Principles of Management Control Systems by Haitham2012

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									   Principles of
Management Control
     Systems




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     ICFAI UNIVERSITY
   Principles of
Management Control
     Systems




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     ICFAI Center for Management Research
        Road # 3, Banjara Hills, Hyderabad – 500 034
 The Institute of Chartered Financial Analysts of India, January 2006.
All rights reserved.
No part of this publication may be reproduced, stored in a retrieval system, used in a
spreadsheet, or transmitted in any form or by any means – electronic, mechanical,
photocopying or otherwise – without prior permission in writing from Institute of
Chartered Financial Analysts of India.




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ISBN 81-7881-995-3

Ref. No. PMCS/A 01 2K6 31

For any clarification regarding this book, the students may please write to ICFAI
giving the above reference number, and page number.

While every possible care has been taken in preparing this book, ICFAI welcomes
suggestions from students for improvement in future editions.
                                  Contents
PART I: AN OVERVIEW OF MANAGEMENT CONTROL SYSTEMS
Chapter 1      Introduction to Management Control Systems      3
Chapter 2      Approaches to Management Control Systems       15
Chapter 3      Designing Management Control Systems           28
Chapter 4      Key Success Variables as Control Indicators    42

PART II: MANAGEMENT CONTROL ENVIRONMENT
Chapter 5      Organizing for Adaptive Control                57
Chapter 6      Autonomy and Responsibility                    71
Chapter 7      Transfer Pricing                               87




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PART III: MANAGEMENT CONTROL PROCESSES




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Chapter 8      Strategic Planning and Programming             99

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Chapter 9      Budget as an Instrument of Control
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PART IV: MANAGEMENT CONTROL TOOLS
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Chapter 10     Reward Systems                                139
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Chapter 11     Management Control of Operations              152
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Chapter 12     Continuous Process Improvement Methods        163
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PART V: MANAGERIAL COSTING
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Chapter 13     Strategic Cost Management                     177
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Chapter 14     Auditing                                      185
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Chapter 15     Audit of Management Functions                 208
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PART VI: MANAGEMENT CONTROL IN SPECIFIC SITUATIONS
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Chapter 16     Control in Multinational Corporations         221
Chapter 17     Control in Nonprofit Organizations            234
Chapter 18     Control in Service Organizations              242
Chapter 19     Management Control of Projects                258

PART VII: MANAGEMENT CONTROL AND EMERGING AREAS
Chapter 20     Control in the Age of Empowerment             279
Chapter 21     Management Control and Ethical Issues         287
Glossary                                                     295
Bibliography                                                 301
Index                                                        304
                        Detailed Contents
PART I: AN OVERVIEW OF MANAGEMENT CONTROL
SYSTEMS
Chapter 1: Introduction to Management Control Systems: Importance of
Control Systems: Elements of a Control System – Nature of Management
Control Systems: Important Features of Management Control Systems,
Management Control Process, Characteristics of a Good Management Control
System, Distinction between Strategy Formulation, Management Control and
Task Control – Types of Management Control Systems: Formal Control
System, Informal Control System – Subsystems and Components of
Management Control Systems: Formal Control Process, Informal Control
Process
Chapter 2: Approaches to Management Control Systems: Cybernetic
Approach to Management Control Systems: Characteristics of a Cybernetic




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System, Cybernetic Paradigm and the Control Process, Designing




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Management Controls, Control Process Hierarchy – Contingency Approach to
Management Control Systems: The Need for the Contingency Approach –

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Strategy and Control Systems: Corporate Strategy, Business Unit Strategy
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Chapter 3: Designing Management Control Systems: Steps in Designing
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Management Control Systems: Choice of Controls, Tightness of Controls –
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Factors Influencing the Design of Management Control Systems: Managerial
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Styles and the Design of Control Systems: Corporate Culture and Design of
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Control Systems, Decentralization and Design of Control Systems,
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Organizational Slack and Design of Control Systems, Stakeholder Controls
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and Design of Control Systems, Communication Structures and Control
Process – Establishing a Customer-Focussed Total Quality Culture:
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Implementing Total Quality Management – Impact of Information
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Technology on Control Systems Design: Providing Information for
Operational and Strategic Decision Making
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Chapter 4: Key Success Variables as Control Indicators: Concept of Key
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Variables - Identifying Key Variables: Input Variables, Production Variables,
Marketing Variables, Asset Management Variables, Sources of Key Variables,
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Types of Key Variables – Key Success Variables and the Control Paradigm:
Dynamics of the Control Process, Identifying Key Variables                 –
Comprehensive Performance Indicators: Limitations of Indicators – Key
Variables in Selected Industries: Insurance Industry, Hotel Industry, Sugar
Industry, Management Training Institute, Power Industry

PART II: MANAGEMENT CONTROL ENVIRONMENT
Chapter 5: Organizing for Adaptive Control: Strategy, Structure and
Control – Decentralization Vs Centralization – Response of Structure to
Strategy: Evolution of the Matrix Structure: Project Organizations, Product
Organizations, Service Organizations, The Matrix Structure and the
Multinational Firm – Evaluation of the Control Factors in Organizational
Design: Matrix Versus Functional – Controller’s Organization – Adaptive
Organization: The Need for Adaptive Organization, Adaptive Controls that
Support the Adaptive Organization
Chapter 6: Autonomy and Responsibility: Divisional Autonomy:
Management Style and Process, Responsibility Structure, Measurement of
Reward Systems – Responsibility Structure: Overall Effectiveness Measures:
Return on Investment (ROI) – Responsibility Centers: Nature of
Responsibility Centers, Types of Responsibility Centers – Performance
Measurement of Decentralized Operations: Measuring Divisional Operations
– Inter Profit Center Relations: Setting Transfer Prices
Chapter 7: Transfer Pricing: Objectives of Transfer Pricing – Principles of
Transfer Pricing: Goal Congruence – Methods of Calculating Transfer Price:
Market-Based Pricing Method, Cost-Based Pricing Method, Negotiated
Pricing Method – Upstream Fixed Costs and Profits: Two Step Pricing, Profit
Sharing, Two Sets of Prices – Administration of Transfer Prices: Negotiation
– Arbitration and Conflict Resolution, Product Classification

PART III MANAGEMENT CONTROL PROCESSES




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Chapter 8: Strategic Planning and Programming: Elements of Strategy –
Characteristics of Strategic Planning: Benefits of Strategic Planning,




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Organizational Relationships, Top Management Style – Strategic Planning
Process: Reviewing and Updating         the Strategic Plan, Deciding on

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Assumptions and Guidelines, First Iteration of the Strategic Plan, Analysis,
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Second Iteration of the Strategic Plan, Final Review and Approval –
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Analyzing Proposed New Programs: Rules, Avoiding Manipulation,
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Acquaintance to Planning Models, Organizing for Analysis – Analyzing
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Ongoing Programs: Analysis, Activity Based Costing, Expense Center – The
Programming Process: Bower's Model of the Investment Decision-Making
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Process. Parameters of the Programming Process, Mutually Supportive
Management Systems for the Implementation of Strategy through
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Programming Decisions, Formal Programming Procedures
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Chapter 9: Budget as an Instrument of Control: Need for Budgeting –
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Forecasting, Budgeting and Strategic Planning – Budgeting Process and
Control: Budget Preparation Process, Budgetary         Control, Behavioral
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Dimensions of Budgeting – Master Budget: Steps in the Preparation of the
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Master Budget, Budget Balance Sheet – Zero Based Budgeting: The ZBB
Process, ZBB Vs Traditional Budgeting, Implementing Issues, Advantages
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and Disadvantages of ZBB – Performance Budgeting: Steps in the
Implementation of Performance Budgeting, Performance Budgeting Vs
Traditional Budgeting – Participative Budgeting – Variance Analysis for
Control Actions: Revenue Variances, Expense Variances, Summary of
Variances, Limitations of Variance Analysis

PART IV: MANAGEMENT CONTROL TOOLS
Chapter 10: Reward Systems: Purpose of Reward Systems:– Components of
Incentive Compensation Plans – CEO Compensation – Incentives for Business
Unit Managers: Size of Bonus Relative to Salary, Cutoff Levels, Bonus Basis,
Performance Criteria, Benchmarks for Comparison – Balanced Scorecard –
Design Considerations: Rewards Integrated with MSSM (Mutually Supportive
Systems Model), Attainability, Formal Rewards, Informal Rewards – Agency
Theory: Concepts of Agency Theory
Chapter 11: Management Control of Operations: Information used in
control of operations: Informal Information, Formal Information, Non
Financial Information – Just-In-Time Techniques: Advantages of Just-In-Time
Techniques, Implications for Management Control – Total Quality
Management: Consequences of Poor Quality, Total Quality Management
Approach, Implications for Management Control – Computer Integrated
Manufacturing – Decision Support Systems: Nature of Decision Support
Systems. Implications for Management Control
Chapter 12: Continuous Process Improvement Methods: Target Costing:
Planning Stage, Development Stage, Production Stage, Benefits of Target
Costing – Benchmarking and Benchtrending: Planning Phase, Analysis
Phase, Benchtrending, Process Benchtrending – Quality Improvements:
Process Quality Teaming – Activity-Based Costing: Traditional Costing vs
Activity Based Costing (ABC)

PART V: MANAGERIAL COSTING




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Chapter 13: Strategic Cost Management: Evolution of Strategic Cost




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Management: Strategic Measures of Success – Three Key Themes of Strategic
Cost Management: Value Chain Analysis, Cost Driver Analysis, Strategic

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Positioning Analysis – Strategic Management and Strategic Cost Analysis
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Chapter 14: Auditing: Benefits of Audit: Identify Opportunities for
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Improvement,      Reality Check, Identify Outdated Strategies, Increase
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Management’s Ability to Address Concerns, Enhances Teamwork, Increase
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Commitment to Change – Limitations of Audit – Timing of an Audit – Audit
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Process: Staffing the Audit Team, Creating an Audit Project Plan, Laying the
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Ground Work for the Audit, Analyzing Audit Results, Sharing Audit Results,
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Writing Audit Reports, Dealing with Resistance to Audit Recommendations,
Building an Ongoing Audit Program – Audit Tools and Techniques: Budget,
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Timing, Projectability, Geography, Surveys, Questionnaires, Focus Groups,
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Interviews, Direct Observation – Management Audit: Objective of a
Management Audit, Development of Management Audit, Benefits of
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Management Audits, Types of Management Audit, Organizing the
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Management Audit, Conditions for Successful Management Audit – Internal
Audit: Need for Internal Auditing – Financial and Cost Audit – Social
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Audit: Social Accounting versus Social Audit, Definition of Social Audit,
Features of Social Audit, Approaches to Social Audit, Types of Social Audit –
Audit Evidence: Persuasive, Relevant, Unbiased, Objective – Auditing for
Continuous Improvement
Chapter 15: Audit of Management Functions: Audit of the Purchasing
Function: Purchasing Procedure, Characteristics of an Effective Purchase
Department – Purchase Audit Areas – Human Resource Audit: Conducting an
HR Audit – Research and Development Activities Audit: Evaluation of R&D
Activities – Production Audit: Characteristics of a Good Manufacturing Audit
– Marketing Audit: Characteristics of Marketing Audit – Sales Audit:
Approaches to Sales Audit, Conducting a Sales Audit, Characteristics of a
Sales Auditor, Process of Collecting Data During Sales Audit
PART VI: MANAGEMENT                      CONTROL          IN     SPECIFIC
SITUATIONS
Chapter 16: Control in Multinational Corporations: Types of Controls
Used By MNCs: Personal Controls, Output Controls, Cultural Controls,
Result Controls, Bureaucratic Controls – Concept of Strategic Control:
Headquarters-Subsidiary Environment, Impact of Global Competition, Impact
of Host Government Demands, Impact of Joint Ventures – Factors Affecting
Control Systems in MNCs: Cultural Differences Across Countries,
Differences in Business Environment – Analysis of Foreign Investment
Projects by MNCs: Taxes on Income from Foreign Investment Projects,
Political Risks, Economic Risks, Exchange Rate Risk – Transfer Pricing in
MNCs: Situation 1-Paying Some Tax, Situation 2-Inflating Profits, Situation
3-Paying No Tax, Situation 4-Getting Tax Rebates, Tax Avoidance Inflates
Profits, Methods of Transfer Pricing – Control of Foreign Affiliates: Currency
Translation, Budgeting for Foreign Affiliates




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Chapter 17: Control in Nonprofit Organizations: Mission of Nonprofit
Organizations – Key Characteristics of Nonprofit Organizations: Atmosphere




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of “Scarcity”, Bias towards Informality, Participation and Consensus, Dual
Bottom Lines: Mission and Financial, Difficulty in Assessing Program
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Outcomes, Governing Board with both Oversight and Supporting Roles,
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Mixed Skill Levels of Staff, Participation of Volunteers – Designing Control
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Systems for Nonprofit Organizations – Employee Characteristics and
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Organizational Culture: Rewards, Performance Measurement, Fund
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Accounting, Programming and Budget Preparation
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Chapter 18: Control in Service Organizations: Control in Professional
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Organizations:   Characteristics of Professional Organizations, Control
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Systems in Professional Organizations         – Control in Government
Organizations: Political Influences, Public Information, Attitude towards
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Clients, Management Compensation – Control Systems in Government
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Organizations: Strategic Planning, Performance Measurement – Control in
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Financial Service Organizations: General Characteristics of Commercial
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Banks, Regulatory Capital, New Products, Management Control Implications,
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Basle Committee Principles on Banking, General Characteristics of Insurance
Companies – Control in Securities Firms: Management Control Implications
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Chapter 19: Management Control of Projects: Differences between the
Control of Projects and the Control of Ongoing Activities: Single Objective,
Focus on Projects, Need for Trade-offs, Less Reliable Performance Standards,
Frequent Changes in Plan, Difference in Rhythm, Environmental Influence –
Project Planning: Planning Process, Nature of Project Plan, Project Scope,
Project Schedule, Project Cost, Project Scheduling – Project Control:
Objectives of Project Control, Control as a Function of Management –
Reporting for Control: Effective Reporting System, Types of Project Reports
– Project Team and Matrix Structure: Matrix Structure – Project Audits:
Levels of Audit – Project Evaluation: Evaluation of Performance, Evaluation
of Results
PART VII: MANAGEMENT CONTROL AND EMERGING
AREAS
Chapter 20: Control in the Age of Empowerment: Balancing
Empowerment and Control: Diagnostic Control Systems, Belief Systems,
Boundary Systems, Interactive Control Systems – Control Systems and
Conflict Resolution: Conflicts in the Planning Subsystem, Conflicts in the
Measuring Subsystem, Conflicts in the Recording Subsystem, Conflicts in the
Appraisal Subsystem, Conflicts in the Reporting Subsystem, Conflicts in the
Subsystem for Remedial Action – Framework for Conflict Resolution
Chapter 21: Management Control and Ethical Issues: Identifying Control-
Related Ethical Issues: Creating Budgetary Slack, Responding to Flawed
Control Indicators, Managing Earnings, Using Excessively Tight Control
Measures – Designing Control Systems to Regulate Ethical Conduct:
Cybernetic Control Process for Developing an Ethics Program – Control
System Supporting the Ethics Program: Management Style and Culture,




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Infrastructure, Rewards, Coordination and Integration – The Ethical Principle
of Fairness In the Design of Control Systems




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AN OVERVIEW OF MANAGEMENT
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     CONTROL SYSTEMS
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Chapter 1

Introduction to Management



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Control Systems

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In this chapter we will discuss:
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    Importance of Control Systems
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•   Nature of Management Control Systems
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•   Types of Management Control Systems
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•   Subsystems and Components of Management Control Systems
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Principles of Management Control Systems


             In 2001, Enron Corp., the global energy giant, collapsed in one of the largest
             cases of bankruptcy filing in U.S. corporate history. Tyco International, a
             diversified manufacturing and service company, had to abandon plans to split
             into four parts, because of doubts about its accounting practices. The stunning
             news that WorldCom, the telecom giant, had artificially inflated its earnings
             by $3.8 billion rocked the corporate world and shook investors’ confidence in
             stock markets. WorldCom's accounting irregularities involved the deliberate
             mis-recording of expenses as capital expenditures, in order to inflate its cash
             flows. The accounting irregularities included transfers between internal
             accounts of $3.06 billion in 2001 and $797 million in the first quarter of 2002.
             As these examples illustrate, the absence or malfunctioning of control systems
             can lead to huge losses, and even to corporate bankruptcy. Defective products
             and poor coordination between departments also arise due to weak control
             systems.
             This chapter focuses on the importance of control systems, the nature of




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             management control systems, types of management control systems, and the




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             subsystems and components of management control systems.


IMPORTANCE OF CONTROL SYSTEMS
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             A control system is a set of formal and informal systems to assist the
             management in steering the organization towards its goals. Controls help in
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             guiding employees effectively towards the accomplishment of the
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             organization’s goals. Establishing a control system in an environment of
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             distributed accountability, reengineered processes, and local autonomy and
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             empowerment is a challenging task.
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             The control process in any organization can be undertaken at three levels.
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             These are: the strategic level, the management level, and the operational level.
             Each type of control occurs primarily at one of the three distinct levels of the
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             organizational hierarchy.
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             •   Strategic control deals primarily with the broad questions of domain
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                 definition, direction setting, expression of the organization’s purpose, and
                 other issues that impact the organization's long-term survival. Strategic
                 control overlaps to some extent with the process of strategy formulation.
                 Strategic control also deals with issues relating to general company
                 objectives and the implementation and monitoring of progress.
             •   Management control deals with effective resource utilization, the state of
                 competitiveness of the unit, and the translation of corporate goals into
                 business unit objectives.
             •   Operational control is primarily concerned with efficiency issues.
                 Occurring at very specific functional or sub-departmental levels of the
                 organizational hierarchy, this mode of control generally conforms to
                 traditional control models. The time horizon of control is very short, the
                 benchmarks are known and well defined, and the outcomes are tangible
                 and easily measurable.

4
                                           Introduction to Management Control Systems



                                            Exhibit 1.1
                            Management Control at Kimberly-Clark
        Kimberly-Clark, the manufacturer of household and health products, is an example
        of a company that mixed up operational and management control issues. The
        company has a good reputation as a manufacturer of household and health
        products. Since 1950s, it also started selling cigarette paper and sheets of pressed,
        reconstituted tobacco-to-tobacco companies for use in cigarettes. The tobacco
        reconstitution process used by Kimberly-Clark enabled tobacco companies to
        manipulate nicotine levels in cigarettes.
        The state of West Virginia in the US alleged that Kimberly-Clark conspired with
        cigarette companies to deceive the public about the hazards of smoking. When the
        company realized that its tobacco business was becoming a legal and financial
        liability, it spun off the tobacco unit.
        At the operational control level, the company did not ascertain whether the




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        advertisements claiming that the tobacco reconstitution process allows nicotine




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        levels to be adjusted to a smoker’s individual requirement was indeed misleading.
        At the management control level, the company did not act immediately once

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        smoking related illness became common. The strategic control failure was not
        making a conscious determination whether the tobacco business was consistent
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        with the company's mission and values. If the tobacco business was consistent
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        with the mission and values, the company then needed to follow up by instituting
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        proper operational and management control systems that protected the
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        organization against legal liability.
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         Adapted from Veliyath, Raj; Hermanson, Heather M. “Organizational control systems:
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         Matching controls with Organizational levels” Review of Business, Winter97, Vol. 18
         Issue 2, p2.
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              It is important to recognize that the three levels of control are not mutually
              exclusive. They represent a nested arrangement. If the control process does
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              not identify and deal appropriately with a problem occurring at a lower level,
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              the problem worsens. The problem then gets kicked up to a higher level of
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              control. This can be illustrated through the example of Kimberly-Clark in
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              Exhibit 1.1. In extreme cases, when the issue gets more complicated,
              threatening the organization’s survival, the problem needs to be handled from
              the highest levels, in terms of strategic control.
              Increased control in an organization will result in reduced creativity and
              entrepreneurship. Hence it is important for organizations to establish the trade-
              off between the amount of control and the level of freedom for employees, and
              to choose the right mix of controls.

Elements of a Control System
              Any control system has four important elements. They are a detector or
              sensor, an assessor, an effector and a communications network, as can be seen
              in Figure 1.1. The detector analyzes the situation that is being controlled. An
              assessor helps in comparing the actual results with the standard or expected
              results. An effector is used to reduce the gap between the actual and the

                                                                                                5
Principles of Management Control Systems


                            Figure 1.1 Elements of the Control Process

                                                    Control                 2. Assessor. Comparison
                                                    device                  with standard




       1.    Detector.  Observed                                            3. Effector. Behavior
       information about what is                                            altering communication,
       happening                                                            if needed


                                                Entity being
                                                controlled




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    Source: Robert N.Anthony, Govindarajan, Management Control Systems, (USA: Irwin, 1995) 5.




                                                                     20
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               standard result. The communication network transmits information between
               the detector, the assessor and the effector.
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               The process of control usually involves four important steps. They are:
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               •    Identifying the goals or objectives,
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               •    Implementing the programs or policies,
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               •    Measuring and comparing outcomes against targets, and
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               •    Analyzing whether the achieved targets are in accordance with the goals
                    or objectives.
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NATURE OF MANAGEMENT CONTROL SYSTEMS
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               The role of the management is to organize, plan, integrate and interrelate
               organizational activities to achieve organizational objectives. The achievement
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               of these activities is facilitated by management control systems. A
               management control system is designed to assist managers in planning and
               controlling the activities of the organization. A management control system is
               the means by which senior managers ensure that subordinate managers,
               efficiently and effectively, strive to attain the company's objectives. According
               to Anthony, Dearden and Govindarajan1 (1992), management control is “the
               process by which managers ensure that resources are used effectively and
               efficiently in the accomplishment of the organization's objectives”.
               If the management monitors the activities of the business units frequently,
               then it is exercising tight control. Limited monitoring of the business units’
               activities can be termed as loose control. The difference between tight and
               loose control thus relates to the degree to which the management monitors the
               1
                   Robert N Anthony and Vijay Govindarajan, Management Control Systems, Eight Edition
                   Irwin Publications.
6
                                         Introduction to Management Control Systems


            activities of a unit. When there is tight control by the management, there is
            extensive involvement of the management in the day-to-day operations of the
            business unit. The budget is considered a binding constraint with a strong
            emphasis on meeting the budgeted targets. Deviations from the budget are
            generally not considered acceptable. Loose control is characterized by limited
            involvement by the management in day-to-day operations. Under loose
            control, the budget is regarded more as a tool for planning and communication
            than as a binding commitment.
            Management control systems involve a number of activities in an
            organization, including:
            •   Planning the future course of action
            •   Coordinating and communicating the various activities of the organization
                to different departments
            •   Evaluating information and deciding the various activities; and finally,




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            •   Influencing people to work in accordance with the goals of the




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                organization.


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Important Features of Management Control Systems       s
            Nature of decisions
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            Management control decisions are based on the framework established by the
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            organization's strategies. Management control decisions also take into account
            the quantity and quality of resources available. Within the constraints of the
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            available resources and the policies of the organization, a manager should be
            able to implement activities that are best suited for a particular business unit.
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            Decisions are made at the highest level, but their actual implementation may
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            require some time. For instance, employees need time to adapt to a new
            technology.
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            Decisions are systematic and rhythmic
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            Decisions in management control process are systematic and rhythmic i.e.
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            they are in accordance with the strategies and procedures laid down by the top
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            management. Plans developed for a unit must encompass the whole
            organization, and the plans for each of the organization’s units must be
            coordinated with one another, so that there is a balance between different
            activities. For example, operations and distribution should be balanced with
            the sales program.
            Strategy implementation tool
            Management control helps an organization to move towards its strategic
            objectives. It is an important vehicle for the execution of strategy. Figure 1.2
            explains how strategies are implemented through management controls,
            organizational structures, human resource management, and culture. Effective
            execution can take place with the help of an efficient organizational structure,
            human resource management and culture. All these are influenced by the
            system of management control, and hence it is an important aspect of strategy
            implementation.


                                                                                           7
Principles of Management Control Systems


                     Figure 1.2Framework for Strategy Implementation

                                      Implementation mechanisms


                                           Management
                                            Controls



                       Organization                       Human Resource     Performance
        Strategy        Structure                          Management



                                              Culture




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        Source: Robert N Anthony and Vijay Govindrajan, Management Control Systems (USA:
        Irwin, 1995) 11.
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             Behavioral considerations
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             People are important assets for an organization. Without the cooperation of the
             employees, managers cannot implement their decisions. To manage people
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             effectively, control systems are required for the following three reasons- lack
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             of direction, motivational problems and personal limitations.
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             Poor performance in organizations can be attributed to lack of direction
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             among employees. Giving employees the required support and direction to
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             accomplish organizational goals is one of the important functions of
             management control systems.
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             Motivation is important to help employees perform to their full potential.
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             Most of the organization’s problems occur because individual goals and
             organizational goals do not match. This results in demotivated performance by
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             the employees. At the managerial level too, lack of motivation will result in
             employees taking decisions that are harmful to the organization. The decisions
             may be made in order to advance the personal interests of the employees
             involved. In extreme cases, this could lead to employee fraud and theft. In IT
             companies, computer-related crime can result in huge losses for the
             organization. Hence, there is a need to control such behavior in an
             organization.
             Another behavioral problem that can have serious consequences for an
             organization is personal limitations. In spite of high motivation to perform,
             certain employees may be unable to perform because of their personal
             limitations. These limitations are specific to individuals, and could also be
             because of inadequate training, lack of knowledge or information, and
             inexperience. Job design also plays an important role in performance. Some
             jobs are designed in a manner that creates stress. This can lead to accidents
             and errors in decision-making. Training plays an important role in reducing

8
                                         Introduction to Management Control Systems


            the severity of limitations at the individual level. Finding effective tools for
            control of such limitations is an important part of control systems.

Management Control Process
            The management control process involves three interrelated activities –
            communication, motivation and evaluation. First, it involves communication
            between the superior and the subordinates. Communication helps the
            subordinates understand the goals of the organization. The superior should
            make sure that the subordinates understand what the organization expects of
            them. Second, for the subordinates to put in their best efforts to achieve
            organizational goals, they have to be motivated. It is the responsibility of the
            superior to motivate the subordinates. Finally, for effective performance,
            superiors should evaluate the work of the subordinates and give them
            feedback periodically. It is essential for the superior to evaluate the
            performance of subordinates without any bias.




                                                                09
                                                            20
Characteristics of a Good Management Control System


                                                       of
            A good management control system ensures success for an organization. Good
            management control here implies that the goals of the organization are clearly
                                                  s s
            communicated to the employees, and that the employee is confident about
                                               la

            performing his tasks well. For example, good inventory control means that
                                            C


            employees have information about the quantity of inventory present and its
            availability at different locations. An organization does not usually have
                                     y
                                   nl




            perfect control. For perfect control all the employees should be working in the
                                  O




            best possible way. But this is not always possible as employee behavior is not
            stable. Good control can be achieved in the following ways:
                              se




            Future-oriented
                          U




            Planning is always oriented to the future. The organization should be focused
                      S
                  B




            on the future. Employees should be encouraged to be flexible so as to respond
                rI




            effectively to change.
            Fo




            Clear Objective
            Good control cannot be established unless the multiple objectives of a
            particular task are considered separately. For example, to assess the control
            system relating to production, all major performance parameters like
            efficiency, quality and asset management, have to be measured.
            Minimum control losses
            Control devices are costly and not always economically feasible. So, control
            devices should be put in place only when the economic benefits exceed the
            costs. The difference between the performance that is theoretically possible
            and one that can be reasonably expected is called “control loss.” An
            organization achieves optimal performance when control losses are
            minimized.


                                                                                          9
Principles of Management Control Systems


Distinction between Strategy Formulation, Management Control and Task
Control
             It is important to analyze the differences between management control and
             other types of control. Management control needs to be distinguished clearly
             from strategy formulation and from task control. While strategy formulation
             takes place at the highest level in an organization, task control takes place at
             the individual level. Management control lies at the middle level between
             strategy formulation and task control. Figure 1.3 explains the distinction
             between strategy formulation, management control and task control.
             Distinction between strategy formulation and management control
             Strategy formulation takes place at the highest level of the management and
             involves formulation of new strategies, whereas management control involves
             implementation of these policies. Strategy formulation takes place in
             accordance with situations, both internal and external to the organization.




                                                                   09
             Hence, strategy formulation may not always follow a clearly defined system.
             The management control process takes place in a systematic manner, and




                                                              20
             involves managers and staff at all levels in the organization. Strategy
             formulation usually involves only those at the highest level of the
                                                         of
             organization. There may be changes in one or a few strategies, while others
                                                      s
             remain unaffected. In contrast, the management control process involves the
                                                   s
             whole organization, and changes affect all the parts since they are linked with
                                                la

             one another. Therefore, a high level of coordination is required.
                                              C



             Task control vs. management control
                                       y
                                     nl




             Task control involves the control of individual tasks. These tasks are carried
                                    O




             out according to the rules and regulations laid down by the management
                              se




           Figure 1.3 General Relationship among Planning and Control Functions
                            U
                        S
                    B




                         Activity                           Nature of
                  rI




                                                            End product
             Fo




                                                            Goals, strategies and
                      Strategy formulation                  policies


                                                            Implementation of
                      Management control                    Strategies


                                                            Efficient and effective
                          Task control                      performance of
                                                            individual tasks



         Source: Robert N.Anthony, Govindarajan, Management Control Systems, (USA: Irwin,
         1995) 9.


10
                                         Introduction to Management Control Systems


            control process. Usually the techniques in operations research and
            management science focus on task control. The information important for task
            control in an organization is usually quantitative in nature e.g. the number of
            items ordered by the customers, the components used in manufacturing the
            products, the number of man-hours used in a particular process, etc. The
            devices used for task control include programmable machine tools, process
            control computers and robots. In task control, each task requires a different
            task control system (a production control system is different from a cash
            management system).
            Thus, it can be concluded that task control is quantitative in nature whereas
            management control is oriented towards behavior. In task control, in some
            cases, such as automated processes, employees may not be involved; in other
            cases, there may be interaction between a manager and a worker. Management
            control involves interaction between two managers or between a superior and
            subordinate.




                                                                 09
TYPES OF MANAGEMENT CONTROL SYSTEMS




                                                             20
            Control systems in an organization fall under two broad areas: formal and
                                                        of
            informal. Formal controls are laid out in writing by the management, whereas
                                                     s
            informal controls arise as a result of employees’ behavior. Examples of formal
                                                  s
            controls are plans, budgets, regulations and quotas. Informal controls include
                                               la

            group norms and organizational culture. Formal controls are framed by the
                                            C


            managers, whereas informal controls often originate with employees and are
                                     y



            affected by general socio-cultural factors.
                                   nl
                                  O




Formal Control System
                             se




            Formal control systems are written, management-initiated mechanisms that
            influence the behavior of employees in achieving the organization’s goals.
                          U




            Formal controls can be classified into three types, based on the nature of
                      S




            management intervention. They are:
                  B
                rI




            Input controls
            Fo




            These are the actions taken by the company before a planned activity is
            implemented. These measures help the company to select the right way to
            undertake the activity. Input controls include selection criteria, recruitment
            and training programs, manpower allotments, strategic plans and resource
            allocations.
            Process controls
            Process controls involve tracking certain variables and taking corrective action
            whenever there is any deviation from specified parameters in the variables.
            The control action takes place before the process of transformation is
            completed and the output is produced. Process control is exercised when the
            firm attempts to influence the ongoing activity to achieve the desired ends.
            The control is applied to the behavior or activities rather than the end results.
            For example, under a feed-forward system of inventory control, the factors
            that affect inventory levels of finished goods, such as the rate of sales or

                                                                                          11
Principles of Management Control Systems


             dispatch delays, are tracked. When the sales begin to decline or there is a
             dispatch bottleneck, this information is fed forward, and the level of the
             finished goods inventory is controlled by reducing production. Thus, the
             inventory levels are prevented from exceeding required levels. Alternatively,
             the managers may realize that the original standards for sales or dispatch
             delays are no longer appropriate and must be revised. This again feeds into a
             loop, which leads to the inventory objectives or plans being updated. Process
             control can also be illustrated using the example of a salesperson’s job. The
             management may direct the salesperson to follow certain procedures for new
             market development, but may not hold the salesperson responsible for the
             extent of new business generated i.e. the end result. In such a case, process
             control has been exercised.
             Output controls
             Output control is exercised when performance standards are set and
             monitored, and the results are evaluated. Output control takes place when the




                                                                  09
             control activity is based on the comparison of actual and planned outcomes.
             Such controls are applicable when it is easy and inexpensive to measure the




                                                              20
             output and when there are few elements of uncertainty. In this type of control,
             the management expects the employee to perform in a result-oriented way, as
                                                         of
             it believes that the employee has the requisite knowledge to undertake the
                                                      s
             activities required, in a suitable manner, and to complete the assigned task
                                                   s
             without management intervention.
                                                la
                                             C


Informal Control System
                                      y
                                    nl




             These are unwritten, typically worker-initiated mechanisms that influence the
                                   O




             behavior of individuals or groups in business units. There are three types of
             informal controls. They are:
                               se




             Self-control
                            U




             It deals with the establishment of the personal objectives by the individual,
                       S
                   B




             monitoring their attainment and adjusting the behavior in the organization to
                 rI




             attain the goals. Self-control can be beneficial to an organization if the
             organization’s goals are in congruence with the individual’s goals. But if the
            Fo




             goals do not match then the performance of the employee can suffer.
             Social controls
             Social control refers to the prevailing social perspectives and patterns of
             interpersonal interactions within subgroups in the firm. In this type of control,
             an organization establishes certain standards, monitors conformity with the
             standard and takes action when deviations occur. Social control arises out of
             the internalization of values and mutual commitment towards some common
             goals.
             Cultural controls
             According to William G Ouchi, culture is “the broader values and normative
             patterns that guide worker behavior within the entire organization.” Cultural
             control can be realized by norms of social interaction, and stories, rituals and
             legends relating to the organization.
12
                                          Introduction to Management Control Systems


SUBSYSTEMS AND COMPONENTS OF MANAGEMENT CONTROL
SYSTEMS

             The subsystems and components of control systems can be discussed on the
             basis of formal and informal processes.

