managers view slack as a prefabricated protective device, as a means of avoiding the stigma normally attached to underachievers. Managers generally create slack in their budgets by underestimation of gross revenue, .inclusion of discretionary increases in personnel requirements, establishment of liberal marketing and sales expense budgets with internal limits on funds to be spent, use of manufacturing costs based on overstated standards and inclusion of discretionary `special' budgets. Sometimes budget slacks introduced at a number of successive levels lead to widespread confusion as to what the true budget is - the budget which is so necessary for planning and decision purposes. This also entails unproductive efforts for maintaining secrecy of the budget figures at different levels. Example of a sales budget for a period (hypothetical but not unrealistic) : Level Marketing Director (MD) Gen. Manager (GM) Sales Manager (SM) Sales Supervisor (SS) Salesperson Accountable To CEO MD GM SM SS Budget Commitment Rs. 100 110 121 133 150 Budgeting and Reporting The Head of Marketing has committed a budget figure of 100 to his superior (CEO), but gets a commitment for 110 from his immediate subordinate GM, providing for a cushion or budget slack of 10. The GM in turn keeps a cushion of 11 and indicates to as well as obtains a commitment from SM for a figure of 121. A slack of 21 has already been built into the budgeting system. But the game goes on at the subsequent levels and, at the end of it all, the field salesman is advised that his budget is 150, the total slack being 50 (i.e. 50%). In this type of game it is important that each manager in the chain of hierarchy maintains `his real budget' a closely guarded secret. But in the process budget loses its significance and reliability as a tool for planning and control. And in the event of a sales review meeting, in the presence of two or three contiguous levels, there will be a total confusion as to what the true budget or expected norm of performance is. In order to deal with such untoward situation, the organisation needs to encourage a culture of faith and trust on the one hand and transparency and free flow of communication on the other. These in turn are very much in the domain of ethicality in the behaviour of the different role players in the organisation. 8.7.4 Problems of Motivation Because of the above-mentioned problems it becomes difficult to motivate all concerned to play an active part in the budgetary control process. In this context Horngren defines motivation as "the need to achieve some selected goal and the resulting drive that influences action towards that goal", and suggests two aspects of motivation a) Direction: efforts of managers should be directed to act in unison to achieve the goal. b) Incentive: Incentive is concerned with getting subordinates to run rather than walk towards the desired goal. 49 Management Control: Process Absence of motivation is evident in both the planning and implementation stages of budgeting. At the planning stage this can be tackled through a participative process in budget setting rather than budget being decided upon at the top and pushed down the line. Management by Objectives (MBO) has been found to be extremely useful in inculcating a participative culture of setting budgets and targets. It is a pity that MBO has almost been discarded worldwide. But it is an acknowledge fact that only the process' and `style' of MBO, if not the outcome, could benefit an organization immensely. No doubt implementation of MBO is fraught with problems. But in discarding MBO have we been throwing away the baby with the bath water? Coming back to the motivational aspect, Atkinson suggests, "while budgets which are best for motivational purposes need to be stated in terms of aspirations" rather than expectations, the budgets which are so necessary for planning and decision purposes need to be stated in terms of the best available estimate of expected actual performance". The expressions are appealing; but we wonder whether this differentiation is practicable and if so, how this can be concretized. At the implementation stage feedback is very important for motivational impact. Unless the individuals are regularly kept informed how actual results are progressing and how these compare with the targets, it will be difficult for them to monitor their performance and take appropriate actions or remedial measures as and when necessary. Apart from the feedback aspect as such the performance evaluation mechanism also needs to be taken a hard look at. There is particularly a strongly emerging need for non-accounting approach to evaluation. Also controllability and non-controllability aspect with reference to the respective budget centres need to be kept in view in any performance evaluation system. Finally, motivational aspects can be taken care of through a culture of all round cooperation and coordination, communication, job enrichment and enlargement and sustained Human Resource Development (HRD) activities covering all such areas. 8.7.5 Behavioral Aspects in Performance Improvement. Review and comparison between budgets and actual on a regular basis and generating budgetary control statements form only one part of budgetary control system. But the other part of the story is the process through which these statements trigger off control actions. The most vital requirement to this end is that somebody has to take the responsibility of initiating such actions. Lack of initiative on the part of managers to take up not-so-easy tasks becomes a stumbling block at this stage. As Annie Besant rightly observed: The world is inhabited by two classes of people. One class says, "Somebody should do it- why should I?" The other class will say, "Somebody should do it-why should then not I?" There is an acute dearth of people in the second group! Because risk taking and unpleasant tough decisions are essential under a situation of consistent adverse variances, generally people do not like to shoulder such responsibility and budgetary control ends there. Consequently, organisational effectiveness through budgetary control system is seriously impaired. After all an organisation is a collection of diverse human beings and as human beings they have imperfections, imprecisions, inhibitions, ego and other psychological aberrations. People have been found to be a bit too sensitive to adverse variances. Confronted with the same, they start building up defence mechanism in their own minds, rather than thinking constructively how to correct the situation. They start 50 finding scapegoats, alibis and excuses to justify non-performance. An atmosphere of mutual faith and confidence has therefore to be restored or created in the organisation whereby people will look. upon variances not as fault-finding or witch-hunting exercises. This is imperative, otherwise the entire budgetary control system will degenerate into only mechanistic rituals with nothing coming out of these. Budgeting and Reporting Psychological considerations are therefore dominant in management control. Activities such as communication, persuading, exhorting, inspiring and criticising are an important part of the process. I f these behavioural aspects of Budgetary Control are not duly considered and dealt with (on the lines broadly suggested above), ethical dimension of MC S will also continue to suffer shipwreck. Activity 7 Discuss the behaviour implications of budgetary slacks. ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... 8.8 SUMMARY A budget is a quantitative translation of an organisations goal in monetary terms for. a specific time period and involves estimation of cash inflows and outflows. The budget process involves the following steps: 1) 2) 3) Identification and setting of long term objectives (Strategic Planning) As per the strategic planning long term objectives are broken into short term goals and resources are dedicated for achievement of these goals. The use of the dedicated resources is monitored and performance is evaluated relative to these goals. The budgeting process recognises the fact that there is a need to view the organization as a system of interacting components that must be coordinated. The success of the process is largely dependent on the fact that how effectively the organization's objectives have been communicated to all organization members and their degree of involvement and participation in the budgeting process. The master budget is a set of operating and financial plans that summarises the. organisation's activity level for the budgeted period which is usually one year. The master budget also includes projected balance sheet, profit & loss account and cash flow statement which are used to evaluate the 1 mancial impact of the budget. This unit also deals with various type of budgets and budgetary concepts. Finally there are important behavioural considerations regarding the budgeting process such as who all should be involved, budget slack, motivation, performance improvement and commitments. 51 Management Control: Process 8.9 A) SELF ASSESSMENT QUESTIONS Theoretical 1) What do you mean by Budget Package and Budget Bargaining? 2) Discuss the important features and requirements of a good financial report. 3) Write short notes on the followings: (any four) (a) Revision of Budget Package. (b) Limitation of Performance Reporting. (c) Cost Control lability. (d) Uses of Probability in Budgeting. B) Problems 1) Boon Institute, which has been operating on the basis of 2,000 patient-days per month, has been reorganised to accommodate 3,000 patientdays per month from December 19X2. The institute charges patients Rs. 30 per day and incurs direct charges per patient - day as under: Rs. Staff salaries Food and provisions 8 8 4 Dressings and medicaments Monthly overhead costs are : At the level of: 2,000 patient days Rs. 000 Supervisory and general staff Administration Other expenses 4 2 8 3,000 patient days Rs. 000 5 3 10 Salaries are paid at the end of each month. Food and provisions are received evenly throughout the month, but dressing and medicaments are delivered in the month prior to use. All are paid for at the end of the month following their receipt. Overhead costs are paid for of the end of the month in which they are incurred except for the following items which are included above in `other expenses'. Rent- Rs. 48,000 per year paid in two equal installments on June and December. Depreciation - Rs. 24,000 per year. Both of these are allocated to the accounts in equal monthly amounts. Patients are invoiced at the end of each month and payments are received: 40% by the end of month following month of invoice; 50% by the end of the next subsequent month; and 10% one further month later. 52 At the end of October there was a bank overdraft of Rs. 50,000. You are required to: a) Prepare i) ii) b) a forecasted financial statement for the three months to January 19X6 showing the contribution and net profit; a cash budget for each of the months of November , December and January; Budgeting and Reporting Advise whether the higher income from the increased capacity will clear the overdraft by 31st January, 19X3; Note: Ignore the effects of taxation and inflation in the calculations. 2. The ABC company is preparing budgets for the first quarter of I 9X4. The company has a single product, the details of which are as follows Rs Budgeted variable costs per unit Materials Labour (4 hours at Rs. 6) Production overhead Selling price 12 24 8 90 Administration overhead is Rs. 23,000 per month and the fixed production overhead is Rs. 15,000 per month, including Rs. 3,500 depreciation. The factory has a normal capacity of 1,500 units per month. Finished goods stocks are valued at full actual production cost and the budgeted opening stock at 1 January 19X1 is 1,200 units valued at Rs. 66,500. It is company policy to keep finished stocks at a constant ratio to the budgeted unit sales of the following month. Extra production over 1,500 units per month can be achieved by working overtime which means paying labour double time for the overtime. Expected sales December 19X3 January 19X4 February 19X4 March 19X4 April 19X4 May 19X4 Units 1,300 1,000 1,400 1,600. 1,800 .1,550 Materials are paid for in the month following delivery and enough stock is kept to cover the next month's budgeted production. Sales are on credit with 30% of debts collected in the month of sale and 67% in the following month, the balance being bad debts. All other costs are paid for in the month they are incurred and no capital expenditure is expected. You are required: a) b) c) to prepare a single budgeted profit and loss account for the quarter (January, February, March); to prepare cash budgets for each month of the quarter; to reconcile the net cash movement for the quarter to the budgeted profit. 53 Management Control: Process 3. ST Ltd. makes a product in three different flavours which require similar materials, labour and production facilities. The company's trading results for the year ending 31st December, 19X I are expected to be as shown below: Pineapple Rs. Strawberry Rs. 40.000 1,29,000 64.500 64,500 2.58.000 1,72,000 Peppermint Rs. Total Rs. Sales Direct materials Direct wages Variable overhead Total variable cost Contribution Fixed overhead Fixed overhead Profit 5.36,000 1,34,000 1,07,200 1,07;200 3,48,400 1,87,600 2,160.000 12 26.000 1,04,000 84,000 84.00() 2.72,000 (12.000) 3,67,000 2,55,700 2,55,700 8,78,400 3,47,600 2,17,600 I,30,000 The peppermint flavour product has been causing management some concern and because it is not possible to raise the selling price, it has decided, reluctantly, to cease production of this flavour. However, the production of the pineapple and strawberry flavours, for which there are willing buyers, is to be increased. Management is unwilling to make anyone redundant and has decided to transfer 60% of the labour which was used on peppermint flavour to the production of pineapple the remainder being transferred to strawberry. This change is proposed to he effective from 1st January, 19X2. Other relevant information for 19X2 is as follows: a) The total direct labour cost in 19X2 is expected to be the same as that of 19X 1. (As part of the no redundancies' policy of management, the trade unions have agreed not to press for pay increases). The unit variable cost structure and selling prices of pineapple and strawberry are to be the same in 19X2 as in 19X1. Fixed overhead will increase by 13,800. b) c) You are required to : a) b) c) Prepare a budgeted statement for 19X2 in a similar format to that shown above. Comment on the statement you have prepared for (a) above. Advise management whether a greater profit would be possible if the 60% of labour from the peppermint line were transferred to the strawberry line and40% of labour to pineapple (Note: there is no need to calculate the profit figure but your reason(s) for your conclusion). 4. Bright Future Ltd. has the following Divisions: Marketing, Manufacturing, Materials Management, Despatch and Warehousing, Research and Engineering, Finance and Secretarial, Personnel and General Administration. All the seven Divisional Heads after many meetings amongst themselves and due deliberation submit through the Managing director, for the consideration of the Board of Directors, the Budget for the year 19X2, indicating therein a pre-tax profit for the year of Rs. 22.5 millions. 54 The Directors are not satisfied with the figure of profit shown in the Budget. They feel that the profit can be improved upon by at least 25% and ask the Divisional. Heads to have another look at the budget as the budget for 19X2 has been prepared simply on the 19X1 basis. Meanwhile the Finance Manager finds that the profit figure shown in the budget has not taken into account the carry over effects of certain actions taken in 19X1: − The effect of Salaries and Wages increase in total would be Rs. 0.5 million, comprising Rs. 20,000 in each of the Marketing, Materials Management and Finance and Secretarial Divisions, Rs. 0.4 million in Manufacturing Division, Rs. 30,000 in Research and Engineering and Rs. 10,000 in Personnel Division. Machine tools reconditioning programme undertaken already would increase the profit by Rs. 0.4 million. Sale price increase effected would add Rs. 0.3 million to profit. Net impact of other actions would result in a saving of Rs. 0.45 million. Actions taken in manufacturing, Engineering, Personnel and General Administration contributed to cost saving of Rs. 0.47 million, Rs. 20,000 and Rs. 0.2 million respectively, while correspondingly cost increases resulted in Marketing, Materials Management, Despatch and Warehousing to an extent of Rs. 30,000, Rs. 0.2 million and Rs. 20,000 respectively. Budgeting and Reporting − − − Scanning the indications of environmental changes in 19X2, the Marketing Manager envisages a market demand which would increase the sales by Rs. 3.3 million, out of which, a third would be clean profit. On the other hand, Materials Manager envisages an inevitable rise in material cost of Rs. 0.8 million. Even when these are incorporated, as the profit comes no where near the target set by the Board, the Managing Director in concurrence with the Divisional Heads draws out a Management Plan of Action to improve the profit. − − − An increase in Sale Price will result in a profit of Rs. 0.7 million. A deeper market penetration to bring in an additional sale of Rs. 9 million with a clean profit of one third. Reduction in material usage would save Rs. 0.5 million. Improvement in manpower utilisation would bring in a saving of Rs; 0.55 million. Expenditure towards additional Sales Promotion would be Rs. 0.15 million and expenditure towards training in manufacturing division would be Rs. 0.2 million and in marketing Rs. 50,000. Other actions taken in the divisions would net a saving of Rs. 0.7 million Machinery to a tune of Rs. 3.5 million (cash outgo Rs. 2.5 million) would be installed and this will effect a saving of Rs. 0.7 million in manufacturing operations, Rs. 60,000 in Despatch and Warehousing and Rs. 20,000 in Engineering, while streamlining in Marketing, Finance and General Administration would increase the cost by Rs. 40,000, Rs. 20,000 and Rs. 20,000 respectively. − Keeping the pre-tax profit of Rs. 22.5 million given in the Budget in the base, you are required to prepare: a) A simple statement for the Directors detailing the improvement on profit, itemwise as aforesaid under the three heads - carry over effect of actions in 19X 1, Environmental changes in 19X2, and changes resulting from Management Action Plan. 55 Management Control: Process b) A profit impact Summary by Divisional Accountability, itemwise, under the three heads, to enable each Divisional head to know his contribution or otherwise, towards profit improvement, for which he is responsible. The Managing Director of your company has been given the following statement showing the results for a recent month: Month ending 31st October 19X5 Master Budget Units produced and sold Sales Direct Materials Direct wages Variable overheads Fixed overheads 10 000 Rs. 40,000 10,000 15,000 5,000 5.000 35,000 (5,000) Actual 9.000 Rs. 35,000 9,200 13,100 4,700 4900 31,900 3,100 Variance (1,000) Rs.(5,000) 800 1,900 300 100 3,100 (1,900) 5) Figures in parentheses indicate adverse variances. The standard costs' of the product are as follows: per, unit Direct material (1 kg at Re.1 per kg) Direct wages (1 hour at Re. 1.50) Variable overheads (1 hour at Re. 0.50) Rs. 1.00 Rs. 1.50 Rs.0.50 Actual results for the month showed that 9,800 kg. of material were used and 8,800 labour hours were recorded. (a) (b) (c) Prepare a flexible budget for the month and compare with the actual results. Calculate the variances which have arisen. Comment on the calculations you have made in (a) & (b). 8.10 FURTHER READINGS Brownwel I P. "Participation in Budgeting Process: When it works and when it doesn't Journal of Accounting Literature no. 1(1982), pp 124-53 Collins F., P Munter and D.W. Finn "The budgeting games people play ". The Accounting Review LXII no. 1 (January 1988) pp. 111-22 Penne Mark "Accounting Systems, Participation in Budgeting and Performance Evaluation. " The Accounting Review 65 no. 2 (April 1990) pp 303-14 56 Srinivasan Umapathy "How successful Firms Budget". Management Accounting, February 1987, pp 25-27 UNIT 9 PERFORMANCE MEASUREMENT Objectives The objectives of this unit are: • • • • to familiarise you with performance measurement principle; to make you aware of measurement metrics system; to familiarise you with key success factors; and to familiarise you with performance measurement process. Performance Measurement Structure 9.1 9.2 9.3 9.4 9.5 9.6 Introduction Paradigm about Measurement Framework for Performance Measurement System Type of Metrics Requirement for a Performance Measurement System Single vs. Multiple Performance Indicators 9.6.1 9.6.2 The G.E. Measurement Project Balance Score Card 9.7 9.8 9.9 9.10 Key Success Factors Summary Self Assessment Questions Further Readings 9.1 INTRODUCTION Leading-edge organization whether public or private use performance measurement to gain insight into, and make judgments about the effectiveness and efficiency of their programs, processes and people. The best in class organizations decide on what indicators will be used to measure the progress in meeting strategic goals and objectives, gather and analyse performance data and then use these data to drive improvement in the organization and successfully translate strategy into action. The concept of performance measurement took birth in the USA when Hoover Commission of 1949 proposed Performance Budgeting. Latter on President Johnson implemented a Program Planning Budgeting system and the Carter administration advocated a Zero Based Budgeting System. The concept of performance budgeting was recognized as a formal management process in the late 1960's when the Department of Defense (USA), as part of an effort to reduce time and cost overruns, issued a set of criteria defining standards for management control systems. These criteria define the capabilities that effective management control system must posses. The main focus of there criteria was performance management system that is capable of providing timely information for management decisions. Even today several US legislations require that government agencies specifically measure their program's performance in meeting these commitments. 57 Management Control Process Kennerly and Neely (2000) state that a performance measurement system has three constituent parts. • • • • Individual measures that quantify the efficiency and effectiveness of actions. A set of measures that combine to assess the performance of an organization as a whole. A supporting infrastructure that enables data to be acquired, collated, sorted, analysed, interpreted and disseminated. Performance measurement is a, tool to help managers control the results of their organizations. 9.2 PARADIGM ABOUT MEASUREMENT Measurement is bone of contention in many companies. These disputes are often caused by difference in paradigms. Traditional paradigms about measurement could be serious roadblocks to effective performance measurement and improvement (Sink and Tuffle, 1989), Some of the traditional paradigms about measurement are listed below: • • • • • Measurement is threatening Precision is essential to useful measurement Single indicator focus Subjective measures are sloppy Standards acts as ceilling on performance 9.3 FRAMEWORK FOR PERFORMANCE MEASUREMENT SYSTEM Purpose of measurement: Performance measurement is a value adding process which has a direct impact on the competitiveness and improvement, but at the same time cost/ benefit has to be evaluated when developing a metrics to measure performance. A clear, unambiguous and well defined purpose make it easier to : Choose the right metrics: Metrics are the methods to quantify the measured information. A clear purpose helps to choose the right kind of metrics. Prioritize Indicators: Measurements are expensive and time consuming, a clear purpose helps to prioritize the indicators to identify the most important ones. Choose appropriate measurement methods Achieve understanding and acceptance: A clear purpose adds to the process of understanding and acceptance, lack of which makes the measurement system prone to manipulations. Other important purpose of performance measurement are : a) b) c) d) e) f) Decision support Monitor effect of strategic plan Performance evaluation Diagnosis Manage a continuous improvement process Motivation 58 g) h) Comparison Record development Performance Measurement 9.4 TYPE OF METRICS Metrics are the building blocks in a measurement system. A metrics is the specific method to quantity the information regarding the variable which is intended to be measured. a) Hard versus soft metrics: Hard metrics are pure facts that are possible to measure directly eg. Input, production, net profit etc. where as soft metrics are used to measure the intangible eg. Customer satisfaction, brand loyalty, employees satisfaction etc. Both hard and soft metrics have their strength and weakness - and should be used according to the purpose of measurement, important thing being that whether the use of a particular metric has been able to provide an understanding or insight about the process and results. The differences between hard and soft metrics are summarized in Table 9.1 Table 9.1: Differences between hard and soft metrics Hard Metrics Objective references Accurately known Hierarchical Soft Metrics Observer bias Surrogate indicator Multi Variable Situation Source: Herald Bredrup "Performance Management" Performance Management: A business process benchmarking approach ed. Asbjorn Rolbtadas, Chapman & Hall (1995) P. 177 b) Financial versus Non Financial Metrics : Financial and non financial metrics are a subset of hard metrics. Traditionally the indicators of performance are translated into financial terms and for those indicators which can't be translated into financial terms they were all together omitted from framework of performance management. Integration of financial and non financial metrics is essential for executing meaningful performance measurement. Tables 9.2 provide examples of traditional financial and non financial metrics. Table 9.2: Examples of traditional financial and non financial performance metrics Financial Performance Metrics Budget Vs. Actual Variance Product/product group Profitability Cash flow Return on total capital Overhead absorption Customer profitability Bad debts EBIT Non financial Performance metrics Inventory turnover Labour efficiency Capacity utilization Defect ratio Lead time Delivery precision Market share Market penetration New product sales Source: Herald Bredrup "Performance Management" Performance Management: A business process benchmarking approach ed. Asbjorn Rolbtadas, Chapman & Hall (1995) P. 178 Financial performance targets which are set as a part of organization planning and 59 Management Control Process budgeting process are an important part of financial result control system. They form a basis for performance evaluation and are critical for motivation. Three basic types of Financial performance targets are: 1) 2) 3) 1) Model based versus Historical versus Negotiated targets. Internal versus externally derived targets Fixed versus flexible targets Model Based versus Historical versus Negotiated Targets Model based targets are used in the situation where there exists a stable deterministic casual relationship between outputs and inputs. These type of targets are also known as engineered targets. There are other model based targets but they are not engineered clue to the fact that one or more variables impacting -the performance are not known and are required to be forecasted. Historical targets are derived from the previous year performance and the management's view of the future market conditions. Negotiated targets are those targets which are set after the mutual agreement between superiors and subordinates. These type of targets are common in situations, where there exists a significant amount of an information asymmetry between superiors and subordinates. This information asymmetry arises due to the fact that the superiors, are more knowledgeable about organization's preferences and resource constraints, where as the subordinates have a fair deal of idea about the links between output and input, opportunities and constraints at the operational level. 2) Internally versus externally derived targets Internally derived performance targets are totally internally focused on what is possible within the organization. In recent years two type of externally focused target setting have become common, they are i) ii) Target costing Benchmarking .In target costing cost targets are price driven e.g. Tata Motors is planning to introduce a family car costing less than Rs. one Lakh. The price and the cost are set in such a fashion that on selling of product or service the company will earn a pre set profit margin. "Companies use target costing to motivate employees to act in a way that will make the companies profitable in the competitive global markets." "Benchmarking is a process in which an organization studies other organization best practices and implement process and systems to enhance it's own performance." Benchmarking can be of two forms: i) ii) 3) Unilateral Co-operative. Fixed versus flexible targets 60 Fixed targets do not vary over a given period of time while flexible targets are changed according to the business conditions prevailing. c) Achievement versus process metrics: Achievement metrics lays emphasis on achievement where as in the process metrics emphasis is on the important characteristics of the process that has an impact on the output. An example could be the functioning of the cross functional teams, if achievement metrics is used to evaluate the performance of cross functional teams the focus would be on the number of changes implemented by the team whereas if process metrics is being used the emphasis would be on the process underlying the change in the existing methods. Business Performance model based on three performance dimensions: Harald Bredrup (1995) has developed a model based on three dimension of performance; efficiency, effectiveness and adaptability. This particular model covers all dimensions of business achievement. Achievement metrics - direct metrics for business achievement Diagnostic metrics - indirect metrics for business achievement Competence metrics -capability of future business achievement Performance Measurement Achievement metrics :These are hard facts and can be measured directly and require little or no interpretation, e.g. net profit, return of investment (ROI) market share, export share etc. One school of thought argues that these metric should be used predominantly to measure performance since the net profit is to be the concern of every company, but facts which are often overlooked while advancing these arguments are: 1) 2) 3) These are lagging metrics (indicator). These metric are heavily influenced by the external factors. These metrics fail to given direction for future action. These metrics represents only a part of the measurement system. Diagnostic metrics: Diagnostic metrics are, indirect metrics for business achievement.. They are critical success factors for competitiveness without a direct bearing on traditional financial achievements. A diagnostic measure has two fold function. 1) 2) Explain the trends in achievement. Based on trends provide an early warning based on which remedial action can be designed. Examples of diagnostic metrics are delivery precision, delivery flexibility product quality, product reliability, lead time, customer satisfaction, outstanding claims etc. Most diagnostic metrics are non financial but at the same time they have potential impact on financial achievements. Diagnostic metric has an impact on marketing too, in the sense that the lacunas identified are corrected and the improved performance communicated to the market will result in increased sales. Competence metrics: These metrics described how well the company is prepared for the future. Examples of these type of metrics are: Investment level in product and service development (e.g. investment by telecom companies in Broad band services) Time to market new product (e.g. advance mobile phones with internet, email and camera features 61 Management Control Process - Stage in the life cycle of the product portfolio Investment in manufacturing technology development (e.g. computer processors, high capacity supersonic aircrafts). Attitude towards change (adoption of computers in banking industry, computer aided manufacturing. Flexibility to manufacture completely new products (Tata motors manufacturing passenger cars, Reliance industries moving from textiles to petrochemicals to refining to oil and gas exploration. Level of training of workforce. - Competence metrics basically measures the preparedness of the organization towards facing future threats and opportunities. These metrics also measures the probability of survival of organization in the future. Relationship between achievement, diagnostic and competence metrics: A good measurement system should contain a balance mix of the above three metrics. The weightage of each metrics would depend upon the fact that for what purpose the measurement is being done. If the purpose of the performance management is to gauge the short term performance achievement metric would have a higher weightage where as if the purpose of performance measurement is to gauge the potential for growth in the medium term than along with the achievement metrics the diagnostic metrics have to be used. A diagnostic metrics along with the achievement metrics helps to understand the underlying current of the trend. While measuring performance at the macro level and time span extending towards several accounting periods the competence metrics along with the above two mentioned metrics has to be used. Achievement metrics have limited predictive validity for future performance, whereas the diagnostics metrics are most valid at the time of measurement due to the fact that the underlying variables are prone to change with passage of time and change in the business environment. Competence metrics are strategic in nature. Efforts to improve competence metrics have a negative impact on achievements in the short run due to diversion 'of resources and efforts. Activity I Specify the conditions under which achievement metrics and diagnostic metric can be used. ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… 62 9.5 REQUIREMENT FOR A PERFORMANCE MEASUREMENT SYSTEM Establishing and updating performance measures Establishing accountability for performance Gathering and analyzing performance data Reporting and using performance information Performance Measurement A typical performance measurement system consist of the following four steps. 1) 2) 3) 4) Each of the above stated step consists of various sub steps which we are going to discuss briefly 1) Establishing and updating performance measures a) Ensure a narrow strategic focus: Out of the various variables impacting an organizations strategic and operational planning; only few have the intensity to alter the course already chartered. A performance measurement system should focus to these few critical variables b) Measure the right thing: An organization should identify and thoroughly understand the process to be measured and a measure critical to the success of the process has to be measured. c) Be a means not an end: Focus on goal achievement not on performance measure. d) What to measure: There are some universal aspects of performance such as Financial measures, customer satisfaction, internal business operations, employee satisfaction, community and stake holders satisfaction etc. Attention to and establishment of measures in these areas are a significant part of successful performance management systems e) Determining a base line and goals : Once the performance measures have been decided the next step is to determine a base line for each of the measures selected. When the data about the performance measure variable is collected for the first time it becomes the base line data. Based on the baseline data the goals are set. In this regard it is important to note that goals should not be unrealistic as the same has potential to demotivate the employees resulting into lower organizational morale. It is also important that proper information about goals and results is communicated to the employees. f) Reviewing measures: In dynamic business environment the traditional performance measures may become redundant, therefore there is a constant need to review measure and weed out the obsolete ones 2) Establishing Accountability for Performance Once the performance measurement are established and performance measurement system is created the next step is to implement it within the organization, this imply that each of the employee identify himself with a part of the process and takes responsibility for that part of the process. Generally upper management act as enablers, senior managers are responsible for developing strategic plans and resource allocation and middle and junior level executives for maintaining and coordinating the performance management system. Some of the techniques used for establishing accountability for performance are: 63 Management Control Process a) Empowerment b) Owner identification c) Reward and incentives d) Open culture and communication e) Institutionalize problem solving approaches 3) Gathering and analyzing performance data In order to ascertain the level of achievement with reference to the goals data has to be collected and analyzed to find the answer. Most of the organizations collect data from number of sources at regular intervals and in an ongoing process, the main focus is on, to zero on the data which measures the strategic alignment of the organization. In order to gather data which throws light on the strategic objectives of the organization the following principles of data gathering should be followed: a) Keep it focused b) Keep it flexible c) Keep it meaningful d) Keep it consistent Data Gathering Responsibilities Line supervisors and employees: They are responsible for data generation related to daily operations and customer services. The operational performance data generated is accessible to anyone in the company and to the company's business partners. Business unit managers: Business unit managers generate data regarding customer interface. Since business unit managers are regularly interacting with the field staff, they are also in a position to gather external data regarding the market condition, market share of competitors etc. Another data set for which the business unit managers are responsible is the program cost. These data set is concerned with the program expense and revenues. The business unit managers are the first line reporting authority due to which they also measure the organization health in terms of employees morale, safety, motivation etc: Executive management: At this level the managers are interested. in aggregate data. They are interested to know that whether the organization is meeting the strategic plan or not. Transforming data into information Data analysis in performance measurement is the process of converting raw data into performance information and knowledge. 4) Reporting and using performance information Organizations do not measure things just for the sake of measurement rather they report, evaluate and use performance information as integral part of their performance measurement systems to a) b) Inform various levels of management about performance information Determine if corrective actions are required 64 c) Determine whether changes are necessary in the performance measurement system for the measure themselves or to the organizations goals. High performance organizations use performance information as empirical information about operations of their organization and their customers or stakeholders requirement and preferences. Performance information is reported, evaluated and used for continuous improvement of overall management and strategic planning process in the following manner. a) Report information : Performance information should be disseminated quickly to the organization's decision makers b) Determines whether corrective actions or changes are required in the performance measurement system, the measures themselves or the organization goals Apart from the above stated micro level applications the performance information should be used for managing the following: • • • • • • • • Feed it into resource allocation decision Use it in employee/Management evaluation Use it to determine gaps between goal and reality Use it to drive reengineering Use it in benchmarking Use it to improve organization process Use it to adjust goals Use it to improve measures Performance Measurement 9.6 SINGLE VS MULTIPLE PERFORMANCE INDICATORS For any good measurement system it is necessary to identify the variables that influence success at any level of organisation so that one can predict and monitor these critical factors. The question which arises is how to identify these variables, the answer is fairly complex. Before answering this question, let us have a look at another aspect of performance measurement which is whether single performance indicators or multiple performance indicators should be used for performance evaluation. One school of thought argues that depending upon the purpose of performance measurement; a single indicator should be used for evaluation, e.g. sales, return on capital or net profit. The main drawbacks of this argument are: i) ii) iii) iv) Single indicators are good measure of macro situation but fail to assess other micro situation. The underlying processes are ignored Single performances indicators fails to link with strategic plans. Single performance indicators are able to measure only one aspect of business performance. Now let us answer the question which we had raised in the beginning how to identify the performance indicator variables. The variables which we want to measure and monitor are those that are related to the goals and objective of the firm and are also 65 Management Control Process Linked to the strategic objectives of the firm. They must be identified at each level and for each responsibility centre of the organisation. Now here lies the catch 22 situation. The decision which one has to take is about inclusion and exclusion of variables from the measurement framework. The common mistake which managers do is to include the variables which are highly visible (stressed upon) and exclude those variables which are not visible but nevertheless important in meeting organization’s strategic goals Managers in general tend to include those variables which are measurable and exclude those variables which are difficult to measure, An example of this type of measurement is where firms lay a lot of emphasis on short run profitability which leads manager to cut on expenses related to market development, research and development, maintenance, employee training and development. In the short run this will result in higher profitability but in the long run it will result in non fulfillment of strategic objectives. This leads us to use number of precautions with regard to the measurement used in any responsibility centre. Firstly the measured variable should be in alignment of the strategy used in pursuit of goals and objectives. Secondly only those variables which are crucial should be measured and measured they should be even if they are qualitative. Qualitative measurements may have quantitative surrogates and even if they do not have the manager should form an opinion about these variables. Any key success factor should not be omitted from the control system just because they are not amenable to measurement. Lastly the measurement system should be designed in a way that measurement taken in the short term relates both to short term goals and long term strategic objectives. In order to understand the measurement process let us have a look at the detailed procedure used by General Electric Company which is a; comprehensive measure of key success factors at the departmental level. 9.6.1 The GE. Measurement Project General Electric sub divided the measurement project into three projects: 1) Those designed to measure overall performance of the department as an economic entity 2) Those designed to measure performance of the functional organizations such as engineering, finance, marketing, production, human resource etc. 3) Those designed to measure the performance of the management of the department. The core principles on which the measurement project was based were 1) Measures were designed to provide factual knowledge to support judgement in performance appraisal of departments. 2) Measures were designed in a way to provide information regarding both short run objectives and long term goals. 3) A minimum number of measures were to be used at each level of the organization. In order to select key success factors the following test was used: "Will continued failure in this area prevent the attainment of management's responsibility for advancing General Electric as a leader in a strong, competitive economy, even though results in all other key result areas are good?" This G.E. Measurement model uses the concept of goal criterion for the determination of key success factors. The long term endless goal of the company was stated to be leader in the market it served. 66 As a result of this analysis G.E. developed the following key success factors for each of its departments: 1. 2. 3. 4. 5. 6. 7. 8. Short term profitability Market share Productivity Product leadership Personnel development Employee attitude Public responsibility Balance between short range objectives and long range goals. Performance Measurement These key success factors of the department level form the basis for the development of key success factors at the functional and management levels. Now let us discuss the methods G.E. used to operationalize each of the measures. Short Term Profitability: G.E. considered many measures for short term profitability which included return on investment (ROI), profit as percentage of sales and many other measures but ultimately G.E. adopted the concept of residual in come as a indicator of short term profitability. The residual income is simply net income as computed from departmental income statement minus a capital charge. Capital charge is the opportunity cost associated with the capital that corporation has invested in the assets of the department, thus the profitability of each department is based upon full cost of doing business. Market Share: This measure is concerned with measuring the degree to which G.E. is attaining its leadership goal in various markets. The first step in computing market share is to define the market which involves deciding about the nature and scope of the market to be served and a view about customer's need. Based on this the market share index is then computed as the ratio of departmental sales to total sales in the market served by the product. Productivity: Productivity is a key measure of the relative competitiveness of the department Trends in productivity indicates the-effectiveness of process in utilizing labour and capital resources. Productivity referred to as total factor productivity index is computed as follows: Value added Departmental Productivity = Labour inputs + Capital inputs Where value added is the difference between departmental sales and input cost of material and services. Labour input is the sum of all wages and salary paid by the department and capital inputs are equal to depreciation expense as computed from departmental income statement. Product Leadership: This indicator measures to the extent the products of a given department where originated by G.E.: This measure also include the effort and, enterprise of the department in Origination of the research and development activities which led to development of the product. This indicator also consider the comparative analysis of G.E.'s product with. That of the competitors. This measure also includes a product review done by internal experts, from marketing engineering and production. This measure is an indicator of long run goal of G E, which is product leadership. 67 Management Control Process Personnel Development: This measure is concerned with the effictiveness of the personnel development program in the department. The process for measuring this index is as follows. First of all an assessment of demand for human resources by type and then forecasting the supply of talent by type. An assessment of the contribution of .the employee development programme to promotions is done to assess the effectiveness of the training programmes. Personnel development measures are few of the most important tools of control and indicator of the future development of the organisation. Employee Attitudes: Lewis (1955) defines employee attitudes as the disposition of the employees to discharge their duties voluntarily to the full extent of their ability and in the best interest of the business." In G.E. employees attitude is measured by traditional indicator such as turnover, absenteeism, tardiness and punctuality etc. Occasional surveys are also undertaken to gauge the attitude of employees toward their work and the company. This measure attempts to assess the extent to which the needs of employees that can be met on the job are being met. Public Responsibility: G.E. aims to be a good corporate citizen and towards this end it is quite sensitive to the well being of all stakeholders which include employees, vendors, local community and local business community. In order to measure the degree of public responsibility, fulfilled by G.E. it uses various indicators such as; for employees these indicators are stability of employment and standard of living. For vendor's the relative attractiveness of doing business with G.E., for local community it assess the impact in terms of economic, social and environmental factors. Balance between long range and short range objectives: The measures outlined above are combination of short term objective of profit and growth and long term goals of business leadership. Each of these factors should be given adequate weightage. 9.6.2 Balance Score Card The traditional performance reporting system focuses entirely on cost control. In today's worldwide, competitive environment companies are competing in terms of product quality, delivery, reliability, after sales service and customer satisfaction. None of these variables is directly measured by the traditional reporting system. Consider a situation where a purchasing department regularly achieved the budget for all expense items. The responsibility performance reporting system therefore suggests that the department was well managed. However, the department provides a poor service to the production departments. Traditional Accounting system report only on details regarding the costs incurred by a department. They do not give information to quality of service it provides. The traditional reporting system therefore needs to be broadened to incorporate non-financial measures besides costs and revenues. These non-financial measure focus on such factors as quality, reliability, flexibility, modernity etc. Since traditional performance measurement, focuses on past accounting data, which is obsolete for planning purposes, therefore what is needed is to provide the information age enterprises with efficient planning tools. Further it is often not clear to managers how the non-financial measure on which their performance is evaluated can contribute to the whole picture of achieving success in financial terms. The need to link financial and non-financial measures of performance and to identify key performance measures provided the impetus for Kaplan & Norton (1992) to devise Balanced Score Card. Meaning of Balanced Score Card : Balanced Score Card is a set of financial and non-financial measure relating to a company's critical success factors. It is approach, which provides information to management to assist in strategic policy formulation and achievement. It emphasizes the need to provide the user with a set of information, which addresses all relevant areas of performance in an objective and unbiased manner. As a management tool it helps companies to assess overall performance, improve operational processes and enable management to develop better plans for improvements. It offers managers a balanced view of their organization upon which they can further add-on. 68 Objectives of Balanced Score Card: The main objectives of Balanced Score Card is to provide a comprehensive framework for translating a firm's strategic objectives into a coherent set of performance measures. Kaplan and Norton recommended that organization should articulate the major goals for each of the four perspectives and then translate these goals into specific performance measures. Generally three to five performance measures are set for each goals. Advantages of Balance Score Card 1) 2) It brings strategy and vision as the center of management focus. It brings together in a single management report, many of the seemingly desperate elements like customer oriented, shortening response time, improving quality etc. on a competitive agenda. Balanced Score Card provides management with a comprehensive picture of business operations The methodology of balanced score card facilitates communication and understanding of business goals and strategies at all levels of an organization The Balanced Score Card provides strategic feedback and learning. The Balanced Score card guards against subordination. It emphasis an integrated combination of traditional and non-traditional performance measures. It helps senior managers to consider all-important performance measures together and let them to see whether an improvement in one area may have been achieved at the expense of another. Performance Measurement 3) 4) 5) Major components of a balanced score card The components of Balanced score card vary from business to business. A well designed balanced score card combines financial measures of past performance with measures of firm's drivers of future performance. The specific objectives and measures of an organization-balanced score card are derived from the firm's vision and strategy. Generally, balanced score card has following four perspectives from which a company's activity can be evaluated.. These are: 1) 2) 3) 4) Customer perspective i.e. how do customers see us. Internal perspective i.e. what must we excel at. Innovation and learning perspective i.e. can we continue to improve and create value. Financial perspective i.e. how do we look to our shareholders. Thus, the scorecard provides a view of an organization's overall performance by integrating financial measures with other key performance indicators. The Learning & Growth perspective is a measure of potential future performance-it directs attention to the basics of all future success-the organization's people and infrastructure. Adequate investment is these areas is critical for long term success. The internal perspective focuses attention on the performance of the key internal processes which drive the business. Obviously, the nature of the processes are dependent on the nature of the organization-the score card is not a `full-cooked' solution, it must be tempered and tailored to meet the specific circumstances of each organization. In order to translate effective internal processes into organizational success, customers' clients must be happy with the service they receive. The Customer perspective 69 Management Control Process considers the business through the eyes of the customers, measuring and reflecting upon customer satisfaction. Finally, the Financial perspective measures the results that the organization delivers to its stakeholders. All these four perspectives provide a balanced view of the present and future performance of the business. Process of creating a Balanced Score Card The diagram given below shows a process to create a balanced scorecard. This diagram also depicts various steps involved to create a balanced score card : 1) 2) 3) 4) 5) 6) To identify a vision i.e. where an organization is going. To identify organization's strategies i.e. how an organization is planning to go there. Define critical success factors and perspectives i.e. what we have to do well in each perspective. Identify measures which will ensure that everything is going in the expected way. Evaluation of Balanced Score Card i.e. ensuring what we are measuring is right. Create action plans and plan reporting of the Balanced Score Card. 9.7 KEY SUCCESS FACTORS 70 The hierarchical structure of an organisation is a response to the limited information processing ability of the decision makers. The firm uses responsibility centre in an attempt to coordinate and control each subunit in pursuance of overall goals. Responsibility centres are designed upon key success factors of a business. Each responsibility centre derives it's goals from overall organisation's goals and the degree of goal congruence will depend upon the control structure and the efficiency of responsibility centres manager. Individuals (managers) are cognitively limited which limits the data processing ability; This limitation gives rise to the process of selective perception of data; which implies that manager focuses upon those data that seems to be important to meet the objectives. The measures so selected becomes the basis for reports (sensors), which are in turn the basis upon which the manager interprets the environment facing the responsibility centre. These identified variables then become the basis for decision making and are referred to as key variables or key success factors. It is necessary to establish key variables for responsibility centre because they in turn become the basis for the establishment of performance measures, responsibility centre designation, reward structures and resource allocation procedures. Identification of key variables : The key variables of the business are those variables in external and internal environment to which the goals and objectives of the firm are most sensitive. Nature of key variables: Some of the key variables are completely outside a firm's control e.g, macroeconomic variables, behaviour of competitors (price, product, quality), inbound logistics, government policies and regulations. Some of the key variables are partially under the firms control e.g. product quality, cost and demand variables. For the key variables which are completely outside the firms control the task of the manager is to monitor and predict the future values of these variables and adapt to the predicted future value of these variables. Key Variables has the following characteristics: it is important in explaining the success or failure of business units operation it is volatile and unpredictable. It can change quickly often for reasons not controlled by managers any change in these variables require prompt action these variables can be measured either directly or via a surrogate indicator. Performance Measurement Examples of key variables are sales, sales return, bookings, back orders, market share, capacity utilization etc. Exception Variables: Key variables are needed to be reported on ;a regular basis, but there are certain other variables which needs to be reported only when their value is outside acceptable or planned limits, e.g. are cost elements such as direct material and labour. Activity 2 Try to find out key performance variables from seven different industries. ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ........................................................................................................................................ 9.8 SUMMARY Business process and operations are dynamic in nature where underlying variables are prone to change with macro economic factors. This gives rise to the problem of control over operations. One of the principle components of control system is performance management. There are number of parameters on which performance can be measured and when these parameters are collected under a single head they are known as metrics. A good performance measurement system should aim at establishing and updating . 71 71 Management Control Process Performance indicators as well as establishing accountability for performance. It should be dynamic in nature. In Performance measurement single or multiple indicators of performance could be used. There are certain key performance indicators which gives a macro picture of the performance of the company. SELF ASSESSMENT QUESTIONS 1) 2) 3) 4) 5) Elaborate on the three constituent parts of performance measurement system. Explain the necessity to have a clear, unambuguous and well defined purpose for performance measurement. List and explain the various purpose of performance management. List the various type of metrics used for performance measurement and identify the purpose for which they are being used. Explain in detail; for what purpose and under which conditions the following metrics can be used. a) b) c) 6) 7) 8) 9) 10) 11) Achievement Metrics Diagnostic Metrics Competency Metrics Construct a roadmap for designing a performance measurement system. List and elaborate the purposes for which performance information is used. What are the main drawbacks of using single performance indicators for performance management? Explain in detail the G.E. performance measurment framework. What are the main features of Balance Score Card which distinguises it from traditional performance measurement system? List and elaborate the key success factors for the companies operating in the following industries. a) b) c) d) e) Textile Automobiles (Two wheelers and Four wheelers) Publication Software Entertainment 9.10 FURTHER READINGS Greenwood Ronald G. Managerial Decentralization, A study of General Electric Philosophy. Lexington, Mass: D.C. heath 1974. Kennerley, M., Neely, A.D. (2000) Performance Measurement Framework -A review. In: Performance Measurement- Past, Present, Future, Conference Proceedings, edited by A.D. Neely, July 2000, Cambridge. Lewis, Robert W. "Measuring Reporting, and Appraising Results of Operations with Reference to Goals, Plkans and Budget." In planning, Managing and Measuring: A Case Study of Management Planning and Control at General Electric Company. New Yori: The Controllership Foundation 1955. Sink, D.S. and Tuttle, T.C. (196' 9) "Planning and Measurement in Your Organisation of The Future" Industrial Engineering and Management Press, Norcross. 