Formal Control Process
             The formal control process has two dimensions- formal planning and formal
             reporting.
             Formal planning process
             The formal planning process has two dimensions: strategic planning and
             operations planning. In most organizations there are two budgets- one for
             operations and one for strategy; and, there are two sets of reports - one for
             strategic projects and one for operating activities. The formal planning and




                                                                   09
             control process should support the style and culture of the organization, and




                                                              20
             should be supported by the infrastructure, the rewards, and the communication
             systems in the organization.

                                                         of
             A strategic planning system is necessary to assist the organization in the
             planning and control of projects. It helps the organization to decide its goals
                                                    s s
             and objectives, and key strategies. An operational planning system undertakes
                                                 la

             activities that are short term in nature.
                                              C


             Formal reporting process
                                       y
                                     nl




             Detailed reports help the organization to assess the progress of its strategic and
             operational planning. Monthly, quarterly or yearly reports help the
                                    O




             organization to analyze its performance periodically, and to decide on the next
                              se




             set of programs to be undertaken.
                           U




             Although planning and reporting appear to be two distinct processes, there
             should be a certain degree of integration. Strategic programs are funded out of
                        S




             current operations and grow out of current activities. Further, strategic plans
                   B




             and programs have a great impact on current operations and so, these strategic
                 rI




             plans should be adjusted from time to time in line with their effect on
            Fo




             operations.

Informal Control Process
             Management decisions are based upon experience, intuition and feeling.
             Informal control processes are formed as a result of interaction between
             people. The informal control process helps in the development of new goals
             and objectives. There are a number of mechanisms for control through
             informal systems. One mechanism is the use of ad hoc teams to solve
             problems, improve productivity and achieve organizational change. Informal
             teams usually consist of cross-organizational groups which work in
             coordination to solve problems related to a particular client, product or
             market. Informal communication systems evolve as people develop work
             relationships. Informal communication is helpful in supporting the key values
             of the organization. Fostering informal communication is critical to the
             development and maintenance of effective informal controls.
                                                                                            13
Principles of Management Control Systems


             Informal rewards and recognition are conferred upon the key team members
             within the informal system. The respect an individual is shown is an informal
             reward for performance. Communication systems are not highly guarded in
             informal systems.

SUMMARY

             The purpose of control is to ensure that an organization meets desired
             objectives and that individual members behave in a manner consistent with
             organizational objectives. In recent times, several companies have lost billions
             of dollars because the necessary controls were absent. Management control
             systems are considered essential for the successful attainment of corporate
             objectives. It is the means by which senior managers effectively and
             efficiently strive to attain company's objectives. Any control system in an
             organization has four important elements that help in synchronizing the




                                                                 09
             organization’s various activities. They are – the detector (which provides
             information about the situation), the assessor (for comparison with




                                                             20
             benchmarked standards), the effector (which tries to bridge the gap between
             the actual situation and the standard required), and finally, the communication

                                                        of
             systems (that help in passing the information between the other three
             elements). Control systems can be divided into formal and informal controls.
                                                   s s
             Formal control systems can be classified as input controls, process controls
                                                la

             and output controls. Informal control systems can be classified into self-
                                             C


             control, social control and cultural control. A clear corporate strategy,
             corporate structure, well-defined centers of responsibility, and reliable
                                      y
                                    nl




             information centers are essential for management control systems to be
             successful. A good management control system is oriented towards the future,
                                   O




             has clear objectives, and minimizes control losses. It is important to analyze
                              se




             the distinction between strategy formulation, task control and management
             control. Strategy formulation takes place at the higher level of the
                           U




             management, and task control involves the control of individual tasks.
                       S




             Management control lies at the intermediate level between the levels of
                   B




             strategy formulation and task control. It helps in the implementation of the
                 rI




             desired strategies.
            Fo




             The subsystems and components of control systems can also be divided on the
             basis of their use in formal and informal systems. Managerial style and
             organizational culture play an important role in determining which
             components are used, and whether the formal or informal processes are
             dominant.




14
Chapter 2

Approaches to Management



                                             09
Control Systems
                                         20
                                     of
                                   ss
                                la
                             C
                       y



 In this chapter we will discuss:
                     nl




 •   Cybernetic Approach to Management Control Systems
                    O
               se




 •   Contingency Approach to Management Control Systems
            U




 •   Strategy and Control Systems
        S
       B
     rI
Fo
Principles of Management Control Systems


             In the introductory chapter, we discussed the importance of controls in
             achieving organizational objectives. In addition to the amount of control, the
             appropriate mix of controls should be used to maintain the right balance in an
             organization. In this chapter, we discuss the various approaches to the
             implementation of management controls. Organizations are complex
             structures; hence, there is a need to design controls for them to function
             effectively. The cybernetic approach helps us to understand the elements and
             design of the control process in an organization. The contingency approach to
             management control systems provides a potential explanation for the
             bewildering variety of management control systems actually practiced.
             Strategies at the corporate and business unit levels have a bearing on the form
             and structure of control systems in an organization.

CYBERNETIC APPROACH TO MANAGEMENT CONTROL SYSTEMS




                                                                 09
             Cybernetics has its origin in the Greek work ‘Kybernetes’ which means
             “steersman.” A steersman is a person who directs the movement of the ship




                                                             20
             along the planned course or direction. In the 1940s, Norbert Weiner coined the
             term cybernetics. According to his definition, cybernetics is the study of “the
                                                        of
             entire field of control and communication theory, whether in the machine or
                                                     s
             the animal”. Cybernetics deals with the self-regulating principles in a variety
                                                  s
             of systems ranging from the human biological system to machine systems.
                                               la

             The human brain is a complex structure that helps in regulating the body
                                            C


             functions and helps the body perform complex activities. Organizations too
             are complex, as they are made up of different individuals. Cybernetics has
                                      y
                                    nl




             been applied in such diverse fields as radar control, animal genetics,
             inferential automation, cryptography and deciphering, automatic machine tool
                                   O




             control, language translation, teaching machines, artificial intelligence and
                              se




             robotics. Due to its broad applicability, it has been popular with general
             systems theorists as a unifying theory of self-regulation.
                            U
                       S




Characteristics of a Cybernetic System
                   B
                 rI




             The following are the characteristics of a cybernetic system:
             Fo




             Complex structures
             There are number of heterogeneous interacting components in a cybernetic
             system, making it complex.
             Mutual interaction
             The various components of a cybernetic system interact in a way that creates
             multiple interactions within and among the subsystems.
             Complementary
             In cybernetic systems multiple interactions take place as a result of multiple
             processes and structures. There are a number of subsystems which interact;
             and hence, there is a need for multiple levels of analysis which complement
             one another.
             Evolvability
             Cybernetic systems tend to evolve and grow in an opportunistic manner, rather
             than being designed and planned in an optimal manner.
16
                                           Approaches to Management Control Systems


             Constructivity
             Cybernetic systems are constructive. They increase in size and complexity by
             building on their existing characteristics and also developing new traits.

Cybernetic Paradigm and the Control Process
             The cybernetic paradigm devised by Griesinger in the late 1970s helps in
             designing the control process in an organization. The cybernetic paradigm not
             only helps in capturing the essential elements of the repetitive control process
             (refer Figure 2.1), but also does it economically. The essential elements of the
             repetitive control process are the following:
             •   Setting goals and performance measures
             •   Measuring achievement
             •   Comparing achievement with the results
             •




                                                                  09
                 Computing the variances resulting from the preceding comparison
             •   Reporting the variances




                                                              20
             •   Identifying the causes of the variation
             •
                                                           of
                 Taking the required action to eliminate the variances in the future
                                                        s
             • Follow-up to ensure that the goals are met.
                                                   s
                                                la

             All goal-oriented controls reflect the basic elements of the cybernetic
                                             C


             paradigm. The paradigm begins with the assumption that decisions are made
             because of the interaction between the decision maker and the external
                                      y
                                    nl




             environment. The manager of each business unit scans the external
             environment for data that could be useful for the organization. The
                                   O




             mechanisms through which managers collect data are called sensors. Sensors
                              se




             can collect data through formal methods like reports, or through informal
                           U




                 Figure 2.1: The Cybernetic Paradigm of the Control Process
                         S
                   B




                                                               Goals
                 rI




           Environment
             Fo




                                                   Factual
                                                   Premises         Value
                                                                    Premises

           Feedback                        Perception                  Comparator




                                                                Behavior
                                                                 Choice
                                                                                Behavioral
                                                                                Repertoire


         Source: Joseph A Maciariello and Calvin J Kirby, Management Control Systems, (USA:
         Prentice-Hall, Inc, Second edition) 42.

                                                                                             17
Principles of Management Control Systems


             methods like interactions with the members of the organization. Sensors can
             be used to collect data with regard to both the internal and external
             performance of the business unit. Based on the data collected, the manager
             builds up certain assumptions about the external environment and the present
             performance of the unit. These assumptions are a starting point for the
             analysis and are termed as ‘factual premises’. Factual premises are formed on
             the basis of perceptions, which are affected by past experiences,
             organizational goals and personal goals.
             The next step involves comparing the factual premises with the organizational
             goals and performance measures. When there is difference between the
             decision maker’s assumptions (value premises) and the assumptions made
             about the environment (factual premises), then every possible step is taken to
             bridge the gap. This is done with the help of a comparator that analyzes the
             difference between performance as measured and performance information
             desired. When there is a shortfall in performance, the decision maker searches
             for a course of action that will help to cover the shortfall; this is referred to as




                                                                    09
             behavioral choice. Choice of behavior could involve selecting a solution on
             the basis of previous experiences. In case there is more than one alternative




                                                                20
             solution to the problem, the feasible alternative with the highest subjective
             utility is chosen. In case no suitable alternative is found, the decision maker
                                                           of
             expands his search for a viable option. After an appropriate method is found to
                                                       s
             cover the shortfall, the next step is the implementation process.
                                                    s
                                                 la

             The implementation process starts with the manager (effector) acting as an
             agent for change by implementing the desired controls. After implementation,
                                               C


             the next step is to get the required feedback to determine the effects of the
                                       y




             action. This feedback helps the manager to judge whether the chosen behavior
                                     nl




             or action has helped move towards the desired performance. If the feedback is
                                    O




             positive, this action can be selected again when similar situations arise in the
             future. The feedback also helps in assessing whether the goals set are being
                               se




             achieved. If the goals are not achieved, the manager has to go through the
                            U




             whole process again. Hence all goal-oriented controls reflect the basic
             elements of a cybernetic paradigm. To achieve goals, organizations need to
                        S
                   B




             design effective individual controls for each activity.
                 rI




Designing Management Controls
            Fo




             There are many issues to keep in mind while designing controls for an
             activity:
             •   The process of establishing controls should be seen as a constructive
                 exercise that will help in enhancing the performance of the employees.
                 The standards set should be challenging, but at the same time, attainable.
             •   The objectives should be measurable to enable evaluation of performance.
             •   Controls should focus on the objectives and key results of an activity.
                 There should be a restricted number of objectives.
             •   There should not be too much focus on easily measurable factors and
                 short-run variables.     Attention should be paid to all the important
                 variables in a balanced fashion.
             •   Responsibility for results should rest with a single individual to avoid
                 duplication of work.
18
                                          Approaches to Management Control Systems


             •   To get the desired results, it is important to compare the actual
                 performance with the desired results. Comparing actual performance with
                 the desired results could be useful for setting controls for the next year.
             •   When establishing controls, the factors that could be hampering the work
                 process, such as stress, tiredness at work and absenteeism, should be
                 identified. Good feedback is an indication of the quality of the control
                 process. Early predictors, can help organizations to improve their
                 performance.
             •   It is advisable to take a sample of the variables to be controlled. This can
                 be done statistically or through observation.
             •   An acceptable range of variation for the value of each variable should be
                 established.
             •   While preparing reports there should be exceptions to desired results and
                 these should be promptly reported to the person responsible for the
                 reports.




                                                                 09
             •   The severity of the problem should be determined by analyzing the cause




                                                             20
                 of the problem and then corrective action should be taken. The results of
                 these actions have to be monitored and compared to the expected values.
             •                                          of
                 A system of controls requires judgment and insight by those establishing
                                                     s
                 them and interpreting results.
                                                   s
                                                la

Control Process Hierarchy
                                             C
                                      y



             The control process in an organization involves the relationship between the
                                    nl




             superior and the subordinates. The relationship can be termed as a means-end
                                   O




             relationship because the superior communicates the goals of the organization
             to the subordinates, who, in turn, devise strategies to achieve those ends. The
                              se




             goals of the subordinates should be congruent to the goals of the superior.
                           U




             Congruency in goals can be achieved through negotiation, and depends on the
             style of management and the communication process in the organization. The
                       S




             hierarchy of the control process can be illustrated with an example. In a
                   B




             hierarchical organization with decentralized decision-making and authority,
                 rI




             the control process begins with the superior meeting the subordinates and
            Fo




             negotiating goals, objectives and targets for the next year. After the goals are
             finalized, the performance is tracked at periodic intervals. The superior and
             subordinates review the overall performance. In areas where performance has
             been unsatisfactory, they try to find the reasons for the unsatisfactory
             performance. Once the reasons are identified, a plan of correction is prepared.
             This plan is prepared on the basis of past corrective actions and the current
             performance. Thus the targets and course of action for the next year are set.
             The same process is carried out throughout the organization. A reward system
             based upon the performance of the employees is designed. First, managers
             decide on the targets they want to give their subordinates. Next, there is
             negotiation between the superior and the subordinates with regard to the
             targets. At this stage, it can be analyzed whether the subordinates’ objectives
             are in congruence with the objectives of the superior. All the targets should be
             specific and measurable. There should be a limited number of targets, so that
             they can be managed well. The targets should cover qualitative variables

                                                                                          19
Principles of Management Control Systems


             (employee training and development, and new product development) as well
             as quantitative variables.
             To summarize, the goal-oriented control process follows the cybernetic
             paradigm and involves planning, decision-making and controls. It operates
             through a hierarchy of control, and its main purpose is the attainment of
             organizational goals and objectives.

CONTINGENCY APPROACH TO MANAGEMENT CONTROL SYSTEMS

             Contingency theory is based on the premise that the design and use of control
             systems is contingent upon the particular context of the organizational setting
             in which the controls operate. Contingency theory was propounded in
             response to the universalistic approach that argues that there is an optimal
             scheme for control design which is applicable in all settings and firms. In
             contrast, contingency theory states that the appropriateness of different control




                                                                  09
             systems depends on the business setting. Contingency approach is an




                                                              20
             extension of scientific management theory The theory also states that the
             appropriateness of different control systems depends on the setting of the

                                                         of
             business.
             The term ‘contingency’ implies that the structure and process are contingent
                                                   s  s
             on various external and internal factors. Prior to the contingency theory, the
                                                la

             classical theory developed by management scientists like Fayol, Burns and
                                             C


             Stalker, and Lussato assumed that people were motivated by economic
             rewards. It also assumed division of labor based on specialization, and the
                                      y




             delegation of routine tasks to subordinates by hierarchical superiors.
                                    nl
                                   O




             Contingency theory focuses on the interaction between the organization and
             its environment. It is assumed that the organization ‘imports’ energy and
                              se




             resources from the environment, and converts them into goods, services and
                           U




             by-products. The goods, services, and by-products are then 'exported’ to the
             environment, thus changing the environmental circumstances in which the
                       S




             organization operates.
                   B
                 rI




The Need for the Contingency Approach
            Fo




             Factors such as technology, organizational structure and the environment have
             led to the emergence of contingency formulations in control systems.

             Technology
             It has long been recognized that technology influences the design of control
             systems. New computer systems enable companies to respond to changes in
             the environment and refashion corporate policies rapidly. Revision of plans
             and estimates and new incentive programs can be worked out quickly and
             passed on to the workforce rapidly. Technology can help managers to use
             resources more effectively, and to collect data for strategic and operational
             decision-making. The increased use of technology has brought in new control
             systems that can help managers identify specific problems in administration or
             factory operations. The contingency approach is able to utilize the new
             technology very effectively in control systems.
20
                                     Approaches to Management Control Systems


Organizational structure
A modern organization’s structure should be such that it can cope with a high
degree of uncertainty, as new tasks are constantly incorporated into the
production or work process. An ‘organic1' organizational structure adapts
easily to unstable conditions in rapidly changing environments. As a business
grows, the work of the management increases, and the organization’s structure
becomes more complicated as new tasks or lines of production are added. The
management control system for such organizations is complex. The
contingency approach helps in designing a control system that meets the
demands of complex organizational structures.

Environment
In order to survive, organizations have to adapt to the demands of their
environment. Management controls in an organization are greatly influenced
by the type of competition faced by the firm. The contingency approach helps




                                                                 09
to develop a highly sophisticated control system in line with the intensity of
competition the firm faces.




                                                            20
Contingency theory greatly expanded the scope strategy and management
control. It emphasizes the “fit” between external environmental factors and the
                                                      of
internal resources of the organization. It analyzes the components of the
                                                  s
organization, its structure and cultural setting, and its ability to adapt to
                                              s
technological and structural changes.
                                           la

Fisher2 (1998) developed an approach to contingency theory and management
                                        C


control by reviewing- contingency theory, management control systems and
                               y




firm outcomes. He suggested that the assumptions that underlie contingency
                             nl




theory are too narrow. Fisher's approach focuses not only on the unique,
                            O




characteristics of control systems, but also on the environment in which some
                      se




control systems have a better fit. Fisher points out that the contingency
approach has enabled researchers to develop generalizations about control
                  U




systems relative to business and organizational settings. By studying
              S




contingency factors in different business settings, Fisher identified five
        B




contingent control variables: uncertainty; technology and interdependence;
      rI




industry, firm and unit variables; competitive strategy; and mission and
observability factors. These factors can be either external or internal to the
Fo




organization, and can affect organizational outcomes, performance, resource
allocation and distribution of rewards.
He suggested potential research areas in contingency control that include:
causal relationships of multiple variables; study of control systems in relation
to other organizational aspects; human resources policies and cultural systems.
These also included non-financial factors such as cycle time, lead time,
frequency of orders and production performance factors. The financial factors
included budgeting and standard cost systems. Fisher suggested new
directions in contingency control research that would move from financial to
operational and production control factors critical to organizational
1
    The organic organization is structured to encourage flexibility and change. The structure also
    motivates and creates a rewarding work environment.
2
    Fisher, Joseph G "Contingency theory, management control systems and firm outcomes: Past
    results and future direction." Behavioral Research in Accounting 1998 Supplement, Vol. 10,
    p47

                                                                                              21
Principles of Management Control Systems


             performance. For example, the contingency approach could be used to explain
             variations in the adoption of just-in-time and activity-based costing methods in
             different organizations.

STRATEGY AND CONTROL SYSTEMS

             According to Kenneth R Andrews, “strategy is a process by which senior
             executives evaluate company's strengths and weaknesses in light of the
             opportunities and threats present in the environment, and decide on a product
             market that fits the company's distinctive competencies with environmental
             opportunities.” Organizations usually treat strategy and control as distinct
             organizational functions. Strategies are developed first, as managers study
             their current and potential role in the environment and determine the
             appropriate response. Controls are designed to help organizations to achieve
             their goals. An organization can gain competitive advantage by integrating the




                                                                  09
             usually separate functions of strategy and control. Management control
             systems are the tools which help in the effective implementation of strategy. It




                                                              20
             is important to analyze the different kinds of strategies, as control systems can
             be designed based on the types of strategies.
                                                         of
             Strategies can be considered at two levels in an organization. There are
                                                      s
             strategies for the organization as a whole (corporate strategy) and strategies
                                                   s
             for each business unit (business unit strategy). For the formulation of
                                                la

             corporate strategy, an organization should consider the suitability of the area
                                             C


             of business for the firm, and the mission or purpose of each business unit. This
                                      y




             analysis will help the firm decide whether to divest or retain a particular
                                    nl




             business, and the amount of resources to allocate for each business. At the
                                   O




             level of the business unit, a firm has to analyze the business unit’s mission,
             and the steps it should take to accomplish the mission. Corporate strategy is a
                              se




             guide to the individual business units, helping them to function in accordance
                           U




             with the organization goals and strategies.
                       S
                   B




Corporate Strategy
                 rI




             Corporate strategy relates to the firm as a whole. Corporate strategy involves
            Fo




             making plans regarding where and how the firm can compete in an industry.
             At the level of corporate strategy, controls refer to the mechanism by which
             corporate executives influence the strategic direction of the firm and the level
             of achievement of the firm's objectives. Corporate strategy and controls should
             be integrated in order to keep employee behavior in congruence with
             managerial goals.
             An organization has a well-aligned structure, it will not function effectively
             without a control system in place. The organizational structure of a firm refers
             to its hierarchies and reporting patterns. For the effective functioning of the
             structure, appropriate control systems are needed. Since planning and control
             requirements are different for different corporate strategies, they need to be
             designed in accordance with the corporate strategies. For example, in the
             electronics business, channels of communication and transfer of competencies
             across various business units are critical for effective functioning, and
             therefore the various departments are interdependent. In such companies, the

22
                             Approaches to Management Control Systems


corporate level managers need to have wide range of control across various
departments. Managers should also have extensive knowledge about the
various departments and their work processes.
Control systems can be framed according to the class into which a company
fits. Companies can be classified into three categories: a single business firm
operating in one line of business; a firm which has undertaken diversification
into businesses that are related to one another; and, a firm which has
diversified into businesses that are not related to one another, (except in being
owned and managed by a common concern.) Corporate strategies of firms are
distinctly different in firms with different levels of diversification. Firms can
be classified into three categories based on the extent and type of
diversification undertaken by them.
Single business firm: The firm concentrates on a single business. For example,
Apple Computers pursues a single business strategy of manufacturing
computers.




                                                     09
Related diversification: The firm has diversified into businesses that are




                                                 20
related to one another and have a common set of core competencies.
Unrelated diversification: The firm operates in different areas of business

                                            of
which are unrelated to one another. The only common link between them is
that they are managed and financed by a common concern.
                                      s  s
Control systems will differ on the basis of corporate strategy with regard to
                                   la

diversification.
                                C



•   More diversification requires that the managers at the corporate level
                         y




    should have a wide range of expertise and knowledge relating to the
                       nl




    various activities of the firm. Management control in diversified firms is
                      O




    often difficult. .
                 se




•   Single business firms and firms with related diversification are based on
              U




    company-wide core competencies. Hence it is important to have good
    channels of communication that can allow interdependence among the
          S




    different units.
      B
    rI




•   In the case of undiversified firms, there is comparatively less
Fo




    interdependence among various units. As a firm becomes more
    diversified, control systems should be altered to foster better cooperation
    among the diverse units and to encourage their entrepreneurial spirit.
There are specific activities that need to be considered when designing a
control system for different corporate strategies
Strategic planning: Conglomerate businesses usually use vertical strategic
plans i.e. the different business units prepare strategic plans, which are
reviewed by the senior management. Strategic planning systems for
diversified business units are usually both horizontal and vertical. The
horizontal process involves the preparation of a plan on behalf of each unit or
group by an executive, with synergistic inputs from the different business
units of the organization. The managers of the individual business units
identify the various linkages to other business units so that they can synergize
their operations. These interdependent units also require joint strategic plans.


                                                                              23
Principles of Management Control Systems


             The strategic plans of the individual business units are often circulated among
             the various business units as this helps in getting feedback.
             Budgeting: In a single business firm, the chief executive can control the
             budgeting operations through informal methods and personal intervention. In a
             conglomerate, it is not possible to rely on informal interpersonal relationships,
             and the chief executive officer may is unlikely to be able to control all the
             budgeting activities in all the businesses. Hence, business unit managers have
             greater influence in developing their product/market environments.
             Incentives and compensation: The plan for employee incentives and
             compensation in organizations varies according to the level of diversification
             of the organization. In the case of conglomerates, bonus is usually formula-
             based. Formula-based plans are not usually popular in highly interdependent
             firms as their performance is based on the decisions and actions of other units.
             In a single business firm, bonus is determined on the basis of subjective
             factors such as the performance of the business. In the case of a business unit




                                                                  09
             manager, the bonus is tied to the performance of the particular unit rather than
             the profitability of the whole firm. In the case of single business firms and




                                                              20
             those with related diversification, the compensation is usually tied to the
             performance of the unit and also the performance of the whole firm. Linking

                                                         of
             incentives to the overall performance of the organization helps to increase
             teamwork and interdependencies.
                                                   s  s
                                                la

Business Unit Strategy
                                             C


             Diversified companies segment themselves into business units and assign
                                      y



             different strategies to different business units. Such companies do not have a
                                    nl




             standardized approach for all their business units, but develop separate
                                   O




             strategies for each business. Business unit strategy deals with creating and
             maintaining competitive advantage in all the businesses the company operates
                              se




             in. Business unit strategy for an organization has two interrelated aspects:
                           U




             mission and competitive advantage.
                         S




             Mission
                   B
                 rI




             A mission statement is a broad organizational goal, based on planning
             premises, which justifies an organization’s existence. There should be
             Fo




             congruence between the mission statement of the organization and the controls
             being used. Management control systems help the manager to make decisions
             on the trade-off between the short term and the long term. In a diversified
             business, the primary task of the CEO is to make basic decisions on the
             businesses to undertake, the resources to deploy in each, and the integration of
             the multiple businesses to make them most effective. There are various
             planning models that help managers at the corporate level to allocate resources
             among different businesses. These models of planning also help in identifying
             the missions of individual business units. The focus of all the planning
             decisions are based on certain factors:
             •   Concentrating on the internal and external factors of the business that
                 determine the attractiveness of the market opportunities available to
                 business units.


24
                              Approaches to Management Control Systems


•   The competitive ability of the business unit is likely to vary from one unit
    to another. So a firm has to emphasize on the performance of each
    business unit before allocating resources.
•   The attractiveness of the industry in which a unit is operating is likely to
    vary. Hence it has to be considered when allocating resources.
Two of the planning approaches most widely used are the Boston Consulting
Group's two-by-two growth share matrix and General Electric Company’s
three-by-three industry attractiveness-business strength matrix. While the
models differ on the methodologies adopted, they have the same set of
missions for a business unit to choose from: Build, Hold, Harvest and Divest.
The company should have a clear idea of the type of mission the business
units have chosen, as this will help in deciding on the control systems to be
used.
Build: This mission indicates that the business unit’s goal is to increase its
market share, even at the expense of short-term earnings and cash flow. A




                                                      09
business unit following this mission is typically a resource user due to the




                                                 20
heavy investment required to build a competitive position. Business units with
low market share in high growth industries typically pursue a ‘build’ mission.

                                            of
Hold: This strategic mission aims to protect the business unit's market share
and competitive position. The cash outflows, for a business unit following this
                                       s s
mission, would usually be approximately equal to cash inflows. Typically,
                                    la

businesses with high market share in high growth industries pursue a ‘hold’
                                 C


mission.
                          y



Harvest: This mission has the goal of maximizing short-term earnings and
                        nl




cash flow, even at the expense of market share. A business unit following such
                       O




a mission would be a resource provider in that it generates more cash than that
required for further investment. Typically, businesses with high market share
                 se




in low growth industries pursue a ‘harvest’ mission.
              U




Divest: This strategic mission indicates a decision to withdraw from the
           S




business either through a process of slow liquidation or outright sale.
      B




Typically, business units with low market share in low growth industries are
    rI




divested.
Fo




The missions discussed above should not be used in a mechanistic manner.
They have to be combined with creativity, innovation and initiative by the
managers for effective control systems.
Thus while framing control systems a manager has to be aware of the mission
adopted by each of its business units. The form and structure of a control
system affects business units with different missions. Strategic planning,
budgeting, and the incentive/compensation system are the main aspects
determining the form and structure of the control system.
Strategic planning process: Strategic planning needs to be designed keeping
in mind the environment in which the company operates. In an environment
where there are greater uncertainties, strategic planning assumes more
importance. For this reason, the process of strategic planning is more critical
for 'build' business units than for ‘harvest’ business units. A ‘build’ mission is
usually undertaken in the growth stage of the product life cycle, and the

                                                                               25
Principles of Management Control Systems


             objective of the ‘build’ mission is to increase the market share. Increasing a
             company’s market share involves uncertainty, particularly with regard to
             competitors, for ‘build’ units.
             Budgeting: Budgeting involves deciding on the allocation of resources and
             targets of each business unit. Budget revisions are more likely in the case of
             ‘build’ units than for ‘harvest’ units because of frequent changes in the market
             environment of ‘build’ units. 'Build' managers, however, usually have greater
             influence on the formulation of budgets, and other important management
             decisions. For ‘harvest’ units, the environment is usually stable, and so inputs
             from managers of ‘harvest’ units are less essential.
             Incentive compensation system: When several elements enter into the design
             of an incentive compensation system for business units. Managers have to
             decide on the size of incentive bonus payments, the measures of performance
             to be considered for incentive bonuses ( sales volume, product development,
             return on investment etc.), the criteria on the basis of which subjective




                                                                   09
             judgments are to be made, the frequency of incentive payments (annual,
             monthly, biennial), etc. The mission of the business unit influences the type of




                                                              20
             incentive package formulated. In many firms, the completion of riskier
             projects is rewarded by higher compensation. Managers in ‘build’ units are

                                                         of
             therefore likely to have higher incentive payments than managers in ‘harvest’
             units. Performance may be measured either over the short term or the long
                                                   s  s
             term. If a firm links incentives to performance in terms of profits, cash flows
                                                la

             and returns on investment, it is said to have a short-term focus, whereas if it
                                             C


             links incentives to performance in terms of market share, new product
             development and development of human resources, it is said to have a long-
                                      y
                                    nl




             term focus.
                                   O




             Competitive advantage of a business unit
                              se




             In order to accomplish its mission, every business unit should develop a
                           U




             competitive advantage. In order to identify its competitive advantage, a
             business unit should analyze the competitive structure of the industry in which
                       S




             it plans to operate. Porter’s Five Forces Model analyzes the competitive
                   B




             structure of an industry on the basis of the following factors:
                 rI




             •   Intensity of rivalry among the existing players
            Fo




             •   Bargaining power of the buyers
             •   Bargaining power of the suppliers
             •   Threat from substitutes
             • Threat of new entrants
             An understanding of these factors, can help a business unit to frame generic
             strategies through which it can respond to the opportunities in the external
             environment. Alternative generic strategies may be developed in terms of:
             Low Cost: The primary focus of this strategy is to achieve low cost relative to
             competitors. Cost leadership can be achieved through economies of scale in
             production, learning curve effects, tight cost control and cost minimization in
             areas such as research and development, service, sales force, or advertising.
             Differentiation: The goal of this strategy is to differentiate the product of the
             business unit, in order to create a product that is perceived by customers as
26
                                         Approaches to Management Control Systems


          unique. Differentiation may be based on brand loyalty, customer service,
          dealer network, product design and features, and product technology.
          Focus: This strategy requires the business unit to focus on a particular buyer
          group, segment of the product line, or geographic market. The focus strategy
          helps the unit to achieve core competency by narrowing its market segment.
          Additional considerations: Although a firm should adopt different controls for
          its units, there are some problems associated with this strategy. The external
          environment of a business unit changes over time and shifts in strategy may be
          required. If a control system is over-committed to a single strategy or level of
          diversification, it may become difficult for the manager to shift to a new
          strategy.
          Secondly, the control system should be appropriate for both the mission and
          the competitive advantage of the firm. Trying to design a control system that
          fits both may result in conflict. In such situations, the manager has to decide
          whether to give priority to the firm’s mission or to its competitive advantage.




                                                                 09
                                                             20
SUMMARY


                                                        of
          The cybernetic approach to management control systems helps in analyzing
                                                    s
          complex activities in an organization. The cybernetic paradigm helps to
                                                 s
          manage the repetitive control process in an organization. Contingency theory
                                              la

          was propounded in response to the universalistic approach that argues that
                                            C


          there is an optimal scheme for control design, which applies in all settings and
                                    y



          firms. Changes in technology, organizational structure and the need to adapt to
                                  nl




          the environment of the industry have contributed to the emergence of
                                 O




          contingency formulations in control systems. Management control systems are
          tools that help in effective implementation of strategy. Hence, it is important
                            se




          to understand the types of strategies firms use in respect of diversification and
                         U




          how control systems can be devised for each strategy. Strategies can be
          considered at two levels: the corporate level and the level of the business unit.
                     S




          Corporate strategy relates to the whole organization and involves decisions on
                B




          where to compete and how to compete. Strategies at the corporate level can be
              rI




          differentiated on the basis of the level of diversification undertaken by the
          Fo




          firm i.e., whether it is a single business firm, a firm with related diversification
          or a firm with unrelated diversification. Business unit strategies deal with
          creating and maintaining competitive advantage in all the areas of business in
          which the company operates. Business unit strategy has two interrelated
          aspects: mission and competitive advantage. The business unit’s mission
          could be: to build, to hold, to harvest or to divest; while it can develop its
          competitive advantage in terms of low cost, differentiation or focus.




                                                                                           27
Chapter 3




                                              09
Designing Management
                                           20
                                     of
Control Systems
                                   ss
                                la
                             C
                      y
                    nl




 In this chapter we will discuss:
                   O




 • Steps in Designing MCS
              se




 • Factors Influencing the Design of MCS
           U




 • Establishing a Customer Focused Total Quality Culture
        S
    B




 • Impact of Information Technology on Control Systems design
  rI
Fo
                                            Designing Management Control Systems

          A management control system is a set of interrelated communication
          structures that facilitate processing of information and coordination between
          different parts of an organization. Control systems help in the effective
          implementation of an organization’s strategy. The subsystems and
          components of management control systems should be mutually supportive so
          that organizational goals can be achieved. When the subsystems are properly
          designed, they provide a basis for an organizational control system. The
          control systems should be designed in such a way that they reflect the goals
          and strategies of the organization. It is also important to design control
          systems in such a way that they contribute to the effective implementation of
          the organization's strategies. This chapter deals with the steps involved in
          designing control systems, factors that influence the design of management
          control systems, the relationship between the style, culture and design of
          control systems, establishing a customer-focussed total quality culture and the
          impact of information technology on control systems design.