72 UNIT 10 Objectives REWARD AND COMPENSATION Reward and Compensation The objectives of this unit are: • • • • to familiarise you with general nature of compensation plan; to familiarise you with long term and short term compensation plan; to explain the process of compensation setting first at corporate level and then at business unit level; and to familiarise you with research findings on organizational incentives. Structure 10.1 10.2 10.3 Introduction Overriding Objectives Characteristics of Incentive Compensation Plans 10.3.1 Short Term Incentive Plans 10.3.2 Long Term Incentive Plans 10.3.3 Organisational Incentives 10.4 10.5 Incentives for Corporate Officers and CEO's Incentive for Business Unit Managers 10.5.1 Type of Incentives 10.5.2 Size of Bonus Relative to Salary 10.5.3 Bonus Basis 10.5.4 Performance Criteria 10.5.5 Bonus Determination Approach 10.6 10.7 10.8 10.9 The Benefits of Performance Dependent Reward Research Finding on Organisation Incentives Summary Self f Assessment Questions 10.10 Further Readings 10.1 INTRODUCTION An `Incentive' or `reward' can be anything that attracts a employee's attention and stimulates him to work. In the words of Burack and Smith, An incentive scheme is a plan or program to motivate individual or group performance. Incentive program is most frequently built on monetary rewards (incentive pay or monetary bonus), but may also include a variety of non-monetary rewards or prizes." On the other hand, French says, the term "incentive system has a limited meaning that excludes many kinds of inducements offered to people to perform work, or to work up to or beyond acceptable standards. It does not include: (i) wage and salary payments and merit pay (ii) over-time payments, pay for holiday work or differential according to shifts, i.e. all payments which could be considered incentives to perform work at undesirable times (iii) premium pay for performing dangerous tasks. It is related with wage payment plans that tie wages directly or indirectly to standards or productivity or to the profitability of the organization or to both criteria. 73 Management Control Process The use of incentives assumes that people's actions are related to their skills and ability to achieve important longer-run goals. Even though many organizations, by choice, or tradition or contract, allocate rewards on non-performance criteria rewards should be regarded as a "pay off" for performance. An incentive plan has the following important features: 1) An incentive plan may consist of both `monetary' and 'non-monetary' elements. Mixed elements can provide the diversity needed to match the needs of individual' employees. The timing, accuracy and frequency of incentives are the very basis of a successful incentive plans. The plan required that it should be properly communicated to the employees to encourage individual performance, provide feedback and encourage redirection. 2) 3) Compensation Enterprise employees are happier with good compensation plans, which are well administered. They will have a salutary effect on their entire work, co-operation and loyalty is higher, amount of output is up, and quality is better. In the absence of such plans compensation is determined subjectively on the basis of haphazard and arbitrary decisions. This creates several inequalities which are among the most dangerous sources of friction and low morale in an enterprise. Although there can be both monetary and non-monetary forms of compensation prevalent in an enterprise, yet it is the former which is most basic element by which individuals are attracted to an organization, persuaded to remain, and induced to engage in behaviour beneficial to the organisation. There are three requisites of a sound compensation structure: 1) 2) 3) It should be internally equitable, It should be externally competitive, and It should pay individuals on the basis of their performance. 10.2 OVERRIDING OBJECTIVES We visualize four objective of reward and compensation system including recruitment of people in the company, control of payroll costs, satisfaction of individuals and reduction of voluntary separations, grievance and conflicts regarding pay and motivation of human resources to higher productivity. First, compensation seeks to accomplish a labour market function of allocating human resources among different enterprises in terms of perceived attractiveness of wages and salary. It is an effective measures to attract human resources for recruitment purposes in a competitive labour market. Second, carefully designed compensation system facilitate control of wages and salaries and labour costs. Management may take care to control the distribution of rates within a predetermined rate range and exert control upon the frequency and volume of pay increments. Accordingly, each department may be allowed to pay only within a prescribed rate range embodied in a tightly controlled table of organization. Third, the financial compensation system seeks to maintain satisfaction of human resources reducing voluntary separations and complaints and grievances stemming from inadequate or inequitable wages, as perceived by the employees. An effective reward and compensation system is likely to give the feeling that the remuneration is fair and 74 that no favoritism has been practiced in its payment. Indeed, in situations where the remuneration is perceived as adequate and equitable, it is likely to check employee dissatisfaction. Fourth, the financial compensation system purports to induce and reward improved performance and forms an effective motivator. It is usually held that increase in pay should be determined on the basis of productivity and that those who produce more should be paid more. It has been observed that although the former three goals are accomplished markedly, the latter motivational goals are largely ignored in organizational settings. It would be a mistaken view to hold that money is not a motivator. Indeed, motivation stems from both financial and non-financial incentives, although one is dominating the other at times. Money in addition to satisfying material necessities of life has a symbolic value. It symbolizes security, prestige, recognition and forms a measure of success and achievement. Thus, it is an effective measure for the satisfaction of higher order needs. However, rigid design and operation of reward and compensation systems, although accomplish the control and equitable functions, discourages the motivational function of financial compensation. Frequently, the contributions of individuals cannot be determined in team activities or process-paced work and the performance appraisal is highly subjective. This further hampers the motivational impact of reward and compensation to accomplish higher productivity of human resources. Activity 1 List the main objectives of a reward and compensation plan. ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… Reward and Compensation 10.3 CHARACTERISTICS OF INCENTIVE COMPENSATION PLANS A manager's total compensation consists of three components (1) A predetermined fixed salary with regular increments over a period of time (2) benefits which include health cover for self and family, pension schemes and other perquisites of various types (3) incentive compensation. These three components are inter related but the third component is specifically related to management control system. In most countries corporate and securities law mandates that incentive compensation plans and revision of existing plans be approved by the shareholder whereas no such approval is required for salaries and perquisites. Before approval by the shareholder the plans have to be approved by the Board of Directors. The compensation committee of the board of directors is deeply involved in the formulation of these plans. The incentive compensation can be divided into (1) short term incentive plans, which are based on the performance of the current year (2) long term performance plans which relate compensation to long term results usually ranging from three to five years. Before discussing further about these plans let us have a look at various forms of rewards and punishments as practised by different companies. 75 Management Control Process Table 10.1: Examples of Positive and Negative Rewards Positive Rewards Autonomy power Member of decision Increments making teams Bonuses Bonuses Stock options Restricted stocks Public praise and recognition Promotion Titles Job assignments Office assignments Exclusive parking space Club membership Job security Company paid vacation trips Participation in conferences, seminars Executive development program etc Activity 2 Try to find out the various forms of rewards and punishments as practised in your organization. ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… …………………………………………………………………………………………. 10.3.1 Short Term Incentive Plans These systems may be broadly classified into three categories: a) b) c) Systems under which the rate of extra incentive is in proportion to the extra output; System under which the extra incentive is proportionately at a lower rate than the increase in output; and System under which the rate of incentive is proportionately higher than the rate of increase in output Negative Rewards Interference in job Loss of job Zero salary increase Assignment to unimportant tasks Chastisement No promotion Demotion Public humiliation Transfer 76 Every employer wants his workmen to do the maximum work they are capable of doing. On the other hand, there is a feeling among the workers that an increase in effort benefits only the employer even when they are employed on a piece-rate basis. The result is that they never produce to their full capacity, and, in most cases, put in the minimum necessary work. This feeling on the part of workers may be removed either through fear or through expectation of gain. It has been found that fear can never produce the desired effect; but a hope of earning a bonus does induce them to work harder and produce more. Incentive plans are, therefore, known as premium plans because they offer a premium for outstanding performance. All bonus of premium plans relate to two factors: one. they set a standard time for the completion of a definite output or piece of work for a fixed wage; two, the fixing of a rate of percentage by which bonus would be earned by a worker over and above his set wage, if the standard time is saved or the standard output is exceeded. Merits: The chief advantages of a short-term incentive plan are: l) When well-designed and properly applied, payment by results may generally be relied upon to yield increased output, lower the cost of production, and bring a higher income to the workers. A works study associated with payment by results is a direct stimulus to workers to improve the organization of work and to eliminate lost time and other waste. Labour and total costs per unit of output can be estimated more accurately in advance. Less direct supervision is needed to keep output up to a reasonable level. The conflicting interests of employers and employees are unified. increased efficiency and smooth working can therefore be promoted and sustained. Reward and Compensation 2) 3) 4) 5) Demerits: The plan suffers from the following defects: 1) 2) Quality tends to deteriorate unless there is a stricter system of checking and inspection; Payment by results may lead to opposition or restriction on output when new machines and methods are proposed or introduced. This is because of the fear that the job may be redesigned and earnings reduced. When paid by result, workers tend to regard their highest earnings as norms, and, therefore, press for a considerable higher minimum wage. The amount and cost of clerical work increases, if done manually. There is a danger of disregarding safety regulations and thereby increasing the rate of accidents. 3) 4) 5) Some Important Short-Term Incentive Plans 1) 2) 3) 4) 5) 6) Halsey Premium Plan. Halsey Weir Premium Plan. Rowan Premium Plan The 100 per cent Premium Plan The Bedeaux Point Plan Taylor's Differential Piece Rate Plan 77 77 Management Control Process 7) 8) 9) 10) 11) 12) Merric's Multiple Piece Rate Plan. Gnatt Task Plan. Emerson Efficiency Plan. Co-partnership System. Accelerating Premium Systems. Profit Sharing. Activity 3 List the merits and demerits of short term incentive plans. ........................................................................................................................................................................ ........................................................................................................................................................................ ........................................................................................................................................................................ ........................................................................................................................................................................ ........................................................................................................................................................................ ........................................................................................................................................................................ ........................................................................................................................................................................ ........................................................................................................................................................................ ........................................................................................................................................................................ ........................................................................................................................................................................ ........................................................................................................................................................................ After discussing the general characteristic and merits and demerits of short term incentive plan, now let us discuss some of the specific short term incentive plans. 1) The total bonus plan : Under this plan the shareholders vote on the formula to be used to calculate the total amount of bonus that can be paid to qualified group of workers in a given year which is called the bonus pool. There are several methods of calculating the bonus pool some of which are described below: a) Let the bonus pool be equivalent to a set percentage of profits. For example if profits of Rs. 20 crore represent an average profitable year and if bonus pool of Rs. I crore is required to make executive compensation competitive, the bonus formula could be set at 5% of the net income to pay bonuses. The main drawback of this method is that the bonuses will be payable even at lower levels of profitability and this method also fails to reflect additional investment due to which there may be increased profits, therefore, many companies use formulas that pay bonuses only after a specified return has been earned on capital. There are many ways to accomplish this. One method is to base the bonus on earning per share, the bonus to be calculated on the earning per share exceeding a predetermined level of earning per share. However, this method fails to take into account the reinvestment of retained' earnings which increases the investment base/capital of the company. This drawback can be overcome by increasing the minimum earning per share by a percentage of the annual increase in retained earnings. b) Another method of relating profits to the capital employed is to take into consideration share holders equity plus long terms liabilities. The bonus is equal to a percent of the profits before taxes and interest on long terms debt minus a capital charge on the total shareholder equity plus long term debt, the underlying reasoning being that managerial performance should be based on employing corporate's net asset profitably and since the capital structure is not determined by the operating managers this proportion should not influence the judgement about operating performance. A variant of the above method is to define the capital as equal to shareholder equity. 78 The main drawback of the above two methods is that a loss year erodes/ reduces shareholders equity resulting in increased bonus in profitable years. This drawback may induce managers to go for big losses in anticipation of increased bonus in the coming years. c) Another method to base bonuses is on the basis of increase in the profitability over the preceding year, the main drawback of this method; is that even a normal performance after a bad year would be rewarded and a good performance after a good year would be ignored. This drawback can be partially tackled with the use of the moving averages of the profits for a number of years. Reward and Compensation d) Another method to base bonus is on the basis of relative performance of the company with reference to industry or its nearest competitor. However, very few companies have identical product mix or employ uniform accounting practises therefore, comparison may be difficult. This method could also result in higher bonus for mediocre performance if the industry had a bad year. While calculating bonus based on profit and capital components certain adjustments need to be made in the reported amount of net income and reported amount of share holder's equity. Extraordinary gains or losses are to be excluded from net profit. 2) Carryovers: Under the total bonus pool method, the total bonus arrived on the basis of predefined formula is available for distribution in that particular year. During recent years we have witnessed volatile swings in the business cycles resulting in volatile swings in earnings of the companies, this gives rise to the problem of managing expectations and motivation. During a good year high bonus will give rise to the expectation of similar bonus for the future period, which is unrealistic. Similarly during bad year low bonus would result in lack of motivation. This shortcoming can be overcome by using the method of carryovers under which the total amount of bonus determined is not available for distribution but only a part as decided by the committee of the board of directors is available for distribution. The rest of the unpaid bonus is transferred to the bonus pool which is available for distribution in future period. This method has two advantages • • it offers more flexibility since amount of bonus is not determined by a formula and the board of directors can exercise their discretion It reduces the magnitude of swings which accompany when bonus payments are strictly as per the formula. The main disadvantage of this method is that the bonus are not related to current performance which may lead to slackness in current efforts. 3) Deferred Compensation: Another variation of carry over method is deferred compensation. Under this method the bonus is calculated every year, but payment to recipients is spread over a number of years usually ranging from three to five years. Under this method managers receive only one fifth of their bonus in the year which it was earned and the remaining four fifth is paid out equally in the next four years, thus a manager working under this plan for five years, the bonus would consist of on-fifth of the bonus of the current year plus one-fifth of each of bonuses pertaining to four previous years. The main advantage of this method is: • managers can estimate, with reasonable accuracy, their cash income for the coming year 79 • deferred payments average the effect of cyclical swings thereby resulting Management Control Process in uniform cash flow; • managers will receive bonus for a number of years even after retirement, Which results in two fold advantage i) ii) • augmentation of retirement income tax advantage due to the fact that retirement income is taxable at lower rates. The deferred time frame encourages long term thinking on the part of managers. The main disadvantage of this method is since the donus is not adequqtely related to the currently performance, therefore, it’s impact as an incentive for current performance is greatly dampened. 10.3.2 Long Term Incentive Plans Long term incentive awards are based on performance measured over a period greater than one year. A basic premise of many long term incentive plans is that the share price of the company reflects the company's long term performance. In other type of long term incentive plan the performance is measured in terms of accounting variables, the most commonly used accounting variables are earning per share growth, return on equity, assets or investment over a period ranging from three to six years. These type of plans are commonly referred to as performance plans whereas the former one's are referred to as stock plans. There are several type' of such plans. The popularity of such plans depend upon host of factors the main among them are prevailing income tax laws, accounting treatment and the state of stock markets, corporate rules and regulations governing these plans etc: Some of the long term incentive plans are discussed below: a) Stock Option: Under this plan a manager is given a right to buy a specified number of shares at or after a given date in the future (Exercise date) at a price agreed upon at the time the option is granted. This price is usually the prevailing market price. The major benefit of these type of incentives is that the efforts of the managers are directed towards both the shot term and longterm performance of the company. An outright purchase of equity under the stock option plan gives manager the equity which he can retain even if he chooses to leave the company. In these type of plan the equity purchased is subject to a lock in period ranging from three to five years. The main drawback of this plan is that there are many factors beyond the control of managers which determine the equity prices. Phantom Shares: Under this plan the managers are allotted shares (notional shares) for book keeping purpose only: At the end of the. specified period the manager receives an award equal to appreciation in the market value of the shares since allotment. This award may be in cash, in shares or a mix of both. The main advantage of this plan over the stock option plan is that it involves no transaction cost, there is no risk of decrease in market price of shares, purchased (during lock in period) and interest cost associated with holding the stock is absent. Stock Appreciation Rights: Under this plan the manager is entitled to receive cash payment based on the increase in value of the stock from the time of award until a specified future date. The stock appreciation rights and phantom shares are a form of deferred cashbonus in which the amount of bonus is a function of the market price of the 'company's share and both of these plans involve uncertainty regarding the amount of bonus. b) c) 80 d) Performance Shares: Under this plan the managers are awarded a specified number of shares when specific long term goals have been met.: Usually the goal is to achieve a specific increase in earning per share spanned over a period of three to five years. The merit of this plan is that the award is based on performance measures that can be at least partially controlled by the manager concerned. One of the drawback of this plan is that the bonus is based on performance measured by accounting measures which may not always bring out the true economic worth of the firm. e) Performance units; In performance unit plan a cash bonus is paid on achieving specific long term targets. This plan is a combination of Stock Appreciation Rights and Performance shares. This type of plans are used by companies either in case , when they are, not listed on stock exchanges or if listed the trading is very thin. The success of this plan largely depends on how well the long term targets have been established. Reward and Compensation 10.3.3 Organisational Incentives Individual incentive systems involve a direct relationship between the magnitude of output and the amount of financial reward and purports to accomplish the higher output per unit time, the organization wise incentive systems involve cooperation among employees, management and the union and purport to accomplish broader objecttves such as an organisation wide reduction in Iabour, material and supply costs, strengthening of employee loyalty to the company, harmonious labourmanagement relations and decreased turnover and absenteeism. There are three types of organization-wide incentive systems: (1) the Scanlon plan, (2) the KaiserUnited Steel workers plan, and (3) Profit sharing. The Scanlon Plan The Scan-Ion plan was devised by Joseph N. Scanlon who rose from an ordinary worker in a steel plant to a senior officer in the United steel workers of America and subsequently a lecturer at the Massachusetts institute of Technology. It purports to accomplish widespread employee participation, industrial harmony and increased productivity and involves a wage formula or incentive and a new type of suggestion system. The wage formula relates to the distribution of earnings from increased productivity proportionately among all individuals involved including clerks, salesmen, supervisors and even in some cases middle and top level managers. Explicitly, the wage formula is tailor-made to suit the needs of specific organizations. However, w a g e s are typically linked with the sales value of goods produced in a manner that I per cent increase in productivity is followed by 1 per cent increase in wages and salaries: This type of bonus forms not only an effective incentive to productivity but also a basis for participants to infer the extent of the organization's success. The suggestion system relates to the establishment of production and screening committees to analyses employee suggestions and prepares general plans for improving productivity. The production. committee consists of a foreman and the production committee man selected or appointed by the union operating at the department level. The screening committee consists of top managers and union leaders and analyses employee's suggestions-which are rejected by the production committee as well as by those influencing the organization as. a whole. Unlike the usual suggestion system, instead of rewarding the individual for accepted decisions, the entire group benefits by an increased bonus if the productivity increases as a result of the suggestions implemented. The individuals come forward with new suggestions instead of concealing them for fear or fight rates and the union renders its fall cooperation rather than worrying for speed-up by the management. Moreover, the management itself 81 Management Control Process suggests problems for mutual discussions rather than passively waiting for suggestions to emerge from employees. Again, both the quality and quantity of decisions are higher as compared to the usual suggestion system. As Strauss and Sayles observe, despite several advantages of a successful Scanlon plan in the form of increased and improved suggestions, enhanced productivity and profits, reduced resistance to change, improved union management relations, increased intergroup and superior-subordinate cooperation and higher motivation to work. There are several conditions which must be accomplished before introducing it in the organization. 1) The management should improve its attitude and learn to consult workers and listen to severe criticism. In companies which practice general supervision and have an effective upward communication system, the Scanlon plan can be easily introduced while in others, it necessitates changes which the management is sometimes unwilling to make. The Scanlon plan requires an initiative on the part of the unions to give up its militant attitude. However, it does not mean that they should ignore the grievances of individual employees in their over enthusiasm to push their members for working harder. Indeed, with active involvement in the plan, the union representatives are likely to be identified with the management ignoring the 'average members. This may cause passive support of the members and fall of there union leaders in the next election. The unions must resolve this dilemma by explaining new development to the rank-andfile and paying heed to the reactions of their members. The plan necessitates a high degree of group cohesiveness and employee identification with the organization as a whole. Obviously, in this system each individual's earning is dependent on the effort of the entire group. Ilard work by few individuals is likely to bring only negligible reward to them. Indeed, self-satisfaction, the desire for praise from the work associates and interest in the team are required to increase productivity. Sometimes, these factors are not likely to be present in the organization, and there may develop some rivalries among sub-groups. These difficulties are likely to increase in larger organizations. The Scanlon plan has been effective, historically, in either depressed organizations where the employees struggle to save their jobs or in highly prosperous companies involving possibilities for earning huge bonuses. The plan may meet an utter failure where market conditions are too difficult to sell increased output and thus, enhanced productivity may cause unemployment to numerous individuals. 2) 3) 4) The Kaiser Plan Kaiser-United Steel workers plan was devised in I963 by a committee consisting of company, union and public representatives with a view to eliminate the threats of strikes by equitably distributing the company's financial gains among the employees, the stockholders and the public, providing job and income securities to the workers in the face of technological innovations and accomplishing gradual elimination of wage inequities in some direct-wage incentive systems. The plan is characterized by guaranteed employment to workers against technological unemployment, sharing of the gains resulting from cost reduction in view of enhanced efficiency between the companies (67.5 per cent) and the employees (32.5 per cent), increases in wage rates and fringe benefits at least equivalent to bargained ones in the rest of the industry and a scheme for gradually eliminating direct wage incentives. As Beach points out, the 82 Kaiser plan which is principally in line with the Scanlon plan, has achieved mixed success. The company and the union in view of their evolving experiences with it have made several changes in the plan. The plan has been more effective during the early years than at present. Indeed, fluctuations in the market demand of the product of the company and in plant utilization have exerted adverse effects on the working of the plan in recent times. Profit Sharing Systems Profit sharing has been defined by the International Cooperative Congress, which met in Paris in 1889 as an agreement freely entered into, by which employees receive a share, fixed in advance, of the profits. Here are three types of profit sharing systems: (1) Current (cash) profit sharing, (2) deferred profit sharing; and (3) combination profit sharing. Current or cash pro fit sharing system It involves payment of profits directly to the employees in cash, cheque or stock just after the determination of profits. Deferred profit sharing system In deferred profit sharing system, profits are credited to the accounts of employees to be paid at retirement or other stated situations such as disability, etc. Combination profit sharing system In combination profit sharing system, part of the profits is paid out currently in cash which part of it is deferred. Profit sharing systems form a part of a progressive personnel policy embodying incentive characteristics and providing results not obtained from other systems. . Effective profit sharing increases profits, enhances efficiency and creates ,a climate for improved employee relations. Effectiveness of These systems is determined by the desire of the individuals involved to make them a success and likewise by the involvement of the top management. Objectives The major objective of the profit sharing system is to strengthen the unity of interest and the spirit of cooperation. They form an effective measure to solve the problem of divergent interests on the part of the workers and management. Specifically, profit sharing systems purport to: (1) inject a feeling of partnership between the employer and an employee, (2) provide a group incentive to the participants, (3) enhance employee security, (4) provide super-wage benefits without involving fixed commitments, (5) attract and retain effective resources, and (6) inspire employee thrift. As Dunn and Stephens point out, throughout the course of history of profit sharing, two objectives have prevailed. These include profit sharing as an incentive and profit sharing as a tool to develop a sense of partnership and commonality of interests. From the viewpoint of an employee, profit sharing accomplishes several objectives depending upon the type of systems adopted. While a cash system directly contributes to an employee's-immediate economic needs, deferred and combination system related to retirement, loss of income in view of disabilityy benefits to the dependents at the death of the employee and allied benefits. From the standpoint of the employer, the major objectives of profit sharing relate to increased productivity and employee satisfaction stemming from rewards to' satisfy their needs. Mechanisms Usually, the share of the total profits to be distributed among participants form a fixed percentage of the corporate net profits. Sometimes, it relates to the percentage of Profits prior to deduction for dividends and taxes, while at other times it involves a percentage subsequent to such deductions. At still other times, attempts are made to Reward and Compensation express the amount paid to the individuals in terms of percentage of the dividends to 83 Management Control Process stockholders. As soon as the volume of the entire fund for any one-year is calculated, care should be taken to immediately allocate the share of the individuals, frequently based upon the magnitude of their yearly earnings in relation to the total payroll of all the participants or their length of service and their wage levels. Prerequisites Beach describes several prerequisites to sound profit sharing systems. 1) 2) Profit sharing should not be a substitute for adequate wages but provide something "extra" to the participants. Before the introduction of the systems, care should be taken to ensure that there prevails satisfactory employer-employee relations and personnel practices are sound. There must be some profits available for distribution among the participants and the enterprise should be free from continued losses. Full support and cooperation of the union forms a major prerequisite to an effective profit sharing programmed. 3) 4) Weaknesses The major weakness of the program is that employee's earnings are linked with profits which are beyond their control and are influenced by numerous extraneous factors such as business cycles, amount of competition, ability of the top management and allied factors. However, historically profit sharing programs have been found to satisfy both the management and the employees. Integrated Approach In addition to the above three types of organizational incentives, attempts have been made to provide an integrated system employing different types of incentives. One of these attempts relates to the Lincoln Electric Company's incentive system introduced in 1934 which involves nine components including a piece-work wage incentive plan with a guaranteed day rate, job-evaluated base rate, merit rating, cash profit sharing ,job security, stock purchase scheme for employees, advisory board, promotions and job enrichment. Overall, as Beach concludes, programs of work incentives and labour management cooperation do not succeed exclusively because of an effective mechanical design. Indeed, an effective managerial leadership, a climate of trust and collaboration and mutuality of interests (in other words, the culture of the organization ) form a vital prerequisite to effective incentive systems. Group Incentive Plans Under such plans, each member of the group receives a bonus based on the output of the group as a whole. There are several reasons for adopting such a plan. Sometimes (as on assembly lines) several jobs are inter-related. Here one worker's performance reflects not only his own effort but that of his co-workers too. In such cases, group incentive plans are advantageous. Secondly, such plans also encourage co-operation among group members. There tends to be less bickering among group members as to who has "tight" production standards and who has "loose" ones. Thirdly, the groups can bring pressure to bear on their members (through badgering, ostracis, etc.) and help 84 keep shirker in line. This, in turn, can help eliminate some of the need for close supervision. Fourthly, group production levels tend to be more stable than individual ones, and group incentive payments vary less than individual ones. Finally, group incentive plans also facilitate on-the-job training, since each member of the group has vested interest in getting a new group member trained as well as quickly as possible. Reward and Compensation 10.4 INCENTIVES FOR CORPORATE OFFICERS AND CHIEF EXECUTIVE OFFICER In any economic environment it is always easy to measure the micro variables but always difficult to assess the macro picture due to the fact that many unmeasured and unexplained variables plays in formulating the macro scenario. This situation when applied to companies raises an important question; how do you measure the performance of corporate officers e.g. Chief financial officer, Vice President human resources, Vice President legal, Vice President Production. To be specific how one is going to measure the performance of staff function. Each corporate officer except the Chief Executive Officer is responsible in part for the company's overall performance and these corporate officers are entitled to and are motivated by a-bonus for good performance. There is no set formula or method for measuring the performance of corporate officers. The usual practise is that the Chief Exectitive Officers recommends the awards to the compensation committee of the board of directors. These awards are based on the subjective assessment by the Chief Executive performance of each persons performance. In some companies Management By Objective System (MBO) is used in which specific objectives are agreed upon at the beginning of the year e.g. bringing attrition rate down by certain percentage, decreasing bad debts, decrease in working capital requirements, bringing down the idle time for plant and machinery etc. and the attainment of these objectives is assured by the Chief Executive Officer. More or less the incentives for senior level management are subjective in nature and this is more so evident in companies where ownership and management are not separate. The Chief Executive compensation is an trick issue and much heat has been generated over this issue in recent past. The usual practise in deciding about CEO's compensation is as follows: After the CEO has made presentation to the compensation committee of the board of directors regarding compensation to the corporate officers, the compensation committee decides about the CEO's incentive compensation. In usual practise the committee may simply apply the same percentage which the CEO has recommended for his subordinates, however, if the board wants to signal it's opinion of CEO's performance it may increase or decrease the percentage depending on performance of the CEO. Activity 5 Try to find out the compensation structure of the corporate officers and CEO of your organization. ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… …………………………………………………………………………………………. 10.5 INCENTIVES FOR BUSINESS UNIT MANAGERS 85 Management Control Process A wide array of options are available for developing an incentive compensation package for business unit managers. These options are displayed in Table 10.2. Table 10.2: Incentive Compensation Design Options for Business Unit Managers 10.5.1 Types of Incentives 86 Basically the incentives can be divided into two broad categories a) Financial b) Psychological and social. Financial incentives include salary increase, bonuses and perquisites whereas psychological and social incentives include promotion, increased responsibility, increased autonomy and recognition. Managers are motivated by both type of incentives, manager in their initial carrier path are motivated more by financial incentives whereas senior managers are more motivated by psychological and social incentives. Reward and Compensation 10.5.2 Size of Bonus Relative to Salary The issue of size of bonus relative to the salary is governed by two contradicting philosophies. One school of thought lays stress on fact; Recruit good people----Pay them well ----- Expect good performance. The other school of thought lays stress on the following process; Recruit good people. ----- Expect good performance ----- pay them well if performance is really good. The companies subscribing to this philosophy practise performance base pay which emphasises on incentives bonus rather than on pay. Since salary is an assured component emphasising on salary may lead to slackness, conservatism and complacency, whereas an emphasis on bonus or incentive pay tends to encourage entrepreneurship and innovation among managers which results in manager putting maximum efforts, Cut off levels: A bonus plan may put the restriction at either of the end: 1) 2) the level of performance at which maximum bonus is reached (upper cut off). the level below which no bonus would be payable (lower cut off). Both of these type of cutoffs may produce undesirable side effects. Suppose the level of performance is well below lower cutoff, there would be no motivation foro manager to improve the performance if in his opinion the performance level can't be reached above the lower cutoff. The managers would not put efforts to improve the performance level which are within the band of present performance and lower cutoff performance. Similarly when the upper cutoff is reached the managers would not be interested to optimize the current profit rather they would be motivated to bring down the current profitability by overspending on discretionary expenses, thereby creating an opportunity for higher bonus in the next year. One way to reduce such difunctional behaviour is to carry over excess or deficiency to the next year which would result into automatic adjustment of bonus. The bonus available for distribution in a given year would be bonus earned during that year plus any excess or minus any deficiency from the previous year. 10.5.3 Bonus Basis In this secltion we are going to search an answer for the question; on what basis business unit manager's incentive bonus should be based? Whether is should be based on total corporate profit or solely on business unit profits or on some mix of the two. The manager's actions and decisions have a direct impact on the performance of the business unit under his control, based on this the manager's incentive bonus should be linked to the performance of business unit under his control rather than that of other units. However, this type of approach would fail to build up synergy within the organization. Adopting this type of approach would create a managerial thinking which would be inward looking and somewhere the organizational goal would be lost. In single business firms where the co-operation between various units is critical; since business units are highly interdependent the manager's bonus is tied to the 87 Management Control Process overall performance of the company. This type of approach foster co-operation within various business units. In a conglomerate basing the incentive bonus on the basis of corporate results would be counterproductive. In these type of organizations business units are autonomous. Basing the incentive bonus on the basis of company's profit would weaken the link between performance and reward. It would also give rise to another problem which is commonly known as problem of "free riders". A reward system based on company's profit would also reward those business unit managers who have contributed below average in the company's profit. Similarly business units giving excellent performance would not be rewarded; therefore, in conglomerates the incentive bonus should be based on units performance rather than overall company's performance. For diversified firms it would be desirable to follow a system which bases itself on twill criteria of unit performance and company's performance. The mix may vary based on relative importance of the unit, unit's contribution towards profit of the company etc. 10.5.4 Performance Criteria One of the main problems which arise while deciding about the incentive bonus is what set of criteria are to be used for evaluating the performance of business unit manager. How to segregate controllable and uncontrollable factors and what should be the quantum of allowance for uncontrollable factors. While a host of criteria are used for performance management, but a set of financial performance parameters always predominates any performance measurement scheme of business unit managers. We will briefly discuss these financial parameters. Financial Criteria The set of financial criteria to be used for performance measurement will depend upon how the business units are organised within the company. If the business unit is organised as profit center the choice of financial criteria include 1) 2) 3) 4) Contribution margin direct business unit profit Controllable business unit profit net income before taxes and net income. In case the business unit is organised as Investment Centre the following financial criteria would be used: 1) 2) 3) definition of profit definition of investment choice between return on investment and residual income. A detailed discussion about these parameters has been done in unit five and seven which deals with Profit Centre and Investment Centre respectively. While using any financial criteria an adjustment regarding uncontrollable factors must be made. At the business unit level there are mainly two uncontrollable factors. for which adjustment need to be made i) ii) Adjust for the expenses which are the result of decisions made by managers about the business unit level. Adjust for the losses which are due to act of nature. 88 Benefits and Shortcoming of Short Term Financial Targets Linking the bonus incentive to financial targets motivate the manager of the business unit to find ways and means to do things in a way which would have a positive impact on the top line as well as bottom line of the company. It fosters a spirit of entrepreneurship and innovation. However, solely relying on financial targets has it's own pitfalls the major one being short terms decisions and actions will not be in sync with the long term goals. The managers may neglect crucial things like regular maintenance of plant and machinery, upgradation of skill set of human resource (Training and development), research and development activity etc. In addition to this the managers may defer investments that promises benefits in the long run but hurt short term financial results. Apart from this there is also a risk of managers engaging in data manipulation to meet current period targets. In the long run all these factors would result in loss of market share and competitive edge. In order to overcome the short term bias company's adopt the following practices. 1) 2) Financial criteria are supplemented with additional incentive mechanism e.g. basing the bonus on multi year performance. Financial criteria are supplemented with non financial criteria such as sales growth, increase in market share, customer satisfaction, product quality, new product development etc. Bonus Determination Approach Reward and Compensation 10.5.5 A bonus award for business unit manager can be determined either objectively or subjectively or a combination of these two approaches. In objective approach the quantum of bonus is dependent on some measurable attribute of the business unit, e.g. a certain percentage of-the business units operating profit. Exclusive reliance on objective based measurement has some clear advantages. 1) 2) Reward system can be stated with precision leaving no room for ambiguity about performance standards. Superior managers bias on favouritism will not come into play. Exclusive reliance on objective measurement (output control) tend to neglect the various sub dimensions of the process which are important but difficult to measure and quantify, therefore, some amount of subjectivity is always desirable in determining bonus. Subjective approach is useful in the following conditions: i) ii) iii) iv) when manager's personal control over units performance is low. when business units are interdependent, thereby reducing scope of action and autonomy.. while pursuing strategic goals which requires trade off when business unit manager inherits problems created by a predecessor. 10.6 THE BENEFITS OF PERFORMANCE 89 Management Control Process DEPENDENT REWARD The performance based rewards acts as an motivational tool and provide impetus for aligning employee's natural skill set and self interest with the organization's objective. They act as a control tool. The first control benefit is informational. The reward system act as a signaling device which signals about organizations priority. In any organization there would he certain variables demanding attention in form of time and resources such as cost, quality, customer service, asset management, future growth, market share etc. Al! these variables are mutually competing for internal resources for the organization. Reward system is based on measurable attribute and the organization by specifying that particular attribute; signals its priority; thereby helping managers to allocate resources. The second control benefit of rewards is motivational. Performance dependent rewards also serves many non control purposes also some of which are listed below: a) Reward are recruitment as well as retention tools. Performance based 'rewards which form a major part of compensation package are a signal to potential employee's and if it is comparable or superior as compared to competitors it helps in recruitment and retention of best available human resource, A properly devised reward system can reduce the tax liability of both the employer and the employee. Some reward systems are designed in such a way that they act as a defense mechanism against hostile takeover. Some performance dependent rewards are designed in a way to make compensation variable with firms performance thus decreasing cash outlay when performance is poor and thereby reducing the company's operating beverage. b) c) d) 10.7 RESEARCH FINDING ON ORGANIZATION INCENTIVES An important function of management control system is to align employees self interest with the organizational goal and this depends on relationship of organizational incentives to personal goals. Reward incentives are inducements to satisfy those needs that individual can't obtain without aligning his self interest with that of the organization. Organizations provide rewards to employees who perform in agreed upon ways. Research findings on rewards and incentives support the following: • individuals are more motivated by the potential of earning rewards rather that fear of punishments thereby implying that management control system should be reward oriented. monetary rewards act as motivational tool up to a certain level beyond that their marginal utility declines thereby suggesting that for junior and middle level managers monetary rewards will act as a motivator but for senior managers non monetary rewards in form of recognition, autonomy, part of decision making process will act as a motivating factor. feedback is an important component of reward system. An objective and timely feedback will lead to achievement, self realization or to sense corrective actions that are needed to meet the objectives. the rewards should be timely, as a lapse of time between action and reward diminishes its effectiveness. for any reward system the targets should be realistic, unattainable targets or too Reward and Compensation easily attainable targets lack motivational • • • • 90 impact. • to make a desired impact, the targets of the reward system should be arrived through mutual consultative process between the superiors and subordinates. When goals are set through mutual consultative process the managers are able to extract a commitment and in all likelihood the commitment is going to be adhered to. Reward and Compensation 10.8 SUMMARY Rewards and compensation will key management control device. Rewards that can be linked to performance or subjective performance evaluation comes in many forms. Both monetary and non monetary rewards are motivational. The incentive plans can be divided into two categories short term and long term incentive plans. Several considerations need to be taken into account while dividing the total bonus pool among business unit managers and corporate managers. While designing an incentive plan both external and internal factors should be taken care of. External factors are industry characteristics competitors compensation policy, managerial and labour market, tax and regulatory environment. The internal factors are value and beliefs of the employees who are rewarded the culture of the organization and the organizational strategies, 10.9 SELF ASSESSMENT QUESTIONS 1) 2) 3) 4) 5) 6) 7) How does the organization wide incentives plans differ from individual incentive plans. Discuss in detail the various types of short term incentive plan. Discuss in detail the various-types of long term incentive plan. List out the underlying differences between short term and long term incentive plan. Define the criteria on which the incentives of business unit managers are decided. "While deciding about the incentive for business unit managers, there should be some scope for subjective evaluation."Comment. Differentiate between the control and non control objectives of the performance dependent rewards. 10.10 FURTHER READINGS Barry Gerhart and George T. Milkovich "Organizational Differences". Academy of Management Journal, December 1990, pp 663-91 JJ Curran, "Companies that Rob the Future" Fortune July 4, 1988, pp84-89 Luis R. Gomej, Henry Tosi and Timothy Hinkin "Managerial Control Performance and Executive Compensation" Academy of Management Journal, March 1987, pp31-70s 91 Management Control Process UNIT 11 NEW DEVELOPMENT / TECHNIQUES OF MANAGEMENT AND MANAGEMENT CONTROL Objectives The objectives of this unit are: • • • to familiarise you with new techniques of management and management control; to familiarise you with the installation and implementation process of these techniques; and to make you aware of the impact of these techniques on management control. Structure 11.1 11.2 11.3 11.4 11.5 11 .6 11.7 11.8 11.9 Introduction Total Quality Management (TQM) Business Process Reengineering (BPR) Enterprise Resource Planning (ERP) Value Added Analysis Programme and Performance Budgeting (PPB) Agency Theory Framework Management by Objective (MBO) Activity Based Costing (ABC) 11.10 Summary 11.11 Self Assessment Questions 11.12 Further Readings 11.1 INTRODUCTION Till late 1980's , most of the Japanese manufacturing products were quite unpopular in the west; so much so that they were rated unreliable and of extremely poor quality. However, this unpopularity and bad quality products took a complete U-turn around the year 1990. The Japanese goods, particularly in the field of electronics and automobile sectors created a revolution by the application of latest management principles. This could become possible due to post second world war restructuring of unions and institutions permitting innovations like just-in-time (JIT), value added management (VAM) and total quality management (TQM). One may consider this as a paradox that famous management gurus of United States like W. Edwards Deming, Joseph Juran, Crosby and Feigen Baum of US were in the forefront in popularizing the concept of TQM as a process of continuous improvement, US corporations were not able to apply these principles in their factories due to strong labour union resistances, thus providing a golden opportunity to Japanese entrepreneurs to implement these ideas at their work places, particularly in the field of automobiles and electronics. 92 11.2 TOTAL QUALITY MANAGEMENT In this section, we will consider an in-depth study of the implementation of the TQM process. A systematic process is adopted to identify and implement solutions to prioritize opportunities for improvement. The TQM approach highlights the need for customer oriented approach to management reporting, eliminating some of our more traditional reporting practices. TQM seeks to increase customer satisfaction by finding the factors that limit performance. The practice of TQM in a manufacturing environment has produced tangible improvements in efficiency and profitability as a result of many small improvements. On the shop-floor, quality concepts have been based around the involvement of employees and an approach according to which each worker sees the next person on the assembly line as their customer. The application of quality concepts to service areas require a similar approach, necessitating a focus on customer requirement. The customers' are the receivers of a product' whose satisfaction' is determined by the usefulness of the product. There is a danger of viewing TQM in terms of statistical processes and control charts. It is much more than this. Quality is not some vague utopian ideal associated with goodness'; it can be seen as requiring that we conform to very specific performance requirements. Close enough is not good enough in this respect. The cost of quality is the monetary impact of a failure to conform, a measurable characteristic which can be reduced through a system of prevention in much the same way as safety standards are implemented. In a manufacturing environment the cost of quality might be viewed as the sum of the costs associated with scrap, reworks, warranty claims and inspection expenses. The same costs. it is generally believed that TQM is exclusively meant for manufacturing sector. But the reality is that this concept is of universal applicability and can be applied very comfortably in service sector as well. Let us first understand what is Quality? A Quality product or a service is the one which has the following attributes: • • • • • • Systematic Conformity Zero defects Cost saving Customer satisfaction Safety and-reliability New Development/Techniques of Management and Management Control Before proceeding further let us define some of the terms related to the quality aspects. Some of the definitions are taken from ISO 9000 series and ISO 8403. 1) 2) 3) Quality policy: The overall Quality intentions and directions of an organization as regards quality, as formally expressed by management. Quality management: That aspect of the overall management function that determines and implements the Quality policy. Quality system: The organizational structure, responsibilities, procedures, processes and resources for implementing quality management. 93 Management Control Process 4) 5) Quality control: The operational techniques and activities that are used to fullfil requirement for Quality. Quality assurance: All those planned and systematic actions necessary to provide' adequate confidence that a product or service will satisfy given requirements for Quality. Product and Service Quality (Feigenboum 1983): 6) "The total composite product and service characteristics of marketing, engineering, manufacture and maintenance through which the product and service in use will meet the expectations of the customer." Karinne Prytz (1995) defines, "Total Quality Management isthe collection of all technical, administrative, creative and social activities in the entire company. TQM aims to create a basis for continuous improvements in all processes and products to satisfy all customer demands, both the specified and unspecified ones. It will lead to Total Quality which is the sign of the ideal production system where all activities are performed right the first time and all times." Total Quality Management (TQM) Comprises three main activities (Imai, 1986) • • • maintenance of Quality quality improvement quality renewal The relationship between these three activities is depicted in figure 11.1 Total Quality Management Approach The total quality management approach may constitute of three parts which are as discussed below: a) Responsibility for quality: The traditional view about quality is that, quality problem arises on factory floor and workers and workmanship are responsible for quality problems. This philosophy gave rise to quality control departments which looked for or "inspected Quality into the product." In contrast to this the TQM approach specifies that everyone in the organisation is responsible for quality. Edward Deming states that a production process can be separated into two parts. 1) 2) the system which is under the control of management; the workers who are under their own control. 94 He found that 85 percent of the Quality problems can be attributed to faulty systems and only 15 percent could be attributed to the workers. The system could be faulty due to many reasons, main among them are product design, procurement of inferior raw material, inadequate maintenance of plant and machinery, poor working conditions and excessive pressure to increase output. Since the system is designed and administered by management quality is the primary responsibility of management. The TQM process tries to "build quality into the product" rather than "inspect quality in the product". The errors have to be detected at the initial stage rather at the terminating stage. The workers should be responsible for workmanship and not for faulty designs and poor quality raw material and components. b) Product Design: Researches have shown that many of the Quality problems are due to design of the product. Common problems encountered at the design stage are: i) ii) Manufacturability of the product Inclusion of parts which are unique to the product whereas parts which are already available, cheap and common to other products would function satisfactorily. Include more separate parts than are necessary which would result in more set up time thus increasing cost. New Development/Techniques of Management and Management Control iii) All these inadequacies in design results in problems at the manufacturing end. Recognizing this the TQM process emphasise on close coordination between designers and manufacturing engineers. Another factor for product design is the market ability of the product. With availability of technology and computer aided designing tools designer tend to create products with multiple features disregarding the fact that wether customer really needs them or not. Stuffing a product with too many features dilute the appeal of the main distinguishing feature of the product. It also results in cost increase thereby reducing competitive advantage of the product, here also the TQM process lays emphasis on close cooperation between designers and marketing people. c) Relation with Suppliers: Few years back the companies preferred to have a host of suppliers for raw material, sub assemblies and components. With improvement in logistics and supply chain management the companies should reduce the number of suppliers, so as to have uniformity in the final product. Managing a large number of suppliers is always a complicated task and in this process the first casualty is quality. While managing a small number of suppliers the company can always monitor quality as well as help suppliers in their R&D efforts and other areas resulting in improved quality of sub assemblies and components. Implication for Management Control Financial Measures: Traditionally, conformance quality was measured by the cost of the product scrapped or reworked. In the new approach all the cost of doing things wrong are estimated and aggregated. The total cost of quality is the sum of the four elements listed below: • • • • Preventive costs Apprisal costs Internal failure costs External failure costs The data about these costs are collected monthly and reports are prepared annually or semi-annually. These reports highlight the total Quality cost and identify areas which require remedial measures. 