                                                              09
STEPS IN DESIGNING MCS




                                                          20
                                                     of
          Designing control systems requires an understanding of what the organization
          wants from each employee individually. This involves identifying the role of
                                                  s
          each individual from the chief executive officer to each employee at the
                                                s
                                             la

          lowest organizational level in achieving organizational goals. MCS cannot be
          designed without an understanding of the key actions being controlled. Since
                                          C


          the purpose of a control system is to influence actions, identifying the desired
                                   y




          actions is important. An organization must find out what knowledge and
                                 nl




          information it requires to control employees’ actions. Another way to
                                O




          understand what has to be controlled is to identify the key actions (KAs). KAs
                           se




          differ from firm to firm, and from individual to individual. For lower level
          employees, such as the production line workers, KAs are easy to identify,
                        U




          because they are routinized and mechanical. KAs of higher level employees
                    S




          which involve identification of problems, team building and making
                B




          investment decisions may not be easily understood as they need professional
              rI




          judgment. It is not easy to judge whether the actions taken are appropriate
          without close monitoring done by someone who has equal or higher
         Fo




          professional knowledge. Most companies have standard sets of actions for
          employees who prepare investment proposals, business plans, and give
          justifications for recruitment decisions. These are called action controls.
          Role demands can also be identified through the Key Results (KRs). Key
          results are the areas which are important for the growth of an organization.
          Examples are sales performance, customer orders received etc., Key results
          change according to the prevailing internal and external environment of an
          organization.
          The step that follows the understanding of role demands involves
          understanding the likely actions or results of the role demands. If the analysis
          shows that what is desired is not different from what is likely, then it can be
          concluded that the company has an effective management control system. If
          the analysis shows a difference between the two, then the reasons would have
          to be investigated. The reason may be lack of direction, motivational problems

                                                                                       29
Principles of Management Control Systems


             or personal limitations. Depending on the severity of the situation, different
             controls should be applied.

Choice of Controls
             The choice of controls depends on the severity of the problem. Control
             mechanisms can be selected from feasible alternatives (that would provide the
             maximum benefits). While analyzing these alternatives, managers should first
             consider personal or cultural control, as these have very few consequences and
             are less costly to implement. Usually in small organizations, most problems
             are solved by implementing cultural and personal controls. However, these
             controls work only when employees have clearly defined roles, understand
             their goals and expected performance levels. Choices among the various
             actions and results control depend on the advantages and disadvantages each
             control has in a particular setting.
             Action controls




                                                                  09
             These are controls that work on the standard sets of procedures. The




                                                             20
             advantages of action controls are:
             •   They are directly linked to the task being performed.
             •                                           of
                 They direct managerial attention towards the actions being taken within
                                                     s
                 the firm.
                                                   s
                                                la

             •   Their application in an organization is uniform in nature and hence they
                                             C


                 aid in organizational coordination.
                                      y



             •   Since these controls work on a standard set of actions, they act as a
                                    nl




                 knowledge repository and guide the implementation process even when
                                   O




                 key managers leave the organization.
                               se




             •  In a positive sense, these controls are means for attaining efficiency, as
                they are a key element in the bureaucratic form of organization.
                           U




             These controls also have their own disadvantages:
                       S




             •   Action controls are useful only for highly routinized jobs.
                   B
                 rI




             •   This type of control does not foster creativity and innovation among
                 employees, as employees have to follow rigid rules.
             Fo




             •   Since these controls do not encourage creativity, employees tend to quit
                 their jobs.
             •   Because of the rigidity of rules, companies have difficulty in adapting to
                 the changing external business environment.
             Result controls
             These are used to control the behavior of employees. These are effective in
             addressing motivational problems. They inform employees about what is
             expected of them and what they should do in order to produce the desired
             results. Results control can be established by first defining the dimensions on
             which the control has to be set. The dimensions could be either customer
             satisfaction or product profitability. The next step involves measuring
             performance based on these dimensions. Setting performance targets and
             providing adequate incentives to encourage employees to perform effectively
             is the final step. The advantages of results control are the following:
30
                                                Designing Management Control Systems

             •   These controls are feasible, and provide effective control even where
                 knowledge as to what actions are desirable is lacking.
             •   Result control provides on-the-job training and also provides employees
                 an opportunity to learn from their mistakes.
             •  Result control results in motivating employees, and commitment towards
                the job as it gives employees greater autonomy to perform their task.
             The disadvantages of result controls are these:
             •   Often the controllable results that the organization desires and the
                 performance of the individual cannot be measured effectively.
             •   Any problem that arises as a result of this control is attributed to the
                 employee’s mistake.
             Result controls and action controls are the major elements of management
             control systems in all organizations. After the choice of controls the next
             decision relates to the tightness of controls.




                                                                  09
Tightness of Controls




                                                              20
             Whether the control should be tight or loose depends on how the organization

                                                         of
             perceives the following issues-the benefits of tight controls, the costs incurred
             due to tight controls, and the side effects of tight controls, if any. Some
                                                   s  s
             organizations prefer tight control in areas that are most critical to their
                                                la

             success. Some forms of tight controls are costly to implement, require a
                                             C


             significant amount of the top management's time, and requires new
             information systems, measuring equipment or extensive studies to gather
                                      y
                                    nl




             useful information. All these may add to organization's expenditure. Finally, it
             is necessary to know whether there are any harmful effects of the control
                                   O




             being used. For example, if the environment in which the employees are
                              se




             working is unpredictable, then tight controls will not work, as employees need
             autonomy to take actions. As tight controls limit adaptability, employees will
                           U




             find it difficult to adjust to changing environment.
                        S




             The best control method would be a combination of tight and loose controls -
                   B




             an environment where autonomy, entrepreneurship and innovation are
                 rI




             encouraged, and, at the same time, employees share a set of rigid values.
             Fo




FACTORS INFLUENCING THE DESIGN OF MCS

             The design of control systems is influenced by a number of factors:
             managerial style, corporate culture, organization structure, organizational
             slack, stakeholders’ control and communication structures.
             Management style and corporate culture play an important role in designing
             the control system. While management style is related to the individual
             manager's whereas corporate culture relates to the overall organizational
             concept. In fact management style and corporate culture are related to one
             another. The style of a manager influences the style of other managers in the
             organization and upon the culture of an organization. Culture consists of
             shared values and norms of the organization and this influences the prevailing
             style of the management. Hence management style and culture are
             intertwined.
                                                                                           31
Principles of Management Control Systems


Managerial Styles and the Design of Control Systems
               Managers differ in their styles of managing employees. The different styles
               have an impact on the design of the control systems. If the control systems are
               not designed with the managerial style in mind, then conflicts might arise
               between organizational goals and managerial styles. The different managerial
               styles that influence the design of control systems are external control, internal
               control and mixed control.
               External control
               External control works on the premise that subordinates can be motivated
               through rewards. This style is authoritative and mechanical as the
               organizational goals are set by the top management. Exhibit 3.1 shows the
               prominence of external control style in ITT. The style also establishes that to
               achieve the goals it is necessary to




                                                                     09
               •   Set difficult goals so that the employees need to stretch themselves.




                                                                20
               •   Form strict regulations so that employees are not able to manipulate their
                   tasks.
               •                                            of
                   Embed adequate incentives in the performance assessment systems, so
                                                        s
                   that employees are motivated to perform.
                                                      s
                                                   la

               This type of control has its advantages and disadvantages. On the positive
                                                C


               side
                                         y




                                             Exhibit 3.1
                                       nl




                                  External Control Style at ITT
                                      O




     Harold Geneen, manager with ITT, adapted an external control style during his tenure as
                                se




     a manager. He was accessible to his subordinates and developed a controller
                             U




     organization. The line managers were supervised by a large staff. Whenever problems
     arose, task forces were set-up to solve the problems. The movement of inventory,
                          S




     payables and receivables were checked by the corporate controller. Geneen developed a
                     B




     control system for ITT with the following characteristics.
                   rI




     • Infrastructure - a highly refined formal system of goals and controls
              Fo




     • Rewards - Bonuses were used to motivate the employees for better performance.
         Bonuses were 30% or more of salary. Managers were paid 12% more than the
         market rate. This resulted in intense competition among employees.
     • Communication and integration - Geneen spent the equivalent of three months per
         year in meetings to solve problems. These meetings helped the employees to build a
         cordial relationship among themselves and with their boss.
     • Control process - A control process was used in order to assist managers to submit
         their report to the top managers found the environment too tensed up to develop and
         succeed. Further, his style did not encourage innovation.
     Geneen’s style was not free of problems. There were some significant costs associated
     with this style. The managers found the environment too tensed up to develop and
     succeed. Further, his style did not encourage innovation.
     Adapted from Joseph A. Maciariello and Calvin J. Kirby, Management Control Systems (New
     Jersey: Prentice Hall Inc., 1994).

32
                                             Designing Management Control Systems

           •   Subordinates may be motivated to perform, as rewards are directly linked
               to performance.
           •  Because of high control executed by the top management, superior will be
              able to monitor subordinates work and there would be no manipulations.
           The disadvantages of this type of control are:
           •   Employees will not have any commitment towards the organization. They
               will perform only to obtain rewards and benefits.
           •   Employees will concentrate only on one aspect of their job and ignore the
               rest. An employee may concentrate on increasing the sales volume, and
               ignore customer service.
           •   Only the positive outcomes of a particular task would be informed to the
               higher authorities. The negative information about it will be withheld,
               fearing deduction in incentives.
           •   Employees will invest all of their potential in their area of work and




                                                               09
               ignore other aspects that are important for the well-being of an




                                                           20
               organization as a whole.
           Internal control

                                                      of
           This style works on the premise that subordinates will be motivated and
                                                   s
           committed to the organization if they are involved in the decision making
                                                 s
           process. United Airlines has achieved success by adopting this style (refer
                                              la

           exhibit 3.2). The style assumes that employees will experience a sense of
                                           C


           achievement, recognition and self-esteem if they are involved in the decision-
                                    y



           making process. The following are strategies that are important to implement
                                  nl




           internal control style:
                                 O




                                     Exhibit 3.2
                              se




                        Internal Control Style at United Airlines
                         U




Ed Carlson, former CEO of United Airlines, used the internal control style. His style
                      S




led to the design of a control system with the following characteristics.
                 B




•   Infrastructure- Personal participation was encouraged. Carlson placed his
               rI




    confidence in the trustworthiness and motives of managers. He developed profit
           Fo




    centers only after extensive consultation. Small staff was employed and task forces
    were used to solve problems.
•   Rewards - Bonuses were paid in relation to performance against plan.
•   Communication and Integration - Carlson emphasized teamwork in problem
    solving. He used the concept of personal communication extensively in order to
    knit the organization together.
•   Control process - Reports were focused on people. Commitments started at the
    lower level of the hierarchical structure. Managers were held responsible for their
    commitments. Carlson's style too was not free from problems. It was extremely
    difficult to implement the participative style in an organization as big as United
    Airlines.
Adapted from Joseph A. Maciariello and Calvin J. Kirby, Management Control Systems (New
Jersey: Prentice Hall Inc., 1994).


                                                                                          33
Principles of Management Control Systems


             •   The management style should be participatory in nature as the employees
                 are involved in the process of decision making. The emphasis here is not
                 so much on achieving the goals, but on how well they are set.
             •   Strategies are designed to solve problems jointly, and not to blame a
                 particular individual for its occurrence. When an employee's performance
                 moves in an undesired direction, the subordinates and managers meet to
                 identify the reasons for this and to develop appropriate solutions to the
                 problem. Thus this system works in a positive direction to analyze
                 problems at an early stage.
             •  Rewards in this system are not based on one or two specific measures of
                performance, but on accountability of the overall performance. This
                management style does not punish an employee for his past actions, but
                intends to improve his performance in the future.
             The advantages of the internal control style are the following:
             •   It inspires high levels of commitment and motivation in the employees.




                                                                  09
                 Since the employees also take part in the decision-making process they are




                                                              20
                 more focussed on achieving the targets.
             •   This type of control encourages accountability towards the work and an

                                                         of
                 open work atmosphere. Employees are free to give their feedback on
                                                      s
                 managerial decisions.
                                                   s
             This style has certain disadvantages too. They are:
                                                la


             •
                                             C


                 It exercises loose control within the organization. In this situation
                 managers will have less control over their subordinates.
                                      y
                                    nl




             •   The information provided in this control is basically meant for identifying
                                   O




                 the problems and suggesting corrective action. Hence it does not work as
                 an evaluation tool for rewarding employees.
                              se




             •   Employees, who are not willing to participate in this kind of management
                           U




                 may not perform well.
                       S




             Mixed control
                   B
                 rI




             The two types of control discussed above have their own advantages and
             disadvantages. Hence a manager has to carefully analyze the benefits of each
            Fo




             style and carefully choose the style that would be most beneficial for the
             organization. The characteristics of mixed control style of Litton industries are
             shown in exhibit 3.3. Sometimes a manager has to balance both types of
             control styles in the organization. In doing so, he has to consider four
             important issues. They are:
             Congruency between control and managerial style: In order to choose the type
             of control to be adopted for the organization, a manager has to first analyze his
             style of management. If his style is participatory in nature, than internal
             control would be a better. If it is authoritative, then adopting the internal
             control style would not work, as the subordinates may not be used to putting
             forward their views during the decision-making. They may not be in a position
             to set realistic goals. Hence, there is a need for congruency between the
             managerial style and the control style.
             Analyzing the climate, structure and reward system of the organization: All
             these factors determine employee behavior. For example, if employees are
34
                                            Designing Management Control Systems


                                      Exhibit 3.3
                        Mixed Control Style at Litton Industries
Roy Ash, co-founder and president of Litton industries, made use of the mixed control
style. His style consisted of the following characteristics:
•   Infrastructure - For a diversified organization like Litton, the appropriate approach
    to decision making and problem solving should be that of an analytical type. Roy
    Ash used the same approach. He chose people who possessed strong analytical
    powers and strategic skills.
•   Rewards – Roy Ash selected only the best people and made sure that they were
    given their dues they deserved.
•   Communication & integration - Roy Ash arranged numerous small meetings in
    order to communicate with people more frequently.
•   Control process - Though the financial plan at Litton was presented yearly, it was




                                                              09
    updated monthly and quarterly. Performance reports against plan and cash flow
    statements were prepared weekly. The numerical reports were fewer in number.




                                                          20
Adapted from Joseph A. Maciariello and Calvin J. Kirby, Management Control Systems (New
Jersey: Prentice Hall Inc., 1994) .
                                                     of
                                                    s
         used to a participatory work environment, and the organization adopts a tight
                                                s
                                             la

         control system, then there will be no congruence of goals.
                                          C


         Reliability of job performance measures: In some organizations control
         systems clearly indicate the performance measures that have to be
                                   y
                                 nl




         implemented in the organization. But some control styles do not indicate the
                                O




         performance of the employees clearly. For example, an external control
         system cannot be implemented if employee's performance is not measured
                          se




         precisely. This requires loose and more internally oriented organizational
                        U




         control.
                    S




         Individual differences among subordinates: It is usually assumed that a
               B




         manager has a clear understanding of the nature of all the employees and their
             rI




         needs. Some employees may be willing to take part in the decision-making
         Fo




         process while others may not be interested in it. A manager should consider all
         these factors while finalizing his choice of control system for the organization.
         It may be difficult for a manager to consider all the factors discussed above.
         Therefore, the manager should sequentially prioritize his decisions.
         •   Firstly, a manager needs to question himself about the managerial style he
             uses, the strategy of the organization, the accuracy and reliability of the
             performance measures and the willingness of the subordinates to
             participate in the decision-making process.
         •   The best way for a manager to choose the most appropriate control style is
             to use the decision tree approach.
         •   Also, a manager should consider the trade-off for different styles that can
             be applied to a particular situation. This trade-off has to be prepared by
             weighing the desirable and undesirable effects that a control system can
             have on some subordinates.
                                                                                       35
Principles of Management Control Systems


             Just as an organizational strategy is important for the implementation of
             organizational plans, a control system and the way it is implemented play an
             important role in making an organization and its employees more productive.
             Management control is the process by which an organization ensures that its
             sub-units act in a coordinated and cooperative fashion so that more resources
             could be obtained and optimally allocated in order to achieve the
             organization's goals. Corporate culture consists of shared values, common
             perceptions and common premises that the members of an organization use to
             achieve goals. Organizational culture influences several basic premises of an
             organization and, hence, has a major influence on the organizational goals.
             Thus, while designing management control systems, the heads of an
             organization should take its culture into consideration. Bureaucracies, markets
             and clans are three types of corporate control mechanisms that exist in varying
             degrees in different organizations. Bureaucracies follow strict formal rules,
             procedures and directives. It has clearly defined roles for each member of the
             organization. The most important component of a market-based approach is




                                                                 09
             creating incentives to motivate performance. In the case of the clan control




                                                             20
             mechanism, the organization depends on values and beliefs to boost
             performance. Values and beliefs are conveyed to the employees at all levels,

                                                         of
             initially through recruitment and socialization process and subsequently
             through training and development.
                                                  s  s
                                               la

Corporate Culture and Design of Control Systems
                                              C


             Corporate culture helps in the overall coordination of all the activities of an
                                       y



             organization. In an organization when the goals and values are shared by the
                                     nl




             individual members, problems are minimized and a sense of group loyalty
                                    O




             prevails. For example, IBM has designed the following belief system for its
             employees.
                              se




             •   Respect for the individual
                           U




             •   Customer service
                       S
                   B




             •   Dedication to work towards excellence
                 rI




             •   Decentralized business
            Fo




             •   Total quality management
             •   Empowerment of people
             Employees should also be rewarded appropriately for understanding and
             implementing the suggestions proposed by the management and achieving
             new goals. Sometimes, as a result of resistance from the leader certain changes
             are prevented from being implemented. In such cases, it is better to change the
             leader. After the change has been implemented, it is important to extend it on
             to other sub-systems of the control system.
             Impact of corporate culture upon control system
             Culture becomes an important asset of an organization when it is properly
             imbibed in an organization. Conversely, it is a liability when it adapts poorly
             to the environmental needs of the organization. The strength of culture
             depends on the following three factors:

36
                                               Designing Management Control Systems

             •   The assumptions made by the organization

             •   The clarity of the assumptions and

             •   How well they are shared within the organization.

             A control system must be so designed that it fits the existing culture of the
             organization. This can be done by stressing on the values that the management
             wants its employees to follow and rewarding them for achieving goals based
             on these values. In order to foster desirable values in an organization, the
             subsystems and components of its formal control systems should be so
             changed as to inculcate these values.

Decentralization and Design of Control Systems
             It is necessary for every organization to decentralize the decision-making
             authority, so that sub-goals can be set. In this way, every decision-maker is




                                                                 09
             made responsible only for a small portion of the overall organizational




                                                             20
             objective. Decentralization ensures that the decision-maker arrives at the right
             decision by making use of sufficient information. However, decision-makers

                                                        of
             should find ways to deal with the complexity in the organizational
             environment even when the information available to them is limited.
                                                   s  s
             The purpose of a control system is to knit the subunits of an organization
                                                la

             together. Without a centralized control system, it would be difficult to bring
                                             C


             this about. There what is important for an organization is not whether it should
                                      y



             be decentralized or not, but to what extent it should be decentralized.
                                    nl
                                   O




Organizational Slack and Design of Control Systems
                              se




             Cyert and March define organizational slack as “the disparity between the
             resources available to the organization and the payments required to maintain
                           U




             the coalition.” Organizational slack occurs when an organization under-
                       S




             exploits its environment. This under exploitation results in higher salaries,
                   B




             wages and perquisites than necessary to carry out the goals and objectives of
                 rI




             the firm. Dividends may be higher than necessary to maintain the confidence
             Fo




             of shareholders. But, in terms of management control systems, slack acts as a
             cushion against changing the business environment and provides resources for
             innovation and adaptation in various areas.

Stakeholder Controls and Design of Control Systems
             The stakeholders of an organization include investors, customers, employees,
             suppliers and the public. It is necessary for the organization to determine the
             goals and objectives, performance measures of each of the above categories. A
             functional organizational structure is designed keeping these goals in view and
             then managerial controls are designed for departments of the organization.
             Based on the relationships and the goals, organizations exercise control over
             stakeholders. The analysis of stakeholder relationships begins with identifying
             all the stakeholders. The next step is to distinguish the most important
             stakeholders. This group consists of stakeholders who are highly influential,
             powerful insofar as the organization's decision-making process is concerned.

                                                                                          37
Principles of Management Control Systems


             The next step is the analysis of the inducements that can be offered to the
             stakeholders. Inducements can include material rewards, power, distinction
             and participation in the activities of the organization. Next, the contribution
             for a particular stakeholder has to be analyzed. Contributions include capital,
             revenue, performance and community support. Finally, the competition for a
             particular stakeholder is analyzed. All these steps help the company in
             identifying crucial stakeholder variables that help in monitoring and
             influencing the control process.

Communication Structures and Control Process
             The formal and informal communication within an organization include
             meetings, day-to-day contacts among managers, body language etc. All these
             formal and informal communication are crucial in understanding and
             improving the control process. Let us discuss how communication structures
             support control process with the help of information systems.




                                                                 09
             The first element of the information system is a formal or informal process,
             which scans the environment in which an organizational subunit operates.




                                                             20
             After this the organization requires a planning process. The planning stage is
             the most crucial of all, as it involves four sub-processes namely strategic

                                                        of
             planning, business planning, long range planning and operations planning. All
                                                     s
             these processes would remain incomplete without proper communication
                                                  s
             across various levels of the organizational hierarchy. Feedback is necessary
                                               la

             after the completion of each stage (environmental scanning, planning). The
                                             C


             feedback is compiled in the form of a report. This is followed by decision-
             making procedures and implementing them.
                                      y
                                    nl
                                   O




ESTABLISHING A CUSTOMER-FOCUSED TOTAL QUALITY CULTURE
                              se




             Organizations in the present-day competitive environment need to concentrate
                           U




             on customer satisfaction. In markets that offer a number of options to buyers,
                       S




             companies can place themselves in an advantageous position by concentrating
                   B




             on customer-focused total quality culture. While, on one hand, organizations
                 rI




             have to respond to the needs of the customer, on the other hand, they have to
            Fo




             increase their efficiency to compete with others in the business. Total quality
             management ensures that organizations attain the required levels of efficiency
             targets as well as satisfy customers. Thus, TQM can be described as a system
             that emphasizes customer satisfaction and commitment to continual
             improvement of its services and products to meet the needs of existing and
             potential customers, through empowerment and active involvement of all the
             staff.
             Control is an integral part of any business. Lack of structured and formal
             quality assurance and control training adversely affects the progress of the
             quality improvement program.
             TQM follows a cybernetic paradigm in solving problems:
             •   First, the top management makes (clear to the rest of the employees) the
                 key philosophical principles of TQM.

38
                                                        Designing Management Control Systems

            •     The top management then sets up a company wide quality improvement
                  program. This program consists of a quality improvement team which is
                  formed according to the mission and targets of the organization. The main
                  task of the team is to communicate the various philosophies and charter
                  subunit teams in a hierarchical fashion.
            •     The next step involves each team coming up with ideas about products
                  and services that need to be launched. It also involves covering
                  manufacturing products according to the expectations of the consumers.

Implementing Total Quality Management
            Implementing TQM is a long process. It may take as many as seven years to
            complete the process. It is the responsibility of the top management to
            implement TQM. The top management should search for expert trainers and
            organize TQM training programs for the different teams within the
            organization. The teams should be encouraged to work towards the




                                                                              09
            improvement of TQM objectives. This encouragement may assume the form




                                                                         20
            of rewards and recognition given to the employees for good work. Middle
            management should ensure that the environment needed for the

                                                                   of
            implementation of TQM is easily susceptible to changes and continuous
            improvement. Figure 3.1 shows the importance of formal and informal
                                                               s
            systems necessary to support a TQM program. The subsystems and
                                                           s
            components of a control system should be so designed as to help a TQM
                                                        la

            program achieve customer satisfaction.
                                                     C
                                            y
                                          nl




IMPACT OF INFORMATION TECHNOLOGY ON CONTROL SYSTEMS
                                         O




DESIGN
                                  se




            Information technology has benefitted traditional control systems1 in many
                               U




            ways.
                          S




            •     Data can be managed more easily, and at a reasonable cost.
                    B




            •
                  rI




                  The various departments of the organization can work towards achieving
                  the organization's goals and collaborate for fast decision-making.
            Fo




            • Data can be collected for strategic and operating decisions.
            With the help of the new spreadsheet technology, the budgeting process of a
            company can be speeded up, and the quality of the budgets can be improved.
            New technology also ensures that managers update the budgets. Data
            architectures2 help companies adapt to regulatory or other environmental
            changes.
            In production facilities, information technology is increasingly being used for
            speeding up the control process. Prior to the advent of information technology,
            any faults in the production process could not be detected until there was some

            1
                William J Burns, Jr. and F. Warren McFarlan “Information technology puts power in control
                systems” Harvard Business Review, Sep/Oct87, Vol. 65 Issue 5, p 89.
            2
                Data architecture gives the desirable features of the corporate database, such as an integrated,
                well-formed business view, while overcoming the practical difficulties like customer, order,
                sales, etc. and the systems in which they appear.

                                                                                                             39
Principles of Management Control Systems


                      Figure 3.1: Management Systems for Total Quality

             INFRASTRUCTURE                                     STYLE & CULTURE
            • SBUs                                             • Style
            • Problem solving teams                            • Participative/teamwork
                                                               • Values
            • Responsibility for
                                                               • Strong customer focus
              quality distributed
                                                               • Continuous
              throughout                                         improvement
            • Staff support for                                • Innovation as a value
              quality methodology                              • Trust




                                      CONTROL PROCESS
                                  • Statistical quality control




                                                                       09
                                  • Informal active planning




                                                               20
                                  • Competitive benchmarking
                                  • Activity-based costing
                                  •
                                  •
                                    Target costing
                                                          of
                                                       s
                                    Other performance measures
                                                    s
                                  • Customer satisfaction
                                                 la

                                    measures
                                              C


                                  • Vendor measurements
                                  • Cost of quality measurements
                                         y
                                       nl
                                      O
                               se




                  REWARDS                                           COORDINATION
                            U




            • Based on quality                                     AND INTEGRATION
                        S




              performance
                                                                   •   Training in TQM
                    B




            • Recognition programs
                                                                   •   Problem solving tools
                  rI




            • Consistent throughout
                                                                   •   Employee involvement
             Fo




              organization
                                                                   •   Open and candid
            • Skepticism tolerated
                                                                       communication
            • Cynicism rejected


        Source: Joseph A. Maciariello and Calvin J. Kirby, Management Control Systems (New
        Jersey: Prentice Hall Inc., 1994) 136.

             major breakdown. But with the new technologies even a slight change can be
             detected. Information technology can also help a company align its control
             and sales-incentive measures. New inventory tracking systems can help
             companies update account balances, monitor inventory and alert
             manufacturers and suppliers for upcoming requirements.
             As control systems operate all the areas of an organization, any change in
             them requires changes to be made in the overall structures and strategies of the
             organization. Therefore, managers should take the right decisions in choosing
40
                                               Designing Management Control Systems

             what type of technology requirements the organization needs. Technology
             should be used for making work easier rather than indulging in complex and
             expensive systems such as costly data, storage systems.

Providing Information for Operational and Strategic Decision Making
             The decline in the cost of information processing led to the rise of ABC
             (activity based costing) systems. These systems provide accurate cost data for
             the operational and strategic decisions in an organization. The availability of
             an electronic equipment, called the optical scanning equipment, has improved
             the efficiency of inventory control techniques. This equipment is also used to
             conduct market research by noting customers’ demand patterns.

SUMMARY




                                                                 09
             Designing control systems require an understanding of what the organization
             wants from each of its employees. This involves identifying the role of each




                                                             20
             individual from the chief executive officer to the employees at the lowest
             hierarchical level in achieving organizational goals. While designing a control

                                                        of
             system, it is necessary that the managerial style and the culture of the
             organization should be clearly analyzed. There are three types of managerial
                                                  s  s
             control systems namely external control, internal control and mixed control.
                                               la

             External control is authoritative and mechanical, as the organizational goals
                                             C


             are set by the top management. This style works on the premise that
             subordinates will be motivated and committed to the organization if they are
                                      y
                                    nl




             involved in all aspects of decision making. In the case of the mixed control
             style, the manager analyzes the benefits of each style and carefully chooses
                                   O




             the one that would benefit the organization the most. The control process
                              se




             includes the essential elements of planning, decision-making and control.
                           U




             Decentralization ensures that the decision-maker arrives at right decision with
             the help of sufficient information. Organization slack occurs when the
                       S




             organization under exploits its resources. In such cases, the organization
                   B




             incurs extra costs in all its functional operations.
                 rI
            Fo




             Stakeholders are the essence of an organization and it is the duty of every
             organization to identify key stakeholders variables and monitor their
             performance. The designer of a control system designer should make use of
             communication structures to coordinate various activities of the organization.
             TQM ensures customer satisfaction and commitment to the continual
             improvement of the organization’s services and products to meet the needs of
             existing and potential customers, through empowerment and active
             involvement of the staff. Subsystems and components of control systems
             should be designed to assist TQM in achieving customer satisfaction. New
             technology has benefitted control systems in a number of ways by helping
             companies manage data easily.




                                                                                         41
Chapter 4




                                               09
Key Success Variables as
                                           20
                                           of
Control Indicators
                                     ss
                                   la
                                C
                        y
                      nl




In this chapter we will discuss:
                     O




•   Concept of Key Variables
               se




•   Identifying Key Variables
             U




•   Key Success Variables and the Control Paradigm
         S




•   Comprehensive Performance Indicators
      B




•   Key Variables in Selected Industries
    rI
Fo
                                      Key Success Variables as Control Indicators


         A key variable is a significant indicator of business activity, whose sudden
         and unpredictable change warrants immediate action by management. Key
         variables are also referred to as key success factors as they help in explaining
         the success or failure of the organization. A small change in a key variable
         will have a significant impact on the performance of the organization. The
         nature of the task, the technology and the environment in which the
         organization operates are the factors which greatly influence the identification
         of key variables. An important function of key variables is that they indicate to
         the management the necessity for prompt action. A manager should identify a
         few variables that are crucial to the attainment of strategy, goals and
         objectives of an organization. Once they have been identified, the manager
         can rely on these key variables to monitor business activities and alert the
         organization to the changes in the business environment that could
         significantly affect the attainment of management goals. The top management
         should analyze the reasons for significant changes in key variables
         continually. Some examples of key variables are profitability, market position,




                                                              09
         productivity and employee attitude. This chapter looks at the importance of
         key variables for organizations, the identification of key variables, and the




                                                          20
         types of key variables.

CONCEPT OF KEY VARIABLES                             of
                                               s  s
                                            la

         A key variable is a significant indicator of business activity. Any change in its
                                         C


         value is expected to have an impact on the performance of the organization. It
                                  y



         is the responsibility of every organization to identify key variables as they are
                                nl




         indicators as to the likely success or failure of the business. The nature of key
                               O




         variables differs from organization to organization depending on the nature of
         the task, the technology and the environment of the organization. Key
                          se




         variables have certain characteristics that help the manager to identify them.
                       U




         However, the actual selection of key variables requires a thorough
         understanding of the business, its operating environment and management
                   S




         goals. The management can identify key variables either for the whole
               B




         organization or for the major centers of responsibility. Although key variables
             rI




         differ from business to business, they have certain characteristics in common:
         Fo




         •   They are important in explaining the success or failure of the business
             unit. A key variable can be identified by analyzing those strategic factors
             which directly influence the attainment of management goals. The
             questions to be asked are: “What is the organization trying to achieve, and
             what factors will cause the organization to achieve or not achieve these
             goals?”
         •   Key variables require examination and in-depth evaluation. At the stage of
             in-depth evaluation, the manager has to make a subjective judgment as to
             whether each factor identified is important in explaining the success or
             failure of attaining management goals. Sometimes it may be necessary to
             reassess the factors that affect the attainment of goals. For example, a
             hospital may be particularly concerned about the quality of its services.
             Factors measuring the number of patients seen by the clinic staff per hour
             may indicate the staff is over- or under-utilized, but would provide no

                                                                                       43
Principles of Management Control Systems


                                                 Exhibit 4.1
                                         Identifying Key Variables
          •       Identifying strategic factors influencing the managerial goal
          •       Accept or reject the above factors
          •       In-depth examination of each factor
          •       Select measurable factors or replace the factors that are not measurable
          •       Identifying factors that are volatile
          •       Identifying the predictable variables
          •       The final step is determining whether appropriate management action is
                  taking place when significant change occurs in a key variable

          Source: ICFAI Center for Management Research.




                                                                       09
                     information on the quality of the services provided. A more appropriate




                                                                  20
                     factor may be the number of appointment cancellations.
              •      They must be measurable, either directly or via a surrogate or substitute.
                                                               of
                     For example, client satisfaction for a non-profit counseling center cannot
                                                          s
                     be measured directly, but a surrogate such as number of follow-up
                                                        s
                     appointments or cancellations, can be selected as a key variable.
                                                     la


              •      Key variables are volatile; they can change rapidly for reasons often
                                                  C



                     beyond the control of the manager.
                                           y
                                         nl




              •      Changes in key variables are not easily predictable. The choice of key
                                        O




                     variables requires the manager to make a subjective judgment. A long and
                     exacting test to determine the volatility of each factor is not necessary, but
                                  se




                     the factors selected for further consideration as key variables should be
                               U




                     more volatile than those rejected.
                            S




              •      Management action is required when a significant change occurs in any
                       B




                     key variable. The manager should select as many key variables as required
                     rI




                     to run the business, possibly two or three, but no more than six. If too
              Fo




                     many key variables are selected, the significance of each one is
                     diminished.
              •      Predictable variables are of little use as key variables. Obviously, if an
                     event can be predicted with a degree of certainty, then appropriate
                     management action can easily be taken. Thus, a variable that tells the
                     management something already known or readily predictable is of little
                     value.


IDENTIFYING KEY VARIABLES

              The most common method of identifying key variables is the input-through-
              output model. The input variables are related to raw material, the throughput
              variables to production, processing and manufacturing, and the output
              variables to marketing.

44
                                          Key Success Variables as Control Indicators


             A generalized list of key variables is given below. However, every
             organization will have to identify the key variables relevant to it for itself.