95 Management Control Process In some American companies the total cost of bad quality amounts to 25% of the total cost, whereas in contrast for Japanese companies it varies between 2.5% to 4%. P.B. Crosby, estimates that for every one dollar which a company spends on prevention results in saving on ten dollars in apprisal and failure costs. Non Financial Measures: In addition to financial measures the companies also use non financial measures for quality management. These non financial measures are basically the process data collected at three levels. The first set of data pertains to suppliers. The various variables in this data set are number of defective units supplied by each supplier, number and frequency of late deliveres. The second set of data pertains to shop floor operations and includes number of parts in a product, common and unique parts in a product, percentage yields, first pass yield, scrap rework, machine breakdown, Frequency and magnitude of change in production and delivery schedule and employee's suggestions, The third set of data pertains to customers and includes Customer complaints, customer satisfaction, warranty claims, field service expenses and number and frequency of product returns. The main advantage of non financial measures is most of the variables and reported on daily basis thereby corrective action can be taken immediately. Secondly non financial measures pin point the trouble spots. Non financial measures is important feedback mechanism for management, managers and workers. TQM Process: In order to implement TQM in an organisation the whole process can be subdivided into three parts (0 Main Focus (ii) Implementation Process (iii) Tools and Methods. The main objective of any TQM process is to create a foundation for customer satisfaction. ;This foundation for customer satisfaction is created by laying stress on the following parameters: a) b) c) d) customer focus/orientation b) process focus long range planning institute training This set of activities essentiaily includes continuous employee's training, supplier's integration to TQM process, to highlight Quality Component as a part of strategic planning. The TQM is a continuous process divided into different programs some of which are as follows: • • • • • • • top management' commitment. status analysis training organising for improvements quality measurements improvement projects quality awareness 96 TQM is a continuous and a dynamic process which covers management behavioural aspects as well as operational aspects. The main methods/tools of TQM are as follows: • • • • • • SPC (Statistical Process Control) team work (Cross functional, Quality circles) long term focus on suppliers and customers and integrating them in development and manufacturing process work unit analysis Process analysis Quality awareness New Development/Techniques of Management and Management Control Table 11.1 depicts the frame work for the six-step TQM analysis, identified by the acronym `PRAISE',. The successful adoption of this sequence of steps demands discipline and commitment. The goal of quality. improvement is paramount and guides the actions of the change team throughout. 97 Management Control Process Activity 1 Identify a few of the Indian Companies Implementing TQM process. ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… Activity 2 List some of the non financial measures of Quality. .................................................................................................................................................... .................................................................................................................................................... .................................................................................................................................................... .................................................................................................................................................... .................................................................................................................................................... .................................................................................................................................................... .................................................................................................................................................... .................................................................................................................................................... .................................................................................................................................................... ................................................................................................................................................... 11.3 BUSINESS PROCESS REENGINEERING (BPR) Michael Hammer and Champy, the management experts, who initiated the reengineering movement, defines reengineering as "the fundamental rethinking and radical redesign of business processes to achieve dramatic improvements in critical, contemporary measures of performance, such as cost, quality,, service, and speed." The concept of reengineering has been around for nearly two decades and was implemented in a piecemeal fashion iii organizations: Production organizations have been in the vanguard without knowing it. They have undertaken reengineering by implementing concurrent engineering, lean production, cellular manufacturing, group technology, and pull-type production systems. These represent fundamental rethinking of the manufacturing process. Reengineering is often compared to total quality management (TQM). Some people have said that the two are, in fact, the same, while others have been argued that they are incompatible. Michael Hammer says that the two concepts are compatible and actually complement one another. Both concepts are centered on a customer focus. The concepts of teamwork, worker participation and empowerment, crossfunctionality, process analysis and measurement, supplier involvement, and benchmarking are significant. contributions from quality management. In addition, quality management in an era of extensive fictionalization of business has reemphasized the need for a "total" view of the organization. Quality management has also influenced company culture and values by Exposing organizations to the need for change. The basic difference between the two is that quality management has emphasized continuous and incremental improvement processes that is in control. Whereas reengineering is about radical, discontinuous change through process innovation. Thus a given process is enhanced by TQM until its useful lifetime is over, at which point it is reengineered. Then enhancement is resumed and the entire cycle starts again. Hammer points oat that this is not a once-in-a-lifetime endeavor. As business circumstances change in major ways, so must process designs. 98 According to (Carr 1993) for successful implementation of Business reengineering process the following conditions are desireable: • • • • • • leadership and guidance from top management external focus through customer research, competitive and economic analysis and benchmarking top level strategy to guide change and leaders who can implement change methods for redesigning processes to meet performance targets use of advance information technology effective change management and ability to develop organisational culture New Development/Techniques of Management and Management Control BPR tends to change the operation in a dramatic way and some of the core focus areas for BPR implementation are listed below: • • • • • • • Customer orientation Process orientation Focus on core business Rule breaking – Devotion for simplification Creative use of information technology Rapid payback Principles of Reengineering Reengineering is about achieving a significant improvement in processes so that contemporary customer requirements of quality, speed, innovation, customization, and service are met. Hammer has proposed seven principles or rules for reengineering and integration. Rule-1 Organize around outcomes, not Tasks: Several specialized tasks previously performed by different people should be combined into a single job. This could be performed by an individual "case worker" or by a `case team". The new, job created should involve all the steps in a process that creates a well-defined outcome. Organizing around eliminates the need for handoffs, resulting in greater speed, productivity, and customer responsiveness It also provides a single knowledgeable point of contact for the customer. Rule 2 Have those who use the output of the process perform the process: Work should be carried out where it makes the most sense to do it. This results in people closest to the process actually performing the work, which shifts work across traditional infra - and inter organisational boundaries. For instance, employees can make some their own purchases without going through purchasing, customers can perform simple repairs themselves, and suppliers can be asked to manage part inventory. Relocating work in the fashion eliminates the need to coordinate the performers and users of a process. Rule 3. Merge Information: Processing work into the real work that produces the information: This means that people who collect information should be responsible for processing it, it minimizes the need for another group for reconcile and process that information, and greatly reduces errors by cutting 99 Management Control Process the number of external contact point for a process. A typical account payable department that reconciles purchase orders, receiving notices, and supplier invoices is a case in point. By eliminating the need for invoices by processing orders and receiving information on-line, much of the work done in the traditional accounts payable function becomes unnecessary. Rule 4. Treat Geographically Dispersed Resources as Though they were Centralized: Information technology now makes the concept of hybrid centralized/decentralized operations a reality. It facilitates the parallel processing of work by separate organizational units that perform the same job, while improving the company's overall control. For instance, centralized databases and telecommunication networks now allow companies to link with separate units or individual field personnel, providing them with economies of scale while maintaining their individual flexibility and responsiveness to customers. Rule 5 Link Parallel Activities Instead of Integrating Their Results: The concept of integrating only the outcomes of parallel activities that must eventually come together is the primary cause for rework, high costs, and delays in the final outcome of the overall process. Such parallel activities should be linked continually and coordinated during the process. Rule 6. Put the Decision Point where the work is performed and Build Control into Process: Decision making should be made part of the work performed. This is possible today with a more educated and knowledgeable workforce plus decision-aiding technology. Controls are now made part of the process. The vertical compression that results produces flatter, more responsive organizations. Rule 7. Capture Information Once- at the Source: Information should be collected and captured in the company's on-line information system only once - at the source where it was created. This approach avoids erroneous data entries and costly reentries. Organizational Changes by implementing BPR Hammer and Champy (1993) emphasise that the following changes occur within the organization by application of BPR in the organization. • Work unit changes from functional departments to process team. It is a team that naturally falls together to complete a whole piece of work - a process. According to Drucker (1992) the team 'performs' and the members only 'contribute'. Task flexibility is a central aspect of lean production system (Womack et.al., 1990), Job changes from simple tasks to multidimensional work. Decentralization of planning, control and several support activities, implies job enrichment for members of process team, but also requires employees to succeed. Elimination of non value adding activities is a primary task resulting in cost reduction due to which resources are freed to reinforce value adding activities. Job preparation changes from training to education. After BPR the jobs are not structured and employees who are members of process team will have to perform multi dimensional jobs. To empower the team member, transfer of knowledge is a must which will help team members in making judgement and taking decisions. Focus of performance measurement shifts from activity to result Advancement criteria changes from performance to ability • • • 100 • • • • Values change from protective to productive which is measured by customer satisfaction. Organization structure changes from hierarchical to flat. Managers change from scorekeeper to leaders. New Development/Techniques of Management and Management Control Activity 3 Outline the major differences in TQM and BPR. ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… Activity 4 List the fore focus areas for BPR implementation. ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… 11.4 Introduction ENTERPRISE RESOURCE PLANNING Enterprise Resource Planning (ERP) is the latest high-end solution which information technology has lent to business application. The ERP solutions seek to streamline and integrate operation processes and information flows in the company to synergize the resources of an organization namely men, material, money and machine through information. Initially only infrastructure companies opted for ERP due to it's high cost. Today, many companies in India have gone in for implementation of ERP. It is expected that in the near future, 60 percent of the companies will be implementing one or the other ERP packages since this will become a must for gaining competitive advantage. Meaning of ERP: Enterprise resource planning software or ERP attempts to integrate all departments and functions across a company into a single computer system that can serve all those different department's particular needs. In fact ERP Combines all computerized departments together with the help of a single integrated software program that runs on a single database so that various departments can easily share information and communicate with each other. The need for ERP: Most organization across the world have realized that in a rapidly changing environment, it is impossible to create and maintain a customer designed software package which will cater to all their requirements and be up-todate. Realizing the requirement of user organizations, some of the leading software companies have designed Enterprise Resource planning software, which offers an integrated software solution to all the functions of an organization. 101 Management Control Process Components of ERP: To enable the easy handling of the system, ERP has been divided into the following core subsystems: sales and marketing, master scheduling, Material requirement planning, capacity requirement planning, bill of materials, purchasing, shop floor control, accounts payable/receivable, logistics, asset management and financial accounting. Features of Enterprise Resource Planning Some of the major features of ERP and what ERP can do for the business system are: • ERP facilitates company-wide Integrated Information system covering all functional areas like manufacturing, selling and distribution, payables, receivables, inventory accounts, human resources, purchases etc. ERP performs core activities and increases customer service, thereby augmenting the corporate image. ERP bridges the information gap across organizations. ERP provides complete integration of systems not only across departments but also across companies under the same management. ERP is the solution for better project management, ERP allows automatic introduction of the latest technologies like Electronic Fund Transfer(EFT), Electronic Data Interchange (EDI), Internet, Intranet, Video conferencing, E-commerce.etc. ERP eliminates most business problems related with material shortages, productivity enhancements, customer service, cash management, inventory problems, quality problems, prompt delivery etc. ERP not only addresses the current requirements of the company but also provides the opportunity of continually improving and refining business Processes. ERP provides business intelligence tools like Decision Support System (DSS), Executive Information system (EIS), Reporting, Data Mining and Early warning systems (Robots) for enabling people to make better decision and thus improve their business processes. • • • • • • • • Benefits of Enterprise Resource Planning In an industry that is sensitive to dynamic market forces, cost fluctuations and manufacturing responsiveness, there are many benefits to be gained from investing in ERP. ERP applications have shifted from assisting after-the-fact monitoring to realtime analysis, control and forecasting; and from facilitation standardization, economies of scale and cost reduction in product, to enable fast, flexible and accurate response and customization. The benefits accruing to any business enterprise by implementing an ERP package are unlimited. 1) Product Costing: Determination of cost of products correctly, is quite critical in every industry. All costing methods and information can be fully integrated with finance. This provides the company with essential financial information for monitoring and controlling costs. Inventory Management: ERP can be used in multi-national, multicompany, and multi-site manufacturing and distribution environments. This system simplifies complicated logistics by allowing one to plan and manage companies in different countries as a single unit and its advanced functionality allows one to process product and financial information flows in several different ways. 2) 102 Entering and managing the basic data required to effectively running once business is an important start for effective warehouse management. The basic data includes warehouses, locations, items, containers, lot and serial numbers, units of measure (including conversion), alias numbers, replacement and substitute items, and more. Inventory reporting supports all reporting of specific and general types of stock transactions, such as various types of stock transfers, reclassifications, ID changes and physical inventory results. Additionally, functions are available for managing different stock and purchase requisitions as well as supporting the selection of appropriate location for receipts. Inventory valuation involves both warehouse management and cost accounting. ERP supports several valuation methods including standard cost, average cost, FIFO and batch-specific prices. 3) Distribution & Delivery: Delivery and distribution in ERP lets one to define logistics processes, flexibly and efficiently to deliver the right product from the right warehouse to the right customer at the right timeevery time. To the customer, the most important element of quality is onetime delivery. It does not matter how well as product is made if it arrives late. Applications support automatic or manual load planning, transportation planning for in-house vehicles or third party agents, EDI support for transport booking, confirmation and dispatch, and proof of delivery processing,processing distribution or acquisition orders involves several closely related activities. New Development/Techniques of Management and Management Control CPFR (Collaborative Planning, Forecasting and Replenishment): In 1996 US retail chain Wal Mart successfully conducted a pilot program in which it used Internet communications with one of its suppliers to achieve significant cuts in inventories. The process use in the pilot was called CPFR (Collaborative Planning, Forecasting and Replenishment). CPFR has since been implemented by many companies seeking to emulate Wal-Mart's success. 4) E-Commerce: Internet enabled ERP offers Internet, Intranet and extranet solutions for business to business, business to consumer, employee selfservice and more. Automatic Control: It ensures automatic quality control procedure. Sales Service: It ensures better after sales service. Improvement in Production Planning: It improves production planning. Quick response: It enables quick response to change in business operations & markets conditions. Competitive Edge's: It helps to achieve competitive advantage by improving business process. 5) 6) 7) 8) 9) Reasons for the Implementation of ERP by the Companies 1) Improve company's business performance: ERP automates the tasks involved in performing a business process- such as order fulfillment, which involves taking an order from a customer, shipping it and billing for it. With ERP, when a customer service representative takes an order from a customer, he or she has all the information necessary to complete the order (the customer's credit rating and order history, the company's inventory levels and the shipping dock's trucking schedule). Everyone else in the company sees the same computer screen and has access to the single database that holds the customer's new order, when one department finishes with the order it is automatically routed via the ERP 103 Management Control Process system to the next department. To find out where the order is at any point, one need only to log into the ERP system and track it down. With luck, the order process moves like a bolt of lightning through the organization, and customers get their orders faster and with fewer errors than before. ERP can apply that same magic to the other major business processes, such as employee benefits or financial reporting. 2) Standardize manufacturing processes: Manufacturing companies often find that multiple business units across the company make the same type of reports using different methods and computer systems. Standardizing those processes and using a single, integrated computer system can save time, increase productivity & reduce headcounts. Integrate Financial data: As the CEO tries to understand the company's overall performance, he or she may find many different versions of the truth. Finance has its own set of revenue numbers, sales has another version, and the different business units may each have their own versions of how much they contributed to revenues. ERP creates a single version of the truth that cannot be questioned because everyone is using the same system. To standardize HR information: Especially in companies with multiple business units, HR may not have a unified, a simple method for tracking employee time and communicating with them about benefits and services. ERP can fix that. 3) 4) Activity 5 Try to find out ten different companies from various industries, which are using ERP. .................................................................................................................................................................................... .................................................................................................................................................................................... .................................................................................................................................................................................... .................................................................................................................................................................................... .................................................................................................................................................................................... .................................................................................................................................................................................... .................................................................................................................................................................................... .................................................................................................................................................................................... .................................................................................................................................................................................... Activity 6 List the major benefits of using ERP package. .................................................................................................................................................................................... .................................................................................................................................................................................... .................................................................................................................................................................................... .................................................................................................................................................................................... .................................................................................................................................................................................... .................................................................................................................................................................................... ................................................................................................................................................................................... 11.5 VALUE ADDED ANALYSIS Activities can be classified as value added or non value added or as efficient or inefficient. This discussion requires an important qualification. To this point, we have considered only the customer's perspective in classifying activities. We must be careful when we are classifying activities to recall that other stakeholders also define constraints that organizations must meet and that some activities may reflect some of the constraints defined by other stakeholders. 104 For example, customers may want products at the lowest possible price. To keep costs low, an organization might spend as little as possible on employee safety and, consequently, provide a dangerous working environment. Even if a dangerous work environment did not affect employee attitudes and performance, most governments consider dangerous working conditions socially undesirable and have passed laws that regulate work environment. Therefore, dangerous working conditions would fail to meet community expectations about the type of work environment that organizations should provide. Similarly, although inspection is usually viewed as an nonvalue-added activity, sometimes the, law requires it. For example, government contracting usually requires 100 percent inspection of parts critical to aircraft. Customer product safety laws require 100 percent inspection of the formulation of batches of chemicals used to prepare prescription drugs that are critical to a patient's life. Therefore, we always must be careful to evaluate whether an activity is value added and efficient within the constraints that the organization's stakeholders define for the organization's operations. As per Porter strategies to create competitive advantage could be divided into three categories a) cost leadership b) Differentiation c) Focusing. To follow any of the strategies one has to evaluate the value chain. The value chain for any firm in any business is the linked set of value creating activities to produce a product and its spans from basic raw material sources for component supplier to the ultimate end product delivered to the final customer. New Development/Techniques of Management and Management Control Fig. 11.2: Value Chain Source : Competitive Advantage : Creating and Sustaining Superior Perofrunanec', Porter, 1985 Free Pres, New York, N. J. Emphasis of value chain is to "segregate a firm into strategically relevant activities in order to understand the behavior of cost and the existing potential source of differentiation". (Porter 1985). in order to understand the concept of value chain more clearly let us divide the activities which adds value to the inputs. As shown above in figure 11.2 the activities can be divided into two main groups a) Primary b) Support activities. 105 Management Control Process a) Primary activities: These are the activities which are required for manufacturing, sales, transfer of the product to customer and after sales service Support activities: These are the activities which are required for efficient and timely performance of primary activities and includes activities like procurement of the resources, technology, human resources etc. Porter has identified five standard type of primary activities: Inbound logistics includes activities related to receiving, storing and distributing factor inputs (raw material for the product) Manufacturing includes physical transformation activities of raw material into products. Outbound logistics relates to collecting, storing and distribution of final products to the dealer network/customers. Marketing and sales relates to communication of product availability features, price etc. It also includes making product available to the distribution channel and persuading customers to buy the same. After sales service is related to improve and maintain the value of the product. The standard set of support activities include: Procurement which is the function to provide factor inputs that are used in the value chain of the company. Technology development which focus on process and product development Management of human resources which includes activities like recruiting, employing, educating, developing and rewarding all kinds of employees. A company's infrastructure which includes activities like administration, planning, finance, accounting, legal maters, communicating with regulatory authorities etc. Each category of primary and support activities contain three subgroup of activities; Direct activities which are directly involved in adding value to the factors (raw material) like manufacturing, assembly, marketing etc. Indirect activities which are basically support activities which include maintenance, planing, administration etc. Quality assura:ce which includes control, inspection, testing, revision, checking, correction and rework. Every company has it unique value chain. As mentioned in the beginning the companies in order to gain competitive advantage can follow only one of the three strategies of cost leadership; differentiation and focusing. In order to follow any of the strategies the companies leave to modify the activities of value chain, for example Dell computers follows the strategy of cost leadership and it has been made possible by modifying the process of inbound logistics and outbound logistics. Dell computers have eliminated intermediaries for procurement of components and simultaneously adhere to Just in Time philosophy (JIT). On the outbound logistic front again the intermediaries have been eliminated and it sells directly to the customer. A part of the resultant savings are passed on to the customer. In this way additional value is created on inbound and outbound logistics point on the value chain. Reliance industries by going for backward and forward integration have created additional value in the value 106 chain as most of it's business is shielded from volatility in prices of inputs (raw material). Process of value analysis Value analysis is particularly directed at reducing cost in products and materials while maintaining or improving the products or process function. It is used after the product has been put into production" (Juran 1988) Value analysis generally proceeds through seven stages: Introduction, specifying the objectives, identifying the process or the product and identifying the individuals who are going to be involved in the study. Collecting information regarding usage, cost, demand, quality, standards and process. Collective analysis and brainstorming which leads to multiple ideas and suggestions. Evaluation of ideas and suggestions generated in the previous step and selection of the most promising one. Detailed study of each idea selected Proposals are made to senior managers for decision. Executing the recommended change, Strategic Aspect For the strategic purpose the value chain analysis may highlight three profit improvement areas Linkage with suppliers Linkage with customers Process linkage within the value chain of the firm As highlighted previously the inbound/outbound logistics play an important role in overall value creation. Inbound logistics (linkage with suppliers) can be improved by reducing the number of vendors, automating order placing process, practising JIT, and by holding vendors responsible for component quality. Similarly outbound logistics (linkage with customers) can be improved by improving the Supply Chain Management (SCM). The areas of improvement includes Order processing, distribution channels, Warehousing, transportation etc. Value chain analysis explicitly recognises that individual value creation activities are not independent but interdependent, value-ereation at a-specific point on value chain will be carried over to other points thereby creating an environment of efficiency. Value Added Analysis/Activity analysis Activity analysis or V AA is an approach to operations control that began to enjoy extensive useduring the 1980s. An activity is any discrete task that an organization undertakes to make or deliver a product or service. Specifically, activity analysis has four steps: 1) Identify, the process objectives that are definedby whatthe customer wants, or expects, from the process. New Development/Techniques of Management and Management Control 107 Management Control Process 2) 3) 4) Record by charging, from start to finish, the activities used to complete the product or service. Classify all activities as value added or nonvalue added. Continuously improve the efficiency of all activities and develop plans to eliminate nonvalue-added activities. Figure 11,3 summarizes these steps. Activity analysis has proved very useful in helping organizations to identify opportunities to reduce costs and to improve quality and processing time in a systematic way. Activity analysis represents a systematic way for organizations to think about the processes that they use to provide products to their customers. Activity 7 Identify the various strategies to create a competitive advantage. .................................................................................................................................... .................................................................................................................................... .................................................................................................................................... .................................................................................................................................... .................................................................................................................................... .................................................................................................................................... .................................................................................................................................... .................................................................................................................................... .................................................................................................................................... .................................................................................................................................... .................................................................................................................................... Activity 8 List the various primary and support activities. .................................................................................................................................... .................................................................................................................................... .................................................................................................................................... .................................................................................................................................... .................................................................................................................................... .................................................................................................................................... .................................................................................................................................... .................................................................................................................................... .................................................................................................................................... ..................................................................................................................................... 108 11.6 PROGRAMME AND PERFORMANCE BUDGETING (PPB) Conventional system of budgeting essentially involved target fixation from the top to next level middle management to the grass root management. The main shortcomings of this system was lack of involvement of grass-root level managers who are really responsible for business. This system was gradually repiaced by zero-base budgeting, which also suffered from following serious limitations: 1. 2. 3. Zero-base budgeting involves huge cost, hence unsuitable to middle-size and small business. The identification of decision units creates numerous problems for the organisation. The Zero-base budgeting system requires expertise and continuous training by the executives. Hence it is time consuming and takes long time to deliver results. The annual or periodical reviews of the programmes become a dry ritual with passage of time, hence ineffective in delivering result. New Development/Techniques of Management and Management Control 4. Above limitations of top to bottom budgeting or zero-base budgeting gave place to more result-oriented system of Programme budgeting and Performance Budgeting (PPB), which are discussed here under:Programme Budgeting As discussed above, theconventional budgeting failed to pay desired attention on the benefits of an activity in its evaluation. Budget proposals are always evaluated with reference to costs. As a result such a budgeting approach does not prove much effective for particularly Government programmes launched mainly for the benefits of the society. Such programmes need in-depth evaluation of cost-benefit relationships. The programme budgeting was developed in early 1960's precisely for this purpose. This type of budgeting is often referred as Planning, Programming, Budgeting system or output budgeting. This system was used for the first time in the United States for defence programme in 1961 by Robort M. Namara. A programme budgeting is a budgetary system tailored to meet the requirements of Government departments and non-profit institutions that focuses upon the output of the organisation rather than on specific inputs. According to David Noviek, Programme budgeting is "the sum of the steps of interdependent activities which enter into the attainment of a specified objectives". Such an approach to budgeting attempts to bridge the gap between the planning activities of the organisation and the budget processes. Under programme budgeting the budget preparations are governed by the objectives of the programme rather than a budget unit. With the result such a budgeting programme become popular day by day among local bodies and Government institutions. The not-for-profit organisation accept such programmes that contribute maximum benefits to the society. Therefore, it is not feasible to evaluate the programme and projects on cost return(income) basis. There should be a system that compares programme benefits with programme costsProgramme budgeting for evaluation ofstate departmental programmes. An efficient programme budgeting may have the following characteristics:1) Programe Accounting- an accounting system with an ability to attach accounting data to specific programme to show the resources used or budgeted for each of the, objective. 109 Management Control Process 2) 3) Multi-year Costing. It attempts to identify costs with a project for its total life rather than just for the future budget period. Detailed Description of Activities- It involves designing and developing of activity description of each programme against which on-going programmes and new programmes are evaluated. Zero-Base Budgeting- A budgeting approach that attempts to revciew and evaluate on-going programes as well as new programmes to justify all resources. The evaluation process of the programmes begins without a resource commitment even it is an on-going programme. Benefit-Cost analysis- a formal technique that evaluates alternative course of action by comparing costs with benefits. 4) 5) Objectives of Programme Budgeting The following are the main objectives of programme budgeting: • • • • • To identify national goals with greater precision and determine the priority among goals: To develop and analyse alternative means of achieving the goals: To project long term costs and relate them to the benefits of each programme; To specify plans for several years ahead that will achieve the stated objectives; and To strengthen control over programmes and budgets through improved measurement and analysis of programme performance in relation to cost. Limitations of Programme Budgeting The main limitations of programme budgeting are: i) ii) iii) iv) v) It simply states about the prgramme to be done but fails to throw light on the operation and implementation process of the programme. The concept of programme budgeting has no relevance to the preparation of actual budget. It does not provide an operating tool for the line executives who implement the policy and programme decisions. The mechanism for funding the programmes and fixing priorities for varying levels of effort are not stated in programme budgeting. it does not focus on the evaluation of on-going programme activities and operations but stresses only on new programmes. Performance Budgeting The concept of performance budgeting was first time used by the Hoover Commission in the US in the year 1949 and then it was applied in the defence budget of the said country in the I960s. This approach to budgeting provide an alternative_to normal industrial budgeting in non-industrial enterprise. Performance budgeting lays more emphasis to the corporate objectives and gives least attention to the money aspect of different objects. 110 Performance budgeting aims to formulate programmes and their evaluation to ensure that programme objectives are achieved. It studies the physical and financial relations of the programme and activities. According to Decoster and Schafer performance budget is " an adjusted budget prepared after operations to compare actual results with costs that should have been incurred at the actual level attained". The National Institute of Bank Management, Bombay, defines performance budgeting as "the process of analyzing, identifying, simplifying and crystallizing specific performance objectives of job to be completed over a period and specifying the framework of the organizational objectives, the purpose and objectives of the job". Thus, performance budgeting is a system of budgeting which states operations in terms of functions and activities. At the same time, it attempts to match monetary cost and benefit of the programme. It gives the definite scope of the activity and its cost. The performance budgeting consists ofthe following steps: Formulation of departmental objectives; i) ii) iii) Identification, evaluation and selection of the programme: Preparation and execution of budget; and Performance appraisal. New Development/Techniques of Management and Management Control Objectives of Performance Budgeting The performance budgeting seeks to achieve the following objectives: i) ii) iii) iv) v) To make budget formulation process simple; To bring coordination between various physical and financial aspects of the programme. To improve the efficiency and quality of performance audit; To make management more accountable for its actions; and To serve as controlling tool for financial operations. Advantages of Performance Budgeting The major advantages of performance budgeting are given below: i) ii) iii) iv) It ensures efficient utilization of resources by suggesting appropriate means of allocating full programmes; It provides a systematic and sound system for performance reporting and evaluation objective; It makes possible the introduction of management-by-objectives (MBO); It ensures achievement ofthe organization objectives by identifying and selecting only such variables, which contribute maximum to these objectives; It facilitates decision making at all levels of management in the organization; It ensures smooth execution of the budget by coordinating its various physical and financial objectives; It improves the quality of financial control. v) vi) vii) Limitations of Performance Budgeting Despite above mentioned qualities of performance budgeting, it suffers from the following defects: 111 Management Control Process i) Performance budgeting evaluates only quantitative and financial variables of the programme. Hence, it looks quantitative approach to the evaluation of the programme which is equally needed for proper evaluation. It can be used only for such programmes where evaluation can be done in a precise manner, and its scope is limited and The use of performance budgeting requires the departments of an organization well organized programmes and activities properly identified which is rare to find, therefore, only a limited organization can be benefited by this approach to budgeting. ii) iii) Activity 9 List the main characteristics of programme budgeting. ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… Activity 10 List the limitations of performance budgeting. ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… 11.7 AGENCY THEORY FRAMEWORK Agency theory explains how to best organize relationships in which one party (the principal) determines the work, which another party (the agent) undertakes (Eisenhardt, 1985). The theory argues that under conditions of incomplete information and uncertainty, which characterize most business settings, two agency problems arise: adverse selection and moral hazard. Adverse selection is the condition under which the principal cannot ascertain if the agent accurately represents his ability to do the work for which he is being paid. Moral hazard is the condition under which the principal cannot be sure if the agent has put forth maximal effort (Eisenhardt, 1989). The problems of adverse selection and moral hazard mean that fixed wage contracts are not always the optimal way to organize relationships between principals and agents (Jensen and Meckling, 1976). A fixed wage might create an incentive fo'r the agent to shirk since his compensation will be the same regardless of the quality of his work or his effort level (Eisenhardt, 1985). When agents have incentive to shirk, it is often more efficient to replace fixed wages with compensation based on residual claimancy on the profits of the firm (Alchian and Demsetz, 1972). The provision of ownership rights reduces the incentive for agents' adverse selection and moral hazard since it makes their compensation dependent on their performance (Jensen, 1983). 112 Concept: An agency relationship exists whenever one party (principal) hires another party (the agent) to perform some services and in doing so the authority for decision making is delegated to the agent: In a corporate setting the chief executive officer (CEO) is the agent of shareholders (Principal) and similarly business unit managers are the agents of CEO. Here the question which gets predominance is how to motivate the agents to act in a way as if they were the principal (owners). One of the key elements of agency theory is that the principal and agents have divergent preferences or objectives. Divergent Objectives of principal and agents: Agency theory assumes that all individuals act in their self interest. The self interest of agent and principal are more than often not al ligned which gives rise to the conflict. Agents receive financial compensation alongwith the perquisites and this involves cost which in turn decreases the return of principal. The principal is primarily concerned with the return on investment. Apart from high perquisites the agents may indulge in work version and work shirking.' Another divergence between the preferences of principals and agents is risk preference. The agency theory assumes agents prefer more wealth to less, but the marginal utility decreases as more wealth is accumulated. Agents wealth can be sub divided into two parts financial wealth and human capital which they posses in form of managerial capabilities and skills. Human capital is the value of the manager as perceived by the market and is a function of firms performance and in order to preserve this wealth the agents are often risk averse. They prefer their present wealth over the wealth which could be earned by taking risky decisions. On the other hand the principal (share holders) have already diversified their risk by investing in many companies and are interested in expected value of their investment and are risk neutral. Non observability of Agent's Action: The divergence in preferences associated with compensation and perquisites arises whenever the principal can't observe the agents action. The shareholders can't always monitor the CEO's action and likewise CEO can't always observe the business unit manager's action. In these cases only the agent knows wether his actions are directed towards the objective of the principal or not. This gap of information is referred to as a information asymmetry. Since the agent is near to the action area, he has the access to information about the task which even the principal does not posses. This type of information is called as private information which is primarily gained due to the proximity to the action area. Due to the divergence of preferences between principal and agent and also the private information of the agent, the agent may be tempted to misrepresent the information to the principal which is referred to as moral hazard. Control Mechanism: Two ways of dealing with the twin problem of divergent objectives and information asymmetry are monitoring and incentives. Monitoring: The first control device is monitoring. The principal can design control systems which defines scope, authority and autonomy of agents as well monitor the agents action to see whether they are within the brief or not. An example of monitoring is the approval of expenses incurred by the agent by other agents who are guided by the policies and procedures of the company. Another monitoring mechanism is that of audit where a third party checks whether the actions taken by the agent are within his ambit or not and also verifies whether internal rules and procedures are adhered by the agents.or not. The effectiveness of the monitoring is increased if the task to be performed by the agent is well defined and structured. The effectiveness of monitoring would also depend upon the choice of the feedback signal. In case where monitoring is not effective a better way of control is through incentive contracting. New Development/Techniques of Management and Management Control 113 Management Control Process Incentive Contracting: The divergent preference of the Principal and AGent can be minimised by identifying those performance measures which leads to goal congruence. and basing the incentives of the Principal on these performance measures. The more the agent's compensation is based on performance measures, the more is the incentive for agent to improve the performance measure, thefore the principal should so define the performance measurs that it furthers his or her interest. An incentive contract which motivates the agent to work in the principal's best interest, tell contract is considered as goal best interest, tale contract is considered as goal congruent. A's compensation scheme looking an incentive contract passes a serious agency problem. The main challenge for the principal is to identify signals that aare corelated to the agents effort and firm value. The comin of the agent's efforot and the macro economic variables determines the firms performance. A performance measure which reflects the agent's performance; the more valuable measure, it is an incentive contract. Even a best designed incentive contract can't lead to complete goal congruence. The underlying reasons being the difference in risk prepference of the two parties, asymetric information and the cost of monitoring. This divergenc is named as residual loss. The cost of incentive compensation alongwith the cost of monitoring and residual loss are known as agency costs. Activity 11 Why are the objectives of principla and agents divergent? ………………………………………………………………………………………… ………………………………………………………………………………………… …………………………………………………………………………………………. ...................................................................................................................... ..................................................................................................................... ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… Activity 12 List the control mechanism for reducing the agency cost. ...................................................................................................................... ...................................................................................................................... ...................................................................................................................... ...................................................................................................................... ...................................................................................................................... ...................................................................................................................... ...................................................................................................................... ...................................................................................................................... ...................................................................................................................... 11.8 MANAGEMENT BY OBJECTIVE [MBO] Introduction A basic concern of management is how to increase the effectiveness of an organization in a changing environment so that it can get the best out of its resources, and satisfy the needs for which the organization has been created. Many critical issues of management arise from this basic concern. Managers often face dilemmas in the quest for performance improvement capability development and auaptation to the changing environment. Both the success and failure throw up new problems, the seeds of which 114 are often found in the solutions of the old problems. As organizational and environmental conditions become more complex, managers discover that the popular and tested methods of yesteryears are inadequate for the problems of tomorrow. In their search for appropriate approaches to handle the issues confronting them, managers in thousands of organizations around the world have come to know Management by Objectives (MBO) as an approach which is capable of offering a framework for dealing with many of the issues of organizational effectiveness. An overview MBO is a comprehensive management approach focusing on objectives or expected results for providing a frame work for organizational and managerial decisions. Although objectives provide the focal point, the thrust in MBO is on management. Thus, the mere existence of objective is not a sufficient condition for MBO. One can have objectives or targets without having M BO. Similarly, the management processes can be kept hyperactive without clear and agreed objectives. The emphasis in MBO is that the objectives should be the central focus in the management process. MBO begins by defining objectives and then uses these statements as criteria to judge the quality of activity (behaviour) and the adequacy of inputs (resources). Agreement on objectives precedes activity planning and resource allocation. In other words, once the objectives are clearly established in terms of outputs or expected results, the resources, and the processes must be geared towards attaining these objectives. Moreover, it should be appreciated that MBO is concerned with both the achievement of objectives as well as the processes by wh ich these objectives are established and achieved. Therefore, MBO emphasizes the development of the system's capability as well as an individual manger's competence and motivation for performance improvement in the short and the long run. Though there is evidence of general agreement on the basic concepts of MBO, its rapid and diverse practice has led to problems of comprehension. MBO has tended to mean different things to different people. Depending on the emphasis on selected aspects, one form of MBO tends to be quite different from another; Peter Drucker's original description had provided a comprehensive focus: What the business enterprise needs is a principle of management that will give full scope to individual strength and responsibility, and at the same time give common direction of vision and effort, establish team work and harmonize the goals of the individual. The only principle'that can do this is management by objectives and self control. However, it appears that actual practice strayed form this broad definition and tended to emphasize specific aspects only. For example, the initial American practice of MBO stressed appraisal and motivation of the individual manager, resulting in an individual-centered MBO, which could be practiced even without the organization wide objectives and philosophy of management. On the other hand, the British pattern of MBO, particularly in the sixties, focused on corporate planning and corporate objectives and viewed the individual manager's contribution as a means to the company's goals of profit and•growth. The American and the British perspectives are reflected respectively, in definitions of MBO offered by George,Odiorne and John Humble. Odiorne defines MBO as "a process whereby the superiorand subordinate managers of an organization jointly define its common goals, define each individual's major areas of responsibility in terms of the results expected of him and use these measures as guides for operating the unit and assessing the contribution of each of its members. New Development/Techniques of Management and Management Control 115 Management Control Process Humble considers MBO as "a dynamic system which seeks to integrate the company's need to clarify and achieve its profit and growth goals with the manager's need to contribute and develop himself." In his view, MBO "is a demanding and rewarding style of managing a business. Later years witnessed a tendency to integrate both these perspectives. The following definition of Redding is an example: "The establishment of effectiveness areas and effectiveness standards for managerial positions and the periodic conversions of these into measurable time bounded objectives, linked vertically and horizontally with future planning." It may be noted here that even Redding fails to adopt a comprehensive view of MBO. Thus, even though a comprehensive view of MBO may be complex, a limited view leads to avoidable pitfalls. Moreover, in order to be effective, the MBO process should be integrated with the key activities of the management process, e.g. planning, organizing, staffing, directing, and controlling. Figure 11.2 indicates that MBO as a comprehensive approach to management implies an effective integration of the MBO process with key managerial activities. Thus, MBO should be considered as a top management planning and control approach, with opportunities for participation in the process. MBO has implications for all aspects of management. Its practice is expected to have an impact on the organization structure and culture, on managerial processes and on the behaviour of the people in the organization. MBO lays stress on result orientation innovation, development of effective systems, and utilization and development ofall resources, especially the human resources. All that is significant for the effectiveness of the organization is directly•or at least indirectly related to MBO because as an approach which deals with organization issues, it offers a result-oriented perspective. Over a period, if an organization has experienced success in the practice of MBO, it becomes a way of life. In fact, MBO is just an application of good management. As peter Hives expressed it, "MBO can be regarded as a codification and systematization of management practices fashioned for our times.' It has one major distinguishing feature-the rigour with which the process of management is carried out. The methodology of MBO is a means to 116 translate the basic concepts and to ensure rigour, Forms, methods and rituals are the supportive means and should not by themselves be regarded as MBO. We should also remember that in practice MBO often falls short of its full potential. Moreover, the MBO literature also shows the existence ofa tendency to reinvent the wheel. Many MBO practitioners and consultants have attempted this by changing terms and placing emphasis on specific parts. Besides the difficulty of operating square wheels, this tendency has also resulted in semantic problems. For example, the following other terms are also used denote Management by Objectives: 1) 2) 3) 4) 5) 6) 7) 8) Accountability Management Action Plan of Objectives Goals Management Improving Business Results Improving Management Performance Management by Objectives and Results Management by Results Performance Results and Individual Development Evaluation New Development/Techniques of Management and Management Control Further, different terms are used for objectives, key result areas, performance reviews, etc. all this naturally creates confusion in comprehending the major aspects of MBO. MBO is said to have gone through three phases over the pas twenty years (Sink and Tuttle, 1989) 1) 2) 3) Performance appraisal Planning and control method Methodof managing productivity by objectives Moreover, the full potential of MBO is often not realized because of the lack of appreciation of its concepts, when applied to real-life situations. The basic concepts of MBO are simple but they demand radical changes in the style and structure of management. The concepts are so simple that on first acquaintance, many managers identify themselves as long established practitioners of MBO. However, when they begin to apply these concepts with rigorous analysis, they tend to get disenchanted with the time-consuming process. The sharp focus on accountability for specific results, as highlighted through the MBO process, h. also not always comfortable for most mangers. It must be remembered that MBO does not work automatically and it is not easy to put the concepts into operation. Of course, over the years an adequate methodology has been developed for this purpose. But, it is by no means simple. It has to be learnt by actual practice. Implementation Process The process of implementation of MBO constitute of the following phases: 1) 2) 3) The top manager and key executives reporting to him study the systems and processes. The top manager and subordinates set up'measures of organisation's performance. Goal setting methods are extended up to first line supervisory level. Goals are set through discussions and meetings between the members of organisational units and their superiors. Goals are mutually agreed upon. 117 Management Control Process 4) The required changes are undertaken in appraisal system, reward & compensation system. Delegation of authority and responsibility is also undertaken. The increased popularity of MBO is essentially due to its common sense appeal and simplicity of concepts. At the same time MBO is an exacting and demanding selfdiscipline as well./Unrealistic expectations, not matched with rigorous process, can lead to disenchantment. Implementation of MBO takes time, expertise, effort and commitment-ingredients usually not found in many organizations. Activity 13 Highlight the main focus of MBO. ................................................................................................................ ................................................................................................................ ................................................................................................................ ................................................................................................................ ................................................................................................................ ................................................................................................................ ................................................................................................................ ................................................................................................................ ................................................................................................................ ................................................................................................................ ................................................................................................................ 