Input Variables
             Key input variables could include the following:
             Raw material availability
             This is an important key variable; its absence leads to lower capacity
             utilization. Organizations find it difficult to recover their fixed costs, when
             raw materials are not readily available. Inability to procure raw material may
             even lead to the closure of the organization.
             Raw material quality
             The quality of the raw material is critical for the quality of the end product,
             and for the profitability of the firm. The quality of raw materials is tested
             through simple sampling techniques. As payment for a product is made on the




                                                                 09
             basis of quality, the maintenance of quality becomes crucial.




                                                             20
             Raw material costs

                                                        of
             The management needs to keep a close watch on raw material costs,
             particularly when they constitute a large percentage of the total cost.
                                                   s s
                                                la

Production Variables
                                             C


             The key variables related to production are:
                                       y
                                     nl




             Capacity utilization
                                    O




             Capacity utilization is an important variable and is affected by either
             marketing variables or procurement variables. For example, in the dairy
                               se




             industry, capacity utilization is affected by milk products sold or by milk
                           U




             procured. Capacity utilization reflects the ability of the production staff to
             schedule and plan what to produce, how much to produce and when to
                       S




             produce. In service-oriented organizations, it is necessary to decide on the
                    B




             appropriate measures to indicate the utilization of resources. For example, in
                  rI




             movie theaters and hotels, percentage of occupancy is an indicator of capacity
            Fo




             utilization.
             Losses
             Another key variable related to production is the percentage of spoilage and
             wastage in process of manufacturing the product. In manufacturing industries,
             the management should monitor the yield percentage closely.
             Quality control
             The quality of the product is important for all organizations. Most
             organizations aim at a zero-defect state. It is necessary to identify the
             measures of quality. The number of complaints from customers and the
             quantity of goods returned are usually good indicators of quality.
             Maintenance
             Maintenance of equipment is crucial to ensure smooth production and better
             capacity utilization. Maintenance can be categorized as preventive
                                                                                         45
Principles of Management Control Systems


             maintenance and breakdown maintenance. The number and percentage of
             productive hours lost due to maintenance may be selected as a key variable.
             Costs
             It is essential to control costs as they have a significant impact on profits.
             Appropriate measures indicating the impact of costs should be developed.
             Delivery
             Timely delivery is critically important in certain situations. Delays in delivery
             systems need managerial attention. For example, the production department of
             a dairy industry has to ensure that the distribution department gets the milk on
             time.

Marketing Variables
             Marketing variables are of crucial importance in a competitive economy.




                                                                  09
             Some important marketing variables are:




                                                              20
             Order book position

                                                         of
             The order book position is important for organizations that undertake
                                                      s
             manufacturing based on orders. It helps the marketing department to decide
                                                   s
             the planning schedules for marketing and distribution.
                                                la
                                             C


             Market share
                                      y



             The market share of a company indicates its performance and its competitive
                                    nl




             strength. This variable helps the company to monitor its performance.
                                   O




             Institutional sales
                              se




             If institutional sales comprise a significant part of total sales, the number of
                           U




             orders received from institutional buyers is a key variable. A decline in
                        S




             institutional sales is a signal of trouble in the marketing area.
                   B
                 rI




Asset Management Variables
            Fo




             The management of fixed and current assets is important for an organization.
             Asset turnover
             The asset turnover denotes the relationship between the total assets in an
             organization and sales volume. A decrease in asset turnover is not a good sign
             for the organization and needs immediate managerial attention.
             Working capital turnover
             The efficiency of management of working capital is indicated by the working
             capital turnover. The inventory turnover and accounts receivables turnover can
             also help in the analysis of working capital. A low inventory turnover
             indicates building up of inventory – an indication that something is seriously
             wrong in inventory management.


46
                                               Key Success Variables as Control Indicators


Sources of Key Variables
             Key variables arise on the basis of:
             Industry characteristics
             In a given industry, there are certain general requirements for success, which
             apply to all the firms. In the insurance industry, for example, the basic
             requirement for the success of a firm is a positive investment performance.
             Similarly, in the hotel industry, the occupancy rate is the criterion for success.
             Environmental factors
             The economic and the political climate are the major environmental factors
             which determine key variables. For example, publishers who depend on the
             postal services are affected by postal rates.
             Competitive strategy




                                                                         09
             The strategy that a company adopts usually determines the variables that must
             be monitored and emphasized. An organization that follows a low-cost




                                                                    20
             strategy will require an analysis of the product cost structure.


                                                               of
             Stakeholders
             Aspects of the business that are important to key stakeholders, namely
                                                         s s
             customers, executives, suppliers or creditors, may also be considered as key
                                                      la

             variables.
                                                   C


             Significant functions
                                           y
                                         nl




             In an organization with a function-based structure, every manager can identify
             one or a few key variables related to the function of the unit. A key variable
                                        O




             for an operations manager, for example, is the quality of goods produced.
                                  se




Types of Key Variables
                               U
                           S




             Key variables can be classified broadly into the following categories: strategy,
                      B




             structural, process and environmental. According to a framework prepared by
                    rI




             Samuel Paul1 there is a positive relationship between the key variables and the
            Fo




             organizational performance. Performance of an organization improves if there
             is congruence between the different variables.
             Strategy variables refer to the long-term choices concerning the programs,
             goals, policies, and action plans that are formulated by an organization. The
             structural variables can be studied in terms of the structure of the organization:
             centralized or decentralized form of organization, and the organizational
             autonomy. Structural variables thus represent the organizational arrangements
             and the distribution of authority and relationships. Process variables refer to
             the processes that influence the behavior of the employees towards the
             achievement or organizational goals. Some examples of process variables are
             the participation, monitoring and control, human resource development, and
             motivation. Environmental variables help in understanding the scope, diversity
             and uncertainty relating to an organization. For example, scope in terms of
             marketing refers to the area that is being covered by the organization. The
             1
                 Samuel Paul, Managing Development Programmes: Westview Press, Colorado, 1982, p. 104
                                                                                                    47
Principles of Management Control Systems


             scope of the environment also depends on whether the firm is well diversified
             or deals in a single commodity. In the case of the former, the scope is broader
             as the interaction between the organization and the environment is complex.
             When all these variables are perfectly aligned then an organization can
             achieve congruence of its performance with its goals.

KEY SUCCESS VARIABLES AND THE CONTROL PARADIGM

             The control system should be designed to fit in with the hierarchical structure
             of an organization. Control experts should weigh the pros and cons of
             different organizational structures. Through decentralization, the management
             gives autonomy to the managers of the various units of the organization.
             Responsibility centers are set up to coordinate and control various activities.
             Each responsibility center has its own goals and strategies. The control
             system designers should design the control systems in a way that helps




                                                                   09
             managers to achieve their unit’s goals without conflicting with the overall
             organizational goals. This can be understood more clearly by analyzing the




                                                              20
             dynamics of the control process.

Dynamics of the Control Process
                                                         of
                                                    s s
             After identifying the key success variables of a firm, it is important to examine
                                                 la

             the dynamics of the control system. A control system has two sets of dynamic
                                              C


             interactions: reinforcing interactions and balancing interactions. The
             interactions can be seen as cause and effect relationships in organizations.
                                       y
                                     nl




             They are usually circular i.e. the last reaction links back to the initial action,
             and are called causal loops. As an example, let us consider three employees
                                    O




             A, B and C. If A expresses confidence in B’s performance at work, he shows
                              se




             trust and respect for B. This motivates B to perform even more effectively
             towards the achievement of the organization’s goals. B’s performance is then
                           U




             noticed by C. If C commends B’s performance to A, it is a positive
                        S




             reinforcement and is called a reinforcing causal loop. Causal loops may also
                   B




             be negative, as will happen if there is reduction in trust between A, B and C.
                 rI




             This also results in a reinforcing circle but in a downward direction.
            Fo




             According to systems theory, a change in one variable causes changes in the
             secondary variables. For example, if A expresses lack of trust in B, this would
             be a reinforcing feedback in the downward direction. But if C has a positive
             opinion of B’s performance and commends his work to A, this checks the
             downward spiral and acts as a balancing force. The feedback of C with regard
             to B is a secondary effect. The above example indicates the importance of
             secondary effects. When one subsystem or element is changed in an
             organization, there are influences on a number of other subsystems. These are
             called secondary effects. When a reinforcing process is set into motion, it too
             has secondary effects that may slow down the process of the work. Delays in
             the control process may occur for the following reasons:
             •   When the management overreacts to a problem.
             •   When the management is faced with a complex problem that it is unable
                 to solve, the gap between performance and expectations is reduced. This
                 results in a lower level of performance that can delay the work process.
48
                              Key Success Variables as Control Indicators


 •   A dominant team member can block informal planning efforts by bringing
     in his own solution to a new problem to be solved. This may increase the
     time taken for planning and further delay the whole process.
 The above dynamic control problems can be minimized by creating an
 organization which “learns” – the type of organization termed as an adaptive
 organization by Senge and Kirby. An organization that is open to new ideas
 and encourages employee creativity and continuous learning can be termed as
 a “learning” or adaptive organization. A participative management style
 supports a learning organization.
 The dynamics of controlling a management team
 A newly formed team must develop a shared vision for its goals or objectives.
 It must also assess the current situation in terms of vision. The team must
 gather information to understand the current situation and then take
 appropriate action. By implementing decisions and getting feedback, members
 work on common goals and strategies that are aligned with the needs and




                                                     09
 vision of the organization.




                                                 20
 A study undertaken by Kirby shows that a reinforcing system of informal
 activities enables successful teams to achieve their goals. The key findings of
 the study are:
                                            of
                                      s  s
                                   la

 Table 4.1 Key Variables Used in Certain Industries
                                 C


 Industry                         Key Variable
                          y




 Accounting firm                  Billed hours/Available hours
                        nl




 Airline                          Paid seats/Capacity seats
                       O




                                  Fuel cost/Miles flown
                      se




 College                          Acceptance/Offers made
                 U




 Counseling center                Number of appointments
            S
       B




                                  Number of cancellations
     rI




 Electrical utility               KWH sold
Fo




 Health clinic                    Customer contacts per day
 Hospital                         Beds occupied/Available beds
 Leasing company                  Number of transactions
 Magazine                         Renewals/ Subscription expired
 Professional organization        Meeting attendance/Total members
 Restaurant                       Labor     cost/Revenue,        Raw      food
                                  cost/Revenue
 Retail store                     Gross margin by departments
 Telephone company                Access minutes of use
Source: Henry Wichmann. Jr et al “key variables as a management tool,” CMA
Magazine, March 1990, p23.


                                                                             49
Principles of Management Control Systems


             •   Successful teams have a culture of trust and openness.
             •   The leaders of successful teams develop certain preconceived premises
                 about the best way to perform any given action.
             •   The group has a shared vision about the objectives to be achieved, and
                 uses free interchange of ideas to promote better ways of achieving the
                 targets.
             •   Further, this sharing of ideas leads to improvement in performance and
                 creates an environment that increases team learning. Providing the right
                 feedback also increases the level of trust and openness in the teams.

             This level of trust and openness reduces the gap between current performance
             and the goals of the team members. This is referred to as “creative tension”.
             When employees are able to perform effectively in order to fill the
             performance gaps, the situation is said to be one of “creative tension”.




                                                                 09
             Sometimes team members are unable to achieve the organizational goals
             because of distractions on account of their ambiguous roles. This referred to as




                                                             20
             “emotional tension”. The matrix structure usually has this role ambiguity
             because of the competing and often ambiguous instructions given to program
                                                          of
             participants by program and functional managers. The way in which teams
                                                     s
             respond to such ambiguous situations separates the excellent from mediocre
                                                    s
             teams.
                                                 la
                                             C


Identifying Key Variables – An Example
                                      y
                                    nl




             Roger Hall identified five key variables for a publishing company:
                                   O




             •   The annual subscription rate.
                              se




             •   The advertising rates of the publisher
                           U




             •   The annual expenditure incurred for the promotion of subscriptions (i.e.
                 advertising the magazine).
                       S
                   B




             •   Annual expenditure for the promotion of the magazine.
                 rI




             •   The size of the magazine i.e. number of pages per issue.
            Fo




             Hall found four critical relationships in the interaction between a magazine
             publishing firm and the environment. The first relationship specified the
             demand for advertising pages as a function of the price or rate charged
             advertisers per thousand of paid circulation. Hall found a negative relationship
             between advertisement page sales and price. The second relationship was
             related to the demand for regular subscription. The demand for regular
             subscription was related to the number of trial subscriptions and regular
             subscriptions that were expiring which created a potential for renewal, the size
             of the magazine, and the rate charged to annual subscribers. The third
             relationship was concerned with the sales of trial subscriptions. This was a
             function of promotional expenditure and magazine size. The fourth
             relationship related to the total cost of producing the magazine. This was a
             function of the size of the magazine i.e. number of pages delivered to the
             readers.

50
                                             Key Success Variables as Control Indicators


              Implications for the control structure
              Important parameters on which the control structure is to be based include:
              •     Efficiency and effectiveness
              •     Economies of scale
              •     Coordination
              •     Assignment of responsibility for profit
              For an effective control system, a divisional structure with departments
              divided on the basis of function, is preferred. In a publishing firm, the
              divisional structure depicted in Figure 4.1 may be adopted. For a publishing
              firm, the quality of editing is crucial. The editor, thus, has a significant
              influence on the quality variable, as well as on the long-term future of the
              business. The control structure put in place depends to a great extent on the
              divisional structure of an organization. Each success factor is assigned as a
              goal for a specific responsibility center. Thus, all the responsibility centers




                                                                     09
              together contribute to the achievement of all the goals of the firm.




                                                                20
                                                              of
                      Figure 4.1: Organization Chart for a Magazine Firm
                                                      s  s
                                             Publisher
                                                   la
                                                C
                                         y
                                       nl




                              Circulation     Distribution      Production        Advertising
                                      O




           Editor
                               manager         manager           manager           manager
                                 se
                              U




  Source: Joseph A. Maciariello and Calvin J. Kirby, Management Control Systems (New Jersey: Prentice
                          S




  Hall Inc., 1994) 87.
                      B
                    rI




              The hierarchical structure of an organization makes it possible to process all
              Fo




              the information pertaining to key success factors in order to make business
              decisions. Through decentralization, the management gives a degree of
              autonomy in decision making to subordinates.
              The designers of the control system establish critical success factors that help
              managers achieve the goals of their sub-units. Each unit and sub-unit of the
              hierarchical structure should coordinate and control the various key success
              factors in pursuit of the overall goals of the firm.

COMPREHENSIVE PERFORMANCE INDICATORS

              Every organization needs to identify the variables that influence its success at
              each level so that it can monitor and predict the values of key variables. The
              main idea of monitoring the performance of key variables at each level of the
              organization is to push them to the desired level and, if that is not possible, to

                                                                                                51
Principles of Management Control Systems


             react to the performance of the key variables so as to compensate
             appropriately. Key variables should be identified at each level and for each
             responsibility center of the organization.
             The measurement of key variables is not free from problems. One danger is
             that of concentrating on the variables that are easy to measure. Variables
             which are difficult to measure but which are important to the achievement of
             long-term goals are often ignored. For example, firms often emphasize short-
             run profits and encourage managers to produce good ‘numbers’ (production in
             term of quantity), regardless of the long-term effects on the business. This
             results in the reduction of expenses on research & development, maintenance,
             and employee development which may not affect the performance in the
             short-run, but play a significant role in the accomplishment of long-term
             goals.
             A number of precautions have to be taken with regard to the measurement of
             performance in any responsibility center. First, the variables that are measured




                                                                  09
             should correspond with the goals and objectives of the organization. Second,
             only those variables that are crucial should be measured, and they should be




                                                             20
             measured even if they are qualitative. Key success factors should not be
             omitted from the control system because they are qualitative. Third, the

                                                        of
             measurement of the factors should be developed in such a way that the
             measures taken in the short term take account of both short-term objectives
                                                   s s
             and long-term goals.
                                                la

             The process for measurement of key performance variables can be observed
                                             C


             by looking at the case of General Electric. General Electric divided the task of
                                      y



             measuring key success factors in the company into three sub-projects which
                                    nl




             involved developing performance measures for each of the company’s
                                   O




             departments. The exercise focused on:
                               se




             •   Measuring the whole department as an economic entity.
             •
                           U




                 Measuring the functional departments such as marketing, finance etc.
             •
                       S




                 Measuring the performance of the management of the departments.
                   B




             On the basis of the above measures, the principles for the control program at
                 rI




             GE were formulated. The principles focused on providing:
            Fo




             •   Factual knowledge to support judgment in the performance appraisal of
                 departments.
             •   Performance information for both short-run as well as long-term goals.
             •   The minimum number of measures for use at each level of the
                 organization.
             GE developed the following performance measures for each of its
             departments:
             1) Short-term profitability
             2) Market share
             3) Productivity
             4) Product leadership
             5) Personnel development

52
                                           Key Success Variables as Control Indicators


              6) Employee attitude
              7) Public responsibility
              8) Balance between short-range objectives and long-range goals

Limitations of Indicators
              Indicators are used to understand an organization’s current state of affairs and
              for initiating corrective action. However, there has to be consensus on what
              the indicator really means and conveys.
              Performance indicators have the following limitations:
              (a) The absence of consensus among managers on the use of indicators
              (b) Problems encountered during the measurement of indicators
              (c) Lack of clear specification of the unit of measurement
              (d) Lack of consistent information leading to incorrect conclusions.




                                                                  09
              These limitations can be overcome by developing systematic and scientific




                                                              20
              methods to improve the quality of the data on which decision-making is based.

KEY VARIABLES IN SELECTED INDUSTRIES                       of
                                                      s
                                                      s
                                                   la

              Given below are important critical variables in various industries. They
                                              C


              illustrate how key variables or key success factors play an important role in
              day-to-day operations.
                                       y
                                     nl




Insurance Industry
                                    O
                               se




              •   Number of claims settled in a given period of time and number of claims
                  outstanding
                            U




              •   Number of policies processed in a given period of time
                        S
                    B




              •   Growth rate in insurance business with respect to each policy
                  rI




Hotel Industry
             Fo




              •   Room occupancy rate
              •   Number of complaints by customers
              •   Amount of food wasted in the restaurant
              •   Percentage of revenue contributed by the restaurant
              •   Percentage of absenteeism among employees

Sugar Industry
              •   Price of sugar sold in the open market
              •   Transport cost per ton of cane
              •   Fuel cost per kilogram of sugar


                                                                                           53
Principles of Management Control Systems


             •   Number of production days lost
             •   Support price by government

Management Training Institute
             •   Number of students appearing for an entrance examination
             •   Percentage of absenteeism among students
             •   Number of research projects undertaken and completed
             •   Time spent by faculty on teaching and research
             •   Time spent on management development programs

Power Industry
             The inputs for a power industry are coal and water. The output variables
             include transmission losses. The key variables include the following:




                                                                   09
             •   Quantity and quality of coal




                                                              20
             •   Availability of wagons for transportation of coal


                                                         of
             •   Availability of water
             •   Capacity utilization
                                                    s s
             •   Preventive and breakdown maintenance
                                                 la
                                              C



SUMMARY
                                       y
                                     nl




             Key variables are those variables to which the goals, strategies and objectives
                                    O




             of the management are most sensitive. Every organization should identify the
             key factors which are important for its success.
                              se




             The most common method of identifying key variables is the input-through-
                           U




             output model. The input variables are related to raw materials and other
                        S




             inputs, the throughput variables to production, processing, manufacturing, and
                   B




             the output variables to marketing. Key variables arise on the basis of: industry
                 rI




             characteristics, competitive strategy, environmental factors, stakeholders and
            Fo




             significant functions. The nature of key variables varies from organization to
             organization depending upon the nature of the task, the technology used, and
             the environment in which the organization operates. Key variables can be
             classified broadly as strategy, structural, process and environmental. The
             control system should be designed to fit in with the hierarchical structure
             established by an organization. Control experts should weigh the pros and
             cons of having different organizational structures. Through decentralization,
             the management gives autonomy and empowers the managers of the various
             units. Responsibility centers are set up by firms to coordinate and control
             various activities.
             Every organization needs to identify the variables that influence its success at
             each level so that it can monitor and predict the values of key variables. This
             is done with the help of performance indicators. The main purpose of
             monitoring the performance of key variables at each level of the organization
             is to direct them towards the desired levels, and if that is not possible, to take
             appropriate compensatory action.
54
                      09
                      20
                of
                s
           PART II:
               s
            la
           C


     MANAGEMENT CONTROL
            y




        ENVIRONMENT
          nl
         O
      se
     U
     S
  B
rI
Fo
Chapter 5




                                                  09
Organizing for Adaptive
                                             20
                                          of
Control
                                    s  s
                                 la
                              C
                       y
                     nl




 In this chapter we will discuss:
                    O




 •   Strategy, Structure and Control
               se




 •   Decentralization Vs Centralization
            U




 •    Response of Structure to Strategy: Evolution of the Matrix
      Structure
        S
    B




 •   Evaluation of the Control Factors in Organizational Design
  rI




 •   Controller’s Organization
Fo




 •   Adaptive Organization.
Principles of Management Control Systems


             For effective implementation of organizational goals, it is necessary to design
             the elements of control system infrastructure (such as organization structure,
             responsibility centers, rewards and performance measures) which are mutually
             supportive and adaptive. An organizational structure should be designed in
             such a way that it facilitates information processing and communications.
             In this chapter, we will discuss the infrastructural aspects important for an
             organizational design. We will also discuss the influence of strategy on
             organizational structure and control requirements; the evolution of
             multidivisional structures in response to the changes in control requirements;
             the importance and organization of the controller's function and the
             characteristics of an adaptive organization.

STRATEGY, STRUCTURE AND CONTROL

             With the rapid changes in business environment, organizations have adopted




                                                                 09
             multidivisional structures. Multidivisional structures are decentralized




                                                             20
             structures where the divisional managers have a fair degree of autonomy in
             decision making and are held accountable for the functioning of the firm in

                                                        of
             terms of profits achieved or assets utilized. Decentralized multidivisional
             structures improve the managers’ ability to evaluate the performance of
                                                     s
             enterprises.
                                                   s
                                                la
                                             C


DECENTRALIZATION VS CENTRALIZATION
                                      y
                                    nl




             As organizations grow in size, decentralization of operations becomes a
                                   O




             critical requirement. Decentralization in the broadest sense means delegation
                              se




             of authority to the lowest feasible level of decision making within a
             framework of predetermined responsibilities and clearly set goals. The
                           U




             advantages of organizational decentralization are:
                       S




             •   As analysis of trade-offs among cost, revenue and investment involves
                   B




                 lower levels of management, information processing becomes simpler.
                 rI




             •   It allows closer control and supervision of subordinates within the
            Fo




                 division.
             •   Since managers are empowered to take decisions, they are motivated to
                 perform better keeping in mind the goals and strategies of the
                 organization.
             •   It helps evaluate overall performance of the various organizational units of
                 the business.
             •   It also ensures that managers are given right environment and autonomy,
                 wherein they are trained to make the right decisions.
             One factor which affects decentralization to a large extent is the development
             of control techniques. A manager cannot delegate authority without having
             some way of knowing whether it will be used properly or not. Improvements
             in statistical devices, use of accounting controls and computers have helped
             managers to develop better control.

58
                                                    Organizing for Adaptive Control

         This type of organizational structure should be used only when the company is
         in a position to support functional groups on a continuous basis. Companies
         managing projects for shorter durations cannot have a decentralized structure
         as this structure best works when the project is large enough to support on a
         permanent basis that can achieve technical excellence and economies of scale.
         However, short duration projects also require the excellence and scale
         economies of the functional organization and coordination and control of the
         decentralized organization.
         Coordination and control problems in a decentralized organization can be
         achieved, if the management has projects that are large enough to support a
         permanent functional organization and at the same time allow for economies
         of scale in the functional organization. This structure will work to achieve the
         coordination and control required to complete the project and also keep in
         view the technical excellence and scale economies of the functional
         organization. In some organizations, decentralization is sometimes associated
         with dysfunctional performance which results in incremental costs. If the




                                                              09
         incremental benefits are more than costs involved, the organization maintains




                                                         20
         a decentralized structure. But if the incremental costs exceed the incremental
         benefits, the organization reverts to a centralized structure.

                                                    of
         Centralization pertains to geographic concentration or it may refer to
         concentration of specialized activities, generally in one department.
                                               s s
         Centralization restricts the delegation of decision-making authority. In a
                                            la

         centralized structure, the overall decision-making power is vested with the top
                                         C


         management. When there are few homogenous markets, it is easier to plan,
         administer and coordinate functional departmental activities, and hence
                                  y
                                nl




         greater the advantage of centralization.
                               O




RESPONSE OF STRUCTURE TO STRATEGY: EVOLUTION OF THE
                          se




MATRIX STRUCTURE
                       U
                   S




         The matrix structure fulfils the requirements for control and functional
               B




         excellence required in organizations. A matrix organizational form is a mixed
             rI




         organizational form in which normal hierarchy is “overlayed” by some form
         Fo




         of lateral authority, influence or communication. There are two chains of
         command, one along functional lines and other along project lines. The matrix
         structure evolved in response to needs of organizations that pursue high
         technology projects, provide complex products and services and have
         operations in different countries. Organizations pursuing high technology
         products need to maintain a high degree of technical excellence in multiple
         disciplines. This can be possible only by having an organizational structure
         that has a high degree of technical excellence in multiple disciplines. This
         requires high division of labor and specialization. To utilize each speciality
         fully, there must be a number of projects where the specialized talents can be
         employed. Thus, a company will be managing multiple projects
         simultaneously. The coordination and control cannot be achieved with the
         functional organizational structure. The incremental benefits of a matrix
         organization are motivation and coordination. The matrix is an example for a
         structural change following strategy to improve control.

                                                                                      59
Principles of Management Control Systems


             The matrix organization helps avoid coordination problems that arise during
             the handling of complex programs. This is because the matrix structure places
             total responsibility in the hands of the manager whose task is to devise plans
             and coordinate and integrate the activities of the organization. This helps
             maintain a balance among performance, cost and time variables.
             In the matrix structure, managers not only achieve the goals and objectives of
             the project, but also share the resources economically among the various
             departments for the achievement of the goals and objectives. The matrix form
             of organization may be appropriate when many interactions between the
             functions are necessary or desirable. The matrix organization is extensively
             being used in the management of the defense projects and projects that require
             complex activities.
             The form an organization chooses depends on its costs and benefits, economic
             and control factors. Control systems help calculate the net benefits of each of
             the three designs (decentralized, centralized and matrix) on a qualitative basis




                                                                  09
             and adopt the best one. The design that is selected should promote
             communication, cooperation, teamwork, motivation and performance.




                                                              20
Project Organizations
                                                         of
             There are short-term as well as long-term benefits for each project. They vary
                                                      s
             according to the time, cost and quality. Hence cost, quality and schedule are
                                                   s
                                                la

             the key variables for any project. A matrix structure helps an organization to
             achieve agreed upon performance with respect to cost, quality and time
                                             C


             variables. The matrix structure for a project organization can be explained
                                      y




             with the help of a matrix (refer exhibit 5.1). The various functions are
                                    nl




             represented in rows and the programs undertaken are represented in columns.
                                   O




             The total functional output for any period of time is found in the last column.
                              se




             It also lists contributions of each function. In most organizations, the outputs
             are identified in the columns of the matrix and the inputs are identified in the
                           U




             rows of the matrix (refer exhibit 5.1). Though the product manager assumes
                        S




             responsibility for the delivery of the product in a matrix structure, he does not
                   B




             have a direct control over the functional organizations. Generally, in
                 rI




             organizations there are two separate authorities to set goals and direct the
            Fo




             work necessary to achieve the goals i.e. knowledge based authority and
             resource based authority. This sometimes leads to confusion as there is no
             unity of command. This problem can be resolved to a great extent in a matrix
             organization where in practice there is a formal and informal relationship
             among program and functional which leads to distribution of authority and
             responsibility.

Product Organizations
             For developing complex products, organizations require closer coordination
             among the various functional departments. Product managers are responsible
             for the planning and coordination of the functional efforts required to
             introduce new products, modify existing products and make changes to the
             advertising programs of any existing products (refer exhibit 5.2). The matrix
             structure allows for such coordination. The matrix structure can also be used
             for the introducing new products as well as monitoring ongoing projects. It
60
                                                           Organizing for Adaptive Control


                                             Exhibit 5.1
                              The Structure of a Matrix Organization
           Program Functions       Program 1      Program 2     Program 3         Total
                                                                               functional
                                                                                 output
          Engineering
          Procurement
          Quality Assurance
          Manufacturing
          Program Management
          Total Program
          Requirements




                                                                   09
          Source: Joseph A. Maciariello and Calvin J. Kirby, Management Control Systems (New




                                                               20
          Jersey: Prentice Hall Inc., 1994) 151.


                                                           of
              can be applied to a product based organization when an organization has too
              many products to manage, when the products require coordination among
                                                    s s
              specialized disciplines, and when the market size is too small to justify
                                                 la

              separate divisions for each product. The application of the matrix structure
                                              C


              and the control process for the management of products is known as product
              control system. The matrix structure in a product organization enables
                                       y




              economies of scale in each discipline and also provides total management of
                                     nl




              each product. This ensures high level of efficiency and coordination.
                                    O
                               se




Service Organizations
                            U




              Service organizations require employees who are highly skilled in a number of
                        S




              areas. The services offered require close cooperation among the various units.
                    B




              Thus, the structure should be designed in such a way that it leads to
                  rI




              cooperation and better control of various activities. The matrix structure may
              be appropriate for service organizations.
             Fo




              The application of matrix structure in a service organization can be best
              illustrated by taking an example of the tourism industry. In the tourism
              industry, business agencies and communities can define their overall
              objectives and monitor their progress. The objectives should provide guidance
              for all decisions including finance, personnel and marketing. The success of
              the tourism industry depends on creating an atmosphere where in employees
              can provide good customer service. This requires close coordination between
              the various departments like hospitality and guest relations, quality control,
              personnel selling, customer service etc. Customers can also be served best by
              providing information through local offices. The matrix structure can be very
              useful for meeting the desired needs of customers and in providing
              coordination between the various departments of the organization. As in
              product management, the functional groups can provide each local office with
              information and resources. These local offices should have resources and


                                                                                            61
Principles of Management Control Systems


                                         Exhibit 5.2
                              Product Matrix Organization

                                           General
                                           Manager

                                                       Controller
                         Treasurer
                                                        Other Staff



  Market      Product      Advertising     Sales       Manager of     Production   Personnel
 Research     Research
                            Manager       Manager       Products       Manager     Manager
 Manager      Manager




                                                                      09
                                                                20
                                          Product
                                                           of
                                                         Product        Product
                                                        s
                                         Manager A      Manager B      Manager C
                                                       s
                                                    la
                                               C



Source: Joseph A. Maciariello and Calvin J. Kirby, Management Control Systems (New Jersey:
                                        y
                                      nl




Prentice Hall Inc., 1994) 153.
                                     O




               plans to market, plan and control client services in a given area. The structure
               is designed in such a way that the functional personnel report directly to the
                                 se




               functional managers, while the local office managers hire the services of
                              U




               functional resources in a manner identical to that of product or project
                          S




               managers.
                     B
                   rI




The Matrix Structure and the Multinational Firm
               Fo




               It is difficult to coordinate in a multinational (MNC) firm as compared to
               domestic product organization. This is mainly due to two reasons. Firstly, in
               an MNC, there is greater geographical dispersion among the various units of
               the enterprise. Secondly, since each division of an MNC is responsible for the
               sale and sometimes production of all the company’s products in the given area
               of the world, little attention can be given to the development, introduction and
               coordination of a given product for the company as a whole. Due to these
               factors, the importance of matrix structure in an MNC has increased greatly.
               Design of organization structure in an MNC is based on the combination of
               the market area and the product rather than on the product and function. The
               products and market area are important for the multinational firm as these two
               conditions can help a firm earn profits by exporting the products even though
               transportation costs and trade barriers exist. However, it is not always
               appropriate to apply a matrix structure. For example if an organization is using
               a standard product design and management focuses mostly on developing a

62
                                                     Organizing for Adaptive Control

         better market for the product. A functional organization is better suitable for
         the same. On the other hand, if an MNC has a worldwide market for the
         products, the management needs to devote time for the development of the
         product. These conditions do not occur frequently in multinational
         organizations as the market characteristics as well as basic labor costs are
         different for most products in various parts of the world and it becomes
         necessary to differentiate the various markets. Thus, the matrix structure helps
         in providing a dual structure for managing both the product and market
         dimension.
         The structure consists of a product manager who is responsible for a particular
         product and an area manager who is responsible for a given geographical area.
         The product manager is responsible for bringing in profits of a particular
         product on a world wide basis, but he has no authority over the functional
         disciplines employed on the product. The area manager has the authority and
         responsibility of maintaining the overall profitability of his division and
         control over the functional personnel assigned to that division. Product




                                                              09
         managers are concerned with current business and technological




                                                          20
         developments of their product in a particular area. Using their expertise and
         knowledge, they help the area managers to implement technical and business

                                                     of
         programs for improving the profitability of their product line on a worldwide
         basis. The product manager also communicates the benefits of the product to
                                               s  s
         the various area managers and tries to reduce bottlenecks among the various
                                            la

         area divisions.
                                         C


         Products differ in their key variables while some products require emphasis on
                                  y



         marketing others require emphasis on engineering or production. The product
                                nl




         manager should therefore ensure that, product lines get the required attention
                               O




         from the different divisions. Moreover, the product manager has to make sure
         that resources are allocated according to the profitability of the product.
                          se




         Sometimes he or she may have to drop a product in one division and expand
                       U




         its sales in another division. Most importantly, when there are rapid
         technological changes the product manager has to forecast such changes and
                   S
               B




         incorporate them into the product in each division.
             rI




         For a matrix organization in a multinational firm, it is necessary that there are
         Fo




         behavioral adjustments between the area manager and the product manager.
         Project based organizations therefore, use teams for accomplishing of
         organizational goals.

EVALUATION OF THE CONTROL FACTORS IN ORGANIZATIONAL
DESIGN

         The activities of an organization can be managed by using three types of
         organizational designs: centralized, decentralized and matrix.
         In a centralized organization, the authority for all products, projects and
         services rests with the top management. In a decentralized organization, a
         division, department or a group is held responsible for the decision it takes.
         These units are allowed to design their own management policies and have
         complete authority over the functional organization.

                                                                                       63
Principles of Management Control Systems


             A matrix structure or a hybrid structure incorporates the advantages of both
             the above mentioned forms and a new structure is then designed.
             Organizations should choose a design structure that is likely to benefit them
             the most. Each design must be evaluated on the basis of efficiency and
             coordination. The best form is the one which operates at minimum cost per
             unit of output.

Matrix Versus Functional
             While managing complex programs, an organization may face several
             coordination problems. A matrix organization helps avoid such problems as
             the total responsibility for the project lies in the hands of a manager who
             coordinates and integrates the multiple functions within the organization. He
             ensures that proper balance is maintained among the costs, performance and
             time variables.
             The incremental cost of a matrix organization is more than that of a functional




                                                                    09
             organization. This is due to two reasons. Firstly, the organization incurs costs




                                                               20
             as result of additional layer of management for managing each program.
             Secondly, difficulties are created by separating responsibility for a program

                                                          of
             from the authority to direct the work necessary to carry out program goals.
             During the process of implementing the matrix structure certain potential
                                                    s  s
             organizational problems occur. Some of these have been mentioned below.
                                                 la
                                              C


             Problems in the implementation of the matrix structure
                                       y
                                     nl




             Difference in orientation: The main aim of any program manager is to
             maintain a balance among performance, cost and time requirements of the
                                    O




             program. The priorities of a functional manager are different from that of a
                              se




             program manager. The functional manager can emphasize on quality and
             competence norms while ignoring the goals of the program. Thus, there is a
                           U




             need to design reward structures and financial controls for both project and
                        S




             functional organizations. If there are tensions between the program and the
                   B




             functional manager’s work it will result in conflict in the workplace, thereby,
                 rI




             making it very difficult to achieve the organizational goals. Thus, reward
            Fo




             structures can be used for balancing short and long run goals and objectives by
             rewarding functional work that also helps achieve program goals. The reward
             structure for programs and functional organizations should reflect a balance
             between the short and long run profits.
             Diffuse responsibility: In a matrix structure, it is difficult to clearly demarcate
             the responsibility for a given activity. This is because program managers have
             program responsibility under the matrix structure, while functional managers
             have technical responsibility and when problems develop it becomes difficult
             to isolate responsibility. As the responsibility is distributed between the
             program and functional personnel, it becomes very difficult to administer
             systems of accountability. This in turn, could lead to greater instances of
             conflict. Conflicts usually arise while resolving technical and cost problems
             and assigning the priorities to various programs.
             Program personnel in temporary assignments: Unlike the functional
             personnel assigned to a permanent organizational unit the project structure is
64
                                                              Organizing for Adaptive Control

         temporary and functions according to the availability of the projects. After the
         project is accomplished the team is disbanded. The primary aim of a program
         manager is to complete the project on time. After the completion of the short
         term projects the staff is temporarily left without any projects. In such a
         situation the functional personnel will hesitate to take up the program
         responsibility and program office personnel may attempt to increase the
         duration of the program artificially at the expense of the program goals, thus
         increasing, the costs of the organization. This problem becomes severe during
         adverse economic periods. The actual costs incurred as a result of these
         potential organizational problems depends upon the ability of the program and
         personnel managers to build effective informal relationships and design goal
         congruent reward structures. In addition there is also a need to design reward
         systems that promote high quality functional performance.

CONTROLLER’S ORGANIZATION




                                                                        09
         A person who is responsible for designing and implementing the management




                                                                   20
         control system is called the controller. A controller plays an important role in
         design and operations of the control system. The main responsibilities of a
         controller are:
                                                              of
                                                          s
         •
                                                       s
                To design the control system
                                                    la

         •      To prepare financial reports and statements for the clear understanding of
                                                C


                shareholders and external parties
                                        y




         •      To develop internal auditing systems for the control of the physical and
                                      nl




                monetary assets of the firm.
                                     O




         •      To conduct educative sessions and create awareness among employees
                               se




                about the matters relating to the controller's function.
                            U




         •      To advice the management on the financial implications of decisions
                       S




                under consideration. To provide functional supervision and training for
                  B




                employees in each of the divisions of the corporation.
                rI




         •      To analyze program and budget proposals and bring together the various
        Fo




                segments of an organization under a single organizational budget.
         The advisory and control systems suggest a direct reporting relationship of
         divisional controllers to divisional general managers since these are very
         important staff functions performed by the controller. In a matrix
         organizational structure, the divisional controller has to report to two persons.
         He has to give functional accountability to the corporate controller and
         operational accountability to the general manager of the division. These create
         several problems as in a matrix organization structure. These tensions must be
         resolved in a manner similar to those of the matrix organization. An empirical
         study of control functions in large multidivisional US corporations conducted
         by Vijay Sathe1 indicates that the degree of involvement of the controller in
         managerial functions depends on the following variables.

         1
             Controller Involvement in Management. Englewood Cliffs, N.J.: Prentice Hall, 1982

                                                                                                 65
Principles of Management Control Systems


             •   The financial orientation of the company, emphasis on financial goals, and
                 the management of its businesses using a portfolio approach.
             •   The importance the organization places upon planning, programming,
                 budgeting and reporting.
             •   The importance the organization gives to development of the controller
                 and the employees assisting him.
             •   The extent to which the controller is involved in the business decisions.
             •   The working capital management of the company. The management
                 development strategy the organization adopts in terms of developing the
                 controller’s function.
             Some of the characteristics essential for a good controller have been specified
             below:
             •   Personal energy and motivation




                                                                  09
             •   Personal integrity and professional commitment




                                                             20
             •   Accounting knowledge and analytical skill
             •   Understanding business problems and recommending actions that are

                                                         of
                 required to run the business successfully
                                                     s
             •   Ability to judge and grasp information that is important for an
                                                   s
                 organization
                                                la
                                             C


             •   Building effective interpersonnel relationships and being flexible in
                 meeting management’s demands.
                                      y
                                    nl




             •   Ability to analyze management’s actions and plans and not hesitate to
                                   O




                 question management’s plans and actions.
                              se




             •   Recognizing the responsibility towards the division as well as corporate
                 management.
                           U
                       S
                   B




ADAPTIVE ORGANIZATION
                 rI
            Fo




             To face the challenges posed by the rapidly changing environment,
             organizations need to develop ‘adaptability’, and modify their structure at
             regular intervals. The rapid environmental changes have made it imperative
             for organizations to gain a global perspective, speed up the decision making
             process and realign resources rapidly. An organization which is not adaptive
             to environmental changes will become inefficient in due course of time.

The Need for Adaptive Organization
             It is not very easy for an organization to adapt to environmental changes. An
             organization needs to steer its resources and realign them to meet the changes.
             Moreover, the culture, and the organizational structure need to be reorganized
             in accordance with the changes. Let us examine the factors which create the
             need for an adaptive organization.


66
                                                         Organizing for Adaptive Control

             Environmental factors
             In order to adapt itself to environmental changes, an organization has to speed
             up the decision-making process, gather large amounts of data that support
             decisions, and implement the decision at the right time. The organization
             should also be able to realign resources in order to meet these changes.
             Moreover, as mentioned earlier, the organizational structure should be
             designed in such a way that it can adjust to various environmental changes.
             Mintzberg in 1979 stated that, “Environmental factors are contingency factors
             in the design of organizational structure.” While the organization is influenced
             by environmental changes, these changes are influenced by certain other
             factors that are discussed below:
             Environmental uncertainty
             Organizations become more informal in response to environmental
             uncertainty. Ad hoc teams are developed to cope with uncertainty and to meet
             the changing needs of the organization. Verbal communication is encouraged




                                                                   09
             so that people can understand the environment better and respond to changes




                                                              20
             accordingly.
             Environmental complexity
                                                          of
             Complexity in the environment may sometimes affect the market in which the
                                                      s
             organization operates as well as the competition prevailing in the market. Due
                                                    s
                                                 la

             to this complexity management may choose to decentralize into focused
             market segments to fully understand smaller market niches.
                                              C
                                       y



             Environmental diversity
                                     nl




             The market is divided into different segments on the basis of customers,
                                    O




             products and geographical locations. This diversity helps the organization to
                              se




             develop various business units in each segment.
                           U




             Environmental hostility
                        S




             When the organization is faced with hostility e.g. adverse political changes,
                   B




             the top management decides to centralize decision making. Efforts are made
                 rI




             to gather information at the earliest and take suitable action.
            Fo




             The control systems designer analyzes these four environmental factors,
             before taking a decision on redesigning the organizational structure to achieve
             control.

Adaptive Controls that Support the Adaptive Organization
             In the adaptive organization, the control mechanism is more implicit. Every
             organization tries to instill its own values in its employees through its training
             programs. In nonprofessional organizations, such an adaptive model can be
             instituted through extensive acculturation, socialization and training programs.
             This is traditionally practiced in Japanese firms. The adaptive organization
             requires high levels of awareness, skill, and integrity within the work group.
             Given the high degree of employee empowerment today, even one poorly
             trained or disruptive employee can cause significant damage to an
             organization. The effectiveness of these controls also may be limited by the
             subjectivity of the control measures used by workplace politics.

                                                                                            67
Principles of Management Control Systems


                  The informal and formal adaptive control for organizations are shown in
                  exhibits 5.3 and 5.4 respectively. The culture of an organization should be
                  such that it should emphasize global awareness, change and opportunistic
                  actions, continuous learning, and flexibility to adjust and accept new
                  assignments. On the formal side, the infrastructure should be characterized by
                  organization structures that can be easily formed and dissolved, the use of ad
                  hoc teams and projects and the use of worldwide purchasing. The planning
                  and control processes should focus on the organization’s vision, strategy,
                  information systems, information flows and other formal procedures. The
                  reward system should be designed in such a way that it helps the organization
                  to achieve excellence in an uncertain environment.


                                              Exhibit 5.3
                        Informal Control for Adaptive Organization




                                                                          09
     Infrastructure                                                Management style and
                                                                   culture




                                                                      20
     • Expert emergent roles for
       local cultures and markets                                  • Global operating perspective
                                                                   • Opportunistic action oriented
                                                                  of
     • Acceptance of temporary
                                                                   • Change oriented
       assignments
                                                               s
                                                                   • Lifelong learning
                                                          s
                                                                   • Agility in new assignments
                                                       la
                                                     C
                                              y
                                            nl




                                    Informal control process
                                           O




                                    • Verbal informal actions
                                     se




                                    • Use of multidisciplinary
                                    U




                                      teams for problem solving
                             S
                        B
                      rI
                 Fo




      Rewards                                                     Coordinating and integration
      • Based on peer recognition for                             • Use of personal travel for
        the adaptive values of the                                  managers to become familiar
        organization                                                with worldwide conditions




 Source: Joseph A. Maciariello and Calvin J. Kirby, Management Control Systems (New Jersey:
 Prentice Hall Inc., 1994) 173.


68
                                                             Organizing for Adaptive Control


                                         Exhibit 5.4
                      Formal Control for Adaptive Organization

     Infrastructure                                      Management style and culture
     • Organization structure                            •   Global operating perspective
       • Easily formed and dissolved                     •   Opportunistic action oriented
       • Use of adhoc Teams                              •   Change oriented
     • Widespread use of outsourcing                     •   Lifelong learning
     • Widespread use of teams                           •   Agility in new assignments




                          Formal control process
                          • Clear company vision




                                                                      09
                          • Integrated information systems




                                                                 20
                          • Rapid response times for
                            information flows

                                                             of
                          • Accurate worldwide reporting
                          • Simple and rapid authorization
                                                        s
                            procedures
                                                     s
                                                  la
                                               C
                                          y




      Rewards                                            Coordinating and integration
                                        nl




      • Emphasize ability to achieve                     • Use of management rotation on
                                       O




        excellence in uncertain                            a global basis
                                 se




        environments                                     • Use of multidisciplinary teams
                                                           for accomplishing specific
                             U




                                                           objectives
                         S
                     B
                   rI
              Fo




 Source: Joseph A. Maciariello and Calvin J. Kirby, Management Control Systems (New Jersey:
 Prentice Hall Inc., 1994) 173.

              The emergent roles for local cultures and markets, temporary assignments,
              constitute the informal infrastructure. The planning and control processes
              should focus on informal actions to solve problems. The coordination
              mechanisms should facilitate training of managers in order to help them adapt
              to worldwide conditions.

SUMMARY

              This chapter examines the role of control systems in designing the
              infrastructure of an organization. With companies expanding, it has become
              important to develop organization structures that support complex

                                                                                              69
Principles of Management Control Systems


             multimarket, multidivisional corporations. The matrix structure has proved
             very useful for product organizations, service organizations and multinational
             firms. Three organizational designs have been identified which are used to
             manage the activities in an organization. They are: a centralized organization,
             a decentralized organization and a matrix structure.
             The role of the controller in relation to the design and operation of the control
             system has also been discussed. A divisional controller in a matrix
             organization has both functional and operating accountability. For a controller
             to function effectively, there is a need for technical competence, business
             judgment and communications skills.
             Due to the rapidly changing environment, there is a need to develop
             organizations which can adapt themselves to these changes.




                                                                  09
                                                              20
                                                         of
                                                   s  s
                                                la
                                             C
                                      y
                                    nl
                                   O
                              se
                           U
                       S
                   B
                 rI
            Fo




70
Chapter 6




                                             09
Autonomy and
                                         20
                                     of
Responsibility
                                   s s
                                la
                                C
                       y
                     nl




 In this chapter we will discuss:
                    O




 •   Divisional Autonomy
               se




 •   Responsibility Structure
            U




 •   Responsibility Centers
        S




 •   Performance Measurement of Decentralized Operations
    B




 •   Inter Profit Center Relations
  rI
Fo
 Principles of Management Control Systems


             An organization uses a number of structural elements to influence the
             behavior of managers. These elements interact with the formal control process
             to influence managerial behavior. These elements play an important role in
             influencing the autonomy of managers at the divisional control level, of an
             organization and also influence the way managerial performance is measured
             and evaluated. This chapter focuses on the autonomy of managers at the
             divisional level and the determinants of such autonomy. Such autonomy can
             be categorized into three divisions- management style and process,
             responsibility structure and reward systems.

DIVISIONAL AUTONOMY

             With most organizations operating in dynamic and highly competitive
             markets, it is important for the top management to decide on the right kind of
             autonomy to be given to the managers. Organizations today require flexibility,




                                                                         09
             innovation and creativity. Thus, it becomes all the more important for the top
             management to decide on the levels of autonomy. The top management must




                                                                    20
             decide upon the level of decentralization of decision-making. To do this, the
             top management should design a tool to help it attain congruence between the
                                                               of
             levels of autonomy it wants to sanction to its subordinates and the extent of
                                                           s
             autonomy that subordinates expect to get. Vancil1 developed a design tool that
                                                        s
             helps the management to communicate the desired levels of autonomy. This
                                                     la

             tool helps the management in designing structures and processes to achieve
                                                  C


             the appropriate levels of autonomy. In this context, it is important to discuss
                                         y



             the variables that influence autonomy in an organization. The variables
                                       nl




             discussed in the Exhibit 6.1 can be grouped into:
                                      O




             •    Management style and process
                                se




             •    Responsibility structure
                             U




             •    Measurement of reward systems
                         S
                    B




Management Style and Processes
                  rI




             Management style plays an important role in influencing the behavior of the
             Fo




             employees in an organization. Managers have different notions about how a
             company’s business can be run. They need to decide whether it can be run in a
             centralized manner or by striking a balance between centralized control and
             decentralized action. All these constitute management style and process. There
             are a number of personal variables that influence the level of autonomy that a
             corporate manager can sanction a subordinate. These include:
             •    The level of involvement of the corporate managers in the business
             •    The interactions of the corporate managers with other managers
             •    The level of trust and confidence of the manager in the ability of the
                  subordinates



             1
                 Vancil, Richard F., Decentralization: Ambiguity by Design. Homewood, III: Dow Jones
                 Irwin, 1979.

 72
                                                              Autonomy and Responsibility


                                       Exhibit 6.1
                          A Theory of Decentralized Management



                                       DIVERSIFICATION                       BUSINESS
CORPORATE MANAGERS                         STRATEGY                         STRATEGY
  Philosophy and Style              Breadth of Lines of Business         Definition of Market
                                                                              Segments




                                        Intended by Corporate
                                              Managers




                                                                   09
                                                                       RESPONSIBILITY




                                                                20
MANAGEMENT PROCESS                           AUTONOMY                     STRUCTURE
 Policies and Procedures                                                   Custody of

                                                         of
                                                      s                 Physical Resources

                                              Perceived by
                                                   s
                                              Profit Center
                                                la

                                                Manager                     REWARDS
                                             C
                                      y



   COST AND ASSET                                                           Physical and
                                    nl




     ASSIGNMENT                                                               tangible
   For Shared Resources                     MEASUREMENT
                                   O




                                               METHODS
                               se




                                            For Assigned Costs
                                                and Assets
                            U




   Source: R F Vancil , Decentralization:Managerial Ambiguity by Design,( Dow Jones-Irwin,
                          S




   Homewood Illinios, 1979) 128.
                   B
                 rI




            •
            Fo




                Management style influences the decentralization process in an
                organization. The company’s plans, budgets, meetings, performance
                reviews, etc., are influenced by the manager’s ‘style.’
            Management policies and procedures
            Policies and procedures help managers decide the way in which decisions are
            to be made. They help in maintaining uniform behavior among profit center
            managers with regard to certain decisions.
            Diversification strategy
            According to Vancil, there is a fair relationship between the diversification
            strategy that the management chooses and the autonomy of the profit center
            managers. In firms that run a single business, the manager’s autonomy seem to
            be restricted, whereas in firms that grow by acquiring or introducing unrelated
            businesses, the extent of autonomy is high. When a firm runs a single
            business, all its functions are centralized which leads to the sharing of
                                                                                             73
 Principles of Management Control Systems


             resources and, thus, to restricted autonomy. When a firm runs a number of
             unrelated businesses into unrelated businesses, there is not much synergy
             between the various businesses and only a few resources are shared. This
             leads to more managerial autonomy.
             Business strategy
             Business strategy is the strategy to be followed in each division of the
             organization. The kind of business strategy chosen by the management
             influences autonomy in the organization. For example, a cost strategy leads to
             less autonomy as there is usually centralization of resources.
             The four variables discussed above-management style, processes,
             diversification strategy and business strategy have a major influence on the
             autonomy of profit center managers. They constitute “the first line of
             influence” that the top managers have over profit center managers.

Responsibility Structure




                                                                  09
             The responsibility structure represents the physical, human and financial




                                                              20
             resources that are entrusted to the profit center manager. These resources
             represent the functional authority of the project center manager, and the

                                                         of
             resources in the custody of a manager influences his/her decision-making
             authority. Responsibility structure can be considered the second line of
                                                   s  s
             influence that the top management has over profit center managers. The
                                                la

             responsibility structure and types of responsibility centers will be discussed in
                                             C


             detail later in this chapter.
                                      y
                                    nl




Measurement and Reward Systems
                                   O




             Cost and asset assignments convey to the division manager those items of cost
                              se




             and investment that the manager should be concerned about.
             Measurement methods show how much concerned the divisional managers
                           U




             should be about the costs and assets assigned. These methods help in
                       S




             allocating resources according to the requirement of a particular division. The
                   B




             common methods of measurement are proration, negotiation and metering.
                 rI




             Proration refers to allocating resources based on standard rules of the
             Fo




             organization. Negotiating and metering give the managers more autonomy in
             deciding upon the quality and quantity of resources they use.
             The reward system is determined on the basis of the performance of a
             particular center. The amount and method of allocating bonuses depends on
             the manager’s autonomy. Rewards given to managers are either tangible or
             intangible. Tangible rewards include financial and related compensation.
             Intangible rewards include power, status, and the feeling of accomplishment.
             While responsibility structures are the second line of influence that the top
             management has over the profit center manager, the measurement and reward
             system constitute the third line of influence.

RESPONSIBILITY STRUCTURE

             The responsibility structure of an organization consists of responsibility
             centers and related performance measurement systems. These responsibility

 74
                                                           Autonomy and Responsibility


             centers work towards the achievement of the organizational goals. This
             hierarchical placement of the responsibility center helps the top management
             to ensure that decisions made in one part of the organization are congruent
             with decisions made in other parts. The responsibility structure includes an
             accounting system. A responsibility accounting system helps managers to
             record the plans and performances of the center for which the manager is
             accountable. The measurement of the performance of a responsibility center is
             done through cost, profit, revenue, investment and quality goals set by the
             organization. There are three different methods of measuring the performance
             of a responsibility center. They are:
             •   The efficiency measure
             •   The process measure
             •   Effectiveness measure
             The ‘efficiency measure’ measures performance in terms of inputs received
             over a specified period of time for a given level of output. The process




                                                                 09
             measure pertains to the production process, and the ‘effectiveness’ measure




                                                             20
             gauges the output of the organization in terms of its goals and objectives. The
             above mentioned methods of performance evaluation help in assessing the

                                                        of
             progress of each subunit, and this is done with those variables for which the
             manager has reasonable amount of control in mind.
                                                   s    s
                                                la

Overall Effectiveness Measures: Return on Investment (ROI)
                                             C


             The most important objective of a firm is to achieve a good return on
                                      y




             investment. The logic behind the hierarchy of responsibility centers and the
                                    nl




             responsibility accounting system is to make all the decentralized subunits of
                                   O




             an organization responsible for various elements of ROI. The performance of
                              se




             responsibility centers in an organization is based on cost, quality, revenue and
             investment.
                           U




             Donaldson Brown of General Motors divided ROI into a number of elements
                       S




             for easy understanding. These elements are helpful in establishing
                   B




             performance measures for various subunits of a division that are goal
                 rI




             congruent and would have an influence over the performance measures.
            Fo




             ROI= Net profit/invested capital
             ROI can be divided into two components- net profit, which is a percentage of
             the sales revenue, and the turnover of investments in relation to the sales
             revenue.
             Profit margin = net profit/sales revenue
             Investment turnover = sales revenue/invested capital
             Exhibits 6.2 and 6.3 show the computation of profit margin and investment
             turnover.

RESPONSIBILITY CENTERS

             Responsibility center is a unit or function of an organization headed by a
             manager who is directly responsible for its performance. In a responsibility

                                                                                          75
 Principles of Management Control Systems


                                                Exhibit 6.2
                                     Computation of profit margin

                                                sales revenue                 cost of goods sold
                                                                         Β                        +
                               net profit =     operating expenses =          period expenses
                                                       Β                               +
                                                                              other expenses
                                                income taxes
             Profit margin =
                                    ÷
                               sales revenue

             Source: Joseph A Maciariello and Calvin J Kirby, Management Control Systems, (USA:
             Prentice-Hall Inc, Second edition) 194.




                                                                     09
             center, the accounting system generates information on the basis of
             managerial responsibility, allowing that information to be used directly in




                                                                 20
             motivating and controlling the action of each manager in charge of a

                                                            of
             responsibility center.
             Responsibility centers can be assigned very narrowly or broadly in terms of
                                                        s
             the activities that senior management decides to assign to a particular
                                                      s
                                                   la

             manager. But the type of responsibility center specifically defines the primary
             objective of the decisions required when managing the assigned activity. For
                                                C



             example, as a cost center, a manager would focus on reducing costs in relation
                                        y




             to a standard cost or budget, and would not be concerned about the profit
                                      nl




             margins of the various products or the implications of these decisions on the
                                     O




             company's profitability. However, in designating this center as a cost center,
                                se




             the senior management should have already decided that the profit
             implications would be controlled by another part of the entire system.
                               U
                         S




Nature of Responsibility Centers
                    B
                  rI




             Every organization has its goals determined, and the management decides
             upon the strategies to accomplish these goals. Responsibility centers help in
             Fo




             implementing these strategies. As an organization is a collagium of
             responsibility centers, the ability of its responsibility centers to meet their
             objectives help an organization to achieve its goals. Every responsibility
             center uses inputs (material, labor, etc.) and needs working capital, equipment
             and other assets to function effectively. The responsibility center produces
             outputs which are classified as goods and services and hence they can be
             measured, whereas in human resources, transportation, accounting and
             administration, the output is services that cannot be measured.
             Measurement of inputs and outputs
             It is easy to identify the monetary costs of physical quantities. The amount of
             money is calculated by multiplying the physical quantity by a price unit of
             quantity. Therefore, the inputs of a responsibility center are referred to as
             costs. While the costs of inputs can be easily measured, outputs are not so easy
             to measure.

 76
                                                              Autonomy and Responsibility


                                               Exhibit 6.3
                               Computation of Investment Turnover
                                         sales revenue
                                                Φ                   current assets
                                                                          +
                                         invested capital =          fixed assets
                                                                          +
            Investment turnover =                                   other assets
                                                                          +
                                                                   other liabilities

           Source: Joseph A Maciariello and Calvin J Kirby, Management Control Systems, (USA:
           Prentice-Hall Inc, Second edition) 194.




                                                                      09
              The performance of a responsibility center can be judged by using the




                                                                 20
              effectiveness and efficiency criteria. Efficiency is the ratio of outputs and
              inputs. These measures are usually used on a comparative basis. If there are
                                                              of
              two responsibility centers, A and B, responsibility center A would be
                                                         s
              considered more efficient than responsibility center B if it uses less resources
                                                       s
              than B but has the same output, or if it uses the same amount of resources, but
                                                    la

              produces more output. If both the centers are found to be performing up to the
                                                C


              company’s expectations, the center that shows the lower costs is considered
                                         y



              more efficient.
                                       nl




              The effectiveness of the unit is decided on the basis of a unit’s outputs and its
                                      O




              objectives. The greater the contribution of the outputs to the accomplishment
                                se




              of the organizational objectives, the more effective is the unit. A unit should
              be both effective and efficient to contribute to the achievement of these goals.
                             U




              The company’s overall profit can be considered as the base for measuring
                         S




              effectiveness and efficiency.
                    B
                  rI




Types of Responsibility Centers
             Fo




              According to the nature of monetary inputs and outputs, responsibility centers
              can be classified into the following:
              Revenue centers
              Revenue centers are those organizational units in which outputs are measured
              in monetary terms. These centers are marketing organizations and they are not
              directly responsible for profits. Revenue centers are also called expense
              centers, as the revenue center managers are held responsible for expenses
              incurred by the unit. The main objective of revenue centers is to maximize
              revenues. For example, a marketing organization is a sales revenue center.
              Such a center is devoted to increasing the revenue, and assumes no
              responsibility for production. In this center, the manager is responsible for the
              level of revenue or outputs of a center, measured in monetary terms, but is not
              responsible for the costs of the goods or services that the center offers.

                                                                                                77
Principles of Management Control Systems


            Expense centers
            In expense centers, inputs or expenses are measured in monetary terms
            whereas the outputs are not measured in monetary terms. There are two types
            of expense centers-engineered expense centers and discretionary expense
            centers. There are two types of cost involved in engineered expense centers
            and discretionary expense centers respectively-engineered costs and
            discretionary costs. Engineered costs are costs that can be estimated to a
            reasonable extent by the management. Examples are direct labor and direct
            material. Discretionary costs, on the other hand, are costs that cannot be
            estimated by the management.
            Engineered expense centers
            In these centers, inputs or expenses are measured in monetary terms and
            outputs are measured in physical terms. These centers are usually found in the
            manufacturing units that use a standard cost system. There are certain
            responsibility centers within administrative and support departments that




                                                                09
            actually are engineered expense centers. In these centers, the cost of the




                                                            20
            product is determined by multiplying the output of each unit with its standard
            cost. Its efficiency is measured by comparing the actual cost with the standard

                                                       of
            cost.                                   s
            Discretionary expense centers
                                                  s
                                               la

            In discretionary expense centers, the output cannot be measured in monetary
            terms. Discretionary expense centers include administrative and support units
                                            C



            like legal, accounting, industrial and public relations units. Here, the
                                     y




            efficiency is not the difference between budgeted and actual expense, but the
                                   nl




            difference between the budgeted input and actual input. In discretionary
                                  O




            expense centers the management decides on certain policies that should
                             se




            govern the company's operation. These relate to the amount of money that
            should be spent on R&D, financial planning, public relations, etc. The
                          U




            decisions related to such activities depend on the way a company operates.
                      S




            Control characteristics for expense centers
                  B
                rI




            The management control systems for expense centers are discussed, taking
            Fo




            into consideration factors like budget preparation, cost variability, financial
            control and measurement of performance.
            Budget preparation: The decisions regarding the budget of expenses for a
            discretionary expense center is different from that for an engineered expense
            center. In engineered expense centers, the costs are determined by the
            management, taking into view the operating budget required to perform the
            task effectively in the future. However, in a discretionary expense center, the
            principal task is to decide on the magnitude of the job that has to be
            performed. These tasks are of two types-continuing and special. Continuing
            tasks take place year after year (like financial statements) while special tasks
            are one-time tasks, for example, developing a profit budgeting system for a
            newly acquired division.
            Management by objectives is a useful technique in preparing budgets for a
            discretionary expense center. Management by objectives is a technique where
            the objectives of performance are jointly determined by subordinates and their

78
                                               Autonomy and Responsibility


superiors. The progress towards these objectives is periodically reviewed and
the rewards are allocated on the basis of performance. Another method used to
understand the appropriate level of spending in a discretionary expense center
is sensitivity analysis. According to this technique, the budget has a section
which explains the activities that can be undertaken if the budget is increased.
Sensitivity analysis is mostly not taken by companies as they think that it is
important for a manager to prepare the possible budget for accomplishing
activities that should be undertaken.
Cost variability: The costs, in a discretionary expense center, tend to vary
from one year to another according to the volume. However, these are not
influenced by short-term fluctuations in volume within a year. In engineered
expense centers, costs vary with short-term fluctuations in volumes.
Financial control: The financial control in a discretionary expense center is
different from that in an engineered expense center. Here, the operating costs
are minimized by setting a standard for the costs and comparing the actual




                                                      09
costs with this standard. In discretionary expense centers, costs are controlled
by determining the tasks that have to be undertaken and the amount of effort




                                                 20
that is required for each task. Financial control is, hence, determined at the
planning stage.

                                            of
Measurement of performance: The financial performance report of a
                                         s
discretionary expense center does not help in evaluating the efficiency of the
                                       s
manager, whereas in engineered expense centers the financial report helps in
                                    la

evaluating the efficiency of the manager. If the two centers are not properly
                                 C


distinguished, the management may consider the performance report of a
                          y



discretionary center as an indication of its efficiency.
                        nl




Administrative and support centers
                       O




Administrative centers include the senior corporate management, the business
                 se




unit management and the managers responsible for their staff units. Support
              U




centers provide services to other responsibility centers.
           S




Problems related to control in administrative and support centers include
      B




difficulty in measuring output, as they basically provide service and advice to
    rI




the responsibility centers. Therefore, it becomes difficult to set cost standards.
Hence, their performance cannot be branded as efficient or inefficient.
Fo




Secondly there is lack of congruence between goals of staff units and
responsibility centers. The suggestions that staff departments may provide
regarding the development of systems, programs or functions may be too
costly when one thinks of the additional profits that these would generate. The
severity of the problems is also related to the organizational level. At the
operational level, the staff activity is controlled by the plant manager, and at
the business unit level, by the business unit manager. When compared to the
plant level, there is more discretion of tasks at the business unit level. Support
centers charge a particular price for the services they provide to other
responsibility centers.
Budget preparation: The budget for a support center consists of expenses, and
is prepared by comparing with the current year’s actuals. This budget consists
of the following components- the basic costs of running a center (for which
there is no need of management decisions), costs incurred by the discretionary

                                                                               79
Principles of Management Control Systems


            activities of the center, and a section containing proposed increases in budget
            (other than those related to inflation).
            Research and development centers
            Control problems in research and development: The problems in research
            and development are:
            Difficulty in measuring quality: The inputs for an R&D activity can be
            measured whereas the outputs are difficult to measure. For R&D activities, the
            time taken for a particular research cannot be estimated as it may take months
            or sometimes years for a particular activity. Also the output is difficult to
            measure because of its technical nature.
            Lack of goal congruence: As in administrative centers, goal congruency is
            lacking in R&D centers, too. Conflict may arise between the research manager
            and the business unit manager. The research manager may want to build the
            best research and development center, no matter what the expense be, while it




                                                                 09
            may not be possible for the company to afford it. Also, the researchers may
            not have sufficient knowledge about the business, in some cases.




                                                             20
            The research and development costs cannot be controlled on a year-to-year
            basis because a research project may take years to show results and the
                                                        of
            organization would have to bear the cost of the project for that period of time,
                                                     s
            mainly the cost on labor.
                                                  s
                                               la

            Marketing centers
                                            C


            There are two types of marketing activities in every organization: order filling
                                     y



            (logistics) and order getting. Order getting is an actual marketing activity.
                                   nl




            Order filling activities include transferring goods from the company to the
                                  O




            customer, and receiving the appropriate pay from the customer. These are
            mostly engineered expense centers. Order getting activities include test
                             se




            marketing, training sales force, advertising, sales promotion, etc. Though the
                          U




            output of a marketing organization can be measured, it is difficult to evaluate
            the marketing effort, as the marketing department has no control over
                      S




            economic conditions or competitors’ actions. These actions may be different
                  B




            from what was expected when the sales budgets were established. In such
                rI




            situations, it is difficult to achieve management control. Also, it becomes
            Fo




            difficult to measure the efficiency and effectiveness of these costs.
            Profit centers
            When financial performance of a responsibility center is measured in terms of
            the organization’s profit, then it is called a profit center. In a profit center,
            performance is measured in terms of the numerical difference between
            revenues (outputs) and expenditure (inputs). A profit center is given the
            responsibility of earning profits. It is involved in the manufacture and sale of
            outputs, and it measures how well the center is doing economically. The profit
            center also determines the efficiency of the manager in charge of the center.
            A profit center helps in motivating managers to perform well in areas they
            control and also encourages managers to take initiatives. The profit center
            helps the organization to make the best use of specialized market knowledge
            of the divisional managers, and entrusts the local managers the responsibility
            of tradeoffs.