11.9 ACTIVITY BASED COSTING [ABC] Introduction In practice it is surprising to find that many business organizations do not wish to know the precise costs of the products they are manufacturing. This is primarily because prices are based on what the market can bear and what competitors are charging. There are, however, other groups of firms who would like to know their accurate average and marginal costs per unit so that they may precisely know the result of charging the prevailing prices of products on their bottom-line. The latter firms have been greatly benefited from the application of activity based Costing (ABC), which is in a way a modern form of absorption costing method, which was evolved during late 1960's to provide product costs more accurately. The following factors are believed to be responsible for the development of ABC system: I) Mounting overhead costs due to increasingly automated production process of products. ft is estimated that the overhead rates that were ranging between 200 percent to 300 percent 20 years back have gone up to 600 percent to 800 percent now. Intense market competition led to ascertaining the product costs more accurately; and 3) Increasing product diversity to reap the benefits of scale economies, diversifying the market with a view to increasing the market share. Meaning of ABC ABC or Activity Based Costing is an accounting methodology that assign the costs, both overhead and direct, to various products and services on some scientific bases. In order to correctly associate costs with products and services, ABC assign cost to activities based on their use of resources. It then assign cost to cost objects, such as products or customers, based on their use of activities. ABC can track the flow of activities in organization by creating a link between the activity (resource consumption) 118 Cost object. Cost drivers Resource Cost drivers Activity Cost Drivers In order to understand how ABC operates it is necessary to understand the meaning of above terms. Definitions A Cost Object- It is an item for which cost measurement is required e.g. a product or a customer. A Cost Driver- It is a factor that causes a change in the cost of an activity. There are two categories of cost driver: A Resource Cost Driver- It is a measure of the quantity of resource consumed by an activity. It is used to assign the cost of a resource to an activity or cost pool;. An Activity Cost Driver- It is a measure of the frequency and intensity of demand, placed on activities by cost objects. It is used to assign activity costs to cost objects. The cost drive for business functions viz., Research & Development and Customer Service are as below: Business functions: Cost Driver Research & Development - Number of research products - Personnel hours on a project - Technical complexities of projects Customer Service - Number of service calls - Number of products services - Hours spent on servicing products. In traditional costing overhead are first related to cost centres (production & Service Centres and then to cost objects, i.e., products/ In ABC overhead are related to activities or grouped into cost pools (depending on the terminology preferred). Then they are related to the cost objects, e.g., products. The two processes are, therefore, very similar, but the first stage is different as ABC uses activities instead of functional departments (cost centres). The problem with functional departments is that they tend to include a series of different activities, which incur a number of different costs that behave in different ways. Activities also tend to run across functions; for instance, procurement of materials often includes raising a requisition note in a manufacturing department or stores. It is not raised in the purchasing department where most procurement costs are incurred. Activity costs tend to behave in a similar way to each er i.e., they have the same cost driver. Therefore, ABC gives a more realistic picture of the way in which costs behave. As with traditional absorption costing ABC rates are calculated in advance, normally for a year ahead, and so the same rates are used for a year at a time. The advantage of this is that any seasonal variations will be spread giving an average cost. If this was not done and actual rates were used the absorption rates would vary monthly. This would mean that when output was high the overhead rate would be low and vice-versa; if New Development/Techniques of Management and Management Control 119 Management Control Process pricing were based on cost the prices quoted would be higher when the business was slack. Stages in Activity Based Costing The different stages in activity based costing are listed below: 1) 2) Identification of the activities that may take place in an organization: Usually the number of cost centres that a traditional overhead system uses are quite small, say upto fifteen. In ABC the number of activities will be much more, say 200; the exact number will depend on how the management subdivides the organisation's activities. It is possible to break the organization down into many very small activities. But if ABC is to be acceptable as practical system it is necessary to use larger groupings, so that, say, 40 activities may be used in practice. The additional number of activities over cost centres means that ABC should be more accurate than the traditional method regardless of anything else. Assigning costs to cost pool for each activity both support.and primary activities, that caused them. This creates `cost pool' or `cost buckets'. This will be done using resource cost drivers that reflect causality. Support activities are then spread across the primary activities on some suitable base, which reflects the use of the support activity. The base is the cost driver that is the measure of how the support activities are used. Determine the cost drivers for each activity that will be used to relate the overhead collected 1 the cost pools to the cost objects/products. This•is based on the factor that drivers the consumption of the activity. The question to ask is - what causes the activity to incur costs ? In production scheduling, for example, the driver will probably be the number of batches ordered. Assigning the costs of activities to products according to product demand for activities: This requires to calculate cost driver rate for each activity, just as an overhead absorption rate would be calculated in the traditional system. 3) 4) 5) 6) The activity driver rate can be used to cost products, as in traditional absorption costing, but it can also cost other cost objects such as customers/customer segments and distribution channels. The possibility of costing objects other than products is part of the benefit of ABC. The activity cost driver rates will be multiplied by the different amounts of each activity that each product/other cost objects consumes. Activities can be grouped into four categories, which are popularly known as the manufacturing cost hierarcliy. These categories are today generally accepted and they were first identified by Cooper (19900.This categorization helps in determining the type of activity cost driver required by the organization. These four categories are as follows:1) Unit Level Activities: The cost of primary activities are highly correlated to the number of units produced. For example, the use of indirect materials/consumables tends to increase in proportion to the number of units produced. Another example of a unit level activity is the inspection or testing of every item produced, if this is deemed necessary or every 1 00th item produced. Batch Level Activities: The cost of mainly manufacturing supports activities are driven by the number of batches of units produced; like material orderingwhere 2) 120 order is placed for every batch of output; or machine set-up costs- where machines need resetting between each different batch of production. Batch of production: Inspection of products- where lm item in every batch is inspected rather than every 100"' item. 3) Product Level Activities: Cost of some activities are driven by the creation of a new product line and its maintenance, designing, producing parts and keeping technical drawings of products up to date. Advertising costs fall into this category if individual products are advertised rather than the company's name. Facility Level Activities: Some costs cannot be related to a particular product line, instead they are related to maintaining the buildings and facilities. Examples are the maintenance of buildings, plant security, business rates, etc. Also included in this category are salaries, such as the production manager's. Advertising campaigns that promote the organization would also be included. New Development/Techniques of Management and Management Control 4) The first and last categories above are the same as those in traditional absorption costing and so if an organization costs are mainly made up of these two categories ABC, will not improve the overhead analysis greatly., But lithe organisation's costs fall mainly in the second and third categories an ABC analysis will provide a different and more accurate analysis. Purposes and Benefits of Activity Based Costing Initially companies switched from traditional absorption costing to ABC in order to produce more accurate cost information for products, as shown above. The managers in some of these companies were surprised by the information reveled, because it gave them a different perspective of the build up of costs/ this led them to adjust their pricing policies and to develop different product strategies, as they found that previously high volume, long production run products had been over-costed and low volume, short production run products under-costed. Total absorption costing averages batch costs, such as set-up, over all products rather than relating them to the batch.) To summarise, ABC is particularly needed by organization for product costing where: • • • • Production overhead are high in relation to direct costs There is a great diversity in the product range Products use very different amounts of the overhead resources Consumption of overhead resources is not primarily driven by volume. But if ABC is only considered to be a more detailed and accurate overhead absorption costing system many organizations may decide to do without it. In France, Germany, the Netherlands and Spain many organizations use a sophisticated "full cost" absorption method and so they have not found it necessary to change to an ABC system. In these organization overheads are usually charged to auxiliary cost centres as well a main cost centres. The auxiliary cost centres are in turn charged to the main cost centres. From the main cost centres the overhead s are charged to products. This is not dissimilar to a full traditional absorption costing system used in the U.K. which uses service or indirect cost centres (such as maintenance) that are then charge in their turn to the direct cost centres. Advocates of using ABC for an accurate overhead apportionment usually compare the ABC technique with the most basic traditional absorption costing system where one blanket overhead rate is applied. 121 Management Control Process Activity Based Cost System Installation and Operation The motives for pursuing an ABC implementation, or at least of investigating its feasibility, must be established at the outset. Most commonly these will be: 1) 2) To improve product costing where a belief exists that existing methods under cost some products and over cost others; or To identify non-value-adding activities in the production process which might be a suitable focus for attention or elimination. In practice the former is the most quoted goal, even though the latter may be more appropriate. This is especially so for firms which are highly labour intensive and which do not have a great diversity of products in their range, and where allocation of over head based on direct labour hours may already function efficiently. Direct costs, like materials and direct labour, are easily assigned directly to products. Some indirect costs, particularly those selling costs which are product specific (e.g. advertising), may be directly assigned to the product too. The remaining indirect costs are those which are problematical and provide the focus for ABC, with resource costs indirectly assigned to the cost object via cost pools and activity driver. A number of distinct practical stages in the ABC implementation are as follows: 1) Staff training: the co-operation of the workforce is critical to the successful implementation of the ABC. They are closest to the process and most aware of the problems. Staff training should be, as far as possible, jargon-free, and create an awareness of the purpose of ABC. It should be nonthreatening in nature, stressing that increased efficiencies resulting from a successful implementation will mean rewards not redundancies. The need for the cooperation of staff in the concerted team effort, for mutual benefit, must be emphasized throughout the training activity. Process specification: Informal, but structured, interviews with key members of personnel will identify the different stages of the production process, the commitment of resources to each, processing times and bottlenecks. The interviews will yield a list of transactions which may, or may not, be defined as `activities' at a subsequent stage, but in any case provide a feel for the scope of the process in the entirety. Activity definition: The problem must be kept manageable at this stage, despite the possibility of information overload from new data, much of which is in need of codification. The listed transactions must be rationalized in order to aggregate those in similar categories and eliminate those deemed immaterial. The resultant cost pools will likely have a number of different events, or drivers, associated with their incurrence. Activity driver selection: A single driver covering all of the transactions grouped together in a `activity' probably does not exist. Multiple driver models could be developed if the data were available, but cost-benefit analysis has rarely shown these to be desirable./ The inter correlation of potential activity drivers will probably be so strong as to suggest that it really does not matter which one is selected. This argument might be employed to avoid the costly collection of data items otherwise not monitored, nor easily accessible/. Costing: A single representative activity driver can be used to assign costs from the activity pools to the cost objects. If, for example, the number of engineering set-ups has been identified as a driver of process costs and the total set-up cost is 2) 3) 4) 5) 122 Rs. 40,000 for a company producing four products (A,B,C,D then the number of set-ups per product can be used to assign these costs/ If product A requires 2 set-ups; B 4 set-ups; C 24 and D 10, then the average cost per set-up of Rs. 40,000/ 40 set ups = Rs. 1,000, a misleading figure made by the different products. However, total set-up costs can be distributed to product groups in proportion to use, i.e., A: Rs. 2,000, B: Rs. 4,000, C: Rs. 24,000 and D: Rs. 10,000 and then assigned to individual units of product in proportion to the total level of output. This procedure can then be repeated for all material activities. Activity 14 List the various stages of ABC implementation. .................................................................................................................... .................................................................................................................... .................................................................................................................... .................................................................................................................... .................................................................................................................... .................................................................................................................... .................................................................................................................... Activity 15 List the categories in which the various activities are classified. .................................................................................................................... .................................................................................................................... .................................................................................................................... .................................................................................................................... .................................................................................................................... .................................................................................................................... New Development/Techniques of Management and Management Control 11.10 SUMMARY Management processes are constantly evolving so as to assimlate the new techniques. The evolution of new techniques is in response to the need of having a mean andlean operations which leads to effectiveness, cost saving and efficiency. In recent years techniques of TQM, BPR and ERP have become quite popular, the underlying reason being their ability of cut costs and increasing productivity. For the successful) implementation of these techniques a close coordination among various units is prerequisite. Value,added analysis helps in identifying the various points in a valaue chain where value can be added MBO deals with setting and meeting objectives. ABC method uses activities rather than cost centres for allocation of overheads. 11.11 1) 2) 3) 4) 5) 6) SELF ASSESSMENT QUESTIONS Identify the attributes of a Quality Product. Identify the main constituents of a Total Quality Management approach. Explain the impact of TQM process on management control system of an organization. In what aspects is the BPR process different from that of TQM. Elabotate the impact of implementing BPR on the organisation processes. Explain the underlying principles of reengineering. 123 Management Control Process 7) In which type of industries the installation of ERP systems would be most beneficial. Draw and analyse the value chain for petrochemical industry. Under what conditions programme and performance budgeting are being used? Also explain why traditional budgeting are being used under these circumstances. How can the agency cost be minimised? Explain in detail the agency theory. Define & explain the concept of Activity Based Costing (ABC) Define the following terms: i) Cost driver 8) 9) 10) 11) 12) 13) ii) Activity cost pool 14) Explain the structuring of organization into cost/activity cost centre, 11.12 FURTHER READINGS Carr. D.K. (1993) Managing for effective business process redesing, Journal of Cost Management, 7 (3). Deming W. Edwards (I 982) Quality, Productivity and Competitive Position. Cambridge Mass: MIT Centre for Advanced Engineering Study, 1982. Feigenbaum, A.V. (1983) Total Quality Contra, Megraw-Hill Inc.-New York, N.J. Imai, M. (1986) KAIZEN: The Key to Japan's Competitive Success, Random I-louse Business Division, New York, N.J. Juran J.M. (1988) Juran on Planning for Quality, Free press, New York, N.J. P.I3. Crosby (1979) Quality is Free Megraw-Hill, New York, Hammer, M and Chyamph, J. (1993) Re-engineering the Corporation. A Mani festo.for Business Revolution, Harper Business, New York, N.J. 124 Prytz Karinne (1995) Performance Management, (ed. Asbjarn Rolstades) Chp. 12 Aspects and Approaches to Quality, Chapman and Hall, London. UNIT 12 SERVICE ORGANISATIONS Objectives The objectives of this unit are to: • • • • • familiarise you with the special characteristics of service organisations; familiarise you with the special characteristics of financial service organisations; enable you to understand how these characteristics lead to control system designs. enable you to understand the specific nature of control system in financial services industry; and familiarise you with non profit organisations. Service Organisations Structure 12.1 12.2 12.3 12.4 12.5 12.6 12.7 12.8 12.9 12.10 12.11 Introduction Characteristics of Service Organisations Financial Service Organisations General Characteristics of Banks Risk Characteristics of Banks 12.5.1 12.6.1 12.7.1 Role of Management Control System in Containing Risk Management Control Implications Management Control System for Mutual Funds Insurance Companies Mutual Funds Non Profit Organisations Summary Self Assessment Questions Further Readings 12.1 INTRODUCTION In the 19th century and upto mid of the 20th century the work force in India was predominantly in agriculture. In the latter part of the 20th century the composition of workforce changed and the employment in the service sector overtook the employment in the manufacturing sector. A major part of our GDP is contributed by the service sector. During recent years we have witnessed a rapid growth in the service sector, the underling reasons being. a) b) c) d) e) f) g) Increase in literacy levels. Increase in level of disposable income. Revolutionary changes in technology. Increased means of communication. Increased mobility of the workforce. Increased level of outsourcing activities. Change in life style pattern. 5 Management Control in Some Special Organisations 12.2 CHARACTERISTICS OF SERVICE ORGANISATIONS 1) Absence of inventory buffer The services can't be stored, if not used at a point of time they get its unused capacity. The cost of many service organisations are fixed in the short run. It can't be reduced with the level of activity in the short run. A key objective in most of the service organisations is to extent possible match current capacity with demand. This can be done in two ways either by stimulation of demand for the current capacity or by adjusting the sise of the workforce. 2) Difficulty in controlling quality It is difficult to quantify the quality of services, even after the service is rendered quantification would be subjective in nature, 3) Labour intensive Service organisations are labour intensive. With the advent of technology the labour intensiveness has decreased but as compared to manufacturing sector, service sector is more labour intensive. 4) Multi unit organisations Some service organisations operate many units at different locations each of which is relatively small. The similarity of these separate units provide a basis for comparison, analyzing budgets and performance evaluation. In order to identify high, medium and low performers the information from each unit can be compared with system wide or area specific averages. Structurally the units may be same but they differ in mix of services they provide and amount of resources they use and this difference should be factored while making such comparisons. A technique which factors in such difference is known as data envelopment analysis. 5) Supply of services can't be increased in the short run Although services are classified as intangibles, but to produce these Intangible services a extensive tangible infrastructure has to be created which requires time and other resources. Activity 1 Take the case of any service organisation and evaluate it's major and implied characteristics. ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………….……………………………………………………………… 6 12.3 FINANCIAL SERVICE ORGANISATIONS The Indian financial system comprising of commercial banks. financial institutions, insurance companies and the capital markets has undergone a very rapid transition during last one and a half decade. In broader terms the transaction has been towards autonomy of these financial institutions and broad baseing the ownership, before we move further let us briefly discuss the general characteristics of the financial service sector. Monetary assets: Most of the assets of financial service firms are monetary or are of such nature that they can be easily converted to monetary units with very little transaction cost. In financial services quality refers to the quality of the financial services rendered and the quality of the instruments offered. Financial assets can be transferred from one owner to another quite easily and transaction cost is quite less as compared to transfer of other assets. With the advent of information technology the fund transfer has become vary easy, fast and accurate but at the same time some questions about the integrity of the system needs to be tackled. Time period of transaction: In case of financial services firms, the impact of the action has short term as well as long term consequences - depending the product which in being offered. For example a fixed deposit offered by a bank carrying interest rate of say 10% and tenure of 5 years. On this fixed deposit bank earns a spread of 3%. This implies that the bank's lending rate in 13%. During the tenure of the fixed deposit there is a downward pressure on interest rates and as a consequence the bank is forced to decrease its lending rate to 11% thereby reducing the spread to 1% only. Here the impact of fixing the interest rate at 10% is felt after a relatively long period. Same is the case when financial firms issue bonds, pension plans etc. Similar circumstances prevail when insurance companies issue policies and decides about insurance premium and maturity of these policies. This implies that the ultimate performance of those involved in authorizing and structuring the financial products can't be measured at the time when initial decisions are being made. On the other hand there are certain type of financial services where the impact of decision made can be continuously measured. Examples are investments made by mutual funds, dealers dealing in foreign currency market, bond market and money market. Risk and reward: Risk and reward is the cardinal principle of any business and more so of financial services sector. The returns are a function of the risk associated with that particular product. If we look at various instruments ranging from fixed deposit with banks, government securities, bonds issued by private companies, mutual funds, equities, in each of the case the return is associated with risk. The returns are lowest in case of bank deposits and government securities (risk being minimum) and highest in case of equities the risk being maximum. The same principle is being followed in case 'of pricing of services which involve high risk in the form of default in payment are priced highly as compared to services which bear minimum risk, example in case of credit cards the interest charged is anywhere from 2% to 3.75% monthly, whereas for bank loans secured by collateral the interest charges are just .75% to 1% monthly. Regulations: Financial services are highly regulated. in India banks are regulated by RBI and various banking laws, capital markets are being regulated by SEBI and the Insurance companies are regulated by various: insurance laws and Insurance Regulatory and Development Authority (IRDA) Service Organisations 7 Management Control in Some Special Organisations Activity 2 Try to find out the various types of financial service organisations and the various services which they provide. ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... 12.4 GENERAL CHARACTERISTICS OF BANKS Management Control Implication If Bank branches are treated as profit centre one needs to look at the following issues. (1) The relationship between rate and maturities of deposits (liabilities) to the rate and maturities of loans (assets), (2) deposit volume (3) loan losses (4) Expenses (5) Join revenue (6) Transfer prices 1) Interest Rates: Let us assume that deposits could be obtained at 7-8% and loans would earn interest of 10-14%, This spread of 3-6% would cover expenses including loan losses and leave a satisfactory profit. If the banks are able to maintain a constant spread. with reasonable volumes, whatever the actual rates may be they would generate a satisfactory profit, but the problem arises when banks advance loans and make deposits at a fixed rate of interest but have to pay a relatively high interest on deposits, charge lower interest on loans and advances to retain customers resulting into inadequate spread. Thus the relationship between interest revenue and interest expense is key variable. Banks regularly calculate the amount of interest sensitive assets and interest sensitive liabilities and the gap which is the difference between them. The monetary amount of this gap is known as interest rate exposure. The interest rate exposure can be controlled by buying or selling securities or by increasing or decreasing the amount of new loan, but nowadays the maters are not as simple. With the introduction of new financial products and innovations such as futures, options, caps, floors and swaps, factoring, securitisation etc. it has become difficult to assess the gap and as a consequence the interest rate exposure. While granting loans the managers look at certain parameters which are popularly known as 4 C's. The borrowers general character, his capability to repay the loan from earnings or other sources, his `capital or net assets and the collateral pledged for that particular loan. In banks many officials are involved in making loan and investment decisions. In India the usual practise is that the sanctioning authority is limited. Branches are allowed to sanction loans upto a certain limit, this limit may vary from bank to bank and branch to branch.: Loans of greater amount are sanctioned by Zonal or Regional headquarters, still if the loan among is higher the loans are sanctioned by the headquarter. As far as investments are concerned_ it is centralised under the direct control of the headquarter. Senior management of banks set the rates on loans of various risks and maturities and also on deposits of various maturities. 8 The cost of obtaining funds is not same for all the funds procured by the bank and the cost will depend upon time, maturity, amount, liquidity in the economy, money market conditions etc. and while calculating transfer price this difference in cost of funds should also be factored. One method to overcome this is to average the cost of funds. Another one is to define "pools" of funds obtained at similar rate and decide the transfer price for each pool. Expense Centre: The arguments regarding the transfer price are common among bank managers, and some bank rules that undue controversy regarding transfer prices will give rise to conflicts and unhealthy competition among the branches. In order to avoid all this the banks use expense centre to control branches and other units. The performance is measured by such indicators as increase in loan disbursement, unit or rupee output per staff, revenue and market share by product, expenses per rupee of revenue as compared with the budget and quality indicators. In India since banks have social obligations certain other parameters like loans and advances to priority sector, agricultural sector, weaker section of the society were taken into consideration for performance measurement. The role of management control system is that the priorities of the top management are communicated within the organisation. It is also equally important that the various rules, procedures, formalities and due diligence are followed and adhered to while making loans and investment. In addition to this the lending and investment managers are restricted in their actions by various statutory restrictions with respect to amount of loans and investment, various types of instruments with respect to maturities. In India certain percent of banks loans have to be channeled to priority sector, weaker sections of the society, agriculture, food grain credit and other priority areas of the government. 2) Volume: Most of the bank expenses are fixed in the short run, thus if the banks can increase the volume of the deposits it can make more loans and increase its profit, In Indian context what we see as of now is that banks are flush with liquidity and as a consequence the interest rate on both loans and deposits have come down drastically. The lowering of interest rates had a positive effect on the economy which can be seen in robust growth in housing, infrastructure, sale of consumer durables etc. The management control issue involved here is that the banks while increasing volume of credit off take should take adequate safeguard to verify the background of borrowers so that in latter stages the loans are not turned into NPA's. 3) Loan losses or Non performing assets: During the late 1980s and early 90s the stability of the Indian banking as a whole was shaken due to the rising levels of NPA's which were hovering around 20-25%. In part this was a consequence of decline in business growth, in part it reflected incompetent or unethical management and to some extent it was result of fraud. To top it up the banks were not making adequate provisions for the same and in order to show higher profits the banks were showing interest income against these loans whereas in reality non existed. In order to stop these practises Reserve Bank of India had imposed strict norms for classification of non performing assets and provisioning. 4) Expenses: Till the early 90s most of the expenses in banks were personnel related. The bank office expenses that of recording the transactions and maintenance of books, which are subject to budgeting and controls are similar to the control In , manufacturing company. Banks have a problem of allocating common cost. Cheque and drafts clearing is done centrally and the cost of such work must be equitably assessed to the branches. Similarly the Automated Teller Machines (ATM systems) are fairly expensive operations which are managed centrally but the benefits are accrued to the branch in which deposits are maintained. In the same way Electronic Transfer of Fund (ETF) facility is centrally operated and maintained but the benefit accrues to the Service Organisations 9 Management Control in Some Special Organisations branch in which deposits are maintained. From the mid 90s there has been a reorientation in the functioning of the banks the proportion of personnel cost in total expenses has decreased over a period of time and this has been made possible by offering Voluntary Retirement Scheme (VRS) and Golden Handshake to the employees. Nowadays the banks lay more emphasis on technology and as a consequence expenses related to technological upgradation, installation of new hardware and software, 'training of manpower to use the same, broad band connectivity expenses are on rise. The management control issue involved here is to overcome the resistance towards technological changes and to make employees aware that huge amount of resources has been invested in the same. The management control systems should be able to communicate to the employees that these technological tools if used properly would provide an competitive edge over the rivals and at the same time will bring the expenses down thereby increase overall productivity. 5) Joint Revenues: Technological advancements in computers and information technology has acted as a catalyst for banks in providing innovative banking services like Any where banking and any time banking. With the application of information technology now a bank customer can withdraw/deposit money in any of the bank branches. He can pay utility bills on-line, in sum and substance he can use whole of the branch network of the bank irrespective of the fact in which particular branch he has opened his account. Now the question which needs to be answered is how the revenues generated by providing services. are going to be distributed among the various branches and this answer becomes more significant if the branches are organised as profit centre. There are alternatives: i) ii) iii) iv) The whole of the revenue generated by providing the services goes to the branch which had provided the service. The whole of the revenue generated by providing the services goes to the branch which is operating that particular account. The revenue generated by providing the services be divided between the branches in an agreed proportion. The revenue generated by using the facilities which are operated centrally be accrued to the headquarter A/C. Out of the four alternatives outlined above choosing (i),(ii) and (iv) will result in a difunctional behaviour among the employees at the branch level, due to the fact that in case whole of the revenue is retained by the branch providing the service the managers would be more focused on providing the services rather than concentrating on opening new accounts and providing loans. In case whole of the revenue is retained by the branch which is operating the account, other branches would not be inclined to provide quality, services to customers of other branches. The arguments outlined above are also valid for alternative no. iv. In such circumstances the management should communicate in very clear terms that satisfied customers are the banks principal assets and in the long run bank will progress only if the branches are able to create satisfied customers. Customer relationship is the key to survival in the long run. 6) Transfer Prices: Many commercial banks set up profit, centre for their branches or for their individual headquarter activities or for both. In banks some branches are loan heavy (their loans exceed deposits) e.g. branches at commercial centres, markets etc. whereas others are deposit heavy e.g. branches in which salary accounts are maintained, situated in residential colonies etc. The profitability of each type of these branches cannot be measured correctly unless the transfer price is fair to each type of 10 branches. If the transfer price for the cost of money is set too high the profitability of deposit heavy branches would be overstated and if the transfer price is set too low the profitability of loan heavy branches would be overstated. Measurement of cost of money is also important in assessing the profitability of loans with different maturities and risk characteristics and loans to different markets. The funds are primarily obtained by customers who make various kind of deposits of various maturities. Deposits are-basically of two types (i) Time Deposit (ii) Demand Deposit. Other type of deposits are either a variation of these two or a hybrid product. The interest cost of borrowed funds and time deposits are-easily determinable, but determining the same for demand deposits is a little bit complicated. While calculating the same two facts are to be factored in (i) Demand deposits are being regularly serviced, the cost of providing the services, should be factored. 2) The government regulations stipulates that certain fraction of deposits be held in reserves on which rate of interest is low. Service Organisations 12.5 RISK C A CTERISTICS OF BANKS The points discussed so far relates to the general characteristics of the banks. Now let us discuss about the risks which are faced by the banks in general and in latter part of this section we are going to discuss about the regulatory framework to contain and minimise these risks. Risk has been always present in the banking system but in recent years the management of risk had gained prominence due to the following factors: i) ii) Growing deregulation of the local markets and their gradual integration with the world markets. Growing diversity in banking operations. Lending and deposit taking are the main functions of a bank, but in recent years the banks have diversified their activities into derivatives trading securities underwriting and corporate advisory service. Some banks have expanded their traditional credit product to include asset securitisation and credit derivatives while others have forced into transaction processing, custodial services or asset management business and venture capital funding. With the advancement of information technology more and more banks are venturing into on-line electronic banking covering traditional banking as well as providing of bill presentation and payment services. iii) All these developments points towards increase in diversity and complexity of risks. Banks would have to develop risk management systems that are rigorous and comprehensive. The banks are facing four types of risks which are as follows a) Credit Risk b) Interest Rate risks, c) Foreign exchange risk & d) Liquidity risk. a) Credit Risk: Credit risk is basically the risk associated with extending the loans and advances. This risk manifest itself in the form of creditors not returning the loans and advances. During the recent east Asian financial crisis the NPA soared to over 30 per cent of the total assets of the financial assets. The credit risk depends upon both external and internal factors. The external factors are the state of the economy, swing in commodity pricey and equity prices, foreign exchange rate, inflation and interest rate. The internal factors are deficiencies in loan policies and administration of loan portfolio which would cover weaknesses in the area of prudential credit concentration limits, appraisal of borrowers financial 11 Management Control in Some Special Organisations position, excessive dependence on collateral and inadequate risk pricing, absence of loan review mechanism and past sanction surveillance etc. With increasing product innovations such risks may appear in more complicated and less conventional forms in credit derivatives or trenches of securitised assets. b) Interest Rate Risk: Interest rate risk arises because banks fix and refix interest rates on their resources and on the assets in which they are employed at different times. Changes in interest rates can significantly impact the net interest income depending on the extent of mismatch between the times when the interest rates on assets and liability are reset. Any such mismatches cash flows (fixed assets or liabilities) or repricing (floating assets or liabilities) expose bank's net interest margin to variations. Foreign Exchange Risk; During recent years the volatility in exchange rates had increased the underlying reason being the sharp swings in imported commodity prices, increased FII activity in local markets, trade deficits etc. Banks running an open position in foreign exchange either in spot or forward market are susceptible to this risk. Liquidity Risk: This type of risk arises from the fact that when the banks finance long term assets (loans) from short term liabilities (deposits) thus subjecting them to rollover or refinancing risk. This risk is also inherent in those transactions where banks finance domestic assets (loans) with foreign currency deposits (liabilities). This problem become more acute with sharp fluctuation in currency prices and market turbulence which results in customers withdrawing foreign; exchange from their accounts. c) d) Activity 3 List the various types of risks being faced by banks. ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... 12.5.1 Role of Management Control System in Containing Risk Banks and financial institutions have unique and important place in economic system of any country. Any instability in the banking system has a cascading effect on the whole of the economic system even across the national boundaries as was witnessed during the east Asian financial crisis. Keeping in view the potential instability which can be created by banks through ill functioning banking system the banking systems are closely regulated at two levels i) Macro level; ii) Micro level. Let us look at these regulations and the role of management control systems in enforcing these regulations. The macro level regulations are broad policy framework issued by central bank (in case of India RBI) within which the banks have to operate. The micro level regulations are specific to a particular bank designed by the top management of the bank which specifies the operating guidelines, authority and power of the managers at different levels. 12 The role of the management control system in banks is to ensure that systems and procedures are designed in such a way that the bank functions in accordance with the regulations specified and if any deviation occurs the same can be detected and acted upon before much harm is done. The management control:system is mainly concerned with risk containment. Major type of risks were discussed in the previous section in this section we are going to discuss how these risks can be contained. Credit risk: In order to minimise credit risk two areas of banking operation require special attention 1) Loan and Investment policy; 2) Ongoing management of loan and investment portfolio. Banks should lay down transparent policies and guidelines for credit dispensation in respect of each of the broad category of economic activity. The banks should clearly articulate risk return philosophy and adopt risk mitigating tools like multi tier credit approving system, prudential portfolio limits, loan grading, risk pricing portfolio management and loan review mechanism. The prudential limits need to be laid down on various aspects of credit viz. benchmark current debt/equity ratio and profitability ratios, debt service coverage ratios, concentration limits for single/group borrowers, maximum exposure limit to industry etc. Banks should develop a comprehensive risk scoring system that serves as a single point indicator of diverse risk factors of a counter party. In case of loan and investment portfolio management the management control systems should centre around adequacy of policies, practises and procedures, operation of the scheme of delegation, classification of assets, loan loss provisioning for loans and investment concentration risk, adherence to prudential exposure norms, scope and adequacy of audit and loan review functions and compliance with rules and regulations. Interest rate risk: In order to contain interest rate risk banks should make a clear distinction between their trading activity and balance sheet exposure. As regards to trading book, Value at Risk (VAR) is presently the standard approach. This method is used to assess the potential loss that would incur on trading position or portfolio due to variation in market interest rates and prices. For balance sheet exposure to interest rate risk banks rely on 'gap reporting system, identifying asymmetry in repricing of assets and liabilities commonly known as gap. Foreign Exchange Risks: The banks in general use the VAR approach to measure the risk associated with foreign exchange exposure. Another strategy is to put limits on the absolute exposure as well as exposure to individual currencies. The banks are required to put 100 percent risk weight to open position limit in foreign exchange. Liquidity Risk: All banks are required to maintain Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR). The RBI can modify CRR; between 3% to 20% and SLR between 25% to 40%, banks should compute these ratios as prescribed by the RBI. In order to contain liquidity risk the banks should monitor the liquidity by measuring the cash flow mismatches which arises due to difference in timings of maturity of assets and liabilities. The future cash flows are to be bracketed indifferent time buckets and a tolerance levels for various maturity mismatches has to be fixed depending upon banks asset-liability profile, extent of stable deposit base, nature of cash flows etc. The mismatches of cash flows (negative gap) in time bucket of 1-14 days and 15-28 days should not exceed 20% of the cash outflows. Apart from containment of risk the management control systems should also provide for clear arrangements for delegating authority and responsibility, separations of the functions that involve committing the bank, paying away it funds, proper account for its assets and liabilities and reconciliation of these processes. It should also provide for appropriate independent external or internal audit and adherence to controls as well as applicable laws and regulations. Another area of concern for management control system should be the internal inspection and audit machinery which is responsible for introduction of internal controls system for prevention of frauds. Service Organisations 13 Management Control in Some Special Organisations In India the onsite inspection of banks are based of (CAMELS) model where CAMELS stands for (Capital adequacy, asset quality, management, earnings, liquidity and systems and control). The management control system should be designed in a way that it is capable of measuring monitoring and controlling the above parameters. Apart from these the MCS should also pay sufficient attention towards the following parameters. 1) 2) 3) 4) 5) 6) 7) 8) Establishment of internal control culture within the bank Internal control activities shall be designed and implemented tc address as an integral part of daily operations. Functional segregation of duties and assignment of responsibilities Establishment of reliable information systems in bank. Control of information system and technologies. Establishment of effective channels of communication. Monitoring activities for internal control process and correction of deficiencies. Risk identification and assessment process. Activity 4 List the parameters on which onsite inspection of banks is done. ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ……………………………………………………………………………………….. 12.6 INSURANCE COMPANIES General Characteristics There are two type of insurance companies a) Life insurance b) General (casualty) insurance. A life insurance company is concerned with insuring the life of human beings. Two type of policies are offered by life insurance companies which are whole life and term insurance policies. Under the whole life policy the person has to pay a premium for a certain period and he is insured for the whole life, the maturity value of the policy would be only payable on the death of the insured person to his inheritors or the beneficiary of the policy. Whereas under term insurance policy the benefit of insurance is available for the term of the policy only, beyond that the benefits are not available. Under this policy on the completion of the term or upon the death of the policy holder whichever occurs earlier the maturity value of the policy would be paid to the beneficiary of the policy. General (casualty) insurance is concerned with the insurance of property and physical assets. A general insurance company collects premium, invest them and make payments to policy holders for specified losses. General insurance policies provide coverage for a short period, generally three years. Some policies pay for claims made during the period; others pay for losses incurred during the period even though claims are lodged in a later period. 14 Insurance Market Structure In a growing/developing country like India, the need for insurance is well recognised. The insurance industry is broadly classified into two categories a) Life Insurance b) Non life insurance also known as general insurance. Up till recently the insurance business was monopoly of state owned Life Insurance Corporation and General Insurance Corporation (GIC) and its four subsidiaries.-The Insurance Regulatory and Development Act 1999 has opened the insurance sector to private participation including foreign equity participation up to 26% of the paid up capital. The share of the insurance premium in the savings of the house hold sector increased from 7.6 in 198081 to 11.4 in 1999-2000. Insurance penetration measured as the ratio of insurance premium to GDP was 2.6 in 1998 which is quite low as compared to world average of 7.4 percent. Activity 5 Try to find out the main features of various life insurance policies ............................................................................................................................................ ............................................................................................................................................ ............................................................................................................................................ ............................................................................................................................................ ............................................................................................................................................ ............................................................................................................................................ ............................................................................................................................................ ............................................................................................................................................ ............................................................................................................................................ ............................................................................................................................................ 12.6.1 Management Control Implications Service Organisations The central management control problem in insurance companies especially life insurance companies is that proper estimation of profits associated with current policy sales can't be estimated until years later. They set premiums based on their best estimates of inflows and outflows associated with the policy. The profit of any policy can't be known until the maturity of the policy and settlement of the final, claims, but management can't wait that long to make control decisions. Due to the nature of insurance business the profits can't be taken as a yardstick for measurement of performance for current business therefore for control purposes insurance managers give more attention to expense control and product pricing. 1) Product pricing Any insurance company may have dozens of policies, targeted at different strata's of society. An insurance policy apart from containing basic feature of insurance may contain many other features like tax saving, financial planning, capital appreciation etc. The pricing of the policy will depend upon the features incorporated in the policy plus the individual characteristic of the person insured i.e. age, gender, risk profile etc. The, actuary's calculation of premium consider's the following factors. Acquisition cost: The commission paid to the sales agents and the cost associated with sales organisation. Servicing cost: Cost associated with collection of premiums, accounting for them and allocation of corporate overhead. Lapse probability: The probability that the policy would be cancelled due to non payment of premium. Investment income: The income that will be earned by investing the premiums until the policy is paid. 15 Management Control in Some Special Organisations Probability of payment: For life policies this depends on the age of the person insured and the probability of death is determined from mortality tables and other demographic data. For casualty companies these estimates depends upon the data on likelihood of occurrence of the events insured against, together with the probable amount of payment against these events. Income taxes and statutory regulations: Income tax regulations for the insurance industry are significantly different from other industry, similarly the insurance companies are required to calculate profits and bonus as per the norms specified. Required earning rate: The rate at which inflows and outflows are discounted to arrive at their present value. 2) Sales Performance Up till recently the insurance business in India was a monopoly business but with the opening of the insurance sector sales are going to be a crucial factor. The management control implication here is that apart from hard core selling, efforts should be made for product development viz. designing policies which caters to the need of a large proportion of insurable population. 3) Expense control As with any other industry expense control should be a major pillar of management control systems. Apart from these general areas the nature of the insurance business implies investment in and the holding of assets. In order to ensure that contractual liabilities of policy holders are meet the assets hold be managed in a prudent manner taking in account the profile of liabilities held by the company and the risk return profile of the assets. The risk return profile should result from on integrated view on product, underwriting, reinsurance policy, investment policy and solvency level policy. The management control system should focus on the following areas. 1) 2) 3) 4) 1) Asset liability management The investment process Risk management function Internal control Assets Liability Management: A key driver of asset strategy by the insurance companies would be it's liability profile and the need to ensure that it holds sufficient assets of appropriate nature, term and liquidity to meet those liabilities which becomes due. This requires the testing of resilience of the asset portfolio on range of market scenarios and investment conditions and it's impact on solvency position of the company. The Investment Process: Depending upon the nature of liabilities an insurance company is likely to hold the following assets either directly or via other instruments or through third party investment managers, a) b) c) Bonds and other fixed income securities Equities and equity type instruments Debts, deposits and other rights Property 2) 16 d) The holding of a given asset portfolio carries a range of investment related risks, technical provision and solvency which needs to be monitored, measured, reported and controlled. The main risks are a) market risk b) credit risk c) liquidity risk d) operational risk. The investment strategy consists of the following steps. a) b) c) d) Formulation and development of a strategic and technical investment policy. Implementation of the investment policy on the basis of clear and precise investment mandate. Control, measurement and analysis of the investment results which have been achieved and the risk taken. Feedback to the appropriate level of authority Service Organisations For a successful investment strategy the insurance companies must ensure the existence of the following a) b) c) The definition of strategic investment policy by the Board of Directors, based on assessment of the risks incurred by the company and its risk appetite. On going Board and senior management oversight of, and clear management accountability for investment activities. Comprehensive, accurate and flexible system which allow identification, assessment and measurement of investment risks, and the aggregation of risks prevailing at various levels. This system should be sufficiently robust to reflect the scale of the risks and the investment activity undertaken capable of accurately capturing and measuring all significant risks in a timely manner understood by all relevant personnel at all level Key control structures, such as segregation of duties, approval, verification and reallocations. Adequate procedures for measurement and assessment of investment performance Adequate and timely communication of information on investment activities at all levels. Internal procedure to review the. appropriateness of the investment policies and procedures in place Rigorous and effective audit procedure and monitoring activities to identify and report weakness in investment control and compliance Procedure to identify and control the dependence on, and vulnerability of the process to key personnels and systems. d) e) f) g) h) i) Formulation and approval of the investment policy is the responsibility of the Board of Directors. The main factors considered by the board for formulation of strategic, investment policy are the insurance company's overall risk tolerance, its long term risk-return requirements, its liquidity requirements and solvency. The investment policy, which should be communicated to all the staff engaged in investment activities should in principle address the following elements. a) The determination of the strategic asset allocation; long term investment over the main asset categories. 