80
                                               Autonomy and Responsibility


Profit centers have been used as a major management control tool. The major
advantages of profit centers are:
•   These help in increasing the speed of making operating decisions as they
    do not have to be referred to corporate headquarters.
•   As the decision-making authority lies with the managers they can make
    better decisions related to the task they are performing, because they can
    understand the nature of the work better.
•   Since profit centers make their day-to-day decisions themselves
    headquarters can concentrate on broader issues of the organization.
•   Managers are motivated to perform more effectively, as they are
    responsible for increasing the profit of their unit.
•   Managers use their imagination, take initiatives to perform more
    effectively, to increase the profit of their unit.
However, there are certain difficulties associated with the creation of profit




                                                      09
centers. The management cannot have considerable control over the different




                                                  20
profit centers when decisions are centralized. The top management has to
depend on management control reports which may not be as effective as the

                                             of
personal knowledge of an operation. There may be no place for competent
general managers in a functional organization because of lack of opportunities
                                          s
for them to develop creative management skills.
                                       s
                                    la

Organizational units compete with one another, and this may, sometimes,
                                 C


result in conflict between different centers and reduction in cooperation
between different units and sharing of resources.
                          y
                        nl




Types of profit centers
                       O




Functional units can be classified as different types of profit centers. A multi-
                 se




business company can be divided into independent profit generating units such
as marketing, finance, manufacturing etc. The decisions regarding whether a
              U




particular functional unit can be a profit center depends on the responsibility
           S




center manager's ability to influence, if not control, other activities that affect
      B




the company's bottom line. The different types of profit centers are discussed
    rI




below:
Fo




Marketing: A marketing activity becomes a profit center if it is charged with
the cost of the products sold. A marketing activity can be given the
responsibility of making profit when the marketing manager has the authority
to make principal cost/revenue trade off in terms of marketing a product,
spending on sales promotion, the appropriate time for this expenditure and on
which media to spend.
Manufacturing: This is an expense center and the management of activities
here is based on performance against standard costs and overhead budgets.
Problems in measurement may occur because of inadequate quality control,
shipping of inferior quality products, and so on, to obtain standard cost credit.
At times, there may arise the need to accommodate an order in-between
production schedules, and the manufacturing managers may be reluctant to
interrupt these schedules. In manufacturing units, when performance is
measured against standards, there may be no incentives for manufacturing
products that are difficult to produce. These factors may demotivate the

                                                                                81
Principles of Management Control Systems


            managers, and eventually, they may not try to improve standards. Hence,
            while measuring the performance of manufacturing activities against standard
            costs, it is important to take into consideration quality control, production
            scheduling and the make or buy decisions.
            Measuring profitability: Profitability measurements in a profit center can be of
            two types-management performance and economic performance. Management
            performance focuses on the manager’s performance while economic
            performance relates to how well a profit center is performing as an economic
            entity. Management performance is a measure used for planning, controlling
            and coordinating the day-to-day activities of the profit center. The
            performance measures of profit centers can be different and hence, the
            necessary purpose for the information should not be obtained from a single set
            of data. For example, the management performance report can show excellent
            performance of a profit center manager. But the economic and competitive
            forces for that particular report can show poor economic performance. As a
            result, the center may run into losses and may even have to close shop.




                                                                  09
            Types of profitability measures: The parameters that can be used for




                                                             20
            measuring the profitability of a profit center are contribution margin, direct
            profit, controllable profit, income before taxes and net income.

                                                         of
            Contribution margin: This performance measure is used on the premise that,
                                                     s
            since fixed expenses are not controllable by the manager, the focus should rest
                                                   s
            on maximizing the difference between revenues and variable expenses. The
                                                la

            problems of using contribution margin is that since many of the center’s
                                             C


            expenses may vary according to the discretion of the profit center manager,
                                      y



            focus on the contribution margin tends to direct the attention of the profit
                                    nl




            center manager away from the goals of the center.
                                   O




            Direct profit: This measure helps in understanding the contribution of the
                             se




            profit center to the general overhead profit of the corporation. It encompasses
            all the expenses directly incurred by profit centers or related to profit centers,
                          U




            irrespective of whether the expenses are controllable by the profit center
                       S




            manager. However, it does not include corporate expenses.
                  B




            Controllable profit: The headquarters expenses in an organization can be
                rI




            divided into two categories-controllable and uncontrollable. Controllable
            Fo




            expenses include expenses that are controlled by the business unit manager.
            The advantage of including such costs in the measurement system is that the
            profit will be calculated after the deduction of expenses that can be influenced
            by the profit center manager. Hence, these are controllable profits. As
            uncontrollable headquarters expenses are taken into consideration while
            calculating controllable profits, controllable profits cannot be compared
            directly with published data or with trade association data, which report the
            profits of other companies in the industry.
            Income before taxes: In this method, all corporate overhead profit is allocated
            to the profit center. The amount of expense incurred by each profit center
            forms the basis of allocation of profit. Such allotment has its own drawbacks.
            Firstly, the costs in departments like finance, and HR are not controllable by
            the profit center and hence, profit centers should not be held accountable for
            such costs. Also, it is difficult to quantify the amount that has been spent on
            human resources in each profit center.

82
                                              Autonomy and Responsibility


However there are certain advantages in allocating costs.
Corporate service units often have a tendency to spend lavishly to make their
units as excellent as possible without paying due attention to the value they
create for the company. Once such costs are allocated to profit centers, the
profit center managers will try to keep a check on the expenditure.
The performance of profit centers is easily comparable to that of competitors’
performance who pay for similar services.
Since the profit center can earn profit only when it has recovered all its costs,
including allocated corporate overhead costs, the profit center manager will be
motivated to make long-term marketing decisions such as pricing, product
mix, and so on, because the center will have to recover its share of corporate
overhead costs.
For profit centers to function with the allocated costs in mind, it is important
that they are allocated budgeted costs, and not actual costs. This ensures that
the profit center managers will perform without complaining about the




                                                     09
arbitrariness of the allocated costs, since there would be no variances in the




                                                 20
allocated overheads in the performance reports.
Net income: The performance is measured by taking into consideration the net

                                            of
income after the payment of taxes. The disadvantage of using this method is
that many decisions that have an impact on the income taxes are made at
                                      s  s
headquarters, and profit center managers should not be judged by these
                                   la

decisions. If the income after tax payment is constant percentage of the
                                C


income before tax payment, then there would be no need to measure
performance based on this method. This method would be useful if profit
                         y
                       nl




centers influence decisions like installing credit policies or disposing of
equipment. This method is also useful to motivate the manager to minimize
                      O




taxes in case the taxable income differs from income, as measured by using
                 se




generally accepted accounting principles.
               U




The performance of profit centers can be measured by comparing actual
results with one or more of the measures discussed above with budgeted
          S




amounts. In addition, data on competitors and industry provide a good
      B




crosscheck on the appropriateness of the budget.
    rI
Fo




Investment centers
An investment center has control over sales revenues and operating costs, and
the assets used to generate profit. An investment unit manager must be in a
position to influence the size of the investment and profit variables. An
investment center is a measure of economic performance, and it analyzes all
elements of profit and investment. The objective of this center is to maximize
profit, given the amount of investment required to generate the profit.
Cost centers
The objective of cost center is to minimize the variance between standard
costs and actual costs. A cost center is a production or service function,
activity or item of equipment the costs of which may be attributed to cost
units. Cost centers are basically related to costs, and not to the revenues or
assets and liabilities of the organization. A cost center is a separate
organizational unit for which separate cost allocation is done. A cost center

                                                                              83
 Principles of Management Control Systems


             forms the basis for building up cost records for cost measurements, budgeting
             and control. From a functional point of view, a cost center is a production cost
             center (where only production is undertaken like a assembly department), a
             service cost center (offering service to production departments like personnel,
             accounting etc.,) or an ancillary manufacturing center (producing packing
             materials).

PERFORMANCE MEASUREMENT OF DECENTRALIZED OPERATIONS

             When a control system designer plans to measure the performance of a
             decentralized operation, a number of difficulties are encountered, especially in
             a multidivisional company. The main issues involved in the measurement of
             the performance with regard to interdivisional transactions are measuring
             profit and investment performance and setting transfer prices for inter-
             divisional transactions. The techniques for measuring performance discussed




                                                                 09
             below like ROI performance measurement, transfer pricing are all suitable for
             formal organizations. In informal organizations like a clan-based one,




                                                             20
             companies rely more on informal control mechanisms. The emphasis here is
             more on teamwork.
                                                        of
                                                     s
Measuring Divisional Operations
                                                   s
                                                la

             The methods used to measure a divisional operation are based on the
                                             C


             responsibility structure and the cost and asset assignments of the firm.
                                      y




             ROI- (Return on Investment) as a measurement of performance
                                    nl




             The objective of any firm is to achieve satisfactory returns on investment.
                                   O




             Elements such as cost, quality, revenue and investment are assigned to a
                              se




             responsibility center in appropriate amounts, and these elements are used to
             calculate the ROI.
                           U




             The design of measurement systems and financial performance of a firm is
                       S




             based on the principles of ROI. ROI is an important organizational issue. Each
                   B
                 rI




             responsibility center should contribute to the ROI. The contribution of each
             center of an organization to ROI depends on allocation of resources to the
             Fo




             center manager. Hence, ROI is an important investment criterion for the
             responsibility centers.
             To calculate the ROI of an investment center, it is important to define the
             revenue, expense and investment allocated to the center. Expenses can be
             assigned through cost assignment methods. Investment can be assigned,
             depending on the assets to be assigned and the methods of measuring the
             assets. When a firm applies a budgeted ROI figure to a responsibility center to
             determine expected profits, the divisional manager uses that figure as a
             criterion for investing in assets. These investments are made keeping in mind
             the ROI budgeted figure. The ROI measure is important as it helps in
             establishing corporate objectives and helps the managers to work towards
             achieving the organizational goals and investment projects that are appropriate
             for the firm.
             The cybernetic paradigm helps in understanding the usage of ROI. When a
             firm functions within the goals of the organization in mind, and attains a

 84
                                                           Autonomy and Responsibility


             certain level of return on the total book value of the investment, then the
             managers of the investment centers can be made responsible for ROI as
             computed in the divisional income statement and the balance sheet.

INTER PROFIT CENTER RELATIONS

             Responsibility centers differ from one another in their activities and
             performance. It is necessary to integrate the activities of the different
             responsibility centers. The performance measurement system should be so
             designed as to encourage the divisional managers to act in the best interest of
             the company.
             One major problem encountered during the measurement of the performance
             of a division is the determination of prices for goods and services that are
             transferred between divisions. This is referred to as the problem of transfer
             pricing.




                                                                  09
             The problem of transfer pricing arises when the business conducts transactions




                                                              20
             with each other. One solution to this problem is to stop business transactions
             among the divisions. However, this solution has some disadvantages. If the

                                                         of
             business transaction between the divisions are eliminated, the organization
             would have to forgo certain benefits, such as economies of scale in
                                                   s  s
             manufacturing and management.
                                                la
                                             C


Setting Transfer Prices
                                      y




             Transfer price is defined as the value of transfer of services between two or
                                    nl




             more profit centers. The transfer pricing system enables the management to
                                   O




             enjoy the benefits of centralization and decentralization. Transfer prices are
                              se




             not set by the corporate staff; they are negotiated by the divisions among
             themselves. The process of determining transfer prices is governed by two
                           U




             criteria-goal congruence and fairness.
                       S




             Goal congruence
                   B
                 rI




             A transfer price is said to be goal congruent if the buying and selling divisions
             Fo




             make decisions regarding the price and quantity of transfers, which would
             have been the same if they were made by the central management.
             Fairness in setting transfer prices
             This means that the profit center gives the divisional managers the required
             autonomy to pursue their objectives. In a profit center, where each division
             operates almost as an independent company, one of the most important
             decisions that the managers need to take concerns the pricing of products
             manufactured by the division. The buying division usually negotiates with the
             selling division to decide upon an appropriate price. However, disagreements
             between divisions on transfer prices is a common occurrence.
             A transfer pricing system is said to be efficient if it encourages managers to
             pursue decentralization of autonomy and, at the same time, not forgo the
             benefits of centralization. It should allow the divisional managers to achieve
             the goals and objectives of the organization and at the same time these goals
             should be in congruence with the organizational goals.
                                                                                           85
Principles of Management Control Systems


SUMMARY

            Assigning the right kind of autonomy and responsibility to employees will
            result in creative ideas. But a manager should be able to strike the right
            balance between autonomy and control. To understand autonomy, it is
            important to identify the variables that influence autonomy. They can be
            grouped under three heads: Management style and process, responsibility
            structure and reward systems. Management style, policies and procedures,
            diversification and business strategy fall in the first group. Reward systems are
            designed on the basis of the manager's ability to manage costs and
            investments. Responsibility structure consists of responsibility centers and
            related performance measurement systems. Responsibility structure
            establishes the physical, human and financial resources that are entrusted to
            the profit center manager. The availability of resources influences the
            decision-making authority of the responsibility center managers.
            Responsibility centers can be classified into revenue centers, expense centers,




                                                                   09
            profit centers, investment centers and cost centers. Revenue center are mainly




                                                               20
            responsible for raising the revenue, and assume no responsibility for profits. In
            expense centers, inputs are measured in monetary terms, whereas outputs

                                                          of
            cannot be easily quantified. There are two types of expense centers:
            Engineered expense centers and discretionary expense centers.
                                                   s  s
            In profit centers, financial performance is measured in terms of the numerical
                                                la

            difference between revenues and expenditures. An investment center is a
                                              C


            measure of economic performance and it analyzes all elements of profit and
            investments. Cost centers are supposed to minimize the variance between
                                      y
                                    nl




            standard costs and actual costs. When divisional autonomy is provided to
            centers, it becomes important to measure the performance of decentralized
                                   O




            operations. Factors ROI, are important for measuring performance. Managing
                              se




            inter-profit center relations is a major task in an organization. It is necessary to
            integrate the activities of the different responsibility centers so that they work
                           U




            towards the accomplishment of the goals of the organization.
                       S
                  B
                rI
            Fo




 86
Chapter 7




                                             09
Transfer Pricing
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                                            of
                                       ss
                                    la

In this chapter we will discuss:
                               C


•   Objectives of Transfer Pricing
                        y




•   Principle of Transfer Pricing
                      nl




•   Methods of Calculating Transfer price
                     O




•   Upstream Fixed Costs and Profits
                se




•   Administration of Transfer Prices
             U
          S
      B
    rI
Fo
 Principles of Management Control Systems


             When an organization has a decentralized structure, it has several separate
             profit centers1. Goods and services are transferred internally from one profit
             center to another, before the final product/service is brought to the market.
             Companies find it useful to account for the value of goods and services
             exchanged, even if the exchange is only internal and does not involve the
             market at all. This helps the company to assess the contribution of each of the
             profit centers separately. To help in such assessment, a mechanism called
             transfer pricing has been developed. Transfer pricing helps to determine the
             value of goods and services transferred before calculating the profits of the
             company. A transfer price is defined as “the price that is assumed to have been
             charged by one part of a company for products and services it provides to
             another part of the same company, in order to calculate each division's profit
             and loss separately.” In this chapter we will discuss the objectives of transfer
             pricing, various methods of transfer pricing and ways of administering these
             prices.




                                                                           09
                                                                      20
OBJECTIVES OF TRANSFER PRICING


                                                                of
             The main objective of transfer pricing is proper distribution of revenue
             between profit centers. If two or more profit centers are jointly responsible for
                                                         s   s
             product development and marketing, then the resulting profit has to be shared
                                                      la

             between the profit centers. Some other objectives of transfer pricing are:
                                                   C


             •     Providing relevant information to the profit centers regarding the trade-off
                                           y



                   between costs and revenues of the company.
                                         nl




             •     Inducing goal-congruent decisions, i.e., decisions that improve the profits
                                        O




                   of business units and also improve the profits of the company (this is
                                  se




                   discussed in detail below).
                               U




             •     Helping to measure the economic performance of profit centers.
                          S




             •     Minimizing tax liability.
                     B
                   rI




PRINCIPLE OF TRANSFER PRICING
             Fo




             The fundamental principle of transfer pricing is that the “transfer price should
             be similar to the price that would be charged if the product were sold to
             outside customers or purchased from outside vendors”.2

Goal Congruence
             While designing the mechanism for transfer pricing, the interests of profit
             centers should neither supersede the interests of the overall organization, nor
             should there be a clash of interests between the organization and its profit
             centers. In other words, there should be goal congruency between profit
             centers and parent organization. Some of the prerequisites for achieving goal
             congruency are:
             1
                 The concept and functioning of profit centers has been discussed in chapter 6.
             2
                 Management Control Systems by Anthony and Govindarajan, 8th edition, Irwin Publications.
88
                                                             Transfer Pricing


•   Competent people
•   Good organizational atmosphere
•   Details of market prices
•   Freedom to source
•   Availability of information
•   Scope for negotiation
Competent people
Organizations need managers who can balance long-term and short-term
goals. Managers are often accused of sacrificing long-term gains for short-
term profits. This approach can prove disastrous for the organization. Transfer
pricing can be misused for manipulating profits, and this gives a wrong picture
of the position of the company. Hence, organizations should have competent
people skilled at negotiation and arbitration, who are capable of determining




                                                      09
the appropriate transfer prices. This makes goal congruency possible.




                                                 20
Good atmosphere


                                            of
In order to achieve goal congruency, managers of profit centers, especially the
buying profit centers, should ensure that the transfer prices charged by the
                                         s
selling profit centers are just. This will create an atmosphere of trust between
                                       s
selling profit center and buying profit centers.
                                    la
                                  C


Details of market prices
                          y



When a product is transferred from one profit center to another, the normal
                        nl




market price for the identical product can be taken as the basis for establishing
                       O




the transfer price. The market price should reflect the same conditions in terms
of quantity, quality, time for delivery, etc. as characterize the product to which
                 se




the transfer price applies. The market price can be adjusted to reflect savings
              U




due to lower expenses on advertising and marketing as the product is sold
within the company.
           S
      B




Freedom to source
    rI




Managers of selling profit centers should be given freedom to sell their goods
Fo




in the external market, while managers of buying profit centers should be
allowed to buy their goods from the external market. Thus the market
becomes the main determinant of the transfer price.
Availability of information
Managers should be fully aware of market conditions and should have all the
necessary information available to them, before they take any decision. For
example, managers should be aware of the alternatives available and the
relevant costs of and revenues derivable from each alternative.
Scope for negotiation
There must be a mechanism for negotiating contracts, and managers who take
transfer pricing decisions should be trained in negotiation.
If all the above conditions are met, then companies can devise a mechanism
for transfer pricing based on the market price. But quite often these conditions

                                                                                89
 Principles of Management Control Systems


             are not fulfilled, and it becomes difficult to achieve goal congruency. Some
             situations that are not favorable for achieving goal congruency are:
             •   Limited markets
             •   Excess or shortage of capacity in the industry
             Limited markets
             Markets for buying and selling the goods of the profit centers may be either
             very small or nonexistent. Some of the reasons for this are:
             Firstly, the profit center may have spare internal capacity, but may not wish to
             make any external sales. Secondly, if the company is the sole producer of a
             differentiated product then outside capacity does not exist. Thirdly, a company
             that has invested heavily in facilities will not want to source goods from
             outside unless the selling price in the market is as low as its own variable cost.
             Excess or shortage of industry capacity




                                                                   09
             There may be situation of excess capacity or shortage of capacity in the
             industry. The selling profit center does not sell in the outside market when




                                                              20
             there is excess capacity in the industry. The buying profit center may purchase
             from outside vendors even though there is capacity available inside the
                                                         of
             company. Thus the company, as a whole, may not be optimizing its profits. In
                                                      s
             a situation of insufficient capacity in the industry, the buying profit center may
                                                    s
             be unable to obtain products it needs from the external market, whereas the
                                                 la

             selling profit center is able to make profits by selling the product in the
                                              C


             external market. This situation occurs when demand is high and industry
                                       y



             capacity is low. Here also, the company, as a whole, may not be able to
                                     nl




             optimize profits.
                                    O




             Sourcing constraints
                               se




             When there is an excess or shortage of industrial capacity, the sourcing
                           U




             decisions taken by the company are vital. A company may allow its buying
             profit center to buy goods from outside, if the profit center is getting a better
                        S
                   B




             deal in terms of quality, price and service. In the same way, a selling profit
                 rI




             center may be allowed to sell its products in the open market if it gets a better
             profit by selling in the market. Whatever be the case, the management should
             Fo




             not get bogged down by pressures within the company and should try to take
             decisions that optimize the profit of the company.

METHODS OF CALCULATING TRANSFER PRICE

             Methods used for calculating the transfer price differ from company to
             company. Companies should evaluate all the methods before adopting one that
             is most suitable for them. The following criteria should be used to evaluate the
             methods for calculating transfer price.
             Goal congruence: As already discussed, transfer prices should balance
             between goals of enterprise as a whole and its profit centers.
             Rationality: Transfer prices should not interfere with the process by which the
             buying center manager rationally strives to minimize costs and the selling
             center manager rationally strives to maximize revenues.
90
                                                                       Transfer Pricing


            Autonomy: Each profit center manager should be free to satisfy his center’s
            needs either internally or externally at the best possible price.
            Performance evaluation: Transfer pricing should aid in objective evaluation
            of the activities of the profit center. It should be used as a tool for making
            proper decisions. It should also aid in appraisal of managerial performance
            and of the enterprise as a whole.
            The three methods of calculating transfer price that are used commonly are:
            •   Market-based pricing method
            •   Cost-based pricing method
            •   Negotiated pricing method

Market-Based Pricing Method
            Companies that use this method price the goods and services they transfer




                                                                 09
            between their profit centers at a price equal to that prevailing for those goods
            and services in the open market. This is similar to ‘arm’s length’ pricing as




                                                            20
            intracompany transfers are priced the same as those for external customers.


                                                       of
            Market-based pricing method has two main advantages for a company. Firstly,
            business units can operate as independent profit centers with the managers of
                                                    s
            these units being responsible for their own performance as well as that of the
                                                  s
                                               la

            business unit. When managers are made responsible for performance of the
            business unit, it increases their motivation and it also becomes easier for the
                                            C



            headquarters to assess the actual operating performance of its business units.
                                     y




            Secondly, tax and customs authorities favor the market price method because
                                   nl




            it is more transparent and they can crosscheck the price details provided by the
                                  O




            company by comparing them with market prices on that date.
                             se




            In practice, however, the use of a market price as a benchmark is difficult
                          U




            because often there is no competitive market which can provide a comparable
            price. For some types of complex capital equipment, an external market may
                      S
                  B




            not exist at all. In some cases, prices may be distorted by monopoly elements.
                rI




            Moreover, a definitive market price may be difficult to determine because of
            variance in prices from one market to another due to changes in exchange
            Fo




            rates, transportation costs, local taxes and tariffs etc. In addition, a company
            may set its selling price depending on the supply and demand conditions
            prevalent in a specific market. In sum, these factors mean that a unique market
            price for companies to follow does not always exist.

Cost-Based Pricing Method
            The cost-based pricing method calculates transfer price on the basis of the cost
            of a good or service. The cost of a good or service is available in the cost
            accounting records of the company. This method is generally accepted by the
            tax and customs authorities since it provides some indication that the transfer
            price approximates the real cost of item. Cost-based approaches are, however,
            not as transparent as they may appear. A company can easily manipulate its
            cost accounts to alter the magnitude of the transfer price.

                                                                                          91
 Principles of Management Control Systems


             Companies that adopt the cost-based transfer pricing method have to choose
             between alternative approaches, which are listed below:
             •   Actual costs approach
             •   Standard costs approach
             •   Variable costs approach
             •   Marginal costs approach
             Apart from this, companies also have to decide on the treatment of fixed costs,
             and research and development costs. These issues can prove problematic for
             the company that adopts a cost-based transfer pricing method. Cost-based
             methods usually create difficulties for the selling profit center, as their
             incentive to be cost-effective may fall, if they know that they can recover
             increased costs simply by raising the transfer price. Without an incentive to
             produce efficiently, the transfer price may erode the competitiveness of the
             final product in the market place.




                                                                   09
Negotiated Pricing Method




                                                              20
             In this approach, buying and selling business units freely negotiate a mutually
                                                         of
             acceptable transfer price. Since each unit is responsible for its own
                                                      s
             performance, this will encourage cost minimization and encourage the parties
                                                    s
             to seek a transfer price which yields them an appropriate profit return.
                                                 la

             However the tax authorities have their reservations about this method because
                                              C


             companies that use this method have greater scope of manipulating transfer
                                         y



             prices, to minimize their tax liability.
                                       nl
                                      O




UPSTREAM FIXED COSTS AND PROFITS
                              se
                           U




             A typical transfer pricing problem is encountered in oil companies, paper
             companies and other integrated companies in which raw material is extracted
                        S




             and processed further for production of the final product. In such companies,
                   B




             in the absence of proper transfer pricing, the division that sells the final
                 rI




             product to outside customers may not be aware of the fixed costs involved in
             Fo




             the internal purchase price. For example, an oil company has three divisions:
             the crude oil division, the refinery division and the sales division. The final
             product of the company, say petroleum, is sold by the sales division, but
             before this, the crude oil division sells its crude to the refinery division, from
             where it is sent to the sales division. In this situation, the sales division may
             underestimate the costs (particularly the fixed costs) incurred during
             extraction and processing. So, it might sell the final product at a price that is
             not sufficient to recover fixed costs. Due to this company may incur losses and
             there can be a conflict between the two divisions.
             In order to tackle these kind of problems, companies should adopt following
             methods.
             •   Two step pricing
             •   Profit sharing
             •   Two sets of prices

92
                                                                           Transfer Pricing


Two Step Pricing
              Two step pricing involves charging for the product being transferred twice.
              First, the product is priced on the basis of the variable cost incurred in
              producing it. At the second stage of pricing, the fixed costs that are incurred
              because of certain special facilities used for production are also included. The
              sum of these two charges constitutes the transfer price for the product.

Profit Sharing
              Under this method, the product is transferred to the marketing unit at the
              standard variable cost. After the product is finally sold, the business units
              share the profit earned. But, this method may lead to disagreements over the
              way the profit is divided between the two profit centers. Sometimes, senior
              management has to intervene to settle these disputes. As the profits between
              units are divided arbitrarily, it does not reflect accurately the profitability of




                                                                    09
              each segment. Also, as the manufacturing unit's contribution depends on the
              marketing unit's ability to sell and the actual selling price, this may be treated




                                                               20
              as unfair by the manufacturing unit.

Two Sets of Prices
                                                           of
                                                     s s
              Under this method, revenue is credited to the manufacturing unit at the market
                                                  la

              sales price and the buying unit is charged for the total standard costs. The
                                               C


              difference between the outside sales price and the standard cost is charged to
              the parent company’s account. These charges are later eliminated while
                                        y
                                      nl




              drawing consolidated financial statements. This method is used when there are
              frequent conflicts between the buying and selling units and they cannot be
                                     O




              resolved by any method.
                               se




              The disadvantages of this method are:
                            U




              1. It is difficult to maintain an additional book each time a transfer of good is
                         S




                 made.
                     B




              2. It motivates the managers to concentrate only on internal transfers (where
                   rI




                 they are assured of a good markup) at the expense of outside sales.
              Fo




ADMINISTRATION OF TRANSFER PRICES

              Implementing transfer pricing involves long negotiations between heads of
              various units, classification of products, and arbitration and conflict resolution
              in case conflicts arise.

Negotiation
              Business units of companies negotiate among themselves before taking
              decisions pertaining to transfer prices. The headquarters does not involve itself
              in formulating transfer prices and leaves it to the line managers of the
              respective units to establish the buying and selling prices. There are two
              reasons for this. Firstly, the line managers of the business units may feel
              powerless if they are denied any say in the transfer prices, and this may affect
                                                                                              93
 Principles of Management Control Systems


             their motivation. Secondly, if the profits of business units are poor then the
             unit managers may argue that it is due the arbitrariness in setting transfer
             prices by the headquarters.

Arbitration and Conflict Resolution
             There may be times when business units are not be able to reach an agreement
             on transfer price easily. In such situations, business units should follow a set
             procedure for arbitrating disputes relating to transfer price. The responsibility
             for arbitration rests with the parent company. It may assign a single executive
             who can talk to the business unit managers and arrive at an agreement over the
             price. Alternatively, a committee may be formed with the following
             responsibilities: to settle transfer price disputes, to review sourcing changes,
             and to change the transfer price rules whenever necessary.
             Organizations can have a formal or informal system of arbitration to
             administer the transfer price mechanism and to resolve the conflicts. In a




                                                                  09
             formal system of arbitration, both the parties submit a written case to the
             arbitrator, who reviews it and decides the price. In an informal system of




                                                              20
             arbitration, most of the presentations are oral.

                                                         of
             Irrespective of the formality of the arbitration and the process of conflict
             resolution in an organization, the goal is to make the system of transfer pricing
                                                      s
             system effective. The management can use any one of the following ways to
                                                   s
                                                la

             resolve the conflicts: forcing, smoothing, bargaining, and problem solving.
             Forcing and smoothing reflect conflict avoidance, whereas bargaining and
                                             C



             problem solving indicate conflict resolution.
                                      y
                                    nl




Product Classification
                                   O




             Sourcing and transfer pricing are greatly affected by the number of
                              se




             intracompany transfers and the availability of markets and market prices. The
                           U




             larger the number of intracompany transfers and the less the availability of
             market prices, the greater the need for more formal transfer pricing rules. If
                         S
                   B




             market prices are readily available, the headquarters can play a vital role in
                 rI




             making sourcing decisions. In some companies, products are classified into
             various categories to help in determining transfer prices. For example, a
             Fo




             company can divide its product portfolio into two classes before taking
             transfer pricing decisions.
             Class I products may include all those products whose transfer price the senior
             management at the headquarters would like to control.
             Class II products may include those products that can be produced outside the
             company without disrupting the normal workflow. These products are small
             in volume and are transferred at market prices.

SUMMARY

             A transfer price is defined as “the price that is assumed to have been charged
             by one part of a company for products and services it provides to another part
             of the same company, in order to calculate each division's profit and loss
             separately.” The main objective of transfer pricing is to aid in the proper
94
                                                          Transfer Pricing


distribution of revenue between profit centers. While designing transfer
pricing systems, organizations should aim at goal congruency. Some of the
factors which help in achieving goal congruency are: competent people, good
atmosphere, freedom to source, market price details, availability of
information, and scope for negotiation. Some factors that hamper achievement
of goal congruency are: limited markets, excess or shortage of industry
capacity, and sourcing constraints. Companies use three methods for
establishing transfer prices. They are the market-based pricing method, the
cost-based pricing method, and the negotiated pricing method. Integrated
companies can use two-step pricing, profit sharing or two sets of prices in
order to overcome problems related to upstream fixed costs. Implementation
of transfer prices is more difficult than formulating them. Companies need to
engage in negotiations, provide mechanisms for arbitration, and classify their
products, to overcome problems that can arise during implementation of
transfer prices.




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           PART III:
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     MANAGEMENT CONTROL
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         PROCESSES
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Chapter 8




                                             09
Strategic Planning and
                                            20
                                            of
Programming
                                      s
                                      s
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                       y
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In this chapter we will discuss:
                    O




•   Elements of Strategy
               se




•   Characteristics of Strategic Planning
            U




•   Strategic Planning Process
         S




•   Analyzing Proposed New Programs
      B
    rI




•   Analyzing Ongoing Programs
Fo




•   The Programming Process
 Principles of Management Control Systems


              Strategic planning involves long-term planning, and is usually undertaken by
              the top management. Strategic planning is the process of deciding on the
              programs that the organization will undertake and the amount of resources that
              will be allocated to each program in the next few years.
              For strategic planning to be effective, it should be accompanied by an
              appropriate organizational structure, an effective management information
              system, a budgeting system and a reward system. Decisions regarding
              strategic planning influence the physical, financial and organizational
              framework within which the relevant operations are carried out. The
              programming process is an organizational process for making long-term
              resource allocation decisions. This chapter examines in detail the significance
              of strategic planning, the strategic planning process and the programming
              process.

ELEMENTS OF STRATEGY




                                                                        09
                                                                   20
              According to Yavitz1 and Newman, there are four elements of strategy-
              domain sought, differential advantage, strategic thrusts and targeted results.

                                                              of
              The domain sought relates to analyzing the environment in which the
              organization is functioning. It addresses issues related to the changing needs
                                                        s s
              of the business activity, the changes in the business environment, changes in
                                                     la

              the customer’s perception regarding the company’s products and best
                                                  C


              practices to deal with competition. All these relate to the domain in which the
              organization operates. Benchmarking is considered an important tool for
                                          y
                                        nl




              comparing the company’s products with those of its competitors.
                                       O




              Differential advantage relates to identifying the strengths and weaknesses of
              different businesses, improving upon the strengths and overcoming the
                                 se




              weaknesses.
                              U




              After an organization analyzes the domain and differential advantage, the next
                          S




              step is to plan the strategies required to achieve the goals. This involves issues
                     B




              related to costs, marketing new products and services, planning the training
                   rI




              and development strategies required for the staff to work in congruence with
              the organizational goals.
             Fo




              The last stage involves analyzing performance. To know whether an
              organization is moving in the right direction, it is important to measure at
              regular intervals the actual results against expected results.

CHARACTERISTICS OF STRATEGIC PLANNING

              Strategic planning is the first step in the management control process. The
              difference between strategy formulation and strategy planning is this: Strategy
              formulation is the process of deciding on new strategies, whereas strategic
              planning is the process of deciding on how to implement these strategies.
              Strategy formulation essentially involves deciding on the goals of the

              1
                  Yavitz, Boris and William H Newman, “Strategy in action: The execution, politics and
                  payoff of business planning,” New York: The Free Press, 1982.
100
                                                    Strategic Planning and Programming


              organization, whereas strategy planning is concerned with developing
              programs to implement these goals effectively and efficiently. Strategic
              planning is systematic; it is usually done annually with prescribed procedures
              and timetables. Strategy formulation is unsystematic and depends on the
              threats or opportunities that the environment offers.

Benefits of Strategic Planning
              1. Strategic planning takes into consideration the changing business
                 environment which is a foundation for organizational change.
              2. It helps in identifying and analyzing the internal business culture and
                 evaluating its impact on the company’s performance.
              3. It helps in analyzing available opportunities and potential threats.
              4. It helps in allocating resources to the most beneficial activities.
              5. It helps managers set realistic objectives that are demanding, and yet




                                                                    09
                 attainable.




                                                                20
              6. It helps in identifying poor performing areas and eliminating them.

                                                           of
              7. It helps in obtaining better information for decision making.
                                                       s
              8. It helps in developing a frame of reference for budgets and short-range
                                                     s
                 operating plans.
                                                  la

              9. It helps in bringing about coordination of internal activities and thereby
                                               C



                 enhances the organization's growth.
                                        y
                                      nl




              In short, strategic planning provides a road map of the company's target, and
                                     O




              how to reach it.
                               se




Organizational Relationships
                            U




              An important purpose of strategic planning is to improve communication
                         S




              between the corporate and business unit executives, and arrive at a mutually
                    B




              agreed upon set of objectives and plans. In some organizations, the controller
                  rI




              organization is involved in preparing the strategic plans while in others, there
             Fo




              is a separate planning staff. In organizations where the controller of the
              organization is involved in the preparation of strategic plans, the plans may
              not be as successful as other organizations. Analytical skills and broad outlook
              may not exist in the controller organization. Such organizations may be
              suitable for fine-tuning the annual budget and analyzing the variances between
              actual and budgeted costs. Even in organizations that have a separate strategic
              planning staff, disseminating guidelines and assembling and bringing together
              the budgeted numbers are done by the controller organization.
              The staff at the headquarters should facilitate the strategic planning process,
              but should not intervene too strongly. They must ensure that the process runs
              smoothly but should not make program decisions themselves. This encourages
              business unit managers to freely put forward their views in the decision-
              making process.


                                                                                          101
 Principles of Management Control Systems


Top Management Style
              The way strategic planning is conducted depends largely on the chief
              executive officer’s style. Some CEOs prefer to make decisions without a
              formal system. If the controller of such companies attempts to introduce a
              formal system, it is not likely to succeed. In some companies, the senior
              executives may prefer an extensive formal analysis and documentation of the
              plan, and hence, the plan is very elaborate. Thus, in designing the system, it is
              important that the senior management’s style be clearly diagnosed and the
              strategic plan be prepared accordingly.

STRATEGIC PLANNING PROCESS

              The strategic planning process involves the following steps:
              •   Reviewing and updating the previous year’s strategic plan.




                                                                   09
              •   Deciding on assumptions and guidelines for the plan.




                                                               20
              •   First iteration of the new strategic plan

                                                              of
              •   Analysis
              •
                                                        s
                  Second iteration of the new strategic plan
                                                     s
              •   Review and approval
                                                  la
                                               C


Reviewing and Updating the Strategic Plan
                                        y
                                      nl




              This involves reviewing and updating the strategic plan that was prepared in
                                     O




              the previous year. Reviewing and updating takes place every year when the
              strategic plan is prepared, depending on the decisions the management takes.
                               se




              There is no fixed time limit set for this review. The updating of these plans is
                             U




              done with the help of a computer program. These programs help in
              incorporating the decisions on revenues, expenses, capital expenditures and
                        S




              cash flow. Updating is usually taken up by the planning staff. The
                    B




              management is involved, only if there are uncertainties or ambiguities in the
                  rI




              program decisions.
             Fo




Deciding on Assumptions and Guidelines
              This step involves making broad assumptions about growth in the gross
              domestic product, cyclical movements, the rate of general inflation, labor
              rates, prices of important raw materials, selling prices, market conditions, and
              the government legislation, in each of the countries in which the company
              operates. All these assumptions are examined and updated with the latest
              information. This process of updating has implications on revenues, expenses
              and cash flows of the existing operating facilities. It shows the amount of new
              capital that is available from the retained earnings and new financing. All
              these data are clearly analyzed so that it is currently valid (for the present
              year) and the amounts are extended for another year. This updating provides a
              rough estimation for the senior management to decide about the key
              guidelines that are to be observed in planning and for designing of these
              methods for achieving these objectives. The objectives are presented
102
                                                    Strategic Planning and Programming


              separately for each product line and are expressed as sales revenue, or as a
              profit percentage or a return on capital employed. There also are guidelines
              regarding wage and salary hikes, new or discontinued product lines and selling
              prices. At this stage, basically the views of the senior management are
              presented.
              To present these objectives to the business unit managers, most companies
              hold meetings between the corporate and business unit managers. Such
              meetings continue for several days, and help all business unit managers in the
              organization know one another. These meetings are held far away from office
              premises, to avoid distractions.

First Iteration of the Strategic Plan
              After the assumptions and guidelines have been framed, the business units
              prepare the first iteration of the strategic plan. Most of the initial
              documentation and analytical work is done by the members of the business




                                                                    09
              unit. After this, a final decision is taken by the business unit managers. The
              staff at the headquarters may also be consulted with regard to drawing up




                                                               20
              these plans. During the preparatory stage, employees from the headquarters
              visit the concerned business unit to find out whether the guidelines,
                                                          of
              assumptions and instructions are being followed.
                                                       s
              The completed strategic plan consists of income statements (inventory,
                                                     s
                                                  la

              accounts receivable) and other balance sheet items (sales and production, of
              expenditures of the plant and other capital acquisitions). These income
                                               C



              statements are elaborately explained and justified. The numbers are presented
                                        y




              in detail. They are also presented for the next two years, individually, with
                                      nl




              summary information for the later years. Then these are submitted to the
                                     O




              headquarters.
                               se




Analysis
                            U




              After the plan prepared by a business unit is received at the headquarters, it is
                         S
                    B




              integrated into the overall corporate strategic plan, which is analyzed in detail.
                  rI




              Employees from all functional areas like marketing and production, and the
              planning staff take care of the analysis. If there is any problem related to a
              Fo




              particular business unit regarding additional funds for research and
              development, or if any slack is detected, then it is resolved through
              discussions between headquarters staff and their counterparts in the business
              units. These discussions form an important part of the strategic planning
              process, because they help identifying planning gaps. Planning gaps occur
              when the individual business unit plans do not work towards achieving
              corporate objectives. The best way to close these gaps is by:
              •   Identifying the areas where the business unit plan can be improved on par
                  with the corporate plan
              •   Making acquisitions
              •   Reviewing the corporate objectives
              Of the three, utmost importance is given to the first method to close the gap.
              The headquarters should also ensure that there is coordination between the

                                                                                            103
 Principles of Management Control Systems


              different departments. For example, if one business unit manufactures for
              another unit, then it should be analyzed whether the unit is manufacturing as
              per the requirements of the other unit. At the planning stage planned cash
              requirements for the organization as a whole are developed, which include
              additional financing or possibly increasing dividends.

Second Iteration of the Strategic Plan
              The analysis of the first plan leads to revision of the plans of certain business
              units. Sometimes, the guidelines may be changed, and this leads to a change
              in the overall plans of all the business units. Technically the revision is simple
              enough, but implementing such changes within the organization it difficult
              and time-consuming, because difficult decisions have to be made. In some
              companies, changes in the business unit plans are negotiated informally, and
              the results are incorporated into the plan by the headquarters.




                                                                    09
Final Review and Approval




                                                               20
              The revised plan is discussed with the senior corporate officials. It can also be
              presented in the meeting of the board of directors, and the final approval

                                                          of
              comes from the chief executive officer. The approval process should be
              completed before beginning the budget preparation process, as strategic
                                                       s
              planning is an important input for budget preparation.
                                                     s
                                                  la
                                               C


ANALYZING PROPOSED NEW PROGRAMS
                                        y
                                      nl




              Ideas for new programs may originate anywhere in the organization- from the
                                     O




              chief executive to the employees in the organization. Giving employees the
                               se




              freedom to put forward their proposals and paying them management attention
              plays an important role in implementing new programs. Every organization
                            U




              should have a management system that is flexible enough to encourage new
                         S




              ideas and pay the required attention to the employees. Adoption of new
                    B




              programs should be viewed as a series of decisions, and not a single decision.
                  rI




              Capital investment analysis is important for taking up new proposals. The
             Fo




              importance of capital investment analysis is to find the net present value of the
              project and the internal rate of return. The present value techniques are not
              used in analyzing the proposals for the project because:
              •   If the proposal is not attractive enough then it is not necessary to calculate
                  the net present value.
              •   The estimates involved in the project are so uncertain that making present
                  value calculations is not worth the effort.
              •   The present value approach concentrates on the increasing profit of the
                  firm. But some projects can be implemented to boost employee morale
                  and to improve the company’s image, or for safety reasons.
              The management control system should look for a systematic way of arriving
              at a decision on proposals that cannot be analyzed using quantitative
              techniques. Organizations must look into the following issues before
              implementing capital expenditure evaluation systems:
104
                                                            Strategic Planning and Programming


Rules
             Companies publish rules and procedures for the submission of capital
             expenditure proposals. These rules specify the requirements for a proposal to
             be approved (of various magnitudes). The proposals are approved by the
             business unit manager, the chief executive officer or the board of directors
             depending on the degree of proposed expenditure. These rules also provide
             guidelines for the preparation of proposals and the general criteria for
             approving these.

Avoiding Manipulation
             Sometimes projects that have a negative net present value may get approval
             because they are made attractive by adjusting the original estimates. This can
             be done by making more optimistic estimates of the sales revenue and
             reducing the amount of contingencies in some of the cost elements. Detecting
             such manipulations is one of the important tasks of the project manager.




                                                                               09
Acquaintance with Planning Models




                                                                         20
             The staff involved in planning should be acquainted with various aspects of
                                                                   of
             budgeting, such as risk analysis, sensitivity analysis, game theory, option
                                                                s
             pricing models, contingent claim analysis and decision tree analysis. These
                                                            s
             aspects will prove useful in situations in which the required data are available.
                                                         la
                                                     C


Organizing for Analysis
                                             y




             A team should be formed to evaluate important proposals. The analysis of a
                                           nl




             project is usually done by a dozen functional and line executives before it is
                                          O




             submitted to the chief executive officer. The project then goes through pilot
                                   se




             testing and, at times, may not be approved for further analysis by the CEO.
             New technological systems like the expert systems2 are very handy for
                                U




             analyzing the proposed programs. Several software systems have been
                           S




             developed, that enable each member of the team to vote and rank each of the
                     B




             criteria used to evaluate the program.
                   rI




             There is no fixed time for the commencement of such an analysis. It begins as
             Fo




             soon as the proposal for the project is received. The projects that are approved
             are included in that year’s capital budget. If a proposal is not approved that
             year, then the formal approval may wait until the next year. The capital budget
             contains the authorized capital expenditures for the budget year and in case
             additional amounts are sanctioned, the cash plans are revised.

ANALYZING ONGOING PROGRAMS

             It is not only important for a company to develop new programs, but also to
             analyze the ongoing programs. The tools used for analyzing ongoing programs
             2
                 An expert system is a computer program that simulates the judgment and behavior of a
                 human or an organization that has expert knowledge and experience in a particular field.
                 Typically, such a system contains a knowledge base containing accumulated experience and
                 a set of rules for applying the knowledge base to each particular situation that is ascribed to
                 the program.
                                                                                                           105
 Principles of Management Control Systems


              are value chain analysis, activity-based costing and discretionary expense
              center analysis.

Value Chain Analysis
              The value chain is a series of activities- from identifying the raw material to
              delivering the product to the consumer. As a part of the strategic planning
              process, a value chain helps an organization to understand the entire value
              delivery system. It highlights three areas for increasing profits-link with
              suppliers, link with customers and process linking within the value chain of
              the firm. The link with suppliers should be managed in such a way that both
              the firm and the suppliers benefit from it. Its relationship with customers is
              equally important. These two should be mutually beneficial. Apart from
              maintaining such relationships with suppliers and customers, it is also
              important for the firm to realize that the value activities in a firm are not
              independent, but interdependent. As part of the strategic planning process, a




                                                                  09
              company may sometimes require information about the linkages within the
              value chain to improve efficiency. For this purpose efficiency in value chain




                                                              20
              should be analyzed. The efficiency of pre-production activities can be
              improved by reducing the number of vendors, adopting just-in-time delivery

                                                         of
              systems and establishing quality standards. The efficiency of the production
              unit can be increased through automation and better production control
                                                    s s
              systems. The efficiency of delivery to the customers can be increased by
                                                 la

              automating the orders that they place, and by improving the channels of
                                              C


              distribution, the efficiency of warehouse operations, and so on. It is important
              that improvements should be evaluated simultaneously, as all the activities are
                                       y
                                     nl




              inter-linked.
                                    O




Activity Based Costing
                               se




              Increased automation and computerization have resulted in the
                            U




              implementation of certain systems for collecting and using cost information.
                         S




              The traditional cost system allocated overhead costs to the products based on
                    B




              the direct labor hours or machine hours. The new cost system uses multiple
                  rI




              allocation bases. Here, direct labor costs are combined with other costs to
             Fo




              obtain the total conversion costs i.e. labor and factory overhead costs of
              converting raw materials into finished products. In the new system, the word
              ‘activity’ means cost center and hence, the cost system is called the activity-
              based cost system. Activity-based costing is discussed in detail in Chapter 12.

Expense Center
              Service and support units, R&D centers, administrative centers are examples
              of discretionary expense centers. The expenses of such units cannot be clearly
              stated and hence, in the strategic planning process, the trend is to take the
              current level of expenses in a discretionary expense center as the starting
              point, and adjusting it upward for inflation and adjusting it further for
              anticipated changes in the workload. Requests for more funds are granted if a
              manager finds them really important. Usually, during the strategic planning
              and budget preparation process, there isn’t sufficient time to analyze the
              discretionary expenses. The alternative is to make a thorough analysis of the

106
                                              Strategic Planning and Programming


         discretionary expense center, following a schedule that will cover all expenses
         over a period of five years. This analysis will provide a new base for
         estimating the expenses in the future years. Such an analysis is called “zero
         based review.” However, in the next five years, new expenses may creep up,
         and require a new base. Usually budgets take into consideration the current
         level of spending as the base, but zero based review takes into consideration
         the resources that are actually needed. The importance of the activity is
         considered after analyzing the importance of the function, the quality level,
         the methods through which it has to be performed and the costs that have to be
         incurred. This approach compares project costs and output measures for
         similar operations. A zero based review follows a strict schedule, and
         managers are always under tremendous pressure, because their operations are
         reviewed and they have to justify their current level of expenditure.


THE PROGRAMMING PROCESS




                                                              09
         The process of programming includes allocating long-term resources.




                                                          20
         Programming involves all the responsibility centers of the organization that
         draw plans for achieving the strategic goals of an organization.
                                                     of
         An important aspect of the programming process is that organizations make
                                                  s
         decisions about resource allocations, that require expenditure in the present, in
                                               s
                                            la

         anticipation of returns in the future. The programming process includes
                                         C


         defining, evaluating and implementing new programs in order to achieve long-
         term goals.
                                  y
                                nl




         As part of the planning process, long-term goals are identified and assigned to
                               O




         responsibility centers. These goals are compared with the expected future
         performance and the gaps in planning are identified. This helps in designing
                          se




         and implementing programs to close these gaps.
                       U




         The decisions involving expenditure in the programming process is crucial to
                   S




         the organization's success. Some difficult decisions that are made during the
               B




         programming process are:
             rI




         1. Replacement of worn-out equipment to remain ‘competitive.’
        Fo




         2. Expansion of the firm’s capacity to produce improved goods and offer
            better services in order to ‘grow.’
         3. Effective adaptation to the changing environmental conditions.
         4. Adoption of a policy of mergers and acquisitions in order to close the gaps
            in planning. Planning and programming go hand-in-hand, as programs are
            developed as a part of the long-term planning process.
         The programming process depends on the size and diversity of the
         organization. The decisions that are made during this process have a
         significant influence on the ability of the firm's ability to survive and achieve
         its goals and objectives.
         In short, the programming process returns a set of feasible programs directed
         toward achieving long-term goals. Programming is carried out simultaneously
         with the long-term planning process.


                                                                                      107
 Principles of Management Control Systems


              As stated earlier, some difficult decisions are made during the programming
              process. Bower's model is a widely cited model for making investment
              decisions.

Bower's Model of the Investment Decision-Making Process
              A ‘discrepancy’ in a performance variable arises when the actual results differ
              from the desired results. This discrepancy forms the basis of Bower’s model.
              One important discrepancy is the planning gap that arises during the long-term
              planning process.
              The discrepancies that arise in the various systems of the organization, such as
              the production and planning system, accounting systems and information
              system, generate the capital expenditure project. The capital expenditure
              project requires both technical and economic analyses, which are carried out
              during the first phase of the resource allocation process.
              During this phase, the discrepancy between the actual and desired values of a




                                                                  09
              key variable is focussed. The key variables include the size of the market, the




                                                              20
              profit margin, prices, operating costs, quality, and technological
              competitiveness. The discrepancy is first detected at the lower level of

                                                         of
              management. Then a project is defined at lower levels of the organization,
              where technical expertise is likely to be found, to overcome the discrepancy.
                                                      s
              The project is then subjected to economic analysis.
                                                    s
                                                 la

              The next step is selling the project. It is at this stage where the greatest
                                              C


              discrepancy arises, when it is realized that projects selected are not the right
              ones. Usually, the major investment decisions are approved by the top
                                       y
                                     nl




              management while the projects that are developed at the lower level are
              approved by the upper-level divisional managers. The duty of the division
                                    O




              manager is to evaluate the goals and objectives of his division, and decide
                               se




              whether to approve the project. During the process of evaluation, the division
              manager keeps in mind the corporate objectives and the reward structure of
                            U




              the organization.
                        S
                    B




              If the reward structure is based on the manager’s batting average (quantifiable
                  rI




              performance), then he selects the projects with a high probability of short-term
              returns (low risk) instead of those with a medium probability of extremely
             Fo




              large returns. In other words, division managers choose projects which have a
              short pay-back period than those which have high, but risky, net present value.
              The projects are ranked according to the speed at which the capital outlays can
              be recovered.
              Division managers use the payback period, rather than the net present value
              method as an economic resource tool. The NPV method is considered only
              when the reward structure is based on the criteria for maximizing profits.
              Thus, Bower’s model suggests that project ideas come from the lower levels
              of management. The middle level of management approves the projects and
              allocates resources to them. In fact, the middle level of management is
              responsible for matching management desires of the lower levels with the
              criteria of the upper levels. The final decision regarding investment is made by
              the top management, which approves the project and determines the reward.
              Top management approves the project and establishes rewards. The authority
              for designing the programming process lies with the top management. This
108
                                                       Strategic Planning and Programming


            includes planning strategy, determining the criteria for acceptance, the
            approval levels, the process of programming and the reward systems.

Parameters of the Programming Process
            Bower’s model has been extended by Kovar3, who has proposed and tested a
            model of the capital investment approval process, which incorporates factors
            that influence employees’ behavior during the early stages of the process of
            making investment decisions. There are three phases of the investment process
            that involve different levels of the organization.
            •     The initiating phase
            •     The integrating phase
            •     The corporate phase
            In the early stages of the investment process, initiating and integrating phases,
            the plans proposed by managers help in identifying new possibilities. The




                                                                        09
            corporate phase helps in identifying and evaluating opportunities for growth




                                                                   20
            within the organization, and the steps to be taken to effect such growth are
            determined. Organizational behavior in the programming process consists of

                                                              of
            the employees’ rational, practical and emotional behavior. These are
            influenced by the design of the project approval process. The approval process
                                                       s  s
            is designed with the rate of return, linkage to strategy and legal constraints in
                                                    la

            view. The control system designers should be aware that emotional and
                                                 C


            practical problems of employees influence investment proposals, and the
            programming process designed should cover all these aspects. None of these
                                          y




            elements should be paid excessive attention. There are a number of aspects
                                        nl




            that are associated with programming process. Kovar has identified nine of
                                       O




            them. They are:
                                 se




            i.      Linkage to the strategic plan: The investment projects that are
                              U




                    undertaken by an organization should be linked to its strategic plan of an
                    organization. At times, profitable investments help to generate new
                          S
                     B




                    strategies.
                   rI




            ii.     Limits of approval: There should be a limit to the number of projects to
            Fo




                    be approved, and it should apply to the entire organization.
            iii. Number of steps in approval: If the number of steps in the approval
                 process is high and if the process requires the approval of several people,
                 then the process of approval will move slower. This will delay the
                 investment process and demotivate the employees.
            iv.     Involvement of the line manager and accountability: The responsibility
                    of the programming process should be entrusted to the line management
                    with the staff acting as catalysts. However, there is a possibility that the
                    process may be taken over by the members of the staff and the line
                    managers may not be accountable for the results. This will affect the
                    decision-making process.


            3
                  Kovar, Donald G., The decision making environment of the capital investment approval
                  process, Phd dissertation, Claremont Graduate School, Claremont Calif., 1986.
                                                                                                  109
 Principles of Management Control Systems


              v.     Financial analysis and supporting detail: The programming process is
                     designed in such a way that it will be able to accommodate all kinds of
                     strategic changes any time in the future. If there is too much emphasis
                     on financial analysis, then some significant strategic elements may be
                     ignored. There has to be a balance between all these elements.
              vi.    Discount rate: An organization should have knowledge of its opportunity
                     cost of funds. However, the firm should not be obsessed with it. Many
                     projects that are successful are quite insensitive to opportunity costs and
                     big changes in the discount rates of these costs.
              vii. External environment analysis: The right investment choice can be made
                   with an accurate assessment of the environment in which the firm
                   operates. Formal processes should be introduced to support informal
                   mechanisms, for an accurate understanding of the external environment.
              viii. Identification and analysis of alternatives: In order to solve problems
                    related to a particular project, similar projects to be identified and




                                                                    09
                    analyzed. Since these projects are likely to have come across problems




                                                                20
                    those facing the project in question now. The solutions to the former may
                    apply to the latter, too.
              ix.
                                                           of
                     Education and training: Extensive education and training on the
                                                        s
                     objective of the programming process and the methodology of carrying it
                                                      s
                     out is quintessential.
                                                   la
                                                C


Mutually Supportive Management Systems for the Implementation of Strategy
                                         y




through Programming Decisions
                                       nl
                                      O




              To examine and redesign the management systems associated with resource
              allocation, the control systems designer needs to develop a model or
                                 se




              framework. This framework would help in deciding making decisions
                              U




              regarding the long-term resource allocation. The framework helps in designing
                          S




              the elements of the programming process. It helps in answering the following
                      B




              questions:
                    rI




              •     Is there consistency between the organization's structure and its strategy?
             Fo




                    Is the control system helpful in implementing the strategy?
              •     Have assignments been given to all the managers in the organization to
                    accomplish strategic objectives?
              •     What role do performance measurement and reward systems play in
                    encouraging managers to focus on short-term and long-term objectives in
                    the resource allocation process?
              •     How do the management style and organizational culture influence the
                    resource allocation process?
              •     What role do planning and reporting systems play in the implementation
                    of the organization's strategy?
              •     What role does communication mechanisms play in the resource
                    allocation process?


110
                                                Strategic Planning and Programming


           Organization structure and strategy
           The point that should be discussed first is whether the structure of the
           organization supports its strategy. The second point is, whether the
           responsibility of achieving the organizational goals has been appropriately
           distributed within the organization.
           Performance measurements and rewards
           The performance measurement and reward systems should be so designed as
           to achieve both short-term and long-term objectives. Bonuses should be given
           both to employees for short-term and long-term success. The rewards system
           should be structured according to the short -term and long-term tasks.
           Management style and organizational culture
           The management style and organizational culture influence the way
           organizational decisions are made. By giving autonomy to the employees and
           encouraging competition between them, the management facilitates innovation




                                                               09
           and entrepreneurship within the organization.




                                                           20
           Planning and reporting


                                                      of
           The planning process should support the decisions regarding the resource
           allocation with formal information available within the organization and
                                                   s
           discussion forums within the organization. The process should also include the
                                                 s
           financial implications of various programs and link them to short term
                                              la

           operating budgets.
                                           C



           Communication mechanisms
                                    y
                                  nl




           Effective communication is essential for managing conflicts associated with
                                 O




           the decision making process for short-term and long-term resource allocation.
           Committees should be set up and schedules for meeting should be established
                            se




           for making such decisions and to resolve conflicts regarding program
           alternatives.
                         U




           In evaluating management systems and their impact on the process of making
                     S
                 B




           decisions about resource allocation, it is important to recognize the importance
               rI




           of the interdependence of the systems.
           Fo




Formal Programming Procedures
           These are procedures developed by organizations for defining, evaluating and
           implementing investment projects. These processes may often take a
           secondary role to the previously identified organizational processes. The
           different steps in evaluating and implementing investment projects are as
           follows:
           Project definition
           If a project is found to have deviated from the organizational goals, as
           reported by the information systems of various responsibility centers, than the
           need for defining the project arises. This helps in identifying the reasons for
           the above said variances. These variances may be caused by equipment
           inefficiencies, sales forecast that exceed the plant capacity and so on. To
           identify these variances, a manager uses information systems to compare the
           actual performance of the firm with its goals.

                                                                                       111
 Principles of Management Control Systems


              In organizations that have complex structures, the operational level of the
              enterprise decides on most capital proposals. The controller plays an important
              role in managing the process of proposing a project and prescribing how the
              proposal should be defined. Detailing of a proposed project includes a
              description of the objectives and purposes of the project and the technology to
              be used. Defining a project also requires the understanding the purpose of
              each project to be looked closely at, and whether these are congruent to the
              organizational goals. The project should be analyzed with its influence on the
              key variables in mind. It should be reviewed, considering the impact it has on
              costs, quality or market shares of the competitors.
              Project evaluation
              In an organization, any employee of any hierarchical level may come up with
              a project proposal. He should be given detailed, concrete instructions about
              the whole process of proposing a project. The procedures and paperwork
              involved in the process of project proposal are usually laid down in ‘capital




                                                                   09
              appropriation manuals.’ There are different procedures based on the category




                                                               20
              of the project and hence, there is a need for different evaluation criteria and
              techniques for each category.          Each project category has its own

                                                          of
              characteristics and has to be distinguished from others.
                                                       s
              Project implementation and control
                                                    s
                                                 la

              Control over capital expenditures begins in the definition and evaluation
                                              C


              phase. Next comes the implementation phase. Projects with major capital
              investment affect the organization as well as suppliers and subcontractors.
                                       y
                                     nl




              Such projects need to be monitored constantly and controlled appropriately so
              as to ensure that the firm accords performance to the proposal, and that the
                                    O




              costs do not exceed the budget.
                               se




              The capital projects manual
                            U




              This consists of details about policies related to project definition, evaluation
                        S
                    B




              and implementation. This is taken as a standard procedure for the entire
                  rI




              organization. It contains instructions about the following:
             Fo




              •   The investment authorization schedule about the various projects and the
                  levels at which these projects can be implemented.
              •   The various forms used in financial evaluation that can be used in project
                  evaluation as well.
              •   Forms related to the duration of the project and the capital expenditure
                  incurred.
              •   Financial and schedule status report for each project, that includes all
                  activities from giving authorizations to estimating costs at completion.
              •   A periodic project audit that analyzes whether the actual results conform
                  to predicted results.
              The formal programming process thus helps to collect, analyze and
              communicate information about strategic and program alternatives being
              considered by the organization.

112
                                                 Strategic Planning and Programming


SUMMARY

          Strategic planning is the process of deciding on the goals of the organization
          and the resources necessary to attain these goals. It enables managers to
          prepare for, and deal with, the rapidly changing environment in which their
          organizations operate. It provides a direction to the organization’s mission,
          objectives and strategy, thereby facilitating the development of plans for each
          of the organization's functional areas. The elements of a firm’s strategy are
          domain sought, differential advantage, necessary strategic thrusts, and
          expected target results. The strategic planning process involves reviewing and
          updating the strategic plan form the last year, deciding on assumptions and
          guidelines, first iteration of the new strategic plan, analysis, second iteration of
          the new strategic plan, review and approval.
          The proposal for new programs in the strategic planning process should
          consider the importance of existing rules and procedures; it should be free of




                                                                 09
          and should be based on existing planning models. Analyzing ongoing
          programs in the strategic planning process can be done through value chain




                                                             20
          analysis, activity-based costing and discretionary expense center analysis.


                                                        of
          The programming process is an organizational process for making long-term
          resource allocation decisions. Bower’s model of investment decision-making
                                                    s
          examines the discrepancy between actual results and desired results. The
                                                 s
          model suggests that ideas, proposals and approval of projects come from the
                                              la

          lower levels of the management.
                                            C



          The investment process has three phases: initiating, integrating and corporate.
                                    y




          The mutually supportive management systems model helps in designing the
                                  nl




          elements of the programming process. Formal programming procedures are
                                 O




          adopted by organizations for defining, evaluating and implementing
                            se




          investment projects.
                         U
                     S
                B
              rI
          Fo




                                                                                          113
Chapter 9




                                                09
Budget as an Instrument of
                                            20
                                       of
Control
                                     ss
                                   la
                              C
                       y
                     nl




In this chapter we will discuss:
                    O




•   Need for Budgeting
               se




•   Forecasting, Budgeting and Strategic Planning
            U




•   Budgeting Process and Control
         S
      B




•   Master Budget
    rI




•   Zero Based Budgeting
Fo




•   Performance Budgeting
•   Participative Budgeting
•   Variance Analysis for Control Actions
                                               Budget as an Instrument of Control

         Organizations prepare plans for the successful execution of strategies. A
         budget is a financial and quantitative statement, prepared and approved prior
         to a defined period of time, of the policy to be pursued during that period for
         the purpose of attaining a given objective. Budgeting refers to the process of
         designing, implementing and operating budgets. The budgeting process starts
         with the dissemination of guidelines approved by senior management.
         Budgetary control refers to the establishment of budgets that relate the
         responsibilities of executives to the requirements of a policy, and the
         continuous comparison of actual with budgeted results, either to secure by
         individual action the objective of the policy or to provide a basis for its
         revision. Managers should participate in the budgeting process to ensure
         consistency in the overall adherence to the corporate goals. In this chapter we
         will discuss the concept of budget, budgetary control, and the variances that
         arise in the budgetary process.




                                                             09
NEED FOR BUDGETING




                                                         20
         Budgets are essential aids in planning because they force management to think

                                                    of
         ahead and look before they leap. The main reasons for the need for a budget
         are:
                                              s  s
         •   Budgets reduce uncertainty by allowing executives to map out the future
                                           la

             course of action. This helps the organization face challenges with
                                         C


             confidence.
                                  y




         •
                                nl




             Budgets increase coordination among the different departments because
             budgetary control forces executives to think as a group. All the
                               O




             departments in an organization tend to function in a well-coordinated
                          se




             manner in an attempt to implement the planned courses of action
             systematically. Budgeting also helps management coordinate the activities
                       U




             of business to the economic trends.
                   S
               B




         •   Budgets identify weaknesses by finding out the reasons for inefficient
             rI




             performance. They help management trace discrepancies in any activity of
             the business and take suitable remedial measures.
         Fo




         •   Budgets help managers analyze the expenditure and keep it under check,
             thereby preventing wastage of all kinds.
         •   Budgets help in the establishment of performance standards for
             operational activities and the adoption of the standard costing technique.
         •   Budgets help identify deviations from pre-planned courses of action.
             Management can later analyze the causes for the deviations and
             implement remedial measures.
         •   Budgets help establish standards of performance. Evaluating performance
             against standards enables employees to analyze their strengths and
             weaknesses.
         To summarize, budgeting is an action plan that is necessary for controlling all
         aspects of the operations of an enterprise for a definite period of time.

                                                                                    115
 Principles of Management Control Systems


FORECASTING, BUDGETING, AND STRATEGIC PLANNING

             Budgeting is different from strategic planning and forecasting. A Forecast is
             an estimate of what is likely to happen under anticipated conditions during a
             specified period of time, whereas a budget shows the policy and programme to
             be followed under planned conditions during a specified period. Forecasts are
             statements of future events. A budget, however is a tool of control.
             Forecasting is a preliminary step in the process of budgeting. Where
             forecasting ends, budgeting begins. Forecasts have a wider scope than
             budgets. Forecasts can be prepared for any period of time and updated
             whenever new information is made available. Finally, variances from
             forecasts are not analyzed formally or periodically. From the point of view of
             management, a financial forecast, which includes estimates of revenue,
             expenses and other items that affect the cash-flow is exclusively a planning
             tool, whereas budget is both a planning and control tool.