17 Management Control in Some Special Organisations b) c) d) e) The establishment of limits for the allocation of assets by geographical areas, sectors, counter parties and currency. The formulation of an overall policy on the selection of individual securities and investment titles. The adoption of passive or active investment management in relation to the level of decision making. In the case of active management, definition of scope for investment flexibility an( autonomy usually through the setting of quantitative exposure limit. The extent to which the holding of various types of assets is prohibited or ruled out or restricted where for example the disposal of the asset could be difficult due to illiquidity of the market or where independent (external) verification of pricing is not available. An overall policy on the use of financial derivatives, swaps, hedging or of structured products that have economic effect of derivatives. The framework of accountability for all asset transactions. The systems should be designed to provide accurate and timely information on asset risk exposure. Remuneration policies are structured to avoid potential incentives for unauthorised risk taking. Adequate segregation of the functional responsibility of measuring, monitoring and controlling investment activities from those conducted for day to day asset transaction f) g) h) i) j) k) 3) Risk Management Function A part of the premium collected by insurance companies is used to meet the expenses and for the purpose of settlement of claims. The remaining part is invested in various financial instruments. The returns from these investments is used to pay bonus on policies and settlement of claims. Bad investment can give risk to non fulfillment of contractual obligation and default on payment of bonus and settlement of claims. In order to avoid this the insurance companies should put in place a risk management team which is capable of identifying, monitoring, measuring, reporting and controlling the risks associated with investment activities. The risk management team should be responsible for a) b) c) d) e) Monitoring compliance with the approved investment policy Formally noting and promptly reporting breaches. Reviewing asset risk management activity and results over the past period Reviewing the asset/liability and liquidity position Assessment of the appropriateness of the allocation limit, to do this regular resilience testing should be undertaken for a wide variety of market scenario and changing operating and investment conditions. Once those situations are identified under which the insurance company is at maximum risk, the risk management team should ensure that appropriate change are made in policies and procedures as defined in it's investment manual. 18 4) Internal Controls: Adequate system of internal control must be present to ensure that the policies and procedures are followed in letter and spirit. The internal control procedure should be documented. The internal control procedure should include the following. a) b) Reconcilliations between front office, back office and the accounting systems. Procedure to ensure that limits and restrictions on the power of all the concerned to enter particular asset transactions are observed. This requires regular and close communication among compliance', legal and documentation divisions. Procedure to ensure that formal documentation is completed promptly. Procedure to ensure reconciliation of position reported by brokers and other intermediaries. Procedure to ensure that trades/positions are properly settled and reported and late payments and receipts are identified Procedure to ensure that transaction are carried out at prevailing market rate terms and conditions. Procedure to ensure that authority and dealing limits are not exceeded and breaches if any be reported immediately. Procedure to ensure independent checking of rates/prices; the system should not solely rely on dealers for rate/price information. Service Organisations c) d) e) f) g) h) 12.7 MUTUAL FUNDS A mutual fund is a vehicle of investment in capital market and other short term money market instruments for investors. Frank K. Reily has defined mutual fund "An investment company is a pool of funds belonging to many individuals that is used to acquire a collection of individual investments such as stock, bonds, other publicly traded securities" John A. Halin has given a more elaborate definition of mutual funds, according to him "Mutual funds are the major type investment companies. Investment companies are financial intermediaries (middlemen) that pools the funds of investors who are seeking some general investment objective and invest them in number of frequently traded different type of securities (e.g. common stock, bonds, money market securities. These pooled funds provide thousand of investors with proportional ownership of diversified portfolios which are operated by professional investment managers". Importance of Mutual Funds Savings which lead to capital formation are an important component of any economy. As the economy grows and develops it's investment pattern are characterised by a mature way of mobilisation of funds - a shift from self financing to direct financing and then to indirect financing. Indirect financing is where financial intermediaries like banks, insurance companies, mutual funds 'and other financial companies come in picture and mediate between savers and borrowers of funds. Mutual funds play a crucial role in an economy by mobilising savings and investing them in the capital markets in form of equity and debt instruments, mutual funds is one of the important links between savings and the capital market. Activities of mutual funds have both short term and long term impact on the national economy. Mutual funds assist in the process of deepening and intermediation. 19 Management Control in Some Special Organisations The average share of mutual funds in household financial assets is over 5 per cent in USA, 8 per cent in Germany, 3 per cent in Japan and Italy and about 5 per cent in India. In India the overall assets under management (AUM) of Mutual Funds is over 1,50,000 crores, and IPO collection of mutual fund during last 6 years is given in Table 12.1. Table 12.1: IPO collection of mutual funds in India Financial year F4 05* F4 04 F4 03 F4 02 F4 01 F4 00 Source : AMFI Till Dec. 04 # Since July 99 Activity 6 Try to find out about the various mutual funds operating in Indian and list the major type of mutual fund schemes. ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… 12.7.1 Management control system for mutual funds The overall activities of mutual funds can be categorised under the following of heads : 1) 2) 3) 4) Fund Management Operations Customer Service Sales and Marketing Amount (Rs. in crore) 12,942 8,549 3,735 3,335 3,929 4,906 Management Control system for each of these activities will span across three dimension : Policies and procedures, systems and organisations. The management control system is basically concerned with the reduction of risks, compliance and overseeing that the regulatory requirements are being meet. The policies and procedures document should build a framework of the fund and should contain 20 • • Investment policy including risk philosophy Operating procedures • • • • Compliance manual Code of conduct Disaster recovery and business contingency plan Reporting framework Service Organisations The systems framework should lay emphasis on an enterprise wide integrated network capable of the following applications • • • • Integrated front and back office systems for fund management, dealing, and trade confirmation Fund accounting system for calculation of Net Asset Value (NAV) Unit holder administration and servicing systems for customer service Financial accounting and reporting system for the Asset Management Company (AMC) The mutual fund organisation should be designed taking into account the following factors, • • • • Segregation of front office and back office in the AMC Independent verification of data input Establishment of committees for investment, valuation and audit Development of a second line for key position Coming to the operational part the management control system should strive to minimise risk and maximise compliance. We are going to discuss in detail the fund management and operation part and it's impact on the management control structure and design along the three dimensions outlined above. 1) a) Fund Management Policies and Procedures The mutual funds should have well documented investment policy which should • • • • • • b) articulate investment strategy and risk philosophy define the objectives, asset allocation, targets and model portfolio define the investment process define limits and procedure for monitoring the same define exceptions and their monitoring provide guidelines for transaction with associate companies and inter scheme transfer define investment norms for debt instruments based on credit rating System: The Mutual Fund should ideally implement a front office system which is integrated with the back office. • setting up of parameters such as asset allocation limits, counter parties, securities, associate. 21 Management Control in Some Special Organisations • • • • • • • • • • C) Straight-through processing (i.e. the flow of order and trade information from the front office) to allow one time capture of investment decisions. system check on preset parameters and reporting of breaches automatic time-stamping of deals maker-checker authorizations exception reporting monitoring of outstanding confirmations, settlements and payments access controls and firewall decision support capabilities and portfolio modelling (e.g. scenario analysis, what-if analysis) risk-adjusted performance measurement (e.g. Value at Risk (VAR) analysis reporting on target vs. actual portfolio. Organisation: The Mutual Fund should establish an Investment Committee. This committee will be responsible for: • • • laying down the Mutual Fund's investment policy and philosophy reviewing performance and positions with regard to the objective of the schemes researching and reviewing counter parties and debt issuers with regard to credit risk. The front office (fund management) and back office functions must be segregated. The Mutual Fund should ideally have segregated research, portfolio management and dealing teams. Specific Risk Management Measure for Fund Management i) ii) iii) iv) v) vi) vii) viii) ix) x) Volatility in performance Unexpected change in market conditions Quality of investment research, facilities, people and procedure Execution of deals at sub optimal prices "Back to back" transactions in debt securities of associates or associate companies Internal deals between schemes or portfolios Investment in securities issued by associates or, purchase and sale of securities to associates Style drift and portfolio concentration Interest rate movements Liquidity issues Credit risk 22 xi) 2) Operational risk a) Policies and Procedures • The Mutual Fund must buy insurance cover against third party losses arising from errors and omissions, liabilities arising out of financial loss to investors or any other third party, incurred due to errors of employees, trustees, R&T agents, etc. Custodians must also buy separate insurance cover for errors and omissions. The Mutual Fund should purchase insurance to cover first party losses. First party losses are the asset based losses (due to natural or unnatural disasters such as fire, flood, burglary, etc. Compliance should review all trading activities at frequent intervals. Operating procedures should lay down reconciliation activities and their frequency: End-of-day broker confirmations with records of deals. End-of-day reconciliation of positions with custodian data At least once a week complete reconciliation of fund accounting system records with custodian. Daily reconciliation between Mutual Fund and others (banks, counter party, etc.) The Mutual Fund should establish a personal trading policy and a code of conduct for employees. Service Organisations • • • • • • • • • b) System: • The Mutual Fund should consider implementing integrated front and back office systems which is capable of: • • • • • • • • • Straight-through processing to allow onetime capture of trade details. Pre-trade compliance checking Automatic time-stamping of deals. Maker-checker authorizations Exception reporting Generation of deal confirmations Monitoring of outstanding confirmations, settlements and payments Cash management Access controls and firewalls, virus protection and other security functionality. Integrated reporting across the Mutual Fund • • The Mutual Fund should ensure that the fund accounting systems used facilitate: Validation of NAV calculations 23 Management Control in Some Special Organisations • • Automated and manual price feeds Identification of missing prices • Flagging of price variances beyond preestablished tolerance levels. Specific Risk Management Measures for operations. 1) 2) 3) 4) 5) 6) 7) Deal errors Settlement Problems NAV and fund pricing errors Inaccurate financial reporting Frauds Failure of mission critical system and infrastructure Obsolete systems As far as other aspects of mutual fund operations are concerned the focus of the management control system is on the following areas. 1) 2) 3) 4) 5) 6) 7) Investor service Prevention of frauds New product development Selling and distribution Prevention of critical knowledge loss Augmentation of skill set of employees thereby reducing skill shortage Compliance with regulations Management control system for mutual funds is basically concerned with reducing risk, which are associated with investments and operations. 12.8 NON PROFIT ORGANISATIONS A non profit organisations is defined as an organisation which cannot distribute assets or income to, or for the benefits, of its members officers or directors however, this does not imply that the employees are not to be given salary. Non profit organisation are not prohibited from making profits, but are prohibited from distribution of profits. If needs to earn moderate profits on average to provide for working capital, and capital expenditure. Special Characteristics 1) Absence of Profit Measure: The goals of the most of the non profit organisation are intangible and qualitative in nature. This absence of satisfactory, quantitative, overall measure of performance is the most serious management control problem in a non profit organisation. Net income of non profit organisation is interpreted differently from that of business organisation. In non profit organisations, net income should average only small amount above zero. A large net income implies that the services are rendered well above their cost. Financial performance is not a dominant goal in a non profit organisation, 24 but it is a necessary goal because the organisations cannot survive if the revenues on average are less that it's expenses. As far as financial parameters are concerned the goal of the non profit organisation should be that of "self sustenance" i.e. its revenues are enough to meet it's expenses. 2 Some peculiar Items: The rules of preparing final accounts of commercial organisations and final accounts of non profit organisations are same, but there are some items which are specific to non profit organisations. The description and the accounting treatment of each is discussed below. Service Organisations a) Capital fund : The excess of assets over liabilities is called capital fund or general fund. It is similar to capital account of commercial organisations. b) Annual subscriptions : It is a revenue item and credited to income and expenditure account. It is one of the primary sources of income of a non profit organisation. c) Life membership fees : It is treated as capital receipt, which is directly added to capital fund. In some case life membership fees is amortised over a period of time. In this case a separate life membership fund is created and an amount equal to annual subscription or other criteria based on average age etc, is transferred to the income and expenditure account every year. d) Government Grant: Most of the not profit organisation depend upon government grant for their activities. These recurring grants are considered as revenue receipts and credited to income and expenditure account. Other grants which are intended for infrastructure creation like buildings, laboratory, library etc, are treated as capital receipts and transferred to capital account. e) Entrance fees: Fees paid by new members at the time of joining the organisation is know as entrance fees. It is treated as capital receipts and transferred to general funds, but in case the amount of entrance fees is insignificant same can be treated as revenue receipts on consideration of materiality. f) Donation : Donations received for specific purposes are capitalised and recorded on liabilities side of the balance sheet. When the donation is utilised for the specific purpose the amount of donation is transferred to capital fund. When the purpose for which donation is to be utilised is not mentioned it is referred to as general donation and treated as revenue receipt (income). However if the amount of general donation is very large it can be treated as capital receipts. g) Legacy: Amount received as per will of person is called legacy, this is treated as capital receipts and recorded on liabilities side of balance sheet. h) Endowment Fund: It refers to fund from bequest or gift. The fund contain assets donated by the donor, with stipulation that income earned by these assets but not the gift itself can be used for principal activities of the organisation. 3) Fund Accounting: Non business organisations sometime maintain separate account/fund for specific activities. All receipts and expenses related to the fund are not taken to the income and expenditure account but adjusted directly in specific fund account. However after adjustment if the fund shows a negative balance the same is transferred to the debit side of income and expenditure account. 25 Management Control in Some Special Organisations 4) Governance: Non profit organisations are governed by board of trustees. Trustees are usually not paid and are persons of eminence from various fields. They usually exercise less control than the directors of a business corporation. Moreover since the performance is more difficult to measure in non profit organisations than in a business the board is less able to identify actual or incipient problems. Activity 7 Identify the various non profit organisations operating in India and also list their field of operation. ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................... Management control system Product Pricing: In case of non profit organisation the motive is not to earn profit but to engage in welfare activities which are beneficial to the society as a whole. This leads to pricing of services and products below cost at subsidised rates. This approach however leads to inefficiency and waste therefore pricing of services and products at full cost is desirable. A full cost price is sum of direct cost, indirect cost and a small allowance for increasing organisations's equity. A pricing mechanism based on full cost facilitates the resource allocation process. Nowadays the trend is to have organisations which are self sustainable. In addition to' this due to increasing fiscal pressures the government all over the world are reducing grants. The same is true of donor agencies and multilateral development agencies. Strategic planning and budget preparations Since the resources of non profit organisations are severely limited the process of strategic planning should chart a framework for allocation of limited resources to worth while activities. Most of the non profit organisation can fairly estimate the revenue stream for the coming year, based on these estimates the activity level and budgets are prepared. Operation and Evaluation: In most of the non profit organisations the optimum operating cost can't be predicted which leads to spending of the budgeted amount without taking into consideration the merit and demerit of the activities. Similarly the activities which can lead to excellent pay offs are not executed due to non inclusion of the same in the budget. Although non profit organisations have a bad reputation of operating inefficiently, this perception is changing gradually. the underlying reason for the same has been the crunch of resources. This led to increased attention to management control. 12.9 SUMMARY Services as compared to products are intangible, due to which they are not amenable to quantification. Financial service organisations provides an important linkage between saving and investment, for any financial service organisation the greatest asset is the faith which the customers put on it's creditability. In order to maintain faith the funds 26 entrusted by the customers should be put to proper use and not exposed to undue risk. It is here where the role of management control system comes into play. The basic objective of any management control system design is to define policies and procedures and develop system and organisation in such a way which minimises risks. The management control systems in financial service organisations are important due to the following factors: i) ii) Instability in financial service organisations will have a cascading effect on the whole economy. Since a major part of the population have entrusted their savings and resources to these organisations, any default-by them will have serious political ramifications. Service Organisations The management control system for financial service organisations focusses on a) Asset liability management b) The investment process c) Risk management and d) Internal control The management control system for non profit organisations differ significantly from that of profit organisation. In this case the focus of management control is on optimum utilisation of resources and meeting the objectives. 12.10 SELF ASSESSMENT QUESTIONS 1) How is a service organisation different from a manufacturing organisation. How do these differences affect the control system design in a service organisation. Design a management control system for an organisation which is working in the field of training local farmers for organic farthing. Describe the unique characteristics of financial service organisations. Explain in detail the various variables of banking system which affect the management control system of a bank. Explain in detail the various risks faced by the banks and how management control system can contain these risks. What are the prerequisites for a successful investment policy. Describe in detail the activities of a mutual fund. In what ways does the non profit organisations differ from differ from normal commercial organisations? 2) 3) 4) 5) 6) 7) 8) 12.11 FURTHER READINGS Agrawal PR, Mutual Funds, A comprehensive approach, Orient Law House, New Delhi. Anthony Robert N, David W. Young, Management Control in Non Profit Organisations, 5th edn. Hamewood, Richard D. Irwin, 1994. Batra G.S., Management of FInancial Institutions and Market, Deep & Deep Publications, Delhi 1996. Guidelines for Insurance Companies on the Risk management of Derivatives, Irish Financial Services Regulatory Authority (IFSRA), July 2001. Hahn, John a; Investors Guide to Mutual Funds, Prentice Hall, UK, p3. Relly, Frank K; Investment, The Dryden Press, USA, pp 525-526 Reserve Bank of India, Annual Reports (Various years). Reserve Bank of India, Currency and Financie Report (Various years). Securities Exchange Board of India, Guidelines on regulation of Mutual Funds. 27 Management Control in Some Special Organisations UNIT 13 Objectives MULTINATIONAL AND EXPORT ORGANISATIONS After studying this unit you would be able to understand the: • • • • differences across countries and its impact on MNC's operations; the transfer pricing process of MNC's and it's affiliates; exchange rate mechanism and different exposures related to it; and control system design issues. Structure 13.1 13.2 13 .3 13.4 Introduction Definition of Multinational Corporation Differences Across Countries Transfer Pricing 13.4.1 Transfer Pricing for an affiliate's of a MNC 13.5 Exchange Rate and Management Control 13.5.1 Different types of Exchange Rate Exposure 13.6 13.7 13.8. 13.9 Control System Design Issue Special Control Issues in MNC's Summary Self Assessment Questions 13.10 Further Readings 13.1 INTRODUCTION During the past two and a half decade there has been a rapid internationalisation of business which has led to changes in the organisational structure and has given rise to additional issues. The additional issues involved are control of foreign affiliates, adjustment to the control process, exchange rates and transfer pricing. This unit also attempts to make you sensitive towards differences across countries, which has an impact on business process. These differences act as catalyst for innovations in the management process. 13.2 DEFINITION OF MULTINATIONAL CORPORATION In the context of international business we hear words like global corporations, international corporations and multinational corporations. While in general these terms may be interchangeably used, there are actually subtle differences between them. Within these differences global and multinational corporations represent two extremes and international .corporations fall somewhere between these two. In a global corporation production facilities are generally centralised, and located in one or a few countries to get the advantage of 28 economy of scale and cost. The products are exported from these countries to the others depending on demand. On the other hand in a multinational corporation, production facilities are generally located separately in each country and each country's operations are organised almost totally independently. However, within such independence, there is always a need for integrating the-operations of local subsidiaries with a view to achieve overall optimality for the parent company. This optimality may be in terms of economy, monetary repatriations, growth, surplus, etc. Whether an international company shall move towards becoming a global company or towards multinational company will depend on the strengths of global pull factors or regional pull factors. If the global pull factors are stronger, the company will tend to become a global company. On the other hand if regional pull factors are stronger the company will become a multinational company. Some of the global pull factors and regional pull factors are given below: Global Pull Factors Strong comparative advantage Production Very high volume requirement for achieving cost competitiveness Regional Pull Factors Strong restrictions in movement of raw materials Strong regulatory barriers to export and import Multinational and Export Organisations When conditions are such that global pull factors are weak and regional pull factors are strong, the situation can be ideal for organising the company on multinational basis. Similarly when global pull factors are strong and regional pull factors are weak, the situation is ripe for organising it as a global corporation. Activity 1 List the name of five companies which are subsidiaries of multinational companies. Also try to find out the percentage equity holding of the parent company in the subsidiary. ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ……………………………………………………………………………………….. 13.3 DIFFERENCES ACROSS COUNTRIES As all dimensions of business operations are becoming global managers need to be aware of national difference In order to make an impact of management practices for the purpose they are designed for, managers must understand how they must adapt their management practices to make them work in international locations. Adapting management and control practices across various countries is complicated process. There are primarily three sets of factors which have affect on control system choices 29 Management Control in Some Special Organisations across countries in systematic manner. These factors are : a) National culture b) Institutions c) Local environments Managers of multinational organisations must adapt their control practices to the set of unique factors faced' in each of the operating country and also prepare for the potential differences in responses of the employees. Let us now discuss each of these unique factors in detail: a), Cultural differences across countries Greet Hafstede defined national culture as "the collective programming of the mind which distinguishes the members of one group or society from another." With reference to management control, people of different national origin will have different preferences for and reactions to management control. National culture differences has a great deal of bearing on Management Control Systems because control problems are behavioral problems, The four cultural dimensions as identified in a major study by Greet Hofstede are : a) b) c) d) Individualism Power distance Uncertainty avoidance Masculinity Each of these aspects has an implication far management control as well as on other facets of an organisation. The individualism dimension of national culture relates to individuals self concept that is in a group, what are the concerns of an individual wether it is I or We. Individuals from individualistic cultures places more emphasis on individual achievement rather than group achievement and believe in interpersonal conflict resolution rather than conflict suppression whereas individuals from collectivism culture lays more emphasis on group's goal achievement and interpersonal harmony. The power distance dimension relates to the degree of the acceptance of unequal distribution of institutional power among the employees. Uncertainty avoidance dimension relates to the outcome of present action in future. When the results of present action are unknown that gives rise to uncertainty. The masculinity dimension relates to the preference for achievement, assertiveness and material success as opposed to emphasis on relationship, modesty and quality of life. Each of the above four dimensions has implication for management control. The countries where employees are high on individualism would prefer individual oriented rather than group oriented work arrangements, goal setting, performance evaluation and compensation. Countries where collectivism runs high the companies can assume that the individuals are not going to act recklessly and indulge in acts which return yields in the short run but is potentially dangerous in the long run. Countries in which power distance is culturally accepted will have organisation structure which is centralised leading to centralisation of decision making authority and 30 less participation in decision making process. In low power distance countries organisations would have a decentralised structure leading to higher employees participation. Culture and countries high in uncertainty avoidance would prefer to avoid, reduce risk and ambiguity. While designing control system for these culture and countries managers should put every thing in black and white. The systems should be elaborate and extensive. The performance standards should be clearly defined, formal and objective. Subjectivity in any manner should be avoided. Local Institutions Social, government and legal system vary significantly across nations. These institutions include government agencies, corporate ownership structure, banking system, labour unions, bargaining and grievances resolution mechanism, regulatory agencies, insurance companies etc. Countries having strong labour unions and rigid labour laws, implementing any performance evaluation scheme, compensation scheme, voluntary retirement scheme, promotions etc. based on productivity will be met with strong resistance whereas it would be easier to implement in those countries where Labour laws are flexible and labour unions reasonable. Another institution which plays important role in designing management control system are the financial markets including regulators. In some countries funds have to be raised from local markets or certain percent of equity had to be disinvested to the public. This requires disclosure and certain type of other information with the advent of FlI's in developing countries event short term accounting profits are reflected in share prices. This coupled with the threat of hostile takeover puts an constant pressure on managers of keep stock valuations high through high short term earnings. The rules and regulation regarding takeover differ from country to country. In USA it is usually easy to make an hostile takeover as compared to European countries. in developing countries the regulations regarding takeovers are still evolving. Another area of difference is the accounting standards. The accounting standards of the countries differ, based on which the accounting statements are being prepared. This leads to variations in profits viz. financial statements of the same company will show different profits when prepared under different accounting standards. This problem is being addressed by preparing financial statements as per the ‘GAAP' Generally Accepted Accounting Principles. Difference in local Business environment: Variables of local business environment such as: Risk and uncertainty Related factors These type of risk arise from the government behaviour, example changes in tax rates both direct and indirect, ban on imports and exports, price fixation and use of various other methods under it's discretion. The basic objectives of such type of action is to channalise capital and labour to the priority areas as decided by the government, price control, exchange control etc. In general in nations where the government has snore powers (developing countries, countries opening up their economies) the business risk is high, but at the same time in case of developing countries the focus of thin governments is on economic development and these governments through various policy measures are trying to attract foreign capital and technology. In newly industrialised countries which are in developing stage the companies are relatively young and in learning phase and are not having a well developed management control systems. Apart from these Multinational and Export Organisations 31 Management Control in Some Special Organisations factors the following factors are also a source of risk and poor functioning of management control systems. Inflation: In general the developing countries are characterised by high inflation as compared to developed countries which have very low inflation. High inflation in the host country can cause a company's assets to deteriorate significantly in value in a short period of time. High inflation effects the congruence of financial measurement system. In can lead to adoption of inflation accounting. It can also lead to use of flexible budgeting to shield managers from uncontrollable inflation risks and partial abandonment of financial measures of performance evaluation. Labour availability and quality : The quality of labour in terms of skills and productivity is generally lower in developing countries, which may lead to centralisation of decision making. The focus of the management control system shift towards action control rather than result control. The above stated factors make it difficult to implement the basic internal control principle, separation of duties. In brief the employers characteristics vary across countries and this leads to the variation in behavioural response towards control systems. Labour Mobility: Labour mobility vary across countries, in some countries the policy is life time employment whereas in some countries it may be hire and fire policy. Keeping in view the policy climate prevailing in the host country the management control system, performance evaluation system and reward and compensation plan •should be designed. Apart from this there are many sectors which are characterised by high mobility of the work force. Activity 2 List the various risk and uncertainty factors which are prevalent in Indian business environment. ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… 13.4 TRANSFER PRICING Transfer pricing of goods, services and technology represents one of the major differences between management control of domestic and overseas operations. In case. of multinationals apart from normal consideration of transfer prices several other consideration are important in deciding the transfer price. They are briefly discussed below 1. Taxation: Income tax rates vary among different countries. A transfer price system that results in saving of aggregate income is followed. Companies operating in countries having high income tax rates will transfer goods and services at cost price thus resulting in zero profit and consequently no taxes. Transfer price mechanism is designed in such a way that maximum amount of profit accrues to companies operating in low income tax countries. Government regulations: Given a choice companies the companies are going to model transfer price in such a fashion which minimise taxable income in the countries with high income tax rates, however government and tax authorities are aware of these methods and had passed legislation to crub these types of practices. 2. 32 3) Tariffs: High tariffs of the importing company will force the exporting company to set the transfer price at lower level to offset the incidence of high tariff but this will result in low profit for the importing company, and for the exporting company low price and consequently low tariff would result into higher profit and hence higher income tax. The net effect of these two factors has to be considered while calculating transfer price. Foreign Exchange controls: Most of the developing countries exercise foreign exchange control in some way or the other. In some countries the profits are not fully repatriable, domestic currency is not convertible, foreign exchange cess to import certain commodities etc. In these circumstance lower transfer price allows the subsidiary companies to import larger quantities of these material. Fund Accumulation : Due to political and economical risks the holding company may not wish to park much of it funds in the subsidiary company, through transfer price funds may be bought into or out of a particular country. Joint Ventures In case of joint venture company the economic interest of the joint venture partner has to be kept in mid while setting the transfer prices, the transfer price should not be detrimental to the economic interests of the joint venture partner. Multinational and Export Organisations 4) 5) 6) Table 13.1 shows the transfer price method used by a sample of multinational companies for their cross-border transfer of goods. Table 13.1: Transfer Pricing Methods Used by Multinational Companies Pricing Method Cost Base Methods Variable cost-actual or standard Full cost - actual Full cost - standard Variable cost plus markup Full cost (Actual or standard) plus Markup Market Base Methods: Market price Market price less selling expenses Others Negotiated price 2 6 I1 2 44 41 19 12 72 20 157 65 1 4 7 1 28 26 12 8 46 13 100 41 Number of firms Percent of total Source: Roger Y.W. Tang "Transfer Prices in the 1990's," Management Accounting, February-1992, p.24. 33 Management Control in Some Special Organisations Activity 3 In the Indian context, list the variables effecting transfer pricing. ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… 13.4.1 Transfer Pricing for an affiliate of a Multi National Company In the previous section we had seen that how the differences in economic variables between the host and home country effects the setting of the transfer price. In addition to the already stated variables two other factors are also of importance 1) Transfer price to an affiliate in a country that is facing high inflation may be set at a relatively higher level in order to offset the effects of devaluation of local currency resulting from relatively higher inflation as compared to the home country. The companies which have set up new affiliates in the host country may set transfer price relatively low in order to capture market share and gain a competitive advantage over already established market players. 2) Since most of the multinational corporations are based in USA and Europe it would be worthwhile to examine the methods followed by these multinational companies based in USA and Europe. In USA section 482 of Internal Revenue Code (IRC) is followed and the same has been recommended by The Organisation for Economic Cooperation and Development (OECD) for European countries. Section 482 of IRC specifies three acceptable ways in which transfer price among affiliates may be determined. These three methods are as follows: 1) Comparable uncontrolled price method or market price method : Under this method the firm sets the transfer price among it affiliates to conform to market price of similar goods and services as determined in market transactions where at least one of the parties to transaction is not an affiliate of the parent company. The reference transaction should not be a distress sale that represents unrealistically low or marginal pricing. Comparability is based on the similarity of the circumstances underlying the transaction. An uncontrolled sale would be considered comparable if the differences are such that they can be reflected by an adjustment of the selling price. Circumstances that may affect the prices include quality, terms of sale, market level and the geographical area in which the produce, is sold but will exclude quantity discount, promotional allowances losses due to currency fluctuations and credit differentials. Comparable Transfer price under this method is Transfer price = Price paid in comparable uncontrolled sales ± Adjustments. 2) The resale price method : Under this method the firm estimate an appropriate transfer price for a product, if that product becomes an input to another transaction within a reasonable period of time. This final transaction has to be/an uncontrolled sale. The transfer price is arrived after the resale price is reduced by an appropriate market percentage based on uncontrolled sale by the same affiliate or by the other resalers selling similar property in comparable market. The market 34 percentage of competitors or industry averages can also be used, Transfer price under this method is as follows : Transfer price = Applicable resale price- Appropriate markup ± Adjustments Applicable resale price is the price at which property purchased in a controlled sale is resold by the buyer in an uncontrolled sale. Appropriate markup = Applicable resale price x Appropriate markup percentage Appropriate markup percentage = Percent of gross profit 3. Cost-plus method : Under this method the transfer price is based on cost of producing the product calculated as per the accounting standards. To the cost is added an appropriate gross profit expressed as a percentage of cost; this gross profit is based on similar uncontrolled sales mode by the seller, by other sellers or the rate prevalent in the industry. Transfer price under this method is computed as follows : Transfer price = cost + Appropriate Markup ± Adjustment Appropriate mark up = costs x Appropriate Gross profit percent Multinational and Export Organisations 13.5 EXCHANGE RATE AND MANAGEMENT CONTROL Exchange Rates ; An exchange rate is the price of one currency relative to the other currency. it can be either expressed as number of units of the home currency to buy another currency (direct. Quote) or the number of units of foreign currency to buy one unit of home currency (Indirect Quote), For e.g. if Indian rupee is the home currency and dollar is the foreign currency then to express Rs. 50/- $ is a direct quote and to express the same as .02$/- Rs is an indirect quote. The exchange rates that are usually quoted are nominal exchange rate. The spot exchange rates are nominal rates that prevail on particular point of time, whereas the real exchange rate is the spot exchange rate after adjusting for inflation differential between the two countries. There are also forward exchange rates which are exchange rates known to day at which transactions can be entered into for completion at some future fixed point of time. The forward rate may be at a discount or premium based upon the probable future inflation difference between two countries, also on the amount of trade deficits/surplus and host of other factors. A currency is said to be appreciating if with the same unit of currency one can buy more units of foreign/reference currency as compared to previous time and a currency is said to be depreciating if the one unit of currency is able to buy less units of foreign reference time. For e.g. a year back 1 euro = Rs. 58.53 the rupee has depreciated against euro. The difference between real and nominal exchange will become clear with the help of this example. Let us assume that a year back 1 $ = Rs. 50 and at present 1 $ = Rs. 55. The prevailing inflation rate during the year in USA was 5 percent and in India it was 10%. The purchasing Power Parity theory would predict that on the basis, of inflation differential the $ should have appreciated by 5% that is 1 $ = 52.5. At the spot rate of Rs. 55/$ the value of Rupee has depreciated 4.7% is the real depreciation in the value of the rupee against the dollar. After adjusting for the interest rate differential between USA and India the real exchange rate would be 1 $ = 52,35. The impact of the real exchange rate changes create changes in cost competitiveness of the domestic manufacturers against its foreign competitors, In the above example this would imply. 35 Management Control in Some Special Organisations that goods manufactured in India and priced in US $ have become 4.7% cheaper as compared to the same goods manufactured in US. Activity 4 Find out the spot and forward exchange rate for Indian rupee against world's major currencies. ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ................................................................................................................... Different Types of exchange Rate Exposure In case of multinational organisations their cash flows are in different currencies and changes in value of the currency relative to the currency in which the holding company prepares it account exposes the multinational companies to various risks. These risks regarding exchange rate fluctuations are classified as 1) 2) 3) 1) Translation Exposure Transaction Exposure Economic Exposure Translation Exposure : This is the risk faced by MNC's when there are changes in nominal exchange rates. The cash flow of MNC's and it subsidiaries are in multiple currencies and when the accounts of MNC's are consolidated they must be in single currency usually home country's currency. In order to understand the translation exposure in MNC's one should try to answer this question. The cash flow of MNC's and its subsidiaries are in multiple currencies and there has been change in nominal exchange rate of these currencies with respect to the domestic currency, how do we consolidate revenue, expenses, liabilities and assets as on a given date or financial year closing date in a single currency. Transaction Exposure is the exchange rate exposure that the firm faces in its cross border transaction. In this type of exposures the transaction are entered as of today but receipt or payment of consideration for the transaction is on future date. During this intervening period nominal exchange rate could change and put the value of transaction at risks. Example of these type of exposures are receivables and payables, debt and interest payments, insurance premium payable in foreign currency. Economic exposure is the exchange rate exposure of the firm cash flow to the real exchange rate changes. 2) 3) 13.6 CONTROL SYSTEM DESIGN ISSUES In view of the above stated exposures control system while evaluating performance should be responsive to the following facts : 1) Subsidiary managers should not be held responsible for translation effects as these factors are beyond their control. The way out is to compare budget and actual results using the same parameters and isolate inflation related effects through variance analysis. 36 2) 3) 4) Transaction exposure is best handled through the parent company keeping in view the overall hedging needs. The subsidiary managers should be held responsible for the dependence effects of exchange rates resulting from economic exposures. The decision to locate or relocate a subsidiary in a particular country should factor in the effects of translation, transaction and economic exposures. Multinational and Export Organisations 13.7 SPECIAL CONTROL ISSUES IN MULTINATIONAL CORPORATIONS Multinational corporations which own and operate business in multiple countries are important institution of trade and commerce. Multinational corporations are similar to large domestic organisations in the sense that in both of these organisation there is a high degree of separation of ownership and control and authority is delegated to large number of decision makers (managers) and control is exercised through financial results control. Since managers of multinational corporations are trained on a large canvas they are better prepared to learn and apply potentially desirable practices used in foreign companies. An some of these practices have universal application across the countries, This is clearly demonstrated by the way in which US multinational organisation have adopted Just in Time (JIT) production methods, and target costing practices from Japanese corporations, similarly in Japanese corporation the traditional Japanese practices of compensation and promotion based on seniority is giving way to performance dependent reward systems. Another peculiar situation faced by multinational organisation's manager is the existence of information asymmetry which prevails between managers at the headquarters and personnel in the foreign locations. The personnel based in the field have first hand knowledge about the operating environments which includes local norms, tastes, regulations and business risks. The prevalence of information asymmetry restricts the corporate manager from using action control as method of management control system. Action control are also more expensive to use due to geographical dispersion of the subsidiaries. MNC's earn profit in multiple currencies and as a consequence bear a real economic risk caused by fluctuating currency value. The value of the foreign investment appreciate or depreciate based on the relative value of the home and foreign currencies. Depending upon the performance evaluation practices used the subsidiary manager may be held responsible for bearing this risk or shielded from it. Most MNC's evaluate the managers of foreign operations in terms of results measured in home country currency the underlying reason being a) b) The home country currency is the unit of measure in which corporate financial objectives are stated. It is the currency in which most of the shareholders would be investing and it is but natural that the returns expected by them would be in the home currency It is the unit of measure used to evaluate top managers. c) In view of the above it is but natural that the top managers encourages the subsidiary managers to take actions which result in increase of home currency denominated profit. However this approach would create problems in cowering performance based on average industry profit or rate of return norm. 37 Management Control in Some Special Organisations In case the MNC's decide to evaluate the performance of subsidiary manager on the basis that he is not responsible for foreign exchange risk any of the following methods could be used. 1) 2) 3) Evaluate the manager in terms of local currency profits as compared to plans and budgets denominated in local currency. Treat the foreign exchange gain or loss as "below" the income statement line for which the manager is accountable. Evaluate the manager in terms of profit measured in home currency but at the same time calculate a foreign exchange variance and treat it as uncontrollable. Convert the home currency budget for the subsidiary in local currency using the end of year, not beginning of year exchange rate. Through this process we are able to create a flexible budget which changes with the change in exchange rates. 4) 13.8 SUMMARY Multinational organisations play a important role in trade and commerce across the world MNC's whose operations spans across countries will have to adopt their management practice in order to factor in the diverse environments in which they operate. Similarly the transfer pricing policy will have to factor in the economic environment of the host country. The autonomy of setting the transfer price is restricted by various rules and regulations. MNC's have to pay due attention towards management of foreign exchange exposure and the management control system should take into consideration that managers.of the subsidiary should not be evaluated on the basis of uncontrollable factors. At the same time the top management should encourage the subsidiary managers to act in a way which maximises home currency denominated profits. 13.9 SELF ASSESSMENT QUESTIONS 1) 2) 3) 4) 5) 6) 7) How do cultural differences across nations alter the Management Control Systems? Explain the reasons for manipulation of transfer price by the MNCs and their effects. Which kind of foreign exchange exposures are controllable by a subsidiary manager. Explain in detail the various methods of transfer pricing follower by MNCs. "Control System Design should factor in various variables." Illustrate. What are the various special control issues faced by MNCs. What role does the local institutions play in designing of management control system of MNCs. 13.10 FURTHER READINGS Geert Hofstede, Cultures Consequences: International differences in work related values, 3rd edition, Beverly Hills, California, Sage Publications 1986. H.A. Davis and F.C. Militello Jr. Foreign Exchange Risk Management: A Survey of Corporate Practises (Morristown, N.J. : Financial Service Research Foundation 1995) A.Rugman and L. Edend, Multinationals and Transfer Pricing (London: Croom Helm, 1985) 38 UNIT 14 Objectives MANAGEMENT CONTROL OF PROJECTS Management Control of Projects After studying this unit, you should be able to understand: • • • • • nature of projects; difference between ongoing operations and project; the control environment of the projects; the project planning process; and project execution and evaluation process. Structure 14.1 14.2 14.3 14.4 Introduction Nature of Projects Contrast with ongoing operations The Control Environment 14.4.1 Project Organisation Structure 14.4.2 Contractual Relationship 14.4.3 Information Structure 14.5 14.6 14.7 14.8 14.9 14.10 Project Planning 14.5.1 Project Planning and Control Techniques Project Execution 14.6.1 System of Reporting for Project Control Project Evaluation Summary Self Assessment Questions Further Readings 14.1 INTRODUCTION Once we mention project management the natural, picture which comes to your mind is that of construction of buildings, flyovers, bridges, railway lines, roads, etc. While much can be learned from studying such cases, everyday manager tackle smaller but no less important projects. The level may differ among the projects but the underlying principle of delivering the result, on time within specified cost and specification remains the same. Project management is no more about managing the sequences leading to completion of the project. It is about working backward and forward, where the needs of the customers are incorporated, creation of a system for resolving trade-offs leading to prioritisation of efforts. It involves working concurrently on all aspects of the project and working with cross functional teams. It also involves working closely with other organisational units like manufacturing, logistics, new product development team and marketing. The project management is not at isolated function but requires high level of cooperation and coordination among various organisational units. 39 Multinational Control in Some Special Organiaation Table 14.1: Phases of Project Life Cycle Key Issues Fundamental Activity Question What is to be Conceptualization Design/Planning Project and organizational done why is strategy, goal to be done how definition, will it be done modelling and who will be Analysis involved in planning, each part when estimation, can it start and resource finish analysis, Proposal conflict resolution and justification Phases Description Generate explicit statement of needs Identify what has to be provided to meet those needs Show how these needs will be meet through project activities Prepare and evaluate financial costs and benefits from this project Point at which go ahead is agree by project sponsor Gathering of resources and assembling project teams Cary out the defined tasks Resources constraint reached or activity Complete. Output of project passed to client/ User Identify the outcome for all stake Holder Put in place improvements to procedures f l l gaps in knowledge, documents lesson for the future Tustification Agreement Do it/Execute Organization, control leadership, decision making and problem Solving How should the project be managed on a day to day Basis Start up Execution Completion Handover Develop Assessment of How can the process and project outcomes of the management project, process be evaluation continually and change for Improved the future Review. Feedback 40 Adapted from : Project management, Marvey Maylor Pearson Education Limited 14.2 NATURE OF PROJECTS A project is a set of activities intended to accomplish a specified end result of sufficient importance to management. Projects are of varied type ranging from simple to complex. Some examples of projects are construction of roads, railways, airport etc. change in plant layout, developing and marketing of new product, consulting engagements, audits, acquisitions and divestitures, computerization of railway booking network, computerization of banks, installation of Management Information system etc. A project can be defined a `non repetitive activity' which has the following characteristics. its goal oriented - it is undertaken with a particular end or goal in mind. It has a particular set of constraints usually time and resources The output of a project is measurable Management Control of Projects Three phases of project management : Any project basically consist of three processes a) b) c) Planning (Design) Do it (Execute) Develop (review and feedback for further improvement). This process is depicted in figure 14.1 Fig 14.1 Cycle for project management Planning: The planning phase involves the formulation and revision of intended activities. This is an elaborate activity where the takes are formulated, the matching resources for the task are identified and if there is a mismatch of tasks and resources tasks are reformulated. In brief during this process a blue print of activities and how to accomplish these activities is being prepared. An optimum process to work upon the task is being prepared in this phase, Execute : In this phase the tasks outlined in the planning phase are executed sequentially. Develop: Although a project is a non repetitive one time activity the insight and 41 Multinational Control in Some Special Organiaation Knowledge generated during execution will be helpful to the organization in many ways. By studying the process one can uncover the strength and benchmarks, allocate resources more effectively and so on. The knowledge and insight generated during the process can be used in planning and execution of the projects underway and the future projects. These three phases can be future broken down as show in table 14.1 14.3 CONTRAST WITH ONGOING OPERATIONS There are some fundamental difference in process and procedures of projects and ongoing activities which gives rise to different management control techniques. Let us look at these difference one by one. Single Objective: As contrasted with the ongoing operations the projects have a single objective. The management of the responsibility centre in ongoing operations takes decision about the day of day activity as well as for the activities of the future whereas a project manager has to take decisions about day to day activities and future activities, but the time horizon of these decision is limited till the completion of the project. The project performance can be judged in form of the end product delivered whereas in an ongoing operations the performance is judged in terms of all the results that managers achieve. Organization Structure : It is usual to find that the organizational structure of an ongoing operation organization is superimposed and passed on project organization disregarding the fact that the projects have special requirements in terms of manpower specialization and functional knowledge, Similarly for control-purpose the same set of control procedures are adapted as for ongoing operations. This may result in undue cost and time over run, but at the same time the management control system of project must mesh at some point with the management control system of the organization. Focus on the project : Project control focuses on the project, whose objectives are to produce a satisfactory product within the time, cost specified or with the use of optimum resources, whereas in the ongoing operation the focus of control is on activities rather than on results. Need for Trade-off : Projects usually involves trade-offs. The trade-offs usually occurs in a project due to constraint of any one of the resources viz. time, and cost. Cost can be reduced by decreasing the scope of the project e.g. In developing LCA (Light Combat Aircraft) the initial scope of the project was to develop the LCA indigenously, but due to time and cost over runs subsequently it was decided to procure engines and sub assemblies from other countries. It the cost has to be kept within limits one many have to reduce the scope of the project. Similarly if the project schedule is important than extra labour have to be employed resulting in cost over run but able to complete the project within time Similar trade-offs do occur in an ongoing organizations but their frequency is quite low as compared to the projects. Less reliable standards : Performance standards tend to be less reliable for projects than for ongoing operations. The causes for variation in performance standard is project design which is unique for every project, although the project specification and methods for producing it are same. The standards for repetitive projects can be developed from historical data or from engineering analysis of time and cost, however the changes in the various variables of the project may make these data unreliable. In civil construction projects the previous practice was to fabricate the whole structure on 42 site whereas now days components of the structure are pre fabricated in casting yards and these pre fabricated structures are transported to the site and joined to form the whole structure e.g. for building flyovers the various spans of flyover are prefabricated and joined on site. The standards derived form previous projects may be helpful in setting the standards but allowances must be made for changes in technology, quality of labour and material and other variables. Frequent Change in plans : Since projects are a set of inter linked activities a bottleneck at any point may force the project manager to change the sequence of activities. Example A consultancy firm discovers certain facts unknown previously, this new information may altogether change the direction of the plan. hi civil construction contracts bad weather may force temporary suspension of outdoor work etc. The probability of facing unfavourable, unprovisined circumstances is much more in projects rather than in ongoing operations. Different Rhythm : The rhythm of projects in terms of level of activity and expenses differ significantly from that of on going organizations. In ongoing organizations the level of activity and expenses are uniform over a period of time and then they change in either direction depending upon the demand and supply factor. In case of projects the initial phase of projects is marked by low level of activity and hence law cumulative expenses, then the level of activity accelerates to reach at its peak and then tapers off as completion is near and only clean up remains. The following figures 14.2 and 14.3 depict the level of activity, and cumulative expenses with respect to time. Management Control of Projects Greater Environmental Influence : Projects schedule tends to be relatively more influenced by external environment as compared with that of an ongoing operations. The underlying reason being that the inputs and processes for project are sensitive to environmental changes (e.g. floods, high temperature, bitter cold, heavy rains etc.) can disrupt project schedule even damage project property whereas the ongoing organization are relatively insulated from these. Activity 1 For a road construction project, list the various activities of designing, executing and developing phases. ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… 43 Multinational Control in Some Special Organiaation 14.4 THE CONTROL ENVIRONMENT 14.4.1 Project Organization Structure A project organization is a temporary organization which is disbanded after the completion of the project. There are many variations in project organization structure depending upon the nature of the project, duration of the project, location of the project, nature of the company executing the project, whether the project is in house or built for an outside agency. Depending upon these factors the product organization would vary and hence the control system. The team members may be the employees of the sponsoring organization, they may be hired on a temporary basis for the purpose of the project or some of them may be engaged under a contract with an outside organization. If the project is entirely handled by an outside organization a formal working relationship should be establish with the personnel's of that organization and both formal and informal means of communication should be developed. The flow of information among the two will depend upon the specifications laid down in the contract. In case the project is undertaken by the sponsoring organization itself a part of the work would be delegated to the various functional units of' the organization, and these functional units will depute some of it's employees in that particular project. In this case also the project managers should develop a working relation with the units in question so that the information flow can be started. For e.g. a cement factory wishing to expand its installed capacity wishes to install a new rotary kiln. In order to execute this project the expertise of finance, marketing and operations department (including civil, mechanical and electrical engineers) is required. The project manager may request the unit heads to depute the required number of personnels to the project. The management control problem in both the cases viz. when outside agency is responsible for project execution and when employees of the functional units are responsible for project execution are same which we are going to discuss below. Matrix organization : As discussed above if the project team consist of members drawn form the various units of the sponsoring organizations the members faces a unique situation of handling two bosses at the same time, one is the project manager other one the manager of the functional unit they are permanently assigned to. Such an organization is called as matrix organization. In such type of organization the basis control question is how to set priority among the project task and the functional unit task. Given an choice the functional units employees inclination would be to give a superior priority to functional unit task and secondary priority to project task and in part their behaviour would also depend upon the decision taken by unit manager who consider the relative priorities of an the projects which requires the resource he controls : In this type of organization the extent of control which a project manager can exercise over the employees is constrained by the authority of the functional unit's manager. This type d conflict in which the project manager and functional unit managers are competing for resources has been aptly described by Richard F. Vancil as "an atmosphere constructive conflict" in an article "what kind of Management Control do you need?". Harvard Business Review, March-April 1973 p.75. Evaluation of Organization Structure: The structure of the project team changes with the progress of the project. In the planning phase most of the members would be from cross functional areas of finance, marketing, human resource, apart from care team from operations area. The team at this stage may include cost accountants, architects, engineers, supply and procurement officer, human resource consultant, market research analyst, statisticians and logistics experts. At the execution stage bulk 44 of the project team would consist of engineers and logistic expert with few members from support function like accounts and finance marketing and human resources. In the final stage as the work tapers of the principal task is that of obtaining the sponsors acceptance where persons with marketing skills are required. 14.4.2 Contractual Relationship In the projects which are out sourced to contractors an additional level of project control is created. In these type of projects the primary responsibility of control is that of the organization which is executing the project. The primary function of the additional level of project control which is there in such type of contracts is to study the control system of the contractor and adapt and modify it in a ways that it is able to feed the control information requirements of the sponsoring organization. The form of the contractual agreement has an important impact on management control. Contracts are basically of two types: fixed price and cost reimbursement with many variations in between. a) Fixed Price Contracts : In a fixed price contract the contractor agrees to complete the specified task by a specified date at specified price. The qualitative and quantitative aspects of the tasks are a part of the contract, The contract also specifies the penalties for negative variations in time and quality. From the above discussion it may appear that since the contractor is taking all the risk therefore the contractor's firm has all the responsibility for management control, but this is not the case, Due to uncertainties involved or lack of foresight at the planning stage the contractor may encounter conditions not contemplated in the contract, while executing the project or the sponsors may want to alter the scope of the, project in such circumstances a change order is issued. Both the parties must agree on scope, schedule and cost implication of the change order, to the extent the change order involves increased cost; the increased cost is to be borne by the sponsor. A simple project like constructing a house may involve a dozen of change orders, whereas complex projects like ship building, airport construction may involve thousands of change orders. The responsibility of auditing of quality and quantity of work under fixed price contracts is with the sponsors of the project, hence continuous monitoring and control is a necessary component of contracts under fixed price contracts. Cost-Reimbursement Contracts: In a cost reimbursement contract, the sponsor agrees to pay reasonable cost plus a profit in percentage terms or a fixed amount. In these contracts a ceiling on cost is also imposed (the cost should be within a certain price band the lower band decided by the contractor and upper band by the sponsor). In these type of contracts sponsors have considerable responsibility in controlling cost therefore they require a management control system. These type of contracts are suitable in those circumstances when the scope, schedule and cost of the project cannot be estimated reliably in advance. Management Control of Projects b) Contrast contract Types: The price of a fixed type contract is a bid by the contractor. Usually the tenders are called and the contractors quoting the lowest rate is awarded the contract. The tender consist of two parts viz Technical part in which all the specification of quality, quantity and other details are furnished and financial tender in which the rates are quoted. In arriving at a particular price contractor includes an allowance for uncertainty, the quantum of this allowance varies with the degree of uncertainty associated with the project. This extra allowance over and above the cost and profit is the reward for taking risk. For projects with high degree of uncertainty the sponsors ends up paying more under fixed price contract as compared to cost reimbursement contract. 45 Multinational Control in Some Special Organiaation The fixed price contract are suitable when uncertainties regarding the project are low and scope of the project can be closely specified. In this type of situation the scope for negotiation of change order is considerably reduced. In cost reimbursement contracts the profit component should be a fixed monetary amount, if it is certain percentage of cost; it is going to motivate the contractor to jack up the cost. Variations: These two type of contract are two extremes, there are many variations possible within these two extremes. In an incentive contract completion date, cost targets or any other variable of the contract are defined in advance and if the contractor is able to surpass these pre defined variables the contractor is rewarded by a certain percentage of cost saved or additional revenue generated by his performance. Such type of contracts are able to overcome the inherent weakness of cost reimbursement contract in which the motivation to reduce cost is totally absent. Different contract types may be used for different activities of a project. For activities having high degree of uncertainty like cost of material wages, direct cost etc. may be reimbursed under a cost reimbursement contract while the contractor's overhead cost may be covered by a fixed price contract which will motivate the contractor to control the cost. 14.4.3 Information Structure Work Packages For the purpose of management control system in project the information is structured by the elements of the project. The smallest element is called a work package and the way in which these work packages are aggregated is called the work break down structure. In construction of a house the work packages are laying of the foundation, raising of walls, electric fittings, sanitary fittings fixture of doors and windows etc. A work package is measurable increment of work, usually of fairly short duration. The work package must have a clear identifiable completion point which is called as milestone, continuing from the example stated above if the walls of the house has been raised up to twelve feet from the foundation it is a milestone or after the electric fittings all the points are having electric connection it is a milestone. If the project consist of many similar work packages each of the work packages should be defined in the same way so that the cost and schedule informations are comparable. Similarly if the industry averages about the work packages, cost and schedule standards are available they should be made use of: Indirect Cost Accounts: Apart from defining work packages for direct project work. The direct costs are changed to the concerned work package, but what about the cost and expenses which can't be charged to any of the work package e.g. for administrative and support activities. For these type of expenses separate cost accounts are established and their estimated cost usually stated as per unit of time (such as month) are charged to these accounts. The cost accounts should be charged as per the rules already defined. These rules relating to charging of costs to the projects, the approving authority and their specific signing powers are developed in advance. The rules and procedures also specify which cost items are to be directly charged to work package, what is going to be the lowest level of monetary cost aggregation, how cost commitments be recorded in addition to actual costs incurred and how the overhead cost and equipment usage be allocated to the work packages. 46 Activity 2 Find out the various differences between ongoing operations and project operations. ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... ......................................................................................................................................... Management Control of Projects 14.5 PROJECT PLANNING In the planning phase the starting point are the rough estimates that were used in decision to undertake the project. These rough estimates are refined into detailed, specification for the product, schedule and cost. In this phase the management control system and underlying task control systems are designed for the project. The planning process prepares a road map regarding how the activities of the project are going to be coordinated how is responsible for which task and the time schedule for completion of each task, The process of project planning takes places at two levels first one being the strategic level tactical level where the question is `what happens'. This is a tactical level plan which needs to be converted into `how' it is going to be carried out or operationalised. For the planning process the inputs is going to be the project brief the control environment both external and internal which provides for activation, the constraints and the quality standards for the planning process and the mechanism$ provide the means by which the process can happen, fig shows this whole activity, of planning Nature of the project plan The finalized plan consist of three parts: Scope, schedule and cost The scope part states the specification for each work package and person or organizational unit responsible for the particular work package. If the project is of the nature where specifications are not known before hand this section is brief and general e.g. R&D projects etc. 47 Multinational Control in Some Special Organiaation The schedule part states the sequence of the activities and the estimated time required for completion of each activity. It also specify the inter relationship between various activities. Costs are stilted in the project budget which is known as control budget, the reason behind calling it control budget is that the actual cost incurred are compared against the cost stated in the budget usually the monetary cost are shown only for aggregate of several work packages until and unless the work package quite large. Resources to be used for each work package are stated in non monetary programs such as number of man hours, cubic foot of cement, kilograms of iron etc. Estimating Costs: Estimating costs is an difficult tasks specially for the projects of longer duration: Recently we have seen a sharp rise in prices of steel and cement. As the .economies of the world are integrating any economic disturbance has an impact on most of the countries. During recent years we have also witnessed an increasing volatility in commodity prices, keeping in mind these factor estimating cost would always prove difficult. As a starting point one can take for reference the cost incurred on similar work packages in the recent past or one can rely on industry norms. While estimating costs two types of unknowns must be factored in cost estimates. The first are the know unknowns, which are the estimates of the cost of activities that are known to be going to occur such as earth removing work for road construction; The cost although unknown may be estimated within reasonable limits on the basis of past experience and industry norms, but if instead of normal soil removal, the earth removing terrain is rocky one the costs are going to be considerably higher than the estimated cost. The other unknowns are the unknown. For these unknowns the cost estimator has no idea whether they are going to occur or not, therefore the cost estimates of these factors can't be built in the estimated cost. These unknown unknowns may be work stoppage, destruction caused by natural calamities, shortage of raw material, labour unrest, delay in statutory clearances etc. The estimator while fixing the estimated cost should also factor in these possibilities in the cost structure. 14.5.1 Project Planning and Control Techniques Several techniques are known to be used for project planning, monitoring an control, but three are very popularly used. These are Gantt Chart, Programme Budget technique and Network technique. Gantt Chart : Gantt is a simple technique of showing through horizontal bar graphs, the starting time and completion time of different activities in a project. Further each activity is broken up into different phases in which starting of a phase depends on the completion of the previous phase.-In Figure 14.5 a simplified version of a Gantt Chart relating to a road project is shown. 48 The chart shows that there are three distinct activities, namely, bridge construction, earth work, metalling and tar covering, which are planned for different period. The actual progress can be marked side by side to show whether actual progress has been as projected or not. As regards dependence within an activity Gantt Chart provides a reasonable picture, but it does not show the dependence of one activity (or stage of activity) on another. For example, in this case the metalling and tar covering activity would possibly be started only after certain earth work is completed, but such conditions are not revealed. However, inspite of such weaknesses of Gantt Chart, it is a very popular method of project monitoring and control, because it is simple and probably understood by most people. Programme Budgeting: When a project is in the implementation stage, but not yet commissioned, Programme budget technique comes handy in monitoring programme of project. The method basically approaches the problem by breaking up the project into several work units and establishing expenditure norms for such work units. If the previous example of road construction is taken, the work could be divided into components of taken, the work could be divided into components of pure earth work, concrete work, metal work, etc. Pure earth work and concrete work can be measured in units of cubic meters 'whereas metal work in cubic meters or square meters. The cost norm for cubic meters or squaremeters of work may also be established. Control under programme budget is done by comparing the actual physical performance (in terms of work units) with planned expenditure. The following formula is used as the basis of control. If the conditions in the formula are fulfilled the project is assumed to be satisfactory. Management Control of Projects The first formula considers only the work done vis-a-vis plan and therefore it measures only the effectiveness of progress. It does not take into account the resources used for doing such work. Thus it fails to reveal the efficiency in resource utilisation. The second method overcomes this problems, but not fully, It shows the effectiveness of progress, but not the degree of effectiveness. Similarly, it indicated that resources are used within budget limit, but fails to indicate the degree of efficiency in resource utilisation. The third formula primarily emphasizes efficiency in resource utilisations. Because of its format of output input or productivity ratio, it appeals to the user and is therefore commonly used for control. In addition to the above three formulae, sometimes a ratio called project status index is also used for monitoring progress. This index into account both time and cost dimensions and combines them to find an overall measure of progress. 49 Multinational Control in Some Special Organiaation Suppose a project should have been completed to the extent of 80% by a specified time but is actually completed to the tune of 60%. Similarly the budget was Rs. 1 lakh while actual expenditure is Rs. 80 thousand, then The status index of 1.0 indicates ‘par’; more than 1.0 indicates that progress has been better than expected on the whole; and less than 1 indicates unsatisfactory progress. PSI is somewhat mechanical, but is extremely useful method for ranking different projects in terms of their overall progress. So far we have discussed about only time and cost. As mentioned earlier quality of work in a project should also be measured if proper control is to be exercised. Sometimes if quality is bad or poor either compensations has to be paid or some amount of rework has to be done on customer complaint. In either case, extra expenditure is incurred. If this expenditure is high in relation to total project's value if indicated that quality of work has not been satisfactory. A Quality index can be computed; Thus the indicator can serve a very useful purpose. Similarly counting of failure during trial-run can provide saline indications about quality. The following ratio for every part of project can show how well part of the project has been executed. Number of successful trial-runs Total number of trial- runs besides these other indicators of quality can also be devised depending on specific project needs. Network technique (PERT) : Project planning and control through Programme Evaluation and Review Technique (or PERT) is a very common phenomenon today. Under this method a project is divided into a number of activities and the time requirement for these activities as well as relationship between the activities are analysed and their precedence established. These activities are drawn on a chart called PERT chart. On a PERT chart an activity is represented by an arrow. The starting and completion points of an activity are known as 'events' and marked by circles. Suppose a project consists of seven activities with implementation as given in Table 14.1 Table 14.1 Time Requirement of Activities Activity requirement in months A-B B-C A-D D-E B-E C-F E-F Preceding Activity 12 5 6 8 6 4 4 Time A-B A-D A-B B-C B-E and D-E 50 The PERT chart indicating the above activities and timing is shown below: Management Control of Projects As indicated in the information, the chart shows B-C activities. only after completion of A-B activity, and D-E after completion of A-D and so on. Now, how long should the project take to complete? It becomes obvious for the chart that there are three parts or chains of activities and time taken by these paths are different as shown below: Path A-B, B-C and C-F: 12+15+4 months = 21 months Path A-B, B-C and E-F: 12+6+4 months = 22 months Path A-D, D-E and E-F: 6+8+4 months = 18 months Out of three paths, the path A-B, B-E and E-F taken the lowest time (22 months) and therefore the project will take at least 22 months for completion. The path A-B, B-E and E-F is known as the critical path. Critical path be shown in bold line. The knowledge of initial path and project completion time is only the starting point. A project manager may be interested in knowing the activities, on which he cannot afford top delay. In this case no delay can be afforded on A-B, B-E and E-F activities, because any delay in there activities will extend the project completion time. On the other hand on A-D, D-E, B-C and C-F activities some delay can be tolerated, or technically expressed, there can exist some 'slack' in these activities. Earliest slack can be calculated through latest start time for each activity. For any activity the difference between the earliest and latest starting time will indicated the slack. A-B, B-E and E-F fail on the critical path and there can be no slack for these activities, but other activities (namely, AD, DE, BC and CF) may have some. Now let's consider the activities A-D, What are its earliest start and latest start times? If we fix the project starting time as 0, A-D having no preceding activity can' well start at 0. So time 0 is its earliest start time. Regarding latest start time, we know that the project will take 22 months and we can work backward on the Path A-D, D-E and E-F . to find out when the work A-D should start at the latest. As the three activities together take 18 months (6+8+4) the latest A-D should start would be 4 months. In a similar manner, the earliest start time, the latest start time and slacks for all the activities can be calculated. The results are shown in Table 14.2 Activity A-B A-D B-C B-E D-E C-F E-F Table 14.2: Start Time and Slacks Earliest Start Latest Start 0 months 0 months 0 months 12 months 12 months 6 months 17 months 18 months 4 months 13 months 12 months 10 months 18 months 18 months Slack 0 months 4 months I months 0 months 4 months 1 months 0 months 51 Multinational Control in Some Special Organiaation It may be pointed out that the slacks indicated here are not necessarily additive. For example for activities A-D and D-E we cannot say that slack available is 4+4=8. In fact, the total slack available on the path (A-D, D-E and E-F) if four months only and if during implementation A-D uses up this slack, no slack may be available for D-E. The same is the case with activities B-C and C-F which together have a slack of 1 month. The above description of PERT takes into account only the time dimension and therefore is known as PERT TIME. Better results are achieved when this is integrated with the cost dimension. By integrating the two, management can optimally evaluate the cost-time trade-offs. The cost-time trade-off works under the assumption that every activity has a normal time of completion and sometimes it can be completed at a reduced time provided more resources are deployed. Thus an activity involves normal cost and reduced time (or created time) and increased cost. The management now is in a better position to decide whether reduction in activity time and therefore in project time a worth the cost increase. In the given example, the normal duration of the project as given is 22 months. Let us further suppose that if it is completed in a lesser duration, it can generated profit of Rs.4 lakh per month during that reduced period. It is also estimated that the only activity for which time reduction is possible is the activity A-B and the estimates are as follows Activity A-B Normal Crash l Crash2 Time 12 months 14 months 10 months Cost Rs. 10 lakhs Rs. 13 lakhs Rs. 18 lakhs It is seen from the above data that by reducing Alb time by one month, the management gets a profit of Rs. 4 lakh and incurs an additional cost of Rs. 3 lakh (Rs. 13-Rs. 10 lakh). Hence the reduction in time is desirable. However following cost increases by rs.5 lakh while profit increase by Rs. 4 lakh only. (The example has been kept simple in order to make the profit about crashing clear. In a real life situation there cap be other complexities involving time value of money, profit life etc., which can be adjusted in the model. Apart from the above PERT helps management in getting better understanding of scheduling problem. If there are parallel activities having slacks and requiring certain constrained resources the activities can be scheduled in such a manner that one activity can start earlier and the other late so that constrained resources (such as equipment) may be better utilised. In addition to understanding of activity time, resource requirement, slacks have led to development of several resource allocation rules such as, • • Allocated resources to the activity having the least slack, When two activities have equal slacks, allocated resources to the activity having longer direction. If two activities require different resources, allocate additional resources to the activity which requires larger amount of resources. All these rules, no doubt, are extremely useful to all management in improving the quality of decisions. • 52 Activity 3 What specific tools or techniques have been used (or are being used) for administering and controlling the project undertaken by the orgainsation with which you have been associated? Describe them briefly. State how these tools/techniques have helped the organisation. What other tools/techniques, you think, could have been used? ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………......................................................................................... Management Control of Projects 14.6 PROJECT EXECUTION The results (output) of the planning process acts as guidelines for project execution. The planning process results into specifying, a specification of work packages, a schedule, and a budget; and the manager who is responsible for each work package is identified. The schedule shows the time associated with each activity, and the budget estimated shows estimated cost of each project part. If the resources required are shown in non monetary terms the control budget converts the same in monetary terms but for a sizeable aggregation of individual work packages. In the control process the actual data regarding specification, schedule and cost are compared with these estimations. Both the sponsors and the project manager are concerned with three questions i) ii) iii) It is project going to be completed Ly the scheduled completion date? Is the completed work going to meet the stated specification? Is the work going to be completed within the estimated cost? The underlying variables for any project are susceptible to change and the changes in these variable have as bearing on answer to these questions. If at any point of time during the course of the project the variations are negative, both the sponsors and project managers need to know the reasons and alternative corrective actions undertaken. These three parameters of specification, time and cost are not independent of each other and some times a trade-off has to be done among the three variables. 14.6.1 Systems of Reporting for Project Control As discussed above the project managers and sponsor are interested in variance of cost, schedule and specifications. For any work Breakdown Structure (WBS) the project manager is interested in the relationship between planned value of work for a given time period and actual cost of work for the same time period. The difference between the two will give the total variance for the task; by computing more detailed variances one can trace ifs course. These are five potential causes for any total variance. 1. ) 2. ) 3. ) Completion of more or less work than scheduled. More or less usage of labour than planned for the actual work. More or less wages paid than planned for the actual labour used. 53 Multinational Control in Some Special Organiaation 4) Usage of more or less material than planned for the work completed. 5) Paid more or less than planned for the material actually used The portion of the variation attributable to (1) as referred above is called the "schedule variance", and the portion attributable to (2) through (5) is called the spending variance. The total variance for a given task is budgeted value of work planned - actual cost of work completed = total variance The schedule variance is given by budgeted value of work planned budgeted value of work completed = schedule variance The spending variance is given by budgeted value of work completed - actual cost of work completed = spending variance The spending variance can be further subdivided into labour and material variance The total labour variance for a task is standard labour cost - Actual labour cost = Total labour variance The total labour variance can be subdivided into labour time and rate variances Labour time variance (Standard hours - actual hours) x Standard rate = time variance Labour rate variance (Standard rate - actual rate) x actual hours = Rate variance Similarly the material variance can he subdivided into quantity and price variance Total material variance Standard material cost - actual material cost = total material variance Material Quantity Variance (Standard quantity - Actual quantity) x Standard price = quantity variance Material Price Variance (Standard price - Actual price) x Actual quantity = price variance These nine variances may be computed for each level of the WBS and for each functional organization at regular intervals. The total variance for a WBS end item tells the project managers wether there is a problem or not regarding cost and schedule performance. If the problem exists manager can request more detailed reporting information for the next level of the WBS and find out where exactly the problem is, concerned with schedule slippage or with labour or material spending variance. In order to keep track of the projects managers require three type of reports which are as follows a) Trouble reports b) Progress reports c) Financial reports Trouble reports reports both the trouble which had already occrued and also anticipated future trouble Critical problems are flagged. Since the areas contained in the report require urgent attention of the manager, these report are communicated through both formal and informal channels of communications. Precision is often 54 sacrificed for the sake of speed. in case the reported information is significant than oral reports are confirmed by written reports so as to provide a record. Progress reports, report about the status of the project and compares the actual schedule and cost with planned schedule and cost. Variances are measured quantitatively and reported. Financial reports are concerned with project costs. These reports are important because based on these reports payments to contractors are made under cost reimbursement contract. The are also necessary for fixed price contracts because based on this financial accounting entries are made. Apart from the above stated reports much of the information comes from detailed records collected in task controls systems. These include such documents as work schedule, time sheet, inventory records, purchase orders, requisitions and equipment records. The task control systems should be designed in a way which would integrate the information generated from these systems with management control systems. Punch list: Near the completion of the project the sponsor prepares a list of work still to be done and a list of defects still to be rectified. This punch list is negotiated with the project manager. The final payment is released only after the agreed upon work is completed. Progress payments made during the course of the project are somewhat less than the cost plus profits to date thereby providing cushion for this purpose. Revisions: Projects are generally complex and lengthy and the probability of not adhering to project plan in terms of cost, scope and schedule is quite high. In case of deviation of any of these three aspects the following alternative exists for the sponsor of the project. 1. 2. Accept the deviation and proceed as originally planned. Include in a trade-offs between these three aspects viz if schedule is critical authorise use of extra manpower which requires payment of over time wages which are higher than normal wages or if scope is critical authorise the cost of increase Replace the project manager if deviations are unwarranted. Terminate the project Management Control of Projects 3. 4. Leaving apart the last alternative choosing any of the above stated alternatives would require the revision of the plan. Once the plans are revised it gives rise to another question, that of tracking future progress-against the revised or original plan. The main drawback of using revised plan is that it hides inefficiencies which have accumulated till date and aptly refereed to as rubber baseline, although revised plans are better indicators of performance that is currently accepted. A way out of this problem is to compare the actual cost with both the revised and original plan. The first part of this report will show original budge, the revision that has been authorised till date and the reasons for the revision. The second part will contain cost estimates and the reasons which caused variance between the revised budget and the current estimates of costs. Project Auditing: Project auditing involves two areas of project (i) cost (ii) quality. There are two approaches which are followed for auditing purpose. One is to audit the work as soon as it is completed and another one is to wait for substantial amount for work to be completed and than start the audit work. Out of these two approaches the former should be adopted as subsequent stages of 55 Multinational Control in Some Special Organiaation work will cover any deficiencies in the earlier work. For example in construction of house plumbing, electric fillings and sanitary fittings should be inspected at the time of execution itself, it done at later stage it is cumbersome and costly and any rectification involves major costs. At the some time the auditors should also be cautious that they do not take undue time for auditing purpose. In recent years the scope of auditing has increased and now includes operational auditing which involves audit of the standards of management actions. Activity 4 List the various variances which are encountered while executing a project. ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ………………………………………………………………………………………… ……………………………………………………………………………………….. 14.7 PROJECT EVALUATION Project evaluation mainly consist of two sperate aspects of the project (1) an evaluation of performance in executing the project (2) an evaluation of the results obtained from the project. The former is undertaken shortly after the completion of the project and the latter is a continuous process and a more complex process. For example computerization of banks is a project. Now as far as first aspect of project evaluation is concerned it is going to measure the cost, time and scope of the project as against the standards envisaged in the plan. The second aspect is concerned with operational efficiency, customer satisfaction, manpower reduction, introduction of new products, strengthening of internal controls etc. Again these variables depend upon other variables. Keeping in view the long term impact of the project, this aspect of project evaluation is complex and continuous process. Evaluation of performance The evaluation of performance in executing the project has two aspects (I) an evaluation of project management (2) an evaluation of managing the project The first aspect of evaluation is concerned with project managers and teams and its purpose is to assist in decision making regarding rewards, promotion, reassignment, transfer, deputation etc. The second aspect of evaluation is mainly concerned with feedback so that the strength and weakness identified in this project could be factored in the planning of future projects. In many cases the evaluation is informal. In cases where the variances are of high order organization opts for formal evaluation. Since the projects are not structured and standardised activities like manufacturing, the project evaluation is more of subjective nature. Cost overruns : When actual costs are more that the budgeted cost, there is said to be a cost overrun, To some this implies that actual cost were high, but an equally plausible conclusion can be that the budgeted cost were low. If there is an cost overrun due to change in the scope of the project or other uncontrollable factors the reason could be inadequacy of planning or underestimate of cost rather that the inefficiency at the operating level. Interpretation of the costs should be done by analysing both the budgeted as well as actual costs. 56 A common error in analysing cost is to assume that the budget represents what cost should have been. It is not, budget is merely an estimate of cost based on the available information at that point of time, it is not an reflection of conditions encountered at the time of execution of budget. Evaluation of results Based on the nature of the project, the time frame for measurement of actual benefits may vary. Some projects have a long gestation period and a still longer period when the benefits of project becomes visible. Another problem with the evaluation of results is that the impact can't be specifically measured as there are other variables effecting the same. To take an example, let us take two example from banking industry (i) Introduction of ATM's (ii) Computerization of bank branches In the first case the result of the project (installation of ATM machines) can be specifically measured which is the reduction in waiting time for cash withdrawals. Now let us take the second example of computerization of bank branches. in this case there are many tangible and intangible results of the project. The tangible results are (i) elimination of arithmetical mistakes (ii) automation of processes (iii) Reduction in clearing time for various instruments. (iv) Reduction in customer pressure. These are tangible benefits which can be measured and attributed to the project. At the same time there are some intangible benefits such as (i) customer satisfaction (ii) employees satisfaction (iii) strengthening of internal control etc. which are not directly measurable. Evaluation of the project should be done in the following cases. i) ii) The project should be important enough to warrant the considerable expenditure of effort that is associated with formal evaluation. The result should be quantifiable and capable of being attributed to the project e.g. if increased sales is the result, the contribution of the project in increased sales should be clearly identifiable. Results of evaluation should lead to action; the evaluation process should lead to refinement of planning and procedures. Management Control of Projects iii) 14.8 SUMMARY One of the most critical difference between management control of ongoing operations and projects is that the projects have a limited life cycle whereas ongoing operations continue for a fairly long period. Due to this difference and requirements of the projects the organization cross functional structure of the projects also differ. A project basically consist of three steps viz planning, execution and evaluation. The management control activities in ongoing operations are repetitive and static in nature whereas in projects the nature of management control activities change with the phases of the project. 14.9 SELF ASSESSMENT QUESTIONS 1. 2. What are the characteristics of a project organisation? Explain how these characteristics affect the control system design of a project. Supose you area project manager involved in laying a 100Km. gas pipe line. List out main activities, precedent activities and time requirment for these activities. Draw a PERT chart and identify critical path. 57 Multinational Control in Some Special Organiaation 3. 4. 5. 6. 7. Explan the weakness of Gantt chart as a technique of project control. Suppose you are hired as a consultant to design and execute the project of computerisation of branch network. How you will go about the task. If a project is treated as a profit centre, what difficulties you forsee in operationalising a control system? How would you overcome such difficulties? Explain the role of financial staff in project evaluation. Why control budgets are prepared just before the start of the scheduled work? 14.10 FURTHER READINGS Lock, Dennis (Ed) Project Management Handbook, Aldershot, Hanks, England: Grower Technical Press, 1987. Maciariello, Joseph A. Management Control Systems, Prentice - Hall, Inc., Englewood Ceffs, NJ Struckenbruck, Linn. C. The Implementation of Project Management : The professional's Handbook, Reading Mass : Addison - Wesley, 1989 Anthony Robert. N & Govindarajan V. Management Control Systems, Irwin, 1995 58 UNIT 15 Objectives OTHER ORGANISATIONS Other Organisations The objectives of this unit are to: • • familiarise you with the characteristics of development organisatios, knowledge organisations and small and medium enterprises; understand the special requirements of these organisations with reference to management control systems. Structure 15.1 15.2 15.3 Nature of Development Organisations Management Control System in Development Organisations 15.2.1 Fundamental of Management control for development organisations Components of Management Control 15.3.1 Control Environment 15.3.2 153.3 15.3.4 Risk Assessment Control Activities Information and Communication 15.3.5 Monitoring 15.4 15.5 15.6 15.7 15.8 15.9 Limitation of Management Control Small and Medium Enterprises (SMEs) Knowledge Organisations Summary Self Assessment Questions Further Readings 15.1 NATURE OF DEVELOPMENT ORGANIZATIONS Development organization are set up with a specific mission like eradication of poverty, elimination of wide spread diseases like malaria, leprosy, aids etc.; spread of awareness of social messages, increase of certain socio economic indicators like education. There are number of organization like National Literacy Mission, District Rural Development Agency, Leprossy Eradication Mission, Khadi and Village Industries Commission (KVIC). The work of the developmental organisations is extremely varied but can be broadly summarised in terms of three main overlapping sets of activities and roles: implementation, partnership and catalysis (Lewis 2001). The implementer role is that of mobilisation of resources to provide goods and services either as part of the development agency own project or programm or that of a government or donor agency e.g. health care, credit, agricultural extension etc. The catalyst role is much broader and is defined as an ability to inspire, facilitate or contribute to developmental changes among other actors at the organisational or the individual level. This include grassroot organising and group formation (and building social capital), empowerment based approaches to development, lobbying and advocacy. (Watson and Lacquihon 1993). The third role of partner encompasses the growing trend for development organisations to work with government, donors and private sector on joint activities (Lewis 1998). 59 Multinational Control in Some Special Organiaation 15.2 MANAGEMENT CONTROL SYSTEM IN DEVELOPMENT ORGANISATIONS The role of the development organizations is that of welfare nature. The development agencies are funded by the government and other multilateral donor and aid agencies. Development and implementation of strategies for reengineering the development programs require that management structure should be designed in a way to ensure accountability for results and cost effective controls. The main focus of management control system is to develop management accountability, which is the expectation that managers are responsible for quality and timeliness of program performance, productivity, costs control and mitigating adverse aspects of agency operations and will assure that programs are managed with integrity and compliance with applicable law. Management controls are the organization policies and procedures to reasonably ensure that i) ii) iii) iv) v) programs achieve their intended results resource are used consistent with agency mission programs and resources are protected from waste, fraud and mismanagement all applicable laws and regulations are followed reliable and timely information is obtained, maintained, reported and used for decision making. Instead of considering the management control as an isolated management tool, it should be an integral part of the entire cycle of planning, budgeting, management accounting, reporting and auditing. For instance good management control system can assure that performance measurements are complete and accurate. Another example is management control standards of organization would align staff and authority with project responsibilities.to be carried out, improving both effectiveness and accountability. Similarly the accountability for resources could be improved by more closely aligning budget accounts with programs and charging significant resources used to produce the program's output and outcome. Audit recommendations should be used to identify and correct lacunas arising from inadequate, excessive or poorly designed controls and incorporate the appropriate controls in new programs. There should be an appropriate balance between the levels of control. Too many controls can result in ineffective and inefficient programs. Managers should benefit from controls, not be encumbered. The management control system of any development organization should at a minimum include all of the following elements • • Plan of organization that provides separation of duties and responsibilities among employees. A plan that limits access to that principal department's resources to authorized personnel whose use is required within the scope of their assigned duties. A system of authorization and record-keeping procedures to control assets, liabilities, revenues, and expenditures. A system of practices to be followed in the performance of duties and functions in each principal department. • • 60 • • Qualified personnel that maintain a level of competence. Management control techniques that are effective and efficient. Other Organisations These elements pertain to all business process of the department, including both financial and non-financial activities. 15.2.1 Fundamental of Management control for development organisations Management control is an ongoing process Management controls is not a single event, but a series of actions and activities that permeate a department's operations. These actions are inherent in methods used by management to conduct the day-to-day operations of the department. Management control should not be viewed as a separate, specialized system within an agency, but rather as an integral part of the business processes administered by management to achieve its organizational objectives. An effective control system is characterized by controls "built into" a department's infrastructure rather than controls added "on top o f the infrastructure. It is prerequisite to efficiently and effectively managing State government operations. Management Control is Affected by People People make management control work. The head of each principal department is ultimately responsible for maintaining an effective management control structure. However, management achieves this through delegation to and performance of specific responsibilities by all employees in the organization. Consequently, it is imperative that people clearly understand their responsibilities and limits of authority and how these influence the overall effectiveness of the department's management control structure. It is people that define measurable business objectives, initiate control mechanisms and activities, and monitor how well controls assist in achieving the established objectives. Management Control Provides Reasonable Assurance, not Absolute Assurance Regardless of how well designed and operated, management control cannot provide absolute assurance that all objectives will be met. Management must design and implement management control based upon related costs and benefits. Once in place, management control provides only reasonable assurance of meeting objectives. Errors in human judgement, management's capacity to override controls, and acts of collusion to circumvent controls can hamper achievement of objectives: Nevertheless, an effective Management control structure provide management with the best assurance that "surprises" will be minimized and that the department will achieve its objectives. Management Control is Focused on Achievement of Objectives in Separate, but Overlapping Categories A department's mission, objectives, and goals relate to one or more of the following categories of objectives ; • • Operational - relates to effective and efficient used of the department's resources. Safeguarding of assets is included as part of this objective. Financial reporting- relates to preparation of reliable financial statements and schedules. 61 Multinational Control in Some Special Organiaation • Compliance-relates to the department's compliance with applicable laws, rules, and regulations. The category into which a department's specific objectives relate depends. upon specific circumstances of an event, transaction, or the environment of the department. Some objectives are common to all entities (e.g., producing reliable financial reports, and complying with laws and regulations). Others, particularly those related t 6 operational efficiency and effectiveness, are department-specific and directed at the individual mission and goals of the agency. 15.3 COMPONENTS OF MANAGEMENT CONTROL Management control consists of five interrelated components, which are derived from methods used by agencies to conduct their business. Management control is part of the department's operating activities, and links among these components from an integrated system that allows management to dynamically react to changing conditions. The Components of management control are: • • • • • Control environment Risk assessment. Control activities Information and communication Monitoring Each component is integrated into the management process (i.e., planning, organizing directing and controlling) and is essential to achieving the objectives of management control. The five components also serve as criteria for evaluating the effectiveness of the management control structure. Each of these criteria must be satisfied according to the unique needs of the department, and underlying activities, being evaluated. The fact that the components serve as both requirements and criteria is very important. This allows management to establish, maintain, and evaluate using the same standard. Establishing measurable objectives, at both the department-side and activity levels, is a prerequisite to effective management control. The objectives should be consistent with the overall mission of the department and provide a target, which guides each department in conducting its activities. All department objectives and goals are categorized into the following separate, but overlapping objectives of management control: • • • Efficiency and effectiveness of operations. Reliability of financial reporting Compliance with laws and regulations. 62 Evaluating the effectiveness of an management control structure is a matter of management's subjective judgment. This requires an assessment about the presence and, proper functioning of each component of management control and its contribution towards the department's achievement of the objectives of management control. 15.3.1 Control Environment The control environment encompasses the attitudes and actions of management regarding control. This environment sets the organisational tone, influence control conciousness and provides a foundation for an effective system of management control. The control environment also provides the discipline and structure for achieving the primary objectives of management control. Control activities are implemented to ensure that management objectives to address risks are fulfilled. Major elements that affects an organisation's control environment are as follows: • • • • • • • Assignment of authority and responsibility. Commitment to competence. Human resource policies and practice. Integrity and ethical values. Management's philosophy and operating style. Organisational structure. Oversight groups. Other Organisations 1 5 .3 .2 Risk Assessment This component of management control highlights the importance of management carefully identifying and evaluating factors that can preclude it from achieving its mission. All departments encounter risks that threaten the achievement of their business objectives. Risks are introduced by numerous external and management sources. Risk assessment is systematic process for integrating professional judgment about probable adverse conditions and events and assessing the likelihood of possible losses (financial and non-financial) resulting from their occurrence. Risk relate to both department-side and activity level objectives. Identifying and analyzing risks is a continuous process critical to maintaining effective management control. Risk assessment incorporates information from various sources, including discussions with management and staff. Department's Mission and Underlying Objectives A precondition to risk assessment is establishment of objectives, linked at different levels and internally consistent, In order to evaluate a department's success, a department must first determine whether its mission and objectives provide clear, well-defined targets for achievement. The establishment of objectives allows departments to formulate critical success factors. These provide the measurement basis for\determining if the department, and the various managed activities, attains established objectives and goals. Critical success factors should be established at department-wide and activity levels (and can be established for each employee through the use of position descriptions and performance factors) T o be effective and ensure positive results, objectives must be measurable, complementary and linked. "Measurable" objectives, allow management to determine, with reasonable precision, how well the department and its activities achieve their objectives. Measurable objectives are fundamental requirement for most quality initiatives. 63 Multinational Control in Some Special Organiaation Evaluating Risks The process for identifying and analyzing risk should be incorporate into a department's normal operations to ensure it is conducted as an ongoing process. Risk Identification Management should perform a comprehensive analysis of identifiable risks, including all risks associated with department-side and activity level objectives (derived from the organi2ation's mission). The activities analyzed should include those that support both financial and non-financial objectives. • • • • • Management planning conferences Periodic reviews of factors affecting the department's activities Qualitative or quantitative methods to identifying and prioritizing control efforts over high-risk activities Short and long-range forecasting Strategic planning Management must consider external factors that may present risks to the agency, including: • • • • • Business, political, and economic changes Changing needs or expectations of agency officials or the public Nature catastrophes New legislation or regulations Technological developments Management factors with inherent risks, include: • • • • • • • • • Changes in management responsibilities Disruption of information, systems processing Downsizing department operations Early retirements that reduce the workforce and knowledge base Highly decentralized program operations Management and employee accessibility to assets Nature of departmental activities and degree of centralization Quality of personnel and training provide Reengineering agency operating processes Risk Analysis After identifying department-wide and activity level risks, management should perform a risk analysis. The methodology may vary since risks are difficult to quantify; however, the process generally includes the following Estimating risk significance Assessing likelihood/frequency of occurrence 64 Considering how to manage risk Risk with little significance and low probability of occurrence may require no action while those with high significance and frequency require special attention. After assessing the significance and likelihood of risk, management, must determine how to control it. Risk Management Economic, regulatory, operational,, and other conditions continuously change. Therefore, a mechanism must be devised to identify and manage the risks associated with change. Further, management must continually anticipate the occurrence of new risk resulting from change. This allows the. implementation of control techniques during the development stages of new or change processes. Changing conditions that warrant special consideration with regard to risk include the following: • • • • • • • • • • • • Acceptance of audit findings and corrective action taken Complexity or volatility of activities Geographical dispersion of operations High personnel turnover Implementation of major new technologies, including information systems Management's judgements and accounting estimates New personnel in key positions Organizational, operational, or economic changes Personnel competence, adequacy, and integrity Rapid growth, expansion or downsizing Restructuring or reengineering New laws, rules and regulations Other Organisations To determine the relative significance of changes, management may weigh the risk factors. This reflects management's judgment on relative impact, when selecting an activity of evaluation 15.3.3 Control Activities Control activities occur at all levels and in all activities of the department. Examples of control activities include: policies and procedures; organizational plans; managerial approvals and authorizations; verifications and reconciliation; performance reviews; security maintenance; restrictions on assess to resources; segregation of duties; documentation of transactions and event cycles by means of flowcharts and narratives. Control activities are implemented to ensure that management's directives are followed, which in turn reduces risks and contributes toward the achievement of department objectives. Type of Control activities Control activities include preventive, detective, and corrective controls. The following categories of control activities are common to all departments 65 Multinational Control in Some Special Organiaation Policies and Procedures: Documented policies and procedures should clearly indicate the actions and responsibilities of all employees relative to performance of job responsibilities. Management should formally approve these with regular updates on change that may have occurred. Review of Performance by Management: All levels of department managers should review performance reports, analyze trends, and relate results to targeted and historical performance. The accuracy of operational summaries should also be verified. Reconciliation: Managers should periodically reconcile summary information to supporting detail. Physical Control: Equipment, inventories, securities, cash, and other assets vulnerable to risk of loss or unauthorized use, must be physically secured, periodically counted, and compared to amounts shown on control records. Performance Indicators: Control activities must be established to monitor performance indicators. This control requires comparisons and assessments, relating different sets of data to one another for analysis of relationships and appropriate corrective action. Management should investigate unexpected results, unusual trends, or conditions that may prevent the organization from achieving its business objectives Information Processing: Several control activities maybe used to verify data accuracy, completeness, and appropriate authorization of transactions. Control activities for information processing include procedures to ensure that : • • • • • Data entered into systems in subjected to edit checks and matched to approved control files, Transactions are accounted for in numeric sequence File totals are compared with control accounts, Exceptions are examined and acted upon, and Access to data, operating system, and program files (source and object code) is granted to only authorized individuals. Segregation of Duties: Duties and responsibilities should be divided among staff to reduce the risk of errors, waste, misuse, or fraud. No one individual should control all key aspects of a transaction or event. 