                                                                 09
             Strategic planning is different from budgeting in the sense that strategic
             planning focuses on activities that extend over many years, whereas budgeting




                                                             20
             usually focuses on activities that take place within a year. Strategic planning
             provides the framework for the preparation of annual budgets. Strategic

                                                        of
             planning is formed on the basis of product lines or other strategic programs
                                                     s
             while budget is structured on the basis of allocation to responsibility centers.
                                                   s
                                                la


BUDGETING PROCESS AND CONTROL
                                              C
                                      y
                                    nl




             Three important aspects of budget process and control must be discussed.
             They are:
                                   O




             •   Budget preparation process
                              se




             •   Budgetary Control
                            U




             •   Behavioral dimensions of budgeting
                       S
                   B




Budget Preparation Process
                 rI
             Fo




             Information is essential for preparing a sound budget. Budgets are prepared by
             managers; the information or the input data needed for budget preparation is
             developed by people lower in the hierarchy according to their responsibilities
             and functions. Managerial forecasts and accounting reports are a major source
             of data for budget preparation. Managerial forecasts provide data on the
             anticipated level of activity, while accounting reports provide data on the
             financial magnitude of past and current operations.
             The formulation of the budget involves the following steps:
             Organization
             The budget department
             The budget department disseminates the information during budget
             preparation. The members of the budget department report to the corporate
             controller. The functions of the department include:

116
                                       Budget as an Instrument of Control

•   Publishing procedures and forms for the preparation of the budget.
•   Ensuring that the information is communicated in the right way between
    the different organizational units.
•   Analyzing the proposed budgets and              making    corrections   and
    recommendations whenever necessary.
•   Carrying out budget revision at regular time periods
•   Coordinating the work of the business units connected to the budget
    department.
The budget committee
The budget committee consists of the heads of various departments within the
organization and members of senior management such as the CEO, financial
vice president, etc. The function of the budget committee is to review budgets,
approve them, and make adjustments wherever necessary. In some companies,




                                                     09
the CEO decides on the budget without the help of any committee. And in




                                                20
some companies, the budget committee meets only the senior operating
executives, while in some other companies, the budget committee discusses

                                           of
the budget with the business unit managers.
                                        s
Issuance of guidelines
                                      s
                                   la

The first step in the budget preparation process is the issuance of guidelines.
The main source of these guidelines is the strategic plan of the organization,
                                C



which is modified from time to time according to the company’s performance.
                         y




Budget guidelines are developed by the staff of the budget department, and
                       nl




these guidelines are approved by senior management. Sometimes, lower-level
                      O




managers are also consulted for the finalization of guidelines. After senior
                 se




management has approved these guidelines, the timetable for budget
preparation is disseminated throughout the organization.
              U




The guidelines issued by the budget department have to be followed by the
          S
      B




responsibility centers. Some guidelines for responsibility centers are based on
    rI




important issues like inflation, wages, promotions and transfers, compensation
etc. These guidelines submitted by the responsibility centers would be a
Fo




source of input data at the time of budget preparation. However, in many
companies the budget preparation process begins as soon as the strategic plan
is approved.
Initial budget proposal
The managers of different responsibility centers within the organization
develop a budget ‘request’ for facilities, personnel, and other resources.
However, these budget requests are modified according to the guidelines
issued to the responsibility centers. The changes responsible for the frequent
modifications of budget requests are:
Changes in external forces: These include changes in the level of economic
activity, changes in the labor rates, changes in the purchased materials and
services, changes in the selling price, and changes in the cost of discretionary
activities like R&D.

                                                                            117
 Principles of Management Control Systems


             Changes in internal policies and practices: These include changes in market
             share and product mix, and changes in production cost and other discretionary
             costs (which are based on changes in workload).
             Negotiation
             The budget planner discusses the budget proposal with his superior. The
             superior judges the validity of each of the adjustments made in the budget
             proposal. The major consideration in this step of budget formulation is that the
             performance in the budget year be an improvement over the performance in
             the previous year.
             Slack
             In most organizations budgetees (the people, who prepare budget proposals)
             tend to budget revenues lower and expenses higher than their best estimates of
             these amounts. The difference between the budget amount and best estimate is
             known as ‘slack.’ It is the duty of the superior to discover and eliminate slack.




                                                                    09
             Review and approval




                                                                20
             The budget proposal developed by the budgetee goes up through successive
             levels in the organization. If at one level the budget is not found satisfactory, it
                                                           of
             is sent back for reworking. The budget committee presents the fully developed
                                                       s
             and reworked budget to the CEO. The final approval is made by the CEO. The
                                                    s
             CEO then submits the approved budget to the board of directors. This process
                                                 la

             of approval of budgets takes place in the month of December, just before the
                                               C


             beginning of the budget year.
                                       y
                                     nl




             Budget revisions
                                    O




             Budgets are revised from time to time in order to check discrepancies, if any.
             Generally, two procedures are followed for revising budgets:
                               se




             •   Procedures that provide for a systematic updating of budgets.
                            U




             •   Procedures that allow revisions under special circumstances.
                        S
                   B




             Systematic updating of budgets requires extra work by the budgetee. Large
                 rI




             Japanese companies generally update budgets. In these companies, the budget
             is prepared for the whole year. Senior management formally approves the
             Fo




             budget during the first six months of the budget period and for the next six
             months, the budget is revised and approved shortly before the budget period
             begins. Budgets may provide for activities that are planned months ahead of
             the time they take place. Thus, management activities should be based on the
             latest information available.
             Budgets are revised only when they are no longer useful as control devices.
             However, it is difficult to get permission from top management to do so.
             Frequent revision of the budget indicates that the budget is not well prepared.
             Administration and review of budgets
             The authority of administration of budgets vests with the top management. A
             budget can be successful only if it is properly administered. A budget manual
             is necessary to facilitate the process of administration of budgets. The budget
             manual contains objectives of budgeting, the process of budgeting, and the
             tasks and responsibilities of the departmental heads and individual managers
118
                                                    Budget as an Instrument of Control

            in the preparation of the budget. Many organizations set up budget committees
            at divisional offices as well as at corporate headquarters. The budget
            committee at corporate headquarters consists of managers of different
            divisions. When some large autonomous institutions come together to form a
            federation, a ‘programming committee' is formed. This committee consists of
            managing directors of the different institutions. The programming committee
            also coordinates the activities of the individual members of the union.
            A major aspect of the administration of budgets is the revision of budgets.
            Budgets can be revised only in extraordinary situations, when not revising will
            significantly affect the budget results. Budgets are also revised when they
            become unrealistic, when budget assumptions are proved incorrect, when they
            are no longer useful as control devices.
            After the budget has been finalized by the budget committee or senior
            management, it must be reviewed and approved. Budgets are reviewed and
            approved to ensure that the departmental and divisional budgets are consistent




                                                                  09
            with overall organizational goals. For example, is the production budget
            consistent with the planned sales volume? Are service and support centers




                                                              20
            planning for the services that are being requested of them? The purpose of the
            review is to ensure that the budget produces a satisfactory profit.

                                                         of
            Budgets are prepared and finalized in accordance with the standards set by the
                                                      s
            top management. Since budgets are used to evaluate the performance of
                                                   s
            various responsibility centers, management must set standards that are
                                                la

            attainable. If standards are too difficult to attain the responsibility centers may
                                             C


            manipulate figures to please the top management.
                                      y
                                    nl




Budgetary Control
                                   O




            The purpose of budgetary control is to find out how the activities of an
                             se




            organization are progressing. To achieve budgetary control, actual results are
                          U




            compared and measured with anticipated results as provided in the budget. If
            any differences are noticed, the budget estimates can be re-examined and
                       S




            necessary corrective actions can be taken. While a budget is a ‘means,'
                  B
                rI




            budgetary control is the ‘end result.' According to The Institute of Cost and
            Management Accountants, London, "budgetary control is the establishment of
            Fo




            budgets, relating the responsibilities of executives to the requirements of a
            policy, and the continuous comparison of actual with budgeted results, either
            to secure by individual action the objective of that policy or to provide a basis
            for its revision."
            Budgetary control focuses attention on deviation from budget standards and
            points out where corrective action is necessary. The budgetary controller, who
            consults with various heads of departments of the organization is responsible
            for the budgetary control.
            Importance of budgetary control
            Budgetary control has a number of advantages. The following are some of the
            advantages:
            Presentation of overall managerial view: Budgetary control offers an overall
            picture of the various functions in an organization. In other words, it presents

                                                                                           119
 Principles of Management Control Systems


             a managerial view of all the activities within an organization structure. Such
             an overall perspective is essential for management success.
             Narrows down the gap between planning and performance: In many
             organizations there is usually a big gap between planning and performance.
             Budgetary control bridges the gap between planning and performance by
             anticipating the results of courses of action, by comparing the actual results
             with anticipated results, and setting up proper standards for performance.
             Promotes division of work and specialization: Budgetary control helps in the
             allocation of responsibility and accountability for performance to each
             member of the organization. It thus promotes division of labor. Division of
             labor in turn promotes the process of specialization, which helps improve the
             overall efficiency of the organization.
             Fosters coordination and integration: Budgetary control helps managers
             coordinate the activities of the organization. The interaction between the




                                                                 09
             employees during the budget development process helps integrate the
             activities of the organization's members. The budget controller conducts




                                                             20
             meetings with the heads of various departments within the organization and
             thus fosters coordination and integration between various departments.
                                                        of
             Budgetary control thus brings about the integration of policy, plans, and
                                                     s
             actions of the different departments.
                                                   s
                                                la

             Budgetary control is done systematically as follows:
                                              C


             •   Determining the objectives
                                      y




             •   Establishing the budget centers
                                    nl




             •   Introducing adequate accounting records and assigning verifiable codes to
                                   O




                 them.
                              se




             •   Preparing a budget organization chart that defines the functions and
                           U




                 responsibilities of each member of management.
                       S




             •   Establishing budget committees which consists of key members of the
                   B




                 organization, chief executive officers and budget controllers. The main
                 rI




                 function of a budget committee is to coordinate the budget activities,
             Fo




                 review the budgets, suggest revisions and approve the budgets.
             •   Preparing the budget manual to develop a schedule to identify who is
                 responsible for what in the organization. The budget manual consists of
                 accounting codes, a budget timetable, budget periods, a budget proforma,
                 etc.
             •   Selecting the budget period. This is done keeping in view the nature of the
                 strategic plan, nature of the business, production period, financial aspects
                 of the business, etc. Usually, a time period of one year is considered the
                 budget period.
             •   Locating the principal factors that influence the budget. The key factors
                 should be correctly identified and examined. For example, the principal
                 budget factors for a sales budget would be consumer demand, marketing,
                 advertising, etc.

120
                                       Budget as an Instrument of Control

•   Determining the budget cost allowance a budget center is expected to
    incur during a given period of time in relation to the level of activity
    attained by the budget center.
Organizing budgetary control
Systematic administration and successful implementation of budgetary control
results in sound budgets for the enterprise. The following steps should be
considered to achieve effective budgetary control:
•   Organizing for budgeting
•   Assigning responsibility for budgeting
•   Determining the budget period
•   Determining the key success factors
•   Preparing the budget report




                                                    09
Organizing for budgeting
Budget center: A budget center is a section of an organization developed for




                                                  20
the purpose of budgetary control and is intended to facilitate the formulation

                                             of
of various budgets with the help of the heads of the concerned departments.
Budgetary control focuses attention on the attainment of the objectives of
                                         s
various departments within the organization or the enterprise. Therefore, the
                                      s
enterprise must have a clear perspective of the objectives that are sought to be
                                   la

achieved through budgetary control. A budget center is established after
                                  C


developing a clear perspective of the objectives that are to be achieved
                         y



through budgetary control.
                       nl




Budget manual: This is a written document that contains standing instructions
                      O




regarding the procedures to be followed at the time of budget preparation. A
                 se




budget manual is maintained to inform the concerned executives about the
procedures to be followed during budget preparation and to avoid frequent
              U




instructions from the controller’s office. A budget manual contains guidelines
          S




for the following:
      B




•   Functions of various officials connected with the formulation of budgets
    rI




•   Steps in the preparation of various budgets
Fo




•   Scheduled date of submission of budgets
•   Review and approval of various budgets
•   Final adoption of budgets
•   Timetable for budget operations
•   Records, reports, and forms to be maintained for the purpose of budget
    operations.
Assigning responsibility for budgeting
In an organization, the budget controller and the budget committees are
responsible for budgeting.
Budget controller: The entire process of budgetary control is handled by the
budgetary controller. A budgetary controller should be experienced in
handling various budgets and should be able to identify and analyze the
                                                                            121
 Principles of Management Control Systems


             deviations from the set standards and initiate corrective measures for the same.
             An important function of the budget controller is to advice management on
             important issues such as budget preparation, revision of budgets, approval of
             budgets etc. The budget controller reports directly to the chairman.
             Budget committees: A budget committee consists of the heads of various
             departments within the organization, viz. production, marketing, finance,
             administration, and accounts. The members of the committee discuss the
             budget figures (and probable estimates) before arriving at a final decision
             before finalizing the budget.
             Determining the budget period
             The budget period refers to the time period for which the budget is prepared.
             A budget can be a long-term or short-term budget depending on the time
             period. A budget prepared for one year or less is called a short-term budget. A
             budget can also be prepared on a quarterly, monthly or weekly bases




                                                                   09
             depending on the requirements of certain operations. Examples of short-term
             budgets are annual sales, income and expenditure budgets. A long-term budget




                                                               20
             covers a period of five years or more. These budgets are prepared when an

                                                          of
             organization plans for expansion, modernization, diversification etc., Long
             term budgets are used for the purpose of planning while short term budgets
                                                       s
             which are designed to implement these plans are used for control purposes.
                                                    s
                                                 la

             Examples of long-term budget are capital expenditure budgets and research
             and expenditure budgets. The time period of a budget can vary depending on
                                              C



             the nature of the business, the production period. Electronics and consumer
                                       y




             goods industries prefer to prepare annual budgets as they experience a high
                                     nl




             rate of “change. For industries such as shipbuilding, the time period of budget
                                    O




             may vary between 5 to 10 years.
                              se




             Determining the key factors
                           U




             The key success factors are those factors that influence the performance of an
                        S




             organization. These factors influence the limit of output and thus have a direct
                   B




             impact on the profitability of an organization. The key success factors include
                 rI




             the availability raw material, skilled labor, cash etc. If any of these is in short
             Fo




             supply work can be delayed. Due to changes in the internal and external
             conditions, the key success factors can change from time to time. In some
             organizations, the critical success factors are consumer demand or expected
             level of revenue. In such organizations, the sales budget should be prepared
             first. This budget will determine the content of other budgets. In some other
             organizations, the most critical success factor can be productive capacity.
             Preparing the budget report
             It is essential to compare actual performance with the anticipated budgeting
             performance; and the results of the comparison should be brought to the notice
             of management through reports. The reports should furnish details of the
             responsibility of each department or executive in budget preparation and the
             reasons for variances in actual and budgeted performance so that corrective
             actions can be initiated.

122
                                                    Budget as an Instrument of Control

Behavioral Dimensions of Budgeting
             The process of budget preparation requires the involvement of managers and
             other people. Since individuals are involved in the process of budgeting, the
             behavioral dimensions of budgeting cannot be ignored.
             Participation in budgetary process
             A budget can either be set by senior management for the lower levels of the
             organization or lower-level managers may participate in setting the budget’s
             targets. When the senior management initiates the budgeting process, the
             process is said to be a “top down” one; and when the lower level managers are
             involved, the budgeting process is said to be “bottom-up.” The bottom-up
             approach to budgeting is more commonly followed than the top down
             approach. The top down approach rarely works because lower level managers
             do not show keen interest in working towards already fixed budget targets.
             Bottom-up budgeting generates commitment among the budgetees to meet the




                                                                 09
             budgeted goals set by themselves.
             However, the actual process of budgeting is a blend of two approaches. The




                                                             20
             lower-level managers prepare the budget proposal and submit the first draft to
             senior management (a bottom-up approach). The senior managers review the
                                                        of
             budget and suggest certain guidelines for improving the budget (a ‘top down’
                                                     s
             approach).
                                                   s
                                                la

             Bottom-up budgeting or participative budgeting is considered an effective
             budgeting approach because it results in greater acceptance of budget goals
                                             C



             (due to personal control) and leads to higher personal commitment towards
                                      y




             achieving these goals. Participative budgeting also leads to exchange of
                                    nl




             information between the budgetee and the superiors. Moreover, once the
                                   O




             budget has been approved, the budgetee can boast of expertise and personal
                              se




             knowledge in budgeting.
                           U




             Degree of budget goal difficulty
                       S




             A budget's goals should be challenging but attainable. Budgeted goals that are
                   B




             difficult to achieve force managers to take certain short-term actions that are
                 rI




             not in the long-term interests of the company. But if the budgeted targets are
            Fo




             achievable, managers do not engage in data manipulation (for example,
             inadequate provision for warranty claims, bad debts etc.) to meet the budget.
             A winning atmosphere and positive attitude spreads throughout the
             organization when managers are able to meet and exceed targets. A budget is
             prepared with the intention of increasing profits in the long-term interests of
             the company. However, when an overly optimistic sales target has been set, a
             profit budget is difficult to attain. Thus a budget, whether it is sales budget,
             profit budget or production budget, should be easily attainable in order to
             ensure the allocation of resources for the budget activities.
             Sometimes when achievable targets have been set, managers will not put forth
             satisfactory effort once the budget has been met. However, this limitation can
             be overcome by providing bonus payments for actual performance that
             exceeds the budgeted performance.



                                                                                         123
 Principles of Management Control Systems


             Involvement of senior management
             A budget is said to be effective only if it is supported by senior management.
             Senior management should review and approve the budgets. In some cases,
             the budgetee may resort to certain unhealthy practices during the
             implementation of the budget, just to meet the budgeted target, if there is no
             participation and supervision by senior management. Feedback from senior
             management is necessary in order to motivate and guide the budgetee.
             The budget department
             It is the budget department’s duty to collect the input data for the preparation
             of the budgets, prepare the budgets, and analyze them in detail. The budget
             department ensures that no excessive allowances are present in the budget. If a
             manager hides a potential situation during budgeting and the budget
             department discloses the fact, then the manager will be placed in an
             uncomfortable position. The manager’s sense of guilt will make him feel




                                                                 09
             inferior to his colleagues. The manager should be warned against repeating the
             mistake. The budget department should ensure the integrity of the budget




                                                             20
             preparation system.


                                                        of
             The members of the budget department should work in a fair and impartial
             manner. In addition, they should learn how to deal effectively with different
                                                     s
             types of people.
                                                   s
                                                la
                                             C


MASTER BUDGET
                                       y
                                     nl




             The following budgets together constitute the master budget:
                                    O




             1. Sales or revenue budget
                              se




             2. Production budget
                           U




             3. Materials budget
                       S




             4. Administrative expense budget
                   B
                 rI




             5. Direct labor budget
             Fo




             6. Promotion & advertising expense budget
             7. Research & development budget
             8. Manufacturing overhead budget
             9. Capital expenditure budget
             10. Selling and distribution expense budget
             11. Financial budget
             The master budget may take the form of a profit and loss account and a
             balance sheet at the end of the budget period. It is the duty of the budget
             committee to approve the master budget. Sometimes more than one master
             budget has to be prepared before the final one is approved by the committee.
             The master budget shows the gross and net profits and the important
             accounting ratios. Thus, the master budget represents the overall plan of the
             enterprise.

124
                                                    Budget as an Instrument of Control

Steps in the Preparation of the Master Budget
             The principal steps in the preparation of the master budget are:
             1. Preparation of the operating budget
             2. Preparation of the budgeted income statement
             3. Preparation of the financial budget
             Preparation of the operating budget
             The operating budget consists of the following activities:
             (a) Sales budget
             (b) Cash collections from customers
             (c) Purchases budget
             (d) Disbursements for purchases
             (e) Operating expense budgets




                                                                  09
             (f) Disbursements for operating expenses




                                                             20
             Sales budget: It is the responsibility of the marketing managers to prepare the

                                                         of
             sales budget. The preparation of the sales budget starts with a sales planning
             exercise. This sales planning exercise develops projections of the expected
                                                      s
             sales volume in physical and monetary terms. The key factors that are
                                                   s
             considered during sales planning are the size of the sales force, selling
                                                la

             expenses, promotion and advertising expenses, and so on.
                                             C



             Cash collections from customers: These cash collections include the current
                                       y




             month’s cash sales plus the previous month’s credit sales.
                                     nl
                                    O




             Purchases budget: The budgeted purchases are computed as follows:
             Budgeted purchases = desired ending inventory + cost of goods sold
                                se




             beginning inventory.
                           U




             Disbursements for purchases: Disbursements for purchases are based on the
                       S




             purchases budget. Disbursements include 50% of the current month’s
                   B




             purchases and 50% of the previous month’s purchases.
                 rI




             Operating expense budget: Operating expenses are influenced by fluctuations
             Fo




             in sales volume and cost-driven activities. Examples of expenses driven by
             sales volume include sales commissions and delivery expenses. Examples of
             cost-driven expenses include rent, insurance, depreciation and salaries. These
             expenses are fixed.
             Disbursements for operating expenses: Disbursements for operating expenses
             are based on the operating expense budget. Disbursements include 50% of the
             last month’s and current month’s wages and commissions and miscellaneous
             expenses.
             Preparation of the budgeted income statement
             The budgeted income statement is developed on the basis of information
             provided in preparing an operating budget. The interest expense (calculated
             after the cash budget has been prepared) is added to the budgeted income
             statement. The budgeted income statement is often used as a benchmark to
             judge management performance.

                                                                                        125
 Principles of Management Control Systems


             Preparation of the financial budget
             The financial budget comprises the capital budget, the cash flow budget and
             ending balance sheet.
             Capital budget: The capital budget relates to the question of capacity and
             strategic direction of the firm. It deals with the evaluation of the alternate
             disposition of capital funds as well as the choice of the best capital structure.
             Cash flow budget: The cash flow budget is a detailed budget of income and
             cash expenditure and incorporates both revenue and capital items. It is
             concerned with liquidity and shows changes in opening and closing debtor
             balances and between opening and closing creditor balances. It also focuses on
             inflows and outflows of cash. A cash budget can be prepared by the receipts
             and payment method, the adjusted balance sheet method.
             Receipts and payment method: In this method, all the expected receipts and
             payments for budgeted period are considered. First the cash inflow and
             outflow of all the functional budgets, including the capital expenditure




                                                                   09
             budgets, are taken. These cash flows are not affected by accruals and




                                                              20
             adjustments in account. Second, the anticipated cash inflow is added to the
             anticipated cash inflow to the opening balance of cash and all cash payments

                                                          of
             are deducted from this to arrive at the closing balance of the cash. This
             method is commonly used in business organizations.
                                                    s s
             Adjusted income method: In this method, annual cash flows are calculated by
                                                 la

             adjusting the sales revenue and costing figures for delays in receipts and
                                              C


             payments. This method eliminates non-cash items like depreciation.
                                       y



             Adjusted balance sheet method: In this method, budgeted balance sheet is
                                     nl




             predicted by expressing each type of asset and short term liability as a
                                    O




             percentage of expected sales. Profits are also a percentage of sales, so that the
             increase in owners' equity can be forecasted.
                              se
                           U




Budgeted Balance Sheet
                        S




             The budgeted balance sheet projects each balance sheet item in accordance
                   B




             with the business plan. It thus indicates the financial status as envisaged at the
                 rI




             end of the budget year. The balance sheet also projects the sources and uses of
             Fo




             financial resources.
             The master budget should undergo a follow up process to ensure performance
             of budget in terms of planned goals and objectives. While the formulation of
             the budget is a planning process, the follow-up of the budget is a control
             process. A follow-up is conducted by preparing performance analysis
             statements on a periodic basis, indicating the budgeted versus actual
             performance.

ZERO BASE BUDGETING

             In zero-base budgeting (ZBB) all the activities are reevaluated each time the
             budget is prepared. In ZBB, each functional budget assumes that the function
             does not exist and that the costs are zero. Budget preparation for each function
             starts with the basic premise that each activity is being performed for the first

126
                                                      Budget as an Instrument of Control

            time and that the cost of each activity is zero. The assumption is that the
            budget for the coming year is zero and every process or expenditure has to be
            justified in order to be included in the budget. The manager is held responsible
            for identifying the resources required for each activity, and he or she has to
            justify the reason for spending the money on an activity by explaining what
            would happen if the proposed activity was not carried out and no money was
            spent on that activity. In ZBB a number of alternatives for each activity, and
            the associated costs, have to be identified so that the one that offers the most
            benefits can be selected. The basic requirements for the application of ZBB in
            an organization are: the presence of a budgeting system in the organization
            and the ability of the managers to develop qualitative measures for
            performance evaluation.
            The important features of ZBB are:
            •     The budget requires the manager to explain the need for spending a
                  particular amount on an activity.




                                                                    09
            •     The selection of each activity is made on the basis of what each unit can
                  offer for a specific cost.




                                                                20
            •     The targets of individual units are linked to the overall corporate targets.
            •
                                                           of
                  The budget requires participation of all the employees at the different
                                                       s
                  decision making levels.
                                                     s
            •
                                                  la

                  The budget has the advantage of maintaining the expenditure level
                  according to the operating costs.
                                               C
                                        y




The ZBB Process
                                      nl
                                     O




            There are three basic steps in ZBB. These steps are discussed below:
                               se




            Identifying decision units and developing decision packages: Decision
            units are synonymous with responsibility centers. These units should be given
                            U




            a prominent place in the organizational chart. Examples of decision units are
                        S




            research and development and capital expenditure units. A decision package
                    B




            describes the activities that take place in a decision unit. A decision package
                  rI




            describes the goals and objectives of each activity, identifies specific measures
            Fo




            of performance, and states the projected costs of the package etc.
            Evaluating and ranking the decision packages: In this step, the decision
            packages are reviewed and ranked in the order of decreasing benefit to the
            firm. Ranking is done on the basis of a cost-benefit analysis.
            Allocating resources accordingly: Top management allocates resources on
            the basis of the ranking of the decision packages. The total available resources
            will determine the acceptable expenditures. Before allocating resources, the
            available resources are forecasted and matched with the ranked decision
            packages on a cumulative amount basis.

ZBB Vs Traditional Budgeting
            ZBB is not based on the previous year’s budget, whereas traditional budgeting
            uses the previous year's expenditure level as the base. The main differences
            between traditional and zero-base budgeting are:

                                                                                             127
 Principles of Management Control Systems


             •   Traditional budgeting is accounting oriented and is based on the previous
                 year’s level of expenditure. The focus of this type of budgeting is
                 determining the additions and subtractions that need to be made in the
                 present budget on the basis of the previous year's budget. ZBB is decision
                 oriented. It relies on the manager’s decision regarding the costs required
                 for carrying out a particular activity.
             •   In traditional budgeting the budget is sometimes inflated by managers; but
                 in ZBB, a rational analysis of the budget is made.
             •   In traditional budgeting top management is usually involved in the
                 preparation of the budget, whereas in ZBB the responsibility center
                 manager takes the necessary decisions.
             •   In ZBB it is easy to identify the important projects that require
                 management attention, whereas in a traditional budgeting it becomes
                 difficult to identify the priority items.




                                                                  09
Implementing Issues




                                                              20
             The successful implementation of ZBB requires the clear statement of the
             corporate objectives and the identification of decision units on the basis of

                                                         of
             functions or departments. The function of each division and the targets it plans
                                                      s
             to achieve must be clearly defined and analyzed. In addition, the performance
                                                   s
             of each activity must be analyzed. The analysis should include a clear
                                                la

             description of each activity, the alternate methods and costs involved in each
                                             C


             activity and the ability to evaluate each activity, the alternate methods and the
             costs involved in each activity. Each activity or decision package must be
                                      y
                                    nl




             evaluated through a cost benefit analysis.
                                   O




Advantages and Disadvantages of ZBB
                              se




             The benefits of implementing ZBB system for an organization are:
                           U




             •   It helps the organization identify the activities that lead to unnecessary
                       S




                 expenditure. Since the manager of the responsibility center is involved in
                   B




                 the preparation of the budget, he can frame the budget keeping in mind the
                 rI




                 requirements of a particular center. Thus wasteful expenditure is reduced.
             Fo




             •   Since the budget is evaluated on the basis of a cost benefit analysis,
                 unnecessary costs are reduced. An activity is taken up only after detailed
                 analysis of various alternatives in terms of cost allotment.
             •   ZBB leads to organizational development because it improves
                 communication and leads to wider participation within the organization.
                 ZBB also leads to a clear identification of the aims of the organization.
             •   ZBB encourages cost effectiveness and efficiency and allows for quick
                 budget adjustments if revenue falls short during the year.
             •   The involvement of all the managers in the preparation of budget ensures
                 their commitment to the successful execution of the budget.
             ZBB has been criticized for the following reasons:
             •   It leads to an increase in paperwork and emphasizes short-term benefits
                 instead of long-term benefits.

128
                                                     Budget as an Instrument of Control

             •   In ZBB decisions are based on the ranking of the decision packages.
                 However, when formulating the budget, management must also consider
                 the opportunities and threats presented by each activity.
             •   The managers of the responsibility centers require adequate training to
                 take the necessary decisions and require adequate management skills to
                 take constructive decisions.
             •   ZBB does not offer significant advantage when determining the costs of
                 research and developmental activities. Even though ZBB, has been
                 criticized for many reasons it is considered to be highly relevant in a
                 continuous improvement environment as it involves continuous evaluation
                 of activities and results in effective cost-benefit decisions.

PERFORMANCE BUDGETING




                                                                  09
             The term performance budgeting was first introduced by the Hoover
             Commission in 1949. It can be defined as a budgetary system in which input




                                                             20
             costs are related to end results. The cost and production goals are first
             established and they are later compared to actual performance. This method of
                                                         of
             budgeting leads to an improvement in management efficiency. It involves
                                                      s
             analyzing, identifying, simplifying and crystallizing the specific performance
                                                       s
             objectives of a job to be achieved over a period within the framework of
                                                    la

             organizational objectives. The budgeting system is aimed at fulfilling the
                                               C


             objectives of the business. The main features of a performance budget are:
                                       y




             •   It presents the purposes for which funds are required and brings out the
                                     nl




                 programs and accomplishments in financial and physical terms.
                                    O




             •   It presents the costs for achieving the various activities along with the
                              se




                 quantitative data for measuring the accomplishments.
                           U




             •   It presents the expected level of performance for each activity.
                        S




             •   It acts as an effective performance audit
                   B




             •   It provides additional tools for management control of the organization's
                 rI




                 finances.
            Fo




Steps in the Implementation of Performance Budgeting
             The main steps in the implementation of the performance budget are:
             •   Classification of the activities
             •   Specification of objectives
             •   Analysis of activities
             •   Establishment of control norms
             •   Establishment of authority and responsibility
             •   Evaluation of the budget.
             Classification of the activities
             This is the first step in the implementation of the performance budget. The
             activities in an organization are classified as. These are again divided into

                                                                                       129
 Principles of Management Control Systems


             programs depending on their time frame and resources are divided based on
             their importance. For example in an organization marketing programme can
             be classified into public relation activities, advertising activities etc., An
             activity is thus a subdivision of the programme to which resources are applied.
             Specification of the objectives
             In this stage the objective of the individual activity is clearly defined. Then the
             resources that have to be spent for each activity are clearly outlined. The
             annual, monthly targets are determined for each activity center.
             Analysis of activities
             The long-term strategy and short-term tactics for achieving the desired
             objectives are considered.       Also, the possible alternative activities are
             identified and their costs and benefits are worked out. Then the activities that
             come closest to achieving the organizational goals are selected.
             Establishing control norms




                                                                   09
             Control norms are established in the form of productivity ratios and




                                                               20
             performance ratios. These are compared to actual performances. Norms are
             also set for non-financial measures of performance.
             Clear lines of authority and responsibility  of
                                                    s  s
             The authority and responsibility for different activities are clearly identified
                                                 la

             and the functions of the activities are clearly demarcated. Financial rules and
                                              C


             accounting systems help in the effective implementation of the activities.
                                         y




             Evaluation of the Budget
                                       nl
                                      O




             To find out if the projects have been implemented according to the plan,
             information and reporting systems (related to financial, economic and physical
                              se




             data) are installed to monitor the execution of the activities.
                           U




Performance Budgeting Vs Traditional Budgeting
                        S
                   B




             Performance budgeting puts more emphasis on expenditure incurred on
                 rI




             functions than on things to be acquired or spent. In performance budgeting
             Fo




             each program is further sub classified as an activity. In traditional budgeting
             system, budget appropriations are made object-wise and clubbed according to
             the nature of expenditure such as pay and allowances, traveling allowances,
             transport, traveling allowances etc.

PARTICIPATIVE BUDGETING

             Participative budgeting is based on the premise that having better
             communication and motivation in an organization will lead to better
             budgeting. Consequently, a participative budget draws on ideas suggested by
             all the members of the organization. The organization should ensure the
             following when developing a participative budget:
             Targets should be achievable: Targets must be realistic and achievable. If
             targets are high, they will be difficult to achieve; if they are set too low, there

130
                                                     Budget as an Instrument of Control

            will be slack in the performance. Unnecessarily high targets results in non-
            achievement and, therefore, lower performance.
            Participation of lower levels: If the lower levels of management do not
            participate actively in decision making, then the whole purpose of a
            participatory budget is lost.

VARIANCE ANALYSIS FOR CONTROL ACTIONS

            Since a budget is an instrument of control, it is necessary to compare the
            actual results with the budgeted results. A variance occurs whenever actual
            costs differ from standard costs. The term variance analysis refers to the
            systematic evaluation of variances in an attempt to provide managers with
            useful information for measuring efficiency and improving performance.
            Variance analysis attempts to isolate the impact of each important variable
            that contributes to the total variation. Variance analysis is done to investigate




                                                                   09
            the underlying causes for deviations in budgets so that management can take




                                                               20
            corrective measures. Thus, variance analysis examines the amount of
            difference between standard costs and actual costs and the reason for the

                                                          of
            difference.
            If the actual cost is less than the standard cost, the variance is favorable. If the
                                                    s s
            actual cost is more than the standard cost, the variance is unfavorable. A
                                                 la

            favorable variance indicates efficiency and an unfavorable variance indicates
                                              C


            inefficiency.
                                      y



            Variances occur due to three reasons. A managerial decision to respond to
                                    nl




            some new developments which were not initially anticipated, uncontrollable
                                   O




            exogenous factors, controllable factors that need to be investigated.
                              se




            The following framework can be used to conduct variance analysis:
            •   Identify the key causal factors that are likely to affect the profits.
                           U




            •
                       S




                Breakdown of the overall profit variances according to the key causal
                  B




                factors.
                rI




            •   Focus on the profit impact of the variation for each key causal factor.
            Fo




            •   Determine the specific, separable impact of each causal factor by varying
                a particular factor while holding all others constant.
            •   Add complexity sequentially to determine the impact of several variables
                on a particular factor.
            •   When the added complexity at the newly created level is not justified, the
                process has to be stopped.

Revenue Variances
            Selling price, volume and mix variances come under revenue variances. The
            variance for each product line is calculated separately and the results are
            aggregated to calculate the total variance. If the actual profit exceeds the
            budgeted profit, the variance is positive and favorable, but if the actual profit
            is less than the budgeted profit, the variance is negative and unfavorable.


                                                                                            131
 Principles of Management Control Systems


             Selling price variance: The selling price variance is calculated by multiplying
             the difference between the actual price and the standard price by the actual
             sales volume.
             Mix and volume variance: Mix and volume variances are not separated in
             general. The mix and volume variance is the product of the budgeted unit
             contribution and the difference of the actual and budgeted sales volume.
             The volume variance results from selling more units than the budgeted. The
             mix variance results from selling a different proportion of products, as