15.3.4 Information and Communication Each department must capture pertinent financial and non-financial information relating to external and management activities. This information must be identified as relevant to managing the agency and communicated to those who need it. Communication should be in a form and time frame that enables all employees to carry out their control responsibilities. Factors management should consider in establishing management controls related to information and communication are described below: Information Pertinent information must be identified, captured, and communicated in a from and time frame that permits users to perform their duties efficiently. Information systems produce data that enables control of relevant information flowing down, across, and up the organization. Management must clearly communicate to all employees that control 66 responsibility is critical. Employees must understand their role in management control and have a means of communicating critical information of management. There must also be effective communication lines with external customers, contractors, suppliers, and regulators. Information systems support the achievement of all three categories of management control objectives - operational efficiency, reliable financial reporting, and compliance with laws, rules, and regulations. The appropriateness of contents, timeliness, accuracy, and accessibility of information are attributes with which to measure information quality. Quality factors are affected by management control and must be inherent in the information to ensure that informed decision are made throughout the department. Communication Information systems inherently imply communications. Information must be captured and promptly' provided to appropriate personnel, so they can perform their operating, financial reporting, and compliance responsibilities. Information must be communicated internally and externally to other appropriate groups. Internal Communication Internal communication is important for effective management control. To ensure that effective internal communication occurs, the following types of control should be in place. • • Management must provide a clear message to all personnel that management control responsibilities are critically important. Employees must understand their specific duties, aspects of management control, and their role in it. They should know how their work relates to the work of others, which may help to address problem recognition, cause, and corrective action. Any uncertainty the employee has should be clarified. Personnel should demonstrate acceptable behavior. Personnel need a means of communicating information upward within the agency. Management must open lines of communication and display a willingness to listen. Separate lines, of communication may be necessary if normal channels prove ineffective. Personnel must know that there will be no reprisal for reporting information. Management must update management oversight groups regarding performance, developments, risks, major initiatives, and other significant or relevant events. Other Organisations • • • • External communication Agencies communicate with various external groups that may have an impact on the operations and activities of the department. To ensure effective external communications, management should provide for open lines of communications with contractors, suppliers, and other customers of the agency. These groups provide significant feedback regarding the quality and design of agency business processes and supporting activities. 15.3.5 Monitoring This component involves assessing the quality of management controls. It involves assessments by appropriate personnel, of the design and operation of controls, noting any deficiencies, and putting into place appropriate corrective actions. A system of management control must be integrated into the everyday operations of each 67 Multinational Control in Some Special Organiaation department. To maintain ongoing assurances about the continued effectiveness of the management control structure, management must continually monitor the system to identify the need for changes. Type of Monitoring Monitoring includes management reviews, comparisons, reconciliation procedures, and other duties performed by department employees. Monitoring activities can be categorized into ongoing and separate periodic evaluations. Effective ongoing monitoring activities will often require less need for separate evaluations. Ongoing Monitoring Activities Numerous type of activities may be used to monitor management control on an ongoing basis. Activities that can be incorporated into agency management controls include procedures to determine: • The extent to which, personnel, in carrying out their activities, obtain evidence as to whether the system of management control is working properly The extent to which communications from external parties corroborate internally generated information Whether assets recorded on the accounting system agree with assets on hand The extent to which employees are responsive to management and external auditor recommendations The extent to which employees clearly understand and comply with the department's code of conduct • • • • Separate Evaluations While ongoing monitoring activities provide important feedback on the effectiveness of management controls, separate evaluations can be useful by focusing directly on the effectiveness of controls at specified points in time. Testing Management Controls An important part of any evaluation activity is testing the reliability of management control procedures. Testing can be done (on an ongoing or periodic basis) by reviewing transactions, performance reports, and supporting documentation of program activities. Additional tests may include making inquiries of appropriate personnel; observing how separation of duties and similar control-related activities are carried out; and personally re-performing selected control activities to verify results. The results of these tests should be reviewed and evaluated by management to assess the significance of any errors or deficiencies. Corrective action plans should be established (and monitored) to ensure that errors and deficiencies are addressed. 15.4 LIMITATION OF MANAGEMENT CONTROL A fundamental concept underlying the definition of management control is that an management control structure provides only reasonable assurance that agency objectives will be achieved. Limitations are inherent in all management control systems. These result from poor judgement in decision-making, human error, management's ability to override controls, collusion to circumvent control, and consideration of costs and benefits relative to management control. No matter how well management control operates, some events and conditions are beyond management's control. 68 Judgement Mistakes Effective management control may be limited by the realities of human judgement. Decision are often made within a limited time frame, without the benefit of complete information, and under time pressures of conducting agency business. These judgement decision may affect achievement of objectives, with or without good management control. Management control may become ineffective when management fails to minimize the occurrence of errors (e.g., misunderstanding instructions, carelessness, distraction, fatigue, or mistakes). Management Override Management may override or disregard prescribed policies, procedures, and controls for improper purposes (e.g., to enhance presentation of their agency's financial or compliance status). Override practices include misrepresentations to state officials, staff from the central control agencies, auditors, or others. Management override must not be confused with management intervention (i.e., the departure from prescribed policies and procedures for legitimate purposes). Intervention may be required in order to process non-standard transactions that otherwise would be handled inappropriately by the management control system. A provision for intervention is needed in all management control systems since no system anticipates every condition. Management's actions to intervene in management control should be documented and disclosed to appropriate personnel. Collusion Collusion activities can result in control failure. Individuals, acting collectively to perpetrate and conceal an action from detection, may alter financial data or other information in a manner that cannot be identified by the management control system. Cost versus Benefits The cost of management control must not exceed benefits to be derived. Potential loss, associated with exposure, should be weighed against the cost to control it. Although the cost-benefit relationship is a primary criterion to be considered in designing management control, the precise measurement of cost is generally not possible. The challenge is to find a balance between excessive control (which is costly and counterproductive) and too little control. Other Organisations 15.5 SMALL AND MEDIUM ENTERPRISES (SMEs) In Indian context the small scale industry is defined as an industrial undertaking in which investment in fixed assets in plant and machinery, excluding land and building does not exceed Rs.1 crore, whereas all small scale units in which investment on plant and machinery (excluding land and building) is up to Rs. 25 lacs are classified as tiny industries. There are certain type of industries/activities where in investment on plant and machinery up to Rs. 5 crore can also be registered under SSI category. Across the globe, specially in the developing countries SMEs are a dominant constituent of the GDP of a nation and key employment engine. SMEs provide flexibility to the economic structure of the economy. The importance of the SMEs can be gauged from the data given in Table 15.1 The rate of growth i n employment and exports is consistently higher than the organized sector. 69 Multinational Control in Some Special Organiaation Table 15.1: Performance of Small Scale Industries No. of units (lakh) Production (Rs. Crore) Employment Exports in lakh (Rs. crore) (at current Regd. Unregd. Total prices)* 1994 95 19.44 6.27 25.71 289886 2,66,05 146.56 29068 (7.66) (23.69) (10.10) (5.15) (14.86) 1994-95 1 1.61 67.99 79.6 1,22,210 1.09,1 191.4 29.068 (4.1) (23.7) (.10.4) (4.8) (14.8) 1995-96 1 1.57 71.27 82.84 1,48,290 1.21,64 197.93 36,470 (4.1) (21.3) (11.5) (3.4) (25.5) 1996-97 11.99 74.22 86.21 1.68,413 1,35,38 205.86 39,248 ((.1) (13.6) (11.3) (4.0) (7.6) 1997-98 12.04 77.67 89.71 1,89.178 1,47,82 213.16 44.442 .. (4.1) (12.3) (9.2) (3.5) (13.2) 1998-99 12 81.36 93.36 2, 12,901 1,59,40 220.55 48.979 (4.1) (12,5) (7.8) (3.5) (10.2) 199912.32 84.83 r; 97.15 2,34,255 1,70.70 229.1 54.2 (4.1) (10.0) (7.1) (3.9) (10.7) 2000 13.1 88 101.1 2.61,289 1,84,42 239.09 69.797 (4.1) (11.5) (8.0) (4.4) (28.8) 2001-02 13,75 91.46 105.21 2,82.270 1,98,61 249.09 71,244 (4.1) (8,0) (6.l) (4.2) (2.1) 2002-03 14.68 95,42 I l0, l 3,1 1,993 2,10.63 261.38 86.013 (4.6) (10.5) (7.7) (4,9) (20,7) 2003-04 15.54 99,68 115,22 3,48,059 2,26,39 273.97 N.A. (4.7) (11.6) (7.5) (4.8) * 1993-94 prices. ** :Based on growth rate of 7.48% achieved in first 9 months of 2003-04 i.e. April-December, 2003. Note : Figures in brackets indicate percentage growth over previous year. Source: Ministry of Small Scale Industries. Year Before looking at the management control system for SMEs, first let us have a look at the problems faced by SMEs in general • • • • • • • • • Shortage of raw material Obsolete methods of production Low productivity Lack of capital High cost, high prices and high taxes Difficulties ii certification and sales Delay in receiving of payments (high receivables) High level of raw materials and finished goods Lack of infrastructure support In order to understand the management control process in SME's first let us have a look at some of its distinctive characteristics, constraints on growth; Distinctive Characteristics • • • An absence of functional manager On the job training Investment and resources are often personal 70 • • • Discontinuities Owner's identification with the business Values Other Organisations Constraints on Growth • • • • • • • • • Availability and cost of finance for expansion Availability and cost of overdraft and credit Marketing and sales skills Management skills Overall growth of market demand Increased competition Lack of skilled labour Acquisition and implementation of new technology Access to overseas markets. Management Control Implications If we analyse the peculiar characteristics of the SMEs, we can understand the needs (requirement) of this particular sector. These needs (requirement) can be further sub divided into the needs at stage of start up, growth & expansion stage and maturity stage. The needs at the start up stage are Capital, Customers, Suppliers, Employees, Infrastructure Management skills and Information and advice. The needs at the Growth and Expansion stage are ensuring resources, delegation and coordination, functional and centralised structure, maintaining control, new product development, product innovation and market research. The needs at the maturity stage are Expense control, increased productivity, niche marketing, product innovation and formal system for objectives and budgets. In the light of the needs (requirements) discussed above the focus of the management control structure should be on the following Innovation: For almost any company, the ultimate achievement barometer is to first to discover - and capitalise on - an idea whose time has come. Innovation and creativity are critically important to all companies as new ideas produce new products and services, which are key to remaining competitive and to fueling value growth. Brands: For companies seeking to maximise long-term value growth, a recognisable brand can be the key to standing out in a crowd. This will be especially important in the future, when consumers will be faced with an even greater sea of choices due to technological advances. Customers and Markets: Creating value for shareholder begins with creating value for customers. Satisfied customers are more likely to be loyal and this offers a critical edge for both expanding existing relationships and establishing new ones. The SMEs should focus on four main areas of which are customer penetration, market growth; market share and customer retention. Supply Chain Efficiency: From product development to distribution, from controls to customer service, the integration of all aspects of a company's supply chain is critical to maximising efficiency and, hence, there is a presumption that companies are world class in this area, or at least moving quickly in that direction. 71 Multinational Control in Some Special Organiaation People: Companies cannot achieve their goals without the right people in the right positions at every level. At a time when the workforce is more mobile than ever, recruting and retaining the best people is the biggest challenge. To assure continuity and hold down the high costs of replacing and training new workers, companies must make investing in their "people equity" a priority. In addition to remuneration, providing a more comfortable work environment and offering opportunities for personal development and continuous learning are important incentives for attracting and retaining employees. Reputation: Damage to a good name is the hardest blow to recover from. This is particularly true when competitors are all too eager to capitalize on another's reputational damage. At the same time, the factors that influence reputation are numerous and include business conduct across the entire "Value Platform." 15.6 KNOWLEDGE ORGANIZATIONS Looking back in history the agricultural society was replaced with the industrial society with the advent of the industrial revolution. The industrial revolution gave birth to the service sector and as of now two third of the world's GNP is contributed by the service sector. The underlying urge of mankind of innovate, to do things differently has given rise to the knowledge organizations. Knowledge organization are those organizations which leverages the knowledge of employees to innovate, create, develop, and improve product and process. Companies working in the areas of software development, pharmaceuticals, bio informatics, genetics, electronics and other sunrise industries are known as knowledge organizations is their capability to harness, capture, share and using productive knowledge to enhance learning and improve performance. These companies beverage on knowledge of it's employees rather than the physical infrastructure. In case of India some examples of knowledge organizations are Infosys, Wipro, Ranbaxy, TCS, ICICI Bank, National Stock Exchange of India, Indian Institute of Science (Bangalore). At global level knowledge organization are Microsoft, Intel, AMD, Pfizer, NEC, Texas instruments, Bell Labs, AT&T, Motorola etc. The knowledge organization are not an easy place to manage due to the shift in power balance. Knowledge workers know more about the technical field than their bosses and are much closer to the customers or the action area. The impact of control is also diminished due to the fact that the primary production factor is creatively and innovation of the employee and not the tangible assets of the employer. Another factor which diminished control is that in knowledge organizations the employees are, most of the time working on nevi problems for which no benchmark indicator of performance or cost is available. The potential long term benefits of knowledge management are a) Revenue growth b) Enhancing competitive advantage c) Employee development d) Product innovation Key short term benefits of know' edge management are a) cost reduction b) improved marketing strategies c) enhanced customer focus. Technology in itself does not constitute a knowledge management program, but knowledge organisations make use of number of technology platforms to implement knowledge management some of which are as follows: a) Artificial intelligence b) Extranet c) Internet d) Intranet e) Groupware f) Decision Support g) Data warehousing/mining h) Document management system. Knowledge management is not just concerned with the technology issue, there are various other variables which poses threat to successful implementation of Knowledge Management initiative. Some of these variables are a) Lack of support of senior management b) User could not see personal benefit c) Lack of training d) Lack of time 72 e) Systems are too complicated f) Lack of user uptake due to insufficient communication g) Lack of integration into normal working. The Knowledge Management strategy includes the following activities: a) b) c) d) e) f) g) h) i) j) k) l) m) n) Measure intellectual capital Create knowledge map Design of other Knowledge Management processes New systems for "communities of practises" Appointment of knowledge officers Creation of knowledge centres Knowledge system audit and assessment Build and develop communities of practice Incentive/rewards for knowledge working Establish format for Knowledge Management networks Knowledge policies 1) Knowledge Management training/awareness Sharing best practices Benchmark/Audit current situation ERP Systems Other Organisations Advantages of Knowledge Management • • • • • • • • • • • Discovery of knowledge Formation of criteria for success competition Transparency Lack of knowledge, elicit weak points Eradication of gaps Optimisation of knowledge saving and access Promote use of knowledge for innovations Further development of the skills of successful companies Generation of application knowledge Core competences Process-optimisation Role of Management Control system Keeping in view the peculiar characteristics of knowledge organizations the focus of management control system shifts from control to creating an environment which facilitates. 73 Multinational Control in Some Special Organiaation • • • • • • • • • Knowledge flow between individual knowledge workers Knowledge flows from individuals to external structure Knowledge flows from external structure to individuals Knowledge flows from group competence to management structure Knowledge flows from management structure to individual competence Knowledge flows within external structure Knowledge flows from external to management structure Knowledge flows from management to external structure Knowledge flows within management structure. External structure is a set of intangible relationship with customers and suppliers and individual competence consist of knowledge workers and their skills. Apart from the above mentioned areas the management control structure should also focus on four critical pillars of knowledge economy which are as follows : • • • • Strengthening the economic and institutional regime Developing educated and skilled workers Creating an efficient innovation system Building a dynamic information infrastructure. A survey done by OECD has bought out the following facts about knowledge management 1) 2) Massive adoption : Nearly one out of two firms have adopted one or more knowledge management (KM) practice. Company size matters : Firms manage their knowledge resources differently depending upon the size rather than industrial classification. Large companies on average used more knowledge management practices than small ones. High tech industries use KM more Companies which have adopted new management methods specially the project based organizations are using more of knowledge management practices Knowledge management practices matter for innovation and productivity performance. 3) 4) 5) 15.7 SUMMARY The management control process is not static in nature, by definition itself it has to adopt itself to the changing structure of the organisations. In case of development organisations the management control system has to be modified to ensure that the resources of the organisation are used for4the purpose they are intended for and timely information is generated and reported. In case of small and medium enterprises the management control process focuses on activities which results in value creation and survival. In case of knowledge organisations the focus is on to create systems which facilitated sharing of knowledge, storing of knowledge for future reference 74 15.8 SELF ASSESSMENT QUESTIONS 1. 2 3 4 5 6 7 8 Name few of the development organisations which are operating in India. Broadly classify the activities of Development organisations. Explain in detail the main elements of Management Control System for development organisation. Explain the main type of control activities for development organisation. What type of controls should be in place for effective management control? Explain in detail the limitations of management control in development organisations. Explain in detail the distinctive characteristics of Small and Medium Enterprises. Analyse the role of management control system in Knowledge Organisations. Other Organisations 15.9 FURTHER READINGS Allen, T.T. (1977), Managing the Flow of Technology, MIT Press, Cambridge, MA Bridge Simon, Neil'o Ken & Cromie STan; (1998); Understanding Enterprise, Entrepreneurship and Small Business. Mcmillan Press Ltd, London. Davenport, T.H., De Long, D.W. and Beers, M.C. (1998), "Successfull Knowledge Management Projects", Stoan Management Review, Winter pp 4357. Dichter, T.W. (1989) Development Management: Plain or Fancy? Sorting out some mudles. Public Administration and Development, 9 pp 381-93 Lewis D. (2001), The Managment of Non-Governmental Development Organisations: An Introduction, London: Routledge. Von Krogh, G (1998), "Care in Knowledge Creation", California Management Review, Vol. 40 No. 3, pp 133-53. 75 CASE 1 BROOKE BOND (INDIA) LTD. (A) Brooke Bond (India) Limited (BB1 ), a FERA company in the Unilever fold, has come a long way since it began operations in India way back in 1912. The 77 -year-old company was incorporated in Calcutta under the name of Brooke Bond & Company (India) Limited with the twin objectives of introducing packaged quality teas to the Indian consumer and also of exporting bulk teas. The early products lines included Black Label, Violet Label, Green Label, Red Label and the popular Kora Dust, Brooke Bond (India) Ltd. has been described as the world's largest tea marketing company by its executives. The company saw a period of growth and expansion during 1927-67 and it introduced new products, including coffee in conventional powder form. The company's main products are tea, coffee and instant coffee. Tea accounts for well over 70% of the company's sales and profits. Apart from tea and coffee which together accounted for an estimated 95% of the pre-tax profits of the company for the year 1981-82, Brooke Bond managers are trying their best to establish other lines of business - meat and leather exports, paper, oleoresins, spices and blades. Marketing and Purchasing Operations To read h largo consumer base, the company in Its initial singes set up a wide marketing organisation involving distributors and agents till over the country which, however, begun gaining ground after 1940 The direct selling system = known ns the depot system =is supposed to establish a permanent bond between BBIs salesmen and the retail outlets, The impressive volume of branded or packaged tea is presently marketed by a large sales force of 1,352 salesmen, 100 controllers, 27 area sales managers, 27 deputy area sales managers and 6 zonal sales managers -"the largest corporate sales force in the world" -- servicing 6,35,856 retail outlets (including 1,50,000 hot tea shops) in 20,000 towns through 1,352 company-owned depots. Contrary to popular opinion, 70% of the company's sales are in the rural areas and the "world's largest corporate sales force also markets the world's cheapest branded article-the-5 paise tea packet" which contributes 18% of the sales revenue of the tea profit centre. Brooke Bond is the single largest buyer of tea for domestic consumption and its team of 16 purchasers bought 67 million kg. of tea in 1981-82 through its five buying centres located in Guwahati, Siliguri, Cochin, Coimbatore and Calcutta. After the tea is purchased, it is dispatched to the company's six factories (where 4,300 employees including 80 executives work) for blending and packaging. The six factories are situated in Calcutta (West Bengal), Tundla (Uttar Pradesh), Kanha (Maharashtra), Jamnagar (Gujarat), Ghatkeser (AP) and Coimbatore (TN). For a packet tea company such as BBI the emphasis is not so much on quality as it is on standardization. When the quality of the teas available in the auctions changes, the company has to vary its blends to maintain consistency in price and quality. Maintaining the consistency of branded tea is considered to be the primary function of BBI so that consumers -most of whom are loyal to a brand for years at a stretch - do not complain of deterioration in quality. The job of the production' department in the tea profit centre is therefore to carefully store and blend the tea as per the branding sheets received from the tasters,-to package them in various packet sizes and dispatch them to the various depots as per indents received. Case (1989) prepared By Dr. M.L. Bhatia, Formerly Member of the, Faculty, School of Managment Studies, IGNOU.Case material has bee, prepared to serve as a basis for class discussion. cases are not designed to present illustrations of either correct or incorrect handling of managerial problem. Copyright © of IGNOU 1 According to the company's Marketing Director, "The style of marketing is organic and unique and quite distinct from that of any other organised sector company in India." The marketing modus operandi has two unique features. Firstly, the company has a direct system of selling which completely eliminates the wholesalers and the middlemen. All the 6.5 latch retail outlets are supplied directly by the salesmen with the aid of a fleet of 1,000 vehicles ranging from motorized vans down to bicycles and mule carts. Secondly, all sales are cash sales and the company has no outstandings. BBI's direct selling system is quite expensive because the average wage packet of the company's 1,352 salesmen is an impressive Rs. 2,400 per month (40% of which is earned by way of incentives). Several officials of the company believe that the direct selling system is the best system for the promotion of low price consumer goods. It eliminates outstanding and wholesaler's discounts. The direct selling system offers the quickest way to distribute a product and ensures a degree of attention to promotion of brand and corporate image that no wholesaler can possibly provide. For example, it could hardly be worthwhile for a wholesaler to promote the five paise tea packet which the company believes is the world's cheapest branded product, as his margin would be extremely small. Paradoxically, this product contributes almost 18% of the sales revenue of the tea profit centre. While the company's direct selling system and its gigantic field force is regarded as the major strength, some officials believe that it could prove to be its Achilles heels. The company believes that the cost of direct selling per product will be reduced as the company diversifies into low cost consumer products such as instant coffee, spices, blades, etc. Marketing Environment The average price of tea in London auction plummeted from an all time high of 156.3 pence (Rs. 26.59) per kg. In 1977 to an average of 107 pence (Rs. 18.19) per kg. During the first half of 1982. The total production in India which yields 32 per cent of all the tea production in the world has increased only marginally from 556 million kg. in 1977 to 561 million Kg. in 1981. With Kenya- a major exporter of tea - having opted out of International Tea Agreement which was painstakingly hammered out to allocate quotas to the tea exporting nations and with the entry of China into the world market for tea, around the corner, the future of Indian tea exports (which accounts for 43 per cent of its production) looks distinctly gloomy. Thus, the tea activity which accounts for well over 70% of the company's sales and profit is plagued with uncertainties, particularly on the profitable export front. For BBI -a company which blend and markets packet or branded tea- the main competition in the domestic market comes from the cheaper unbranded tea which is sold loose in the market place. In 1981-82 the company sold the same volume of tea as in 1971, but its market share vis-a-vis loose tea is now much less. During this period the total share of packet tea has come down from 45 per cent to 30 per cent with a corresponding gain for loose teas. Though 1981-82 was considered a year of recovery and the company recorded a notable gain in sales volume, it was a challenge for the company to sustain this trend. In the instant coffee business, the company has been playing an uncomfortable second fiddle to Food Specialities Limited (Nestle) whose brands Nescafe and Ricori together command a 60 per cent share of the national market, BBI spokesmen attribute Food Specialities market dominance to its larger licensed capacity and to the fact that the BBI was obliged to suffer production capacity constraints. For several years the company was not given a licence to expand production. However, by mid-1982 the company's third instant coffee plant at Hosur (TN) will go on stream, augmenting the production of the company's instant coffee - chicory combination market under the brand name Bru. Though the company has carved out a, comfortable 16 per cent share in the national market for conventional coffee with their brands Green Label Cafe and Family, their real battle will not he fought against Food Specialities Limited (FSL) whose sales was to the order of Rs. 55.6 crores in the year ended December 1981 -which is the Indian associate of the multimillion dollar multinational conglomerate Nestle Holdings Limited - Bahamas, The company executives claim that Brooke Bond instant coffee - chicory blend has a 40 per cent share of the national instant coffee market which puts it ahead of Food Specialities prime brand Nescafe which is supposed to have a 39 per cent market share. However, they concede that because Food Specialities coffee-chicori blend Ricory has a 21 per cent market share FSL has an aggregate market share of 60 per cent 2 of the instant coffee market. How Brooke Bond compares with other similar companies is presented in Exhibit 1. With the Hosur factory which is expected to go into production in June 1983, marketing plans to promote Bru with greater vigour and launch a pure instant coffee (yet unnamed) with a reported sales promotional budget of Rs. 30 lakh per year are taking shape in Bangalore. The Changing Profile The Annual Report for the year 1981-82 states about the changing face of BBI in the following words: Change is a natural process of life. Without change, there would be no growth. In the life of a corporation too, change must come. Except that this process of metamorphosis cannot be an involuntary one. It must be controlled, channelised, carefully planned. It must depend on transformations taking place in the environment, the company's awareness of these changes and its ability to anticipate and mutate to meet the challenges of the future. Thus has it been with Brooke Bond. Today, Brooke Bond is a different Company from what it was a few years ago. Planned changes have been effected in the vital areas of holdings, operations, product mix and employment-an expression of corporate philosophy that has made the Company stronger, more dynamic, more responsive to the times. Brooke Bond today is a multi-product, multi-divisional company, far removed from the beverage company that it was until the late seventies. A large measure of credit for masterminding and spearheading the company's diversification drive is given to T.S. Nagarajan (55) Vice-Chairman and Managing Director who supervises corporate planning and diversification function. A graduate of Banaras Hindu University, Nagarajan began his career in Hindustan Lever in the year 1948. Profit Centre Structure The profit centre organisation built around product groups is supported by service and advisory functions. The profit centres include all major operating activities which now act as separate organisational entities; each reporting to a profit centre head. Commodity purchase, Marketing and Production functions report to the head of each profit centre. These profit centres are supported by common services such as Finance, Transport and Distribution, Purchase of Packaging Material, and Advisory Service such as Technical and Secretarial. The services operates on functional basis, serving all profit centres. The ten profit centres, as shown in Figure 2, are aggregated into three groups, each headed by an Executive Director of the company. A brief overview of the performance of each centre for the financial year ending on 27th June, 1981 is given below: Tea: This is the major profit centre which contributed nearly 85% of the sales revenue and an estimated 80 of the pre-tax profits. The profit centre consists of Domestic Packet Tea, Domestic Bulks, Export Packet Tea, Export Tea Bags, and Export Bulks. Industrial Machinery: This profit centre sold gravure cylinders and components, packaging and printing machines valued at Rs. 24.54 lakhs. Only 30% of the industrial machinery is sold in the market place. 70% is produced for captive consumption. Paper: The company's Rs. 7 crone, 15,000 tonne paper manufacturing plant located at Bilaspur (M.P.) is scheduled to begin commercial production by the end of 1983. Meat: The wholly integrated buffalo meat processing plant located in Aurangabad (Maharashtra) at a capital cost of Rs. 7.5 crores is the only one of its kind in the country and is a 100% export unit. Turnover, of its products (Export Corned Beef, Frozen Beef,' and Leather) amounted to a little over Rs. 6 crores. It has broken even. Leather: In September, 1982 an affiliated leather processing unit went into commercial production and will produce value added processed leather and, later, on, shoe uppers for export. 3 Oleoresins: This profit centre which envisages the export of value added oil of resins, rather than the more bulky resin wood, has yet to get off the ground. Coffee: Conventional coffee constituted half of total coffee value (conventional and instant) sold during the year. Instant Coffee: Company executives claim that their instant coffee-chicory blend Bru has a 40% share of the instant coffee market and, as indicated earl lei, has been constrained from winning a larger market share only because of a delay in getting a licence to expand capacity. Currently the company's third plant with a production capacity of 750 tonnes per annum is taking shape in Hosur, Tamil Nadu, and is expected to go on stream by mid1983, Spices: The company is test-marketing packaged and branded spices in the domestic market. In the meanwhile it sold one crore rupee worth of spices in the export market. Blades: Since 1979 the company has been marketing safety razor blades manufactured by the Centron Industrial Alliance Ltd., a Bombay-based unit with its factory in Aurangabad. This profit centre sold 35 million blades acquiring a 5.3% and 9% share in terms of units and value respectively of the Rs. 31 crores national market for razor blades, The last four profit centres, comprising Group 2 accounted for 21% of the company's pre-tax profit. As for 1981.82, the ten and two coffee profit centres (conventional and Instant) contributed an estimated 95 per cent of the pre tax profit of the cornpany, Thus the other profit centres are relatively speaking small potatoes for Brooke Bond, As Indicated earlier, the meat processing project is the largest and contributes turnover of Rs, b crores and it has broken even, The razor blades profit centre which has been marketing. blades manufactured by the ailing Centron Industrial Alliance Limited, Bombay, under the brand name Swish Stainless, Super Swish Silver, Steelex and Platinex made a contribution of Rs. 3 crores, But the future of this profit centre is dependent upon whether the company's proposed merger with Centron, stymied by the powerful Malhotras who dominate the indigenous razor blade industry, goes through. Thus, for the present management's ambitious plan to merge the ailing Centron into the company has been stymied by a host of' legal and bureaucratic hurdles. The company's packaged spices business is still at the test marketing stage. The company's leather plant commenced production in September 1982 and the paper manufacturing project will become operational at the end of 1983. Profit Centres : Practices and Procedures The following are the salient futures of profit centre structure at BBI and the practices and procedures followed: Organisation was considered adequate, or perhaps effective, as long as business of the company was less complex and limited to tea and coffee. Mr. Samuel (53) has been the Chairman and Managing Director of the Company since 1978.- Earlier a Chief Accountant at Hindustan Lever Ltd. (HLL), Mr. Samuel, joined Brooke Bond in 1971 as Finance Director. Mr. Samuel is the main force behind restructuring the 60-year-old company. When the company commenced its meat project at Aurangabad. it found the need to make this unit a separate division to help identify the costs and profitability of the new project. At the same time, a group of people to work exclusively on the meat project was assigned and who could be held responsible for its performance and results. This development was the beginning of the concept of "profit centres" in the company. When the company decided to go into the distribution of blades, the domestic marketing of spices, and with a third instant coffee plant, a leather unit and a paper project (which was round the corner), it felt the need to give these operations a more distinct identity. The responsibility for operations and results and accountability had to be clearly established at senior management levels. 4 The company gave serious thought to the opportunities presented by the profit centre type of organisation, on which by then the company had some encouraging experience with the meat operation. It took some months, however, to implement the re organisation on a new pattern before it became fully operational throughout the organisation. Figure-1 captures the past and present of the company in so far as the organisation structure and management control are concerned. 5 According to Nagarajan, the diversification process has been spread out over three phases. The first phase began when the company made its diversification into the instant coffee business in pursuance of its perception that the demand for a product in a given market was neither constant nor inherent. It was the availability of a product in the market place that stimulated demand. This belief was put to test in the instant coffee market for which the national demand at that time was 200 tonnes per year. Today the company's production of instant coffee-checori blend is 1,600 tonnes per year and the demand for this blend and Bru exceeds supply. A second phase in the company's diversification process began in the mid-seventies after the Foreign Exchange Regulation Act, 1973, was enacted and the equity shareholding of the parent company, the London based Brooks Bond Group was reduced from 100 per cent to 40 per cent in 1977-78. Under the provision of the Act, the company's future expansion had to be in relatively high technology areas or in the export sector. It was in this context that the company set up its meat export project in Aurangabad at a capital cost of Rs. 7.50 crores in 1976. In the year ended 27'" June, 1981 the company's meat exporting plant exported 6.25 million 340 gr. cans of corned (buffalo) meat valued at Rs. 4 crores. The meat is marketed in Britain and EEC countries. BBI's plant is regarded by the officials of the company as the first scientific meat processing plant set up in the country and is designed and integrated in such a manner that there is no wastage in operations. Even the effluent is used as fertilizer. In the second phase of its diversification, the company also set up its oleoresins plant for export purposes, and an industrial machinery (printing and packaging) business which together recorded a sales turnover of Rs. I crore in 1981-82. In the third phase, 13B1 set up a leather processing unit at Aurangabad, got its instant coffee plant at Hosur going by mid 1983 and set up a 15,500 tonnes per year paper manufacturing unit in Bilaspur, M,P, Of the recent diversifications, only the meat processing products is presently contributing to the profit pool of the company, The company's top management is convinced that the other diversifications, though currently at an incipient state, have very good potential. The relevant excerpts relating to diversification projects of the company taken from the Directors' Report to shareholders for the period 28 June 1981 to 3 July 1982 are presented in Exhibit 2. Operations and Performance The BBI has a successful track record to its credit (see Exhibit 3). The company recorded an income of Rs. 217.24 crores for the financial year ended 3° July 1982. The total income of the company has increased more than twofold since 1971-72 and pre-tax profit has increased nearly three-fold. Though the exports since 1977-78 have declined, the company has been concentrating more on value-added exports (see Exhibit 4). The company's net worth which was Rs. 879 lakhs in 1967 has risen to Rs. 3,002 lakhs by 1982. The financial highlights for the ten year period (1972-73 to 1981-82) are given in Exhibit 5. The Finance Director of BBI thinks that the financial health of the company is excellent. According to him "one important yardstick of gauging corporate performance is to take a look at a company's post-tax return on net worth. It denotes the money for distribution to shareholders and available to the company for re-investment. The company has earned a post-tax return on net worth of 18 per cent. The pre-tax profit in the recently concluded year which ended on 3'd July 1982 was 256 per cent higher than it was in 1977-78. The sharp increase in profitability is attributed to higher employee and machine productivity, control of overhead costs and exports. Further, according to him, the company's debt equity ratio is a mere 0.1: 1 against the IDBI's debt equity norm of 1 : 1 for non-capital intensive companies. The company's borrowals at Rs. 21.60 crores is only 1' per cent of its sales turnover of Rs. 212.69 crores in 1981-82. Exhibits 6 and 7 present Balance Sheet and Profit and Loss Account of the company respectively. Roger Ballester, who is President of the tea profit centre, attributes the improvement in sales and profitability on tea front to two factors. Firstly, there was an over production of tea and slackness in overseas demand. As a result the company was able to purchase tea from the auctions at a reasonable price. Secondly, the position of availability of sugar, which has a considerable bearing on the demand for tea, was comfortable. 6 Profit Centres: The Genesis Earlier the organisation structure at BBI was based on functions. There were separate departments for managing factories, sales and markets, finance, commodity buying, etc. The responsibility for operating results to a great extent was diffused at senior management levels except for the collective responsibility for performance at the level of Board of Directors. Interdependence: The profit centres at Brooke Bond are independent, except the leather profit centre which is dependent upon the meat profit centre for its input, viz. hides which are transferred at the current market price. There is no need for transfer pricing for other profit centres. Method of Determining Profits: The procedure for determining profits of profit centres is: a) b) All the variable expenses are charged against the specific income of each profit centre. Presently, depreciation is charged to profit centres on the same basis as is being used for income tax purposes. However, the company is contemplating to provide depreciation on "Replacement Cost" basis in near future. All fixed expenses, where they are easily ascertainable, are again specifically charged to products. The remaining indirect overheads, including support and advisory services, are allocated to all profit centres on a "reasonable basis". The methods used depend on the type of services that are being rendered by the department concerned. All such allocations are clubbed together under "Indirect Overheads", Interest charges are notionally debited to profit centres on the basis of Gross Working Capital employed. c) d) e) Goals and Targets: The methods (or yardsticks) used for measuring the performance of profit centres for the purpose of evaluation are: (a) Profit before interest and income tax (absolute amount), (b) ROI percentage, (c) Percentage of contribution to sales, (d) Percentage of profit to sales, (e) Investment to turnover - times, and (f) Residual profit (i.e., after notional interest but before income tax). Determination of Investment Base: The investment base of profit centres (technically, investment centres) for the purpose of ROI calculation is determined by taking fixed assets at the original cost which is assumed to equate very closely to the next replacement cost for the rest of the useful life of the assets. To this is added the working capital on gross basis, i.e., without deducting sundry creditors and other current liabilities. A Climate of Optimism The Chairman and Managing Director of the Company stated that the reorganisation of management structure (by product groups rather than by function) permitted it to act more independently. At the same time, if permitted this independence within an umbrella of corporate objectives and policies, determined by the Board of Directors. The independence permitted the profit centres to finely tune their operations to profitability in their own product groups, whether in commodity buying or marketing, production or development. This independent approach, according to the Chairman, had already started showing results though it was barely nine months since the change was introduced. "Each profit centre was not working on new ideas of their own, with greater relevance to their problems and opportunities. There was an understandable, even desirable, competitiveness between them which, of course, was held in balance so that the benefit was to the overall company interest. The, new organisation presented the company a new dimension in its attempt to maintain growing profitability with diversification. The profit centres have generated a new enthusiasm. There is also a new aggressiveness about how they operate; fully justified by the results they produce. 7 Shifting of Headquarters In order to make the functioning more effective, the headquarters of smaller profit centres: Coffee, Instant Coffee, Blades and Spices were shifted (though not to the liking of Marxist Administration of West Bengal) to Bangalore where the Corporate Office is now located. The change of location was justified by the Chairman & M.D. for its being closer to commodity sources and major markets. "It has produced independence and impact to our expectations, and far in excess of what could have been possible if they had stayed in Calcutta. The profit centres, which are now small, are also our hopes for the future. So it is important that they receive the attention they now get for these operations. The shift to Bangalore has helped provide the attention which we hope will also assure future growth." The tea profit centre, on the other hand. described as the backbone of the company's operations was allowed to stay in Calcutta which is the major centre for tea. Similarly, the paper project, which is more accessible from Calcutta, as well as Machine Building which is located at Calcutta, continue to be managed from there. Overall, therefore. the Chairman and M.D. exhorted: "We have combined the necessities of geography and business conditions with the organisational needs of the company for today and tomorrow." The Chairman decided to operate from both Bangalore and Calcutta. With his confidence in the Heads of profit centres, he hoped he would have less to do with the operations of individual profit centres and thus pay still more attention to overall corporate growth. As the reorganisation involved relocation and shifting of staff from Calcutta to Bangalore, there was an understandable initial reaction from the employees to the changes, However, no member of the staff was forced to move, and no employee was retrenched because of the move, With understanding and accommodation, shown on both sides, it was possible to effect the changes without unhappiness, The shifting of the headquarters to Bangalore has been effected with unusual smoothness and without disturbing the tempo of the company's operations. The shifting of the company's headquarters from the chaos of contemporary Calcutta to the more salubrious environment of Bangalore has coincided with the completion of a full year since the erstwhile functional structure was thoroughly overhauled in June 1981. Thus the. Company’s recently concluded financial year (1981-82) was its first an organisation divided into ten profit centres and organised. for administrative convenience into three major groups (see Figure 2). "The sales and profits in the first year after the structural reorganisation have zoomed." The improvement in the operating results was stated to be not only the consequence of a notable recovery in the domestic (tea and coffee) market but it also "reflects the effectiveness of the corporate reorganisation completed in 1981," said C.S. Samuel. "The marked improvement not only reflects the effectiveness of the major corporate reorganisation but also the theory lying behind it." Personnel and industrial Relations The immediate challenge before the top management is to groom in-house and recruit new managerial talent to man the ten profit centres that have spring to life consequent upon the restructuring of the company in 1981. Over the next five years the cornpany is likely to experience a large number of senior level retirements even as it is expanding the range and breath of its operations.. After five years, over 50 per cent of BBIs executives will have less than five years experience in the company. The challenge before the management is to preserve the healthy traditions of the company as relatively new recruits move into top and middle level positions. The company's Employee's Federation has had the good sense to steer clear of all political parties. Fortunately, for all the constituents of the company, the apex level leadership from the very beginning has been provided by N.M. Barot, a leading light in the Mazoor Mahajan, Ahmedabad, founded by Mahatma Gandhi at the turn of the Century. The influence of Barot and the Mazoor Mahajan has kept industrial relations in BBI on an, even keel. 8 Questions 1. What triggered the introduction of profit centre system in BBI? Was the adoption of the profit centre structure, in your view, at the right time? Should the BBI have waited for some more years so that its recent diverse activities attained a level of maturity before introducing the concept of profit centres. 2. What are your comments on the practices and procedures regarding: i) determination of profitability and RO1 of Profit (or Investment) Centres, and ii) measuring of the performance of Profit Centres. 3. Evaluate the strategy of the company and its recent diversifications. 4. Do you share the optimism of the Chairman of the Company? 5. What are some apparent strengths and weaknesses of BBI? Comment on the i) Direct Selling System of the Company (should it be changed in favour of distribution through intermediaries?); and ii) Performance of the company. EXHIBIT-1 HOW BROOKE BOND COMPARES Year Net Sales Profit before tax Profit after Return on ending (Rs. Crores) (Rs. Crores) tax Net worth Capital (%) employed (%) Brooke I3orItl Lipton Food Specialities Hindustan Lever Voltas * Loss 30 06.8I 30.06.81 31-I2-8I. 31-12-81 31-08-81 179,69 69.90 55.65 533.65 273.18 10,64 (2.46)* 6.70 41.42 8.90 19,13 -31.75 21.36 25.53 18.21 11.66 28.39 18.95 17.94 Total liabilities Net worth 150 1157 92 145 582 Source: Stock Exchange Official Directory. EXHIBIT-2 DIVERSIFICATION AT BBI MEAT There was a general decline in price on the international meat market and the unit realisation was comparatively lower than the previous year. During the year, shipments to Egypt -.our major market remained suspended, but have now resumed. We received another welcome order from Romania for an additional 1, 00,000 cases valued at Rs. 190 lakhs. The major part of this order was executed during the year, but unfortunately could not be completed because of a trade balance problem between India and Romania. This has now been resolved and shipments are expected to be resumed shortly. Steps, considered essential by the UK/EEC authorities for import of meat into these countries, have now been taken by the Government of India for implementing meat inspecting procedures in our Aurangabad Plant. Representatives from the UK are expected to visit our meat plant soon for a final approval which should open up considerable opportunity for marketing our corned beef to the UK -- a major consumer. LEATHER The leather finishing plant at Aurangabad was commissioned on schedule in June 1982. The finished products from the plant covering Safety Prints, Upholstery and Softy leather were developed and displayed at the Paris Leather Fair and evoked considerable interest and response. The unit is now geared for regular commercial production. INSTANT COFFEE Our plans to commission the third instant coffee plant at Hosur by June 1983 are progressing satisfactorily. 9 We are taking suitable steps to meet our commitments to the Government on the introduction of a pure instant coffee in the domestic market and to export 50% of the production from the Hosur Plant. PAPER MILL Civil construction works at Bilaspur site are progressing satisfactorily. Imported paper machine has been received at site and work for overhauling and minor modifications is being taken up. Orders for the indigenous plant and equipments are being placed progressively. Barring any unforeseen developments, the paper mill is expected to be commissioned by December, 1983. CENTRON MERGER In January 1 982, the Company received the approval of the Central Government under Section 23(2) of the MRTP Act, 1969. 1-larbans Lal Malhotra & Sons Limited, a company engaged in the manufacture and distribution of razor blades filed an appeal in the Supreme Court and obtained a Stay against the operation of the order of the Central Government. The Supreme Court admitted the appeal but vacated the Stay. The proceedings for sanction of the Scheme of Merger are currently in progress before the Bombay and Calcutta High Courts. The State industrial and Investment Corporation of Maharashtra and the United Commercial Bank who initiated the proposal of merger of Centron with the Company and voted for the Scheme of Merger at the meeting on 271" January, 1981 held under the direction of the High Court in Bombay have now chosen to consider an alternate Scheme offered by Malhotras. During the year Company has maintained a satisfactory level of sales of blades manufactured by Centron. EXHIBIT-3 BBI; TRACK RECORD Year Total Income Pre-tax Profit 1971-72 1972-73 1973-74 1974-75 1975-76 1976-77 1977-78 1978-79 1979-80 1980-81 96.49 101.98 119.93 142.22 159.86 188.32 182.20 183.65 195.86 183.28 4.90 5.12 5.96 4.47 5.33 4.58 5.06 8.59 10.11 10.64 12.96 1981-82 217.24 Source: Company's Annual Report for various years. EXHIBIT-4 BROOKE BOND (INDIA) LTD Exports Year 1977-78 1978-79 1979-80 1980-81 1981-82 Source: Company's Annual Report for various years. Rs. (in !acs) 4,356 3,532 3,771 3,402 3,167 Value added Export lacs) -1,236 1,716 1,838 1,820 (in 10 EXHIBIT-5 BROOKE BOND (INDIA) LTD. TEN YEAR'S FINANCIAL HIGHLIGHTS Rs. In lakhs 1981-82 1980- 1979-80 81 WORKING RESULTS Total income 2172,1 18579 10586 Total Expenditure 20428 17515 18575 Profit Before 1296 1061 1011 Profit After Taxation576 529 451 Proposed Dividend 340 303 303 Retained Profits 236 226 148 TOTAL ASSETS Gross Fixed Assets 2281 1826 1785 Net Fixed Assets 1282 916 970 Investments 19 19 19 Current Assets, 5988 5978 6552 Loans and Advances Total Assets 7289 6913 7541 BORROWINGS AND LIABILITIES Secured Loans 371 810 1278 Unsecured Loans 808 794 800 Current Liabilities 3108 2543 2924 and Provisions Total Borrowings 4287 4147 5002 and Liabilities NET WORTH Share Capital 1512 Reserves and 1490 Shareholders' Fund 3002 1512 1254 2766 1512 1027 2539 1978-79 1977-78 1976-77 1975-76 1974-75 1973-74 1972-73 18365 17506 859 374 216 158 1741 1017 19 5172 6208 757 542 2518 3817 18220 17714 506 247 171 76 1525 894 12 5542 6448 1597 341 2383 4321 18832 18374 458 181 160 21 1273 722 4 4774 5500 1095 86 2288 3469 15986 15453 533 139 134 5 1041 533 5 3584 4122 691 163 1608 2462 14222 11993 13775 11397 447 596 167 214 134 74 33 140 966 502 5 3688 4195 805 19 1716 2540 947 528 5 3313 3846 701 122 1395 2218 10198 9686 512 204 134 70 920 548 5 2558 3111 437 137 989 1563 1512 879 2391 1424 703 2127 1409 622 2031 670 990 1660 670 985 1355 670 958 1628 670 878 1548 Source: Company's Annual Report, 1982. EXHIBIT-6 BROOKE BOND (INDIA) LTD. BALANCE SHEET AS AT 3" JULY 1982 ASSETS Rs. Lakhs 1982 1981 1512.31 1512.21 Fixed Assets 1490.13 370.94 807.84 1253.98 Investments 810.15 793.35 Current Assets Loans and Advances Rs. Lakhs 1982 1981 1282.25 916.41 18.72 5216,03 771.56 7288.56 18.84 5557.44 419.88 6912.57 LIABILITIES Share Capital Reserves and Surplus Secured Loans. Unsecured Loans Current Liabilities 3107,44 2542.88 and Provisions 7288.56. 6912.88 Source: Company's Annual Report, 1982 11 EXHIBIT•7 BROOKE BOND (INDIA) LTD. PROFIT AND LOSS ACCOUNT FOR THE 53 WEEKS ENDED 3RD JULY, 1982 Rs. in Lakhs 1982 Income Sales Other Income Expenditure Materials Expenses Interest Depreciation 12352.43 7711.92 260.67 91.06 20416.08 1308.46 Provisions Made Doubtful Debts and Advances 1293,71 Provisions Withdrawn Doubtful Debts and Advances Contingencies Profit on Disposal of Assets Profit before Taxation Provision for Taxation Profit after Taxation Development Rebate Reserve written back Appropriations to Investment Allowance Reserve Proposed Dividend (subject to deduction of income tax) General Reserve 29.00 340.25 221,15 590.40 Source: Company's Annual Report, 1982. 9.00 302.44 220.30 531.74 1,76 0,93 1296.40 720.00 576,40 14.00 590,40 9,04 22,00 0.41 1064,24 535,00 529.24 2.50 531.74 14 75 1293.71 3 53 1032.79 10628,36 6552.83 266.59 92.25 17543.03 1036.32 21269.68 454.86 21724.54 18220.47 358.88 18579.35 1981 12 CASE 2 DAKSHIN RASAYAN NIGAM LIMITED Dakshin RASAYAN Nigam (DRN) is a large public sector undertaking based in Tamil Nadu set up for the manufacture of urea and other complex petrochemicals. It has five plants each of which is treated as cost centre. This case relates to the secretarial and legal department of the company. This department is situated at the corporate headquarters in Madras. As indicated in the organisation chart (Exhibit-1), the head of this department Mr. Sivaprakasam reports directly to the Managing Director. Under this structure, the department can play the role of an outside counsel, and given judgement uncoloured by departmental loyalties. The annual budget of the department was Rs. 30 lakhs for the year 1978-79, as compared to the Rs. 3 crones spent in the overall corporate overhead. The function performed by this department can be broadly classified into three areas: a) Share transfers: Eleven out of the fifteen Assistants in the department do this function. Bulk of the work is documenting share transfer which is very routine task. Also, this section handles queries from shareholders which is of a non-routine nature. Secretarial work: This consists of the obligatory duties imposed by the Companies Act. The work involved is confidential in nature and cannot be delegated to outsiders. The three people employed in this section mostly handle duties such as arranging board meetings, recording resolutions etc. Legal work: The work of this section broadly relates to the legal aspects of corporate transaction, This section looks into the contracts entered into by the company and handles cases with regard to bad debts, it advises top management on the legal implications of the various amendments of different laws. Also by scrutinising contracts this department ensures that the interest of DRN are protected in every contract. Most of the work in this department is of a non-repetitive and specialised nature and is given to outside counsel. b) c) Share Transfers Share transfers are relatively routine work. it has been estimated that each share transfer, including preparation, verification and dispatch. takes about 30 minutes. During the peak period about 8000 share transfers per month are handled. However, due to the continuous losses suffered by the company during the past few years, the number of share transfers has dwindled to about 4000 transfers a month. The company, however, staffs on the average load basis and handles extra work through overtime, rather than hire temporary labour. The budget for this section is based on the projected volume of share transfers during the next period. It is expected that as the performance of the company is projected to improve in 197980, the volume of share transfers will also increase, say about 15% for the year 1979-80 as compared to 1978-79. Also, a better performance will elicit lesser number of queries from shareholders who are now not so anxious about their investment in the company. Considering the above factors, it is planned to hire additional manpower to cope with the expected increase in work. It has to be clone in advance as it takes about six months before a person becomes proficient in his work relating to share transfer. Secretarial Work The volume of work done by this section is related to the provisions in the Companies Act spelling out the duties of a company secretary. The work done is fairly repetitive over the years but is highly confidential in Case (1980) prepared by Mr. B. Ramamurthy, Research Associate, under the guidance of professor V. Govindarajan. Copyright 0 1980 of the Indian Institute.of Management, Ahmedabad. Case material is prepared to serve as a basis liar class-discussion. Cases are not designed to present illustrations of either correct or incorrect handling of administrative problems. 15 nature. Also strict adherence to the letter of the law is needed. As such, all the work is done by the section itself without any aid from outside agencies. The volume of work here is fairly stable over the years and the budget is prepared taking into consideration last year's figures and any projected increase in costs. Firm adherence to the provisions of Companies Act is the major concern of this section rather than controlling costs of such adherence. Legal Department. The work done by this department consists of scrutiny of contracts entered into by DRN to ensure that the interest of DRN are fully protected. Also it advises top management of the legal implications of any changes in the law of the land. it also looks after problems relating to customs and excise duties. The bulk of the work is given to outside counsels. This is so because each contract is unique in itself and it will be very expensive and difficult to develop the legal expertise within the company itself. Also, it might lead to under utilisation of the capacities of some legal specialists employed by the company. DRN selects the outside counsel and mostly pay their tees. DRN's own counsel, however, actively participates in the preparation of all the contracts. He frequently prepares the first draft or in lieu reviews the draft prepared by the outside counsel. He thus acquires a broad based knowledge of the legal problems in the company and also ensures consistent application of the company's policies. The major objective is to turn out `defect free' contracts, as even a small defect can cost a large amount of money to the company. Budgeting and Control The output of the secretarial and legal department is controlled through a budget. Early September every year, the budget committee, headed by Mr. Gopal, sends out a memorandum to every department to submit their budgets for the folk wing year. The budget for the legal and secretarial department is the aggregate of the budgets of the three sections detailed above. The department head is answerable for large overruns, though a leeway of 5% over budget is automatically given. The management recognised that as work done by this department was largely qualitative, not much significance is attached to the budgeted costs and overruns. Due to the high cost of training and the specialised nature of work, extreme care was taken in selecting a person for the department. Mr. Sivaprakasam also kept himself informed about the working of the department by occasionally going through the output of an assistant. The aim of the department was to produce `no-defect' contracts and to expedite share transfers. It may be mentioned here that it is possible to get the share transfers done by the company registrars' office at 50% of the current costs, but in the interest of customer satisfaction, the company is willing to spend the extra 50%. Budget Reports Mr. Gopal was thoroughly familiar with the above background information as he contemplated the budget reports given by the secretarial and legal department for January 1979. The budget summary for each of the three sections are given in Exhibit 2: Mr. Copal was wondering what questions he should ask Mr. Sivaprakasam and how should he use the information available to correctly assess the performance of the department. Questions 1. How well do budgets help as a total of cost control in the secretarial and legal department of ©RN? 2. If you believe that budgets are not an affective tool of control what other method of control, would you recommend? 16 Share Transfer Salaries, Full-time Salaries, overtime Allocated rent Equipment depreciation Office supplies Electricity Telephone Postage Travel Printed forms etc. Miscellaneous Secretarial Department Salaries Salaries, overtime Allocated rent Furniture depreciation Office supplies Electricity Travel Miscellaneous Legal Department Salaries Fees to outside counsel Miscellaneous Budget 1,17,850 10,000 2,500 600 1,450 1,325 250 8,400 450 600 250 29,700 -2,000 650 1,200 650 1,500 600 2,500 67,500 600 2,40,575 29 Actual 1,07,850 14,700 2,500 600 1,700 1,250 7,479 200 872 284 Variance 10,000 (4,700) --(250) 75 (25) 921 250 (272) (34) (4,000) (2,000) --56 75 (950) (350) -(40,900) 250 (51,854) 33,700 2,000 2,000 650 1,144 575 2,450 950 2,500 1,08,400 350 2,92,429 17 CASE 3 BENGAL STEEL LIMITED "Since our organisation and business activities are growing at a rapid pace, we are now thinking of delegating more and more responsibilities to our managers. However, we believe that successful delegation will largely depend on the effectiveness of the company's control; system. In our company, we have already set up a flexible budgetary and standard costing system to control the costs of our products. We also measure the profit performance of our operating departments every month. The profit that we determine is based on the standard rates for materials, wages and service charges. Annually, we estimate overheads and interest expenses and allocate them to each department after taking into consideration factors like capital employed, number of employees, conversion costs (total cost of production minus material cost), and direct wages. We estimate depreciation charges by the written down value method at a composite rate on replacement cost of the assets. One-twelfth of the annual charges estimated for overheads. Interest and depreciation is charged every month in the monthly profit and loss account. The sales value for the month is estimated at standard selling rates and/or transfer prices fixed annually for internal transfers. "However, some executives have expressed their reservations about the profit performance measurement made by the company. Their objections relate to the way in which "transfer prices are fixed and overheads allocated. We have discussed these points from time to time in the Department Head's meetings. "We would appreciate it very much if you could suggest a method of measuring profit performance of our operating, departments." This was how Mr. Gupta, Controller of Accounts of Bengal Steel Limited, expressed the problem to Professor Vaidya, a member of the faculty of Indian Institute of Management, Ahmedabad, who had called on him in the motning of May 15, 1965, for obtaining information on the company's management practices. Mr. Gupta had arranged for briefings by other executives in the morning hours in order to acquaint the visitor with the company's situational factors. He appraised Professor Vaidya of the senior executives' meeting, which had been scheduled for the afternoon, at which he could observe the reactions to the performance measurement system. Company Background Bengal Steel Limited (BSL), located in Eastern India, was a large manufacturer of quality castings, ingots and rolled products such as squares, octagonals, rounds and wire rods. The company's sales volume had steadily been increasing during the past ten years: sales in 1964-65 were about Rs. 9 crore. BSL had about 2,500 employees on its roll as of April 1, 1965. The organisation structure of BSL is. set out in Exhibit-1. For control purpoes, the company had established a number of cost centres for collecting cost information (see Exhibit 2). It also measured profit performance of the following three main operating departments: 1. Electric Furnace 2. Steel Foundry 3. Rolling Mills Electric Furnace In the Electric Furnace Department, melting operations and ingot-making were carried out. The company Case (1967, revised 1972) prepared by Professors S.K. Bhattaeharya and K.L. Varshneya Copyright m 1967 of the Indian Institute of Management, Ahmedabad. Case material is prepared to serve as a basis for class discussion. Cases are not designed to present illustrations of either correct or incorrect handling of administrative problems. 18 purchased steel scrap in bulk and melted it in the electric furnaces for making molten steel. For this purpose, BSL also used internally generated scrap, such as runners and risers, and defective castings arising from foundry and ingot operations. Molten steel was either transferred to the steel foundry for making castings or. used in the Electric Furnace Department itself for casting ingots. Ingots were sold in the market, or used in place. of billets in manufacturing operations relating to rolled products.* In the process of melting, some waste material (known as skull) was turned out. Skulls were sold to scrap dealers and fetched a price equivalent to 35 to 45% of prevalent scrap prices. Steel Foundry In the Steel Foundry, molten metal was turned into castings of various sizes and designs. The operations included (a) mould and core making, (b) pouring of metal into the moulds, (c) taking out castings from mould boxes by removing the sand when it had become cold, (d) cleaning and fettling work (i.e. gas cutting, annealing, shot blasting and finish fettling) before machining, (e) machining, and (f) final finishing and painting. Most of the company's castings were sold to railways, automobile manufacturers and other manufacturers against orders booked in advance. The company usually booked orders for castings at an estimated full cost plus profit margin, calculated as a percentage of the full cost (see Exhibit 3). The profit percentage varied according to the complexities of castings and market conditions. Scrap, such as runners and risers, and defective castings, inherent in foundry operations, were transferred to the Electric Furnace Department. For such transfers, credit was given to the Foundry at a standard scrap rate. The same rite was also charged for all steel scrap issued to the Electric Furnace Department. This rate was approximately equal to the purchase price of scrap from the market over the period of time. Rolling Mills After heating, billets and ingots were rolled into rounds, rods, flats and squares. The company generally used billets for making rolled products for selling in the market, Defective rods and bars and cut-pieces were also sold in the market at a price lower than that charged for good pieces. A flow chart is given in Exhibit 4. A typical statement showing input/outputs of the Electric Furnace, Steel Foundry and Rolling Mill departments for the month of April 1965 is set out in Exhibit 5. Monthly Department Profit and Loss Account The company's accounts department prepared a monthly columnar profit and loss account for each of tie three departments. A typical profit and loss account for the month of April 1965 is set out in Exhibit 6. The account showed production in tonnes during the month; sales value of such production; its budgeted cost; gross budgeted margin; favourable and un-favourable variances; gross actual margin; overheads, interest; depreciation on replacement basis, profit before tax; and managing agents' commission. The profit after charging depreciation on replacement cost but before tax and managing agents' commission was related to investment base (amortised cost of the fixed assets of the department,,the standard working capital, and allocated share of the investment in the service and staff departments) to find out the rate of return. This rate of return usually fortfied a base for judging the performance of the department. The accounts department also worked out the profit before tax on the basis of depreciation of the assets at actual cost and after providing for managing agents' commission. Sale Value of the Production For the purpose of preparation of the monthly profit and loss accounts, the total production of the month was assumed as sold in the same month. Molten metal transferred to the Foundry was valued at budgeted cost plus a "reasonable" rate of return on investment, * The quality of rolled products made of billets was considered better than whose made of ingots. Moreover, billets, if procured at controlled prices, were cheaper than ingots, However, because of scarcity conditions and irregular supply of billets, re-rollers had to use ingots. The prices of ingots fluctuated very sharply, depending on the demand and supply position. 19 Similarly, the sale value of the production of ingots was assigned at a standard rate which was equivalent to the budgeted cost of ingots plus a "reasonable" return on investment. However, actual realisation on sale of ingots in the market was higher by 10 to 25%, depending on current market conditions. The difference between the actual realisation and the amount calculated at standard price was credited to what was called a "price adjustment account". Credit for skull was granted at an estimated ex-works realisation (on sale of such material) for the year. The sale value of the production of castings in a particular month was determined on the basis of rates at which orders for the castings produced were booked. Any castings not produced against a specific order, but meant for stock and sale, were valued at the company's selling prices. The sale value of castings produced was further split up for various processes on the basis of estimates prepared at the time of booking the orders. A typical estimate made at the time of booking the order for castings is set out in Exhibit 3. Such a breakdown enabled the company to determine the gross margin of profit on the various processes in the Foundry. For working out the monthly profit and loss account of rolled products, the value added, i.e., sale value minus cost of raw materials, was taken as revenue. The cost of raw materials was also excluded from the budgeted • cost of production. Sale value of rolled products was estimated at the company's selling prices which covered standard cost of production plus a certain percentage as profit margin. Budgeted Cost of Production The company prepared flexible budgets annually for its operations and budgeted the cost of production. In such cost determination, overheads, interest, depreciation, managing agents' commission and direct taxes payable by the company on its income were not included. This budgeted cost of production was adjusted for variation in the level of actual production during the month for the purpose of monthly profit and loss account to arrive at the gross budgeted margin. Favourable and Un-favourable Variances The accounts department compiled departmental expenses called "production costs" every month and compared them with the budgeted expenses for the actual level of activity in the month. In arriving at the actual departmental expenses during the month, the same standard price of materials, wages and service charges were applied as had been used for the purposes of budgeted cost of production. If the actual expense amount so estimated was higher than the budgeted expense figure, the difference was called "un-favourable variance". If it was lower than the budgeted figure, the difference was termed "favourable variance". In the monthly profit and loss account, the gross actual margin was worked out after adjusting favourable and un-favourable variances in the gross budgeted margin. Overheads ,Interest and Depreciation Annually, the accounts.department also estimated overheads, interest and depreciation charges for the year, and the amounts so .estimated were divided by twelve to arrive at the monthly charges. Depreciation was estimated by the written-down, value method at a composite rate on replacement cost. The amount thus arrived at charged to departmental monthly profit and loss accounts to arrive at the profit to be applied in determining the "rate of return" on 'investment. The Department Heads' Meeting In the afternoon of May 15, 1965, the senior executives of Bengal Steel Limited held a meeting in which the profit performance of the three departments during the month of April, 1965 was discussed. ProfessorVaidya was introduced to the gathering as a person with considerable insight into the management planning and control function, interested in observing real-life management problems for the benefit of students of business administration. 20 Initiating the discussion, the General Manager expressed his concern about the loss arising out of the operations of the Electric Furnace Department. He said, "In the past two years, the company has made a substantial investment in installing the electric furnaces. When the decision to install electric furnaces was taken, it was estimated that the investment in the electric furnaces would yield a very attractive return. We find that in reality the Electric Furnace Department is operating at a loss!" The manager of the Electric Furnace Department was surprised at the views expressed by the General Manager. He commented: "We first set up an arbitrary methods of measuring profit performance of the departments and then find a scapegoat. I wish we were discussing the performance of the maintenance department. How can you operate properly if one of the three electric furnaces is constantly out of commission due to breakdown! " However, let's look at our accounting procedure. Anybody would agree that setting transfer prices of molten metal on the basis of standard cost plus the so-called reasonable return on investment is arbitrary and inequitable. We are selling castings at a price equivalent to estimated cost plus an average profit margin of 15%. Why not apply the same principle in determining the transfer price of molten metal? Clearly, we are winking at ourselves and adopting double standards. By transferring molten metal at standard cost plus a "fair return" on investment, the profits of the Electric Furnace Department are pulled down, so that the gravy can be distributed to the Foundry Department." Explaining his point further, he mentioned that the Electric Furnace Department had not been able to earn the standard profit in the month of April 1965 (see Exhibit 5) in spite of its production being more than the target fixed for the month, This was because of the unfavourable variances which arose due to frequent breakdowns in one of the furnaces. The frequent breakdowns increased overtime payment, consumption of electricity, electrodes, and maintenance materials. Production. from the affected furnace was 111 tonnes less than what had been budgeted. This shortfall was, however, made good by stepping up production on the other two furnaces. The actual production of molten metal in all three electric furnaces was 2,028 tonnes against the budgeted production of 2,000 tonnes. The department had still not been able to earn standard profit. The blame for frequent breakdowns resulting in the poor profit performance could not be laid at the door of the operating department. He, therefore, strongly advocated the revision of transfer price of molten metal on the basis adopted for determining sales price of castings to customers (see Exhibit 3). Alternatively, he suggested that it should be geared to the final selling price of castings by making appropriate allowances to cover the cost and a reasonable return on investment for the intervening processing departments. The foundry manager said that he could not possibly accept the views expressed by the manager of the Electric Furnace Department. "Metal melting is only one of the many operations we go through to make final castings. Under the circumstances, the price based on standard cost plus reasonable return on investment should provide a fair basis for appraising performances and for control purposes. From the management point of view, the standard profit is of little significance. What matters is whether performance standards have been achieved." The Rolling Mills Superintendent supported the views expressed by the manager of the Electric Furnace department. He, however, favoured linking the transfer price of molten metal to the selling prices of ingots. He pointed out that the operations involved in making ingots from molten metal were relatively simple, and, therefore, transfer price of molten metal should be set on the basis of selling price of ingots after deducting standard cost of additional operations. He mentioned that such a price would be very close to the concept of "value added" which, he understood, was adopted extensively in other countries. The Controller of Accounts, however, saw practical difficulties in implementing the suggestion due to frequent price changes in ingots. Ingot prices fluctuated very sharply; depending on the demand and supply position. If the market price of ingots was taken as a base for deriving the transfer price of molten metal, the cost of final castings would vary significantly from month to month 21 Another question which came up during the discussion related to the determination and allocation of overheads, interest and depreciation. The foundry manager complained that his operation was heavily overburdened with the allocated charge of overheads and interest. He suggested that only those costs which were directly identifiable with the individual operating departments be considered for measuring the profit performance of the department. The Rolling Mills Superintendent questioned the reasonableness of the present method of determination of investment base. He argued that investment in the service and staff departments should not be allocated to the operating departments. He felt that since operating departments did not have any control over investment in service and staff department, they should be excluded from the investment base. The Secretary of BSL suggested a further improvement in evaluating departmental performance. He mentioned that currently the net book cost of fixed assets plus, standard working capital and allocated share of investment in service and staff departments was being taken a4"investment" for finding out the "rate of return". He felt that historical costs introduced great anomalies in profit performance appraisal as it operated against departments with relatively modern plant and equipment. He suggested that ROI based on replacement value of assets would be more equitable and appropriate. The General Manager, after listening to the views expressed by the various executives, could see that the present method was generating a lot of resentment; but he was not clear as to the proper way of evaluating departmental profit performance. He also doubted whether, in his organisation, monthly reporting of profit performance served any useful purpose. He was almost certain, however, that after the meeting Professor Vaidya would ask him as to how he would resolve the issues raised by his executives. Questions 1. 2. Evaluate the Bengal Steel performance appraisal system. What are the reasons which led to non-acceptance of the system by the managers concerned? How valid are these criticisms? What changes would you suggest in the system, keeping in view the operational characteristics of Bengal Steel Limited? 22 23 24 25 26 27 28 CASE 4 SUN CELLULAR LIMITED Sun Cellular Limited is a Cellular Mobile Telephony Services provider in one of the metro cities of India. It is a joint venture between a leading industrial house and an international telecom major. Management team headed by CEO manages all day to day operations, who represents to the Board of Directors. Sun is operational since 1995 and enjoys a market share of 48% in a duopoly environment under the telecom policy of Government of India. Presently there are two operators in the licensed area, MTNL; a major fixed line service provider is slated to enter the market as third operator. The entry of MTNL is likely to trigger price was in the industry, as the market is highly price sensitive. The major department and the company's organisation structure is given below: In a cellular industry Marketing, Sales, Collection, Customer care, credit monitoring, IT Billing and Technical departments plays a very significant and specific role. Marketing department is responsible for developing innovative schemes and products, brand promotion, advertising etc. Sales department, implements these schemes and products in the market, take care of dealers and distribution channels. The complete responsibility of successful implementation of schemes and products and acquiring new subscribers lies with sales department. IT/Billing takes care of subscribers billing records, maintenance of billing system and monthly bill generation. Technical department looks after mobile network planning, network erection and maintenance. Collection department takes care of dispatch of customer's monthly bills and payment collection from subscribers. Credit monitoring is a part of collection department only. This department evaluates the credit worthiness of individual customers, setting up a credit limit and then closely monitoring customer's airtime usage against those limits and then taking a corrective/necessary actions, Any small mistake on the part of this group cost company a revenue loss of several thousand rupees. Though all these departments play a very specific and crucial role having a direct impact on company's revenue, only sales department gets incentives on each new subscriber acquisition and this is the root cause of conflict between sales and other departments. That's why when Mr. Anand, newly joined CEO of the company expressed his concern over the .ising bad debts of the company and poor performance of collection department and asked explanation from collection chief, Mr. Sudhir, he immediately answered. 29 "Sir, for this situation sales department is directly responsible. At the time of new acquisitions, sales people do not verify the credit worthiness of the individual customer or properly verify the related documents like residence proof, contact numbers etc. Many times they even do not complete the required documentation which is mandatory as per company policy, All these lead to fraud cases and have adverse impact on collection and rising bad debts. Sir, as per company's incentive policy, sales team gets incentives on the basis of total no. of new acquisition and not on the basis of quality of the subscribers they brings in. Thus, if a person brings a new subscriber who generates high revenue for the company, he gets the same amount of incentive as that of a person who brings a subscriber with very low usage or even turned out a fraud case. Another reason of poor collection performance is the very low morale of the collection team. They feel dejected because in-spite of their equally important function as that of Sales and their hard work, they do not get any incentives. So, sir, in my opinion, to improve the collection performance and to reduce bad debt in future we must change our incentive policy., Incentives should be based on the quality of the subscriber and not only on the quantity. Moreover, we must put some onus of bad debt and fraud cases on sales team and should de-incentives those who brings such fraud cases. To boost the Collection team's moral incentives should be given to collection people also on the basis of their monthly collection." In his defence Mr. Basu, Chief- Sales argued "Mr. CEO, the explanation given by Mr. Sudhir is completely biased and one sided. It is an attempt to hide one's incompetence by blaming others. Sir, let me explain you that as per the company policy, deciding subscriber's credit worthiness is not at all the responsibility of Sales, we have no means to determine that. In fact it's the primary responsibility of Credit Monitoring Group. Sir, we all know that sales incentive is very common practice across the industry and it is not something special in our case. Now, the question raised by Mr. Sudhir is whether incentives should be dependent on quantity or quality of the subscribers. In this regard let me clear one thing that our industry is such that we will always have customer mix of low end and high end users. Moreover, formulation of new sales promotion schemes and new products to target a specific audience is not sales function. Marketing does this function and as per company strategy they decide which target segment should be addressed through which product/scheme. So we practically don't have any role to play in deciding customer profile. We only implement these schemes. Every month management set a target for sales to acquire new subscribers under particular schemes and I can very proudly say that despite all odds and against stiff competition, we always achieved our targets in the past 4 years. Sir, it is very important to note that it takes a same efforts and pains to acquire a low end subscriber as that of high end subscribers. So why there should be any difference in the incentive structure? Regarding fraud cases, it is very surprising to know that in-spite of having a detailed and comprehensive credit policy frauds are taking place. Sir, at the time of new acquisition, we take Rs. 3000/- as a security deposit and on this basis we set credit limit of that subscriber. As per the credit policy, as soon as airtime usage of any subscriber reaches to this level we ask for the interim payment from that subscriber. If anybody wants more credit then he has to deposit equal amount of security with the company. So the question of exceeding airtime usage to that of security deposit and then the fraud taking place giving rise to bad debts should not arise at all if the credit monitoring policies are properly implemented. Then Credit Monitoring should be held responsible for frauds and bad debts. We should not punish our sales people for the incompetence.of Credit Monitoring group." After hearing these arguments, CEO formed a cross-functional team to probe and to take decision on the following issues: a) b) c) d) To find out reason of increasing bad debts and poor collection. To review the incentive policy and possibility of linking it to the quality of the subscribers. To find but possibility of judging subscriber's credit worthiness at the time of acquisition. To review credit monitoring policy. 30 Questions: 1) 2) 3) 4) 5) Is the decision of forming such kind of team is correct? What is the other alternative? In your opinion what should be the composition of this cross-functional team? Keeping in mind the type of industry, do you think that sales incentives should be linked with quality and with the usage of the subscriber? Is it fair to penalise sales people for bad debt or for the fraud cases? What are your views on giving Incentives to collection team? Will there be any impact of this policy on other departments? 31 CASE 5 THANA DISTRICT CO-OPERATIVE FISHERIES PROJECT (B) In early December, 1972, Mr. S.L. Divekar, General Manager of the Thana District Co-operative Fisheries Project, Satpati, was considering what additional control information should be collected and what control practices be adopted so that the venture be successful and conform to plans. He was concerned about the increasing outstanding balances in the current accounts for supplies and requisites to fishing boats. On November 30, 1972 there was a debit balance of Rs. 1,01,202.67 in the current accounts of all the 40 boats provided by the project. The outstanding amount payable by the group operating the boats was continuously increasing. For example, the outstanding amount payable by the group operating the Anuradha boat had increased to Rs. 9,206.72 by November, 1972. Similarly, the outstanding amount payable by the group operating the Kalpana boat had increased to Rs. 8,911.36 on that date. A full recovery of the installments for the repayment of the boat loan had not been made from some of these boats. For example, only Rs. 4,038.36 and Rs. 1,941.20 were recovered from the Anuradha and Kalpana boats as against Rs. 8,625.68 , though a full year had elapsed since these boats went into operation. (See Exhibits Ito IV for current, temporary loan and boat loan accounts of the boats Anuradha, Kalpana, Divyatara, and Pavan Nauka. Anuradha and Kalpana were not doing well, whereas Pavan Nauka and Divyatara showed best performance among the project boats during the fishing season 1971-72). Background The Thana district had a coastline of about 110 km, and its coastal waters were endowed with the most important commercial sea fish-pomfret,' It had 45 fishing villages with a fishermen's population of 41,000 out of which 8,000 were active fishermen. The district had-38 primary fishermen's co-operative societies with a total membership of about 19,000. All these societies were affiliated to the Thana Zilla Machhimar Madhyawafti Sahakari Sangh Limited, Palghar (TZM S) - a federation of fisheries co-operatives at the district level. The principal activities of TZMS were marketing of fresh fish and supply of fishery requisites to the primary societies. It also operated two ice plants with a daily capacity of 29 tonnes, and a cold storage with a daily capacity of about 100. tonnes at Palghar. Though pomfret constituted the most important commercial fisheries of the Thana district, they were being exploited largely by the operation of bag nets (locally known as dol nets) till the mid-60s. Later on, fishermen of the Thana district, particularly from Satpati, first started using nylon twine for the gill nets. These nets were tried in deeper water for pomfret fishing. The early experiments met with very good success and a number of boats started using nylon gill netting for pomfret fishing. Since then their use had been increasing. Exhibit V details the annual sea fish production in various districts of Maharashtra during the period 1960-61 to 1970-71. Exhibit VI gives information on fishermen population and types of boats and nets used in Maharashtra and the Thana district. Although the use of nylon gill nets for pomfret fishing had proved to be more profitable, it required initial capital investment to have the fishing vessel equipped with the necessary fishing gear and this was beyond the reach of the economically weaker sections of fishermen. In view of the above, the Directorate of Fisheries prepared a project to develop fisheries., especially pomfret fishing and to provide better livelihood to economically weaker fishermen located in the Thana district, specially in the compact areas of Gatpati Murbe, Kharekuram, Dhakti Dahanu, Gangawada, Bassien, Arnala, etc. After discussion among the representatives of the Agriculture Prepared by Prof, K, L, Varshneya, Indian Institute a-Management, Ahmedabad, Descriptive and analytical material is produced at the Indian institute of Management, Ahmedabad, under contract with the Food and Agriculture organisation, Rome, for use in class discussion. It is not designed to illustrate effective or ineffective handling of administrative problems. Opinions directly stated or implied in this material are the writer's and do not necessarily reflect those of the Indian Institute ofo Management, Amedabad. Although.pomfret fisheries constituted only 3.7% of Maharashtra's total production by tonnage, their percentage in turnover by value was about 32% of the state's fish production. 32 and Co-operation Department, TZMS, Agricultural Refinance Corporation, and Directorate of Fisheries, the project was finally sanctioned by the Maharashtra State Government on December 29, 1970. The sanctioned project involved the following activities and capital investment. 1. 2. 3. Operation of 40 mechanized fishing boats at a capital cost of Rs. 1.20 lakhs each (Exhibit Vll) Operation of three fish carrier vessels (for carrying fish to markets, essentially at Bombay) at a capital cost of Rs. 2.40 lakhs each Establishment of three small service stations (to repair engines) at a capital cost of Rs. 8,000 each Rs.48,00,000 7,20,000 24,000 Rs.55,44,000 The capital investment of Rs. 55.44 lakhs was to be financed as under: 1. Rs. 41,52,460 as a loan at an interest rate of 8 % % per annum, repayable in 10 installments, by the Agricultural Refinance Corporation through the Maharashtra State Co-operative Bank and the Thana Zilla Central Co-operative Bank. Rs. 13, 48,000 as special redeemable share capital from the state government which would ultimately be treated as subsidy. Rs. 43,540 to be provided by TZMS. 2. 3. The working capital requirements involved in the project were to be met by TZMS. However, TZMS could draw funds for the working capital from the District Central Co-operative Bank by way of cash credit arrangement at an interest rate of6'/n % per annum. Economics of the Project The operation of fishing boats was expected to provide an annual profit of Rs. 24,591 (to a group of 10 persons operating a boat) besides covering the food expenses of all members while on a fishing trip and their estimated wages for the nine-month fishing season. (see Exhibit VIII). TZMS, which was responsible for operating the scheme, was expected to earn Rs. 6, 22,581 annually from different schemes under the project as detailed below: Total gross receipt 1. 2. 3. 4. 5. Commission on fresh fish marketing of catches by the boats Freezing of pomfrets to be purchased from the catches of the boats Operation of carrier vessels Establishment of service stations Administrative staff Total 17,50,000 9,03,690 48,362 29,89,552 16,90,71 3,96,000 35,652 99,120 23,66,97 59,281 5,07,690 12,710 (99,120) 6,22,581 2,87,500 1,45,480 1,42,020 Total expenditure Profit/Loss TZMS was responsible for supervising the construction and equipment of boats and the running of carrier vessels and service stations. These boats were to be allotted to a group of fishermen through the agency of primary societies. The group to which the boat was allotted was to operate the boat, catch fish, and hand it over for packing, transporting, and marketing to the project working under TZMS. TZMS along with the primary societies was responsible for the repayment of loan provided for the construction and equipment of the vessels. 33 Under the plan, 20 boats should have been constructed in the first year of the project and 20 in the second year. However, there were delays in the construction of boats due to the non availability of engines and some parts in time. it was only in October/November 1971 that 13 boats went into operation. In November 1972, all the 40 boats had gone into operation. The: plan for installing three service stations was revised and it was decided to have only one service station. They were thinking over the existing government (Fisheries Department) service station, for which negotiations were going on. The scheme on carrier vessels was dropped due to operational difficulties. Allotment of Boats, their Cost, and the Repayment of Instalment Each boat was allotted to a group of fishermen, who were members of the primary co-operative societies affiliated to TZMS, under a hire purchase agreement detailing ownership, responsibility of boat operations delivery of catch to the project, repayment of loan, etc. (Exhibit IX). The estimated cost of each boat was Rs. 1.20 lakhs. it was to be financed from TZM S' funds (Rs. 910), a special subsidy by the state government (Rs. 29,500), and a bank loan (Rs. 89,590). However, the actual cost was somewhat lower. Therefore, the actual bank loan for each boat was Rs. 86,256.83 which meant a liability on TZMS of paying an annual instalment of Rs. 8625.68 towards loan repayment plus an interest on the outstanding amount for the next ten years. TZMS, in turn, was to recover the amount from the groups of fishermen through the sale proceeds of their catches to repay the bank loan. Besides the bank loan, TZMS was also to recover (I) credit granted for each fish trip; (2) temporary loan for repair and replace accessories and fishing gears, and (3) Rs. 910 contributed by TZMS before the title to the boat was passed on to the group Management and Administration The project was to work under the policy direction and control of the TZMS board and its executive committee) Besides, Mr. Divekar, an official in the Fisheries Directorate, was deputed as General Manager responsible for the administration of the project, Mr. Divekar was assisted by a staff of 23 persons (an accountant, a cashier, seven clerks, three supervisors, 10 packers, and a peon) to discharge his responsibilities. His functions were supervising catches brought at the landing point by the boat, taking quality fish, packing and dispatching them to TZMS' sales office at Bombay for sale, receiving accounts of sales from the Bombay office and keeping an individual account for each boat, arranging for supplies (both required for each trip as well as for repair and maintenance) and cash for each boat going on a trip, recovering such credits for supplies, requisites, and instalment of the boat loan, and settling the accounts of the groups. Operation of Boats, Procedures followed for Handling Catches, their Sales, Supplies and Requisites, and Settlement of Accounts Each boat-was allotted to a group of seven who were responsible for operating and maintaining it, delivering all catches, and repaying the loan for the boats, requisites, supplies, etc. The group usually employed three contract labourers (on an average) and paid them monthly wages of Rs. 75 to Rs. 100 besides their food expenses while on trips. Thus, a crew of 10 persons operated the boat for fishing. Most of the fishermen who were allotted these boats had experience in fishing; they had served on wage basis as labourers on other boats. Moreover, the Department of Fisheries arranged to give fisheries training, under stipend scheme, to at least one person from the group in each boat. Before starting on a trip, the group drew supplies of diesel, mobile oil, and ice w kind and cash for food expenses and miscellaneous, supplies from the project. Usually, these amounted to Rs. 450 to Rs. 500 for a trip of 4/5 days. For, keeping a control over these expenses, the general manager of the project in consultation with the TZMS board had set a limit of Rs. 750 per trip or 40% value of the previous catch whichever may be The Management and control of TZMS was vested in a board of 14 directors of whom nine were representatives of primary societies, two of individual members, one nominee each from the district co-operative bank, state co-operative department, and department of fisheries. its bylaws were recently changed to provide one more director representing the groups of the boat. The chairman of the board, the manager of TZMS, two directors of the societies, and one director of individuals formed the executive committee. Recently, TZMS took a decision to enlarge the executive committee to seven members - chairman and vice chairman of the board, manager, one representative each from the societies, individuals, bank and government. 34 the maximum. Usually the cost of diesel, mobile oil, and ice alone, for a trip of 4/5 days, amounted to Rs. 350. Most of these fishermen knew through experience areas rich in fish. They developed their own indicators for discovering where they could get good fish catches. The Department of Fisheries had also got the coastal areas surveyed for a variety of prawn fish (see Exhibit X for survey results) in the mid-60s. The Superintendent of Fisheries was to provide information for the development of fisheries and arrange meetings to discuss such matters. However, fishermen rarely consulted the fisheries office on such issues and made fishing trips on their own judgement. They usually remained on sea waters for four days and thereafter returned to a landing place for delivering the catch to the project. The supervisors of the project kept vigilance on the harbour. Since the coastline was spread over more than a hundred kilometers it was impossible to keep a check everywhere. The boat could come to the harbour only on high tides and, therefore, the supervisors remained present at the place during such times. However, as they resided close to the harbour, they Could be contacted at any time. As soon as a boat returned to the harbour with the catch, the headman of the group informed the person on duty of the project office and arranged for delivery of quality fish to the project. All fish brought in the boat were sorted out in two lots - quality fish to be sold fresh in the Bombay market through the project and non-quality fish to be disposed off in the local market and/or to be dried and then sold by the group. Quality fish were further sorted out into saraga (white and silver pomfret of medium size) and other miscellaneous fish mostly consisted of Yam, Shingara, Ghol, Dara, Halva, Tamb, and Komda. The project kept separate production and sale accounts for saraga and the miscellaneous fish, Varieties of non-quality fish such as, cat, fish, shark, and dhoma were sold in the local market in case of demand, otherwise they were dried and sold by the groups. Proceeds from the sale of non-quality fish (sold in the local market) and dried fish were kept by the fishermen themselves. According to them, such fish did not have any significant value. However, the project officials started making an approximate estimate of the quality of non-quality fish that was left with the group of fishermen. Quality fish handed over to the project were packed in crates and transported through trucks to the TZMS sales office at Bombay. Bombay was located about 90 kms. from Satpati. The fish auction market at Bombay had 46 commission agents and three co-operatives which sold fish in wholesale through auction. One commission agent handled roughly 18 to 20 per cent and three co-operatives together handled another 20 to 25 per cent of the sale; the balance was divided among the remaining 45 agents. About 700 to 800 fisherwomen and men purchased fish for retailing, about 50 to 60 persons purchased fish for parcelling to outstations, and 8 to 10 stockists purchased fish for deep freezing. Practically all commission agents and co-operatives charged seven per cent commission from their principals-fishermen and fisherman's societies whose fish they sold. However, co-operatives usually granted one per cent rebate out of their seven per cent commission to the co-operative societies offering fish for sale. After verbal negotiations between the representatives of sellers and buyers, the market opened with a set selling price for each variety of quality fish everyday early in the morning at 5 a.m. These prices depended on the demand and supply. If fish were not lifted at this rate, either due to poor quality or some other reasons,' within a few hours, they were auctioned at lower prices. Practically all major auction sales were completed by 10 a.m. Prices were usually lower in the fishing seasons, when the supply was large; they were the highest during the monsoon-an off season. Daily prices for various varieties of fish during November 1972 are given in Exhibit X1. Exhibit XlI gives the different rates at which pomfret was sold by the TZMS sales office, If the prices quoted in the auction market were very low, TZMS sometimes purchased fish for deep freezing and sold it later in the expectation of profit., However; so far it had not purchased fish from the consignments sent by the project. TZMS did not purchase any quantity for freezing during the season 1971-72 and the current season. 35 Immediately after sales, the TZMS sales office prepared a bill giving details of the quantity, rate, and total value at which fish of each crate/case were sold and sent it to the project office where the account clerk checked the calculation and kept the bill on file. At the end of the month, the TZMS sales office sent a consolidated statement for each fish boat and overall bill for the project indicating the total sales, value, expenses such as TZMS' commission (seven per cent), cartage, hamali and market fee the deduction at a set percentage of sales value towards bank loan repayment,' and balance payable to the project. The project office completed each individual boat's current account in which debits for supplies and cash payment to the groups of boat were also recorded. They also kept accounts for each boat for the boat loan and temporary loan, besides the current account and adjusted repayment of these loans in the proportion of 60% towards boat loan and/or temporary loan account and 40% towards the current account as per the bank's requirements. Between the boat loan account and temporary loan account, the first recovery was. effected towards the temporary loan account. The project office, after the completion of accounts, rendered monthly accounts to each group of fishermen by the 6th or 7th of the next month. If there was any balance payable to the group after recovering the amount on account of supplies and requisites in the current account, the group could do very little to recover the amount. Though the boat and engine lives were considered to be more than 10 years (a period over which the instalment payments of the loan were spread), the navigational lights, fire-fighting equipment, accessories, and fishing gear had a much shorter life and needed replacement. Usually, in the off season (May-August) fishermen repaired their nets for which they required nylon twines, nets, ropes, floats, sinkers, etc., and overhauled some parts of the boat. It was estimated that about Rs. 13,000 would be needed per year per boat for maintenance and replacement. The project envisaged the payment of this amount to the fishermen's group at one time in the off season, to be recovered by the end of the next fishing season, i.e., May. Since the boat had gone into operation only a few months back, only a few payments had been made so far. In some accounts, the full recovery of such loans had been effected. However, in a few accounts, some amounts were still outstanding. The project office first adjust any deduction from the sales proceeds of fish in their temporary loan account and thereafter, in the boat loan account as was done by the bank. The General Manager's Problem Mr. Divekar was concerned about the increasing debit balance in the current accounts of some groups. He did not know what measures he should take to make the project successful. Some groups were handling over their catches to them since the operation of the scheme, but except for taking care of the variable expenses of the . boat trips, the project had not paid them anything for their family needs. He was finding it difficult to enforce their decision to limit their credit for requisites and supplies to 40% of the previous catch as the next trip required a larger credit even for the bare requirements like diesel, mobile oil, and ice. Some of the groups which had brought large catches in the earlier season were bringing lower catches in this season. (A statement showing fish catches and their values for the period November 1971 and November 1972 is given in Exhibit XIII. Also catches by some boats and their values during the period August 18, 1972 to October 31, 1972 are given in Exhibit XIV). In the overall supplies, there was a shortfall of 47,237 Kg. of fish (Rs. 47,668 by value) by November, 1972. (Exhibit XV). He wondered whether the season was bad that year for fishing or whether some boats were not handing over their total catches to the project or whether they did not know where to get fish catches. (A statement showing the catches of some other gill net boats operating in the same area and selling their catches through a private commission agent is given in Exhibit XV). He was considering what information he should collect and what the group to maintain a log book,' but this was not introduced so far. The authorities of the co-operative bank had decided that in the first year of the operation of the scheme, 50% of the sales proceeds from the catches brought by each group be adjusted towards the loan account and the temporary loan for replacement of gears and maintenance. This percentage was revised to 60% in the second year of operation as the value of the catches brought by the groups were not sufficient to cover the bank loans. The bank first recovered the temporary loan, if any, from such deductions and thereafter, made adjustments twoards the boat loan. The bank maintained the loan accounts in only one name, viz. the Thana Zilla Machhimar Sahakari Sangh Project. However, the TZMS project office maintained boatwise loan accounts. z 1 In the log book, an account of each trip was to be recorded. It would contain details of diesel, mobile oil, ice, other supplies, catches brought, etc., for each trip. 36 He believed that he could do very little on the marketing side, as that was handled by the TZMS sales office over which he had no control. He wondered if any control on market prices could be exercised by him. Should he hold supplies in anticipation of higher prices to fishermen? Sometimes fish was kept in the.Satpati Society's cold storage at a cost of 50 Ps. Per case, but this was only for one or two days either due to delay in transporting or if the catches brought to the project were too small to be dispatched to Bombay. Moreover,. TZMS was purchasing fish on its own for freezing purposes, but he was not sure whether this should be done on behalf of the group of fishermen instead of the TZMS and if so who should take the decision. He was also concerned about the replacement of the maintenance requirements of fishermen. Some groups, it appeared to him, would not be in a position to repay the amounts from the value of the catches delivered to the project. He wondered whether the overall systems and procedures adopted by the project provided any incentive for more production and delivery of catches to the project. EXHIBIT-I Account of the Boat "Anuradha' HEADMAN: SHRI ANIL CHOWDHARY Month Debit for Supplies & requisites Rs. November December January February March April May June July August September October November 1971 1971 1972 1972 1972 1972 1972 1972 1972 1972 1972 1972 1972 56.05 1852.94 2034.09 1800.40 3684.00 3576.00 1826.00 2328.00 1597.00 1353.00 1970.00 662.00 Credit for Fish deliveries and sales Rs. 1332.00 2349.00 1052.00 1407.00 1038.00 1012.00 1686.00 1199.95 1236.70 1920.20 Balance Debit/Credit Rs. 2352.00 3579.00 4353.00 5274.00 5833.00 6174.00 6458.00 7120.00 7120.00 7176.05 7829.04 8626.43 9206.72 Dr. Dr. Dr. Dr. Dr. Dr. Dr. Dr. Dr. Dr. Dr. Dr. Dr./Cr. 37 TEMPORARY LOAN Loan amount granted In June/July, 1972 Rs. 10,055.90 Amount recovered till November, 1972 Rs. 3,653.85 BOAT LOAN Month of loan disbursement. Amount of loan Rs. November, 1971 86,256.83 Amount recovered Till Nov. 1972 Rs. 4,038.36 Balance amount to be recovered Rs. 82,218.47 Balance amount to be recovered by the end of May, 1973 Rs. 6,402.05 38 39 40 T 41 42 43 EXHIBIT-IX Draft Agreement Between the Boat Group and TZMS (Translated from Marathi Version) We, the undersigned partners of the boat group in the Co-operative Fishing Project enter into the agreement with the Federation (TZMS). The Maharashtra Government has sanctioned the Thana District Co-operative Fisheries Project and has given it to the Federation for implementing it. We the partners of the boat group had applied to the Federation to approve of our group and the Federation has approved it. We, the chief of the group and my partners. enter into the agreement with Thana District Fishermen's Central Cooperative Federation Limited that have accepted from the Federation the Boat No............and engine, other implements, and nets, etc. mentioned in Appendix A, which belongs to the Federation, on Hire Purchase basis. We agree that: 1. We shall remit the yearly rent of the above mentioned boat, as the annual instalment under Hire Purchase scheme, out of the proceeds of the sale of fish, beginning from the first season, regularly and without fail. We shall accept due receipt from you. In case of default on our part, you can reserve your rights to cancel the agreement of Hire Purchase and to take back from us the boat and other implements (which are loaned by you to us). 2. We shall keep the boat in our possession and at the location mentioned by the Federation. We shall not give it to others, sell it, mortgage it, or dispose of it otherwise, without your written permission. 3. We shall pay the insurance premium on the boat regularly. 4. If for any inevitable reasons or misfortune, that boat and implements are damaged, we (entering into contract) make good the loss of the sum from our fixed assets. The sum to be made good for will be in 'excess of repaid installments and interest paid by us so far. 5. Total price of the boat is to be paid in 10 yearly instalments. 6. If we abide by all terms and pay the rent of the boat (with principal and interest) in 10 instalments, then, you will accept this sum as the price of the boat and implements and will transfer the ownership of the same to us. 7. We should have paid you the sum as agreed to in (1) as yearly instalments, before you give us the receipt for the sale of the boat. 8. If we do not pay instalments regularly, or do not abide by any term properly, then we cannot ask the Federation to sell us the boat. If the agreement is cancelled, you are not bound to sell the boat to us. Under these circumstances you have the right to retain the amount paid by us as the rent. We will not complain, and return the boat and implements to you in good working condition compensating for any damage. 9. This boat will be used only for catching and transporting the fish. 10. The boat will be examined every year by the Fishery Department Office. We abide by their decisions. 11. Until all instalments on the boat etc. are paid, and until the Federation demands it, we shall sell all or fresh and dried fish through the Federation. We shall give them daily production figures. If we do not give them fish, they have the right to reclaim the boat from us. 12. As the Federation has taken loan from the Government and the Thana District Central Co-operative Bank for building the boat, and as the boat is a collateral to this loan, we shall abide by the terms set by the bank until the loan is repaid. 13. We abide by conditions set by the Thana District Fishermen's Federation from time to time. 14. The first part (i.e. Federation) will be legal owners of the boat, implements, etc. mentioned in Appendix until the agreement is over and the sale completed. In case the Federation thinks that the agreement is broken, the other party to the contract (i.e. we) should make good the loss of the Federation and if we do not do so, the Federation through customs and police can recover all the implements, boat, etc. 44 Similarly as chief of group and partners we agree to following conditions: 15. We will not give nets and accessories etc. to anyone else. If it is found that we have given the nets, etc. to others or other groups, we are open to criminal suit. 16. We shall go on a fishing trip only with required outside people. If any partner is absent, we shall give written intimation to the Satpati Project Office. 17. We shall note in the boat's log book all information of the fishing trip and give it to the Project Officer for signature. 18. We would not give or sell our catch to others or load on other boats. If we are found doing so by the Project Officers, it will be a cognizable offence. 19. When we go for a fishing trip, or return from it, or on it, the officers of the project office have full right to examine our boat. We won't obstruct and will give full cooperation. 20. After a fishing trip, we will give full report of the fish caught, etc. and hand over all the fish catch (except that which can't be sold in Bombay and other markets) to the officers of the project. 21. Fins and edarblande collected after every fishing trip will be handed over by us to the project offices. We should be paid and credited to our account its market price. 22. We shall purchase diesel oil, mobile oil and ice only from the Thana District Co-operative Federation and not from other traders. 23. We shall complete our accounts by 3150 May of every year, paying to the Federation our share of the instalment of bank loan and interests thereon. 24. The money accruing to us out of sale of fish will be used by us to make expenditure on ice, diesel, and consumption expenditure. We will not demand advances from the Federation. In every month, we shall at least, make five trips to catch. 25. We shall seek advice, if it found that our production is less than that of other boats in the project and try to increase production. 26. We shall go in the port designated by the Federation, to catch fish. 27. If we don't abide by any of the above mentioned terms. The Federation has the right to cancel the agreement or demand back boat and implements from us. 28. We abide by terms set by the Federation from time to time EXHIBIT-X Map of Maharashtra Coastal Area Surveyed for Fishing 45 46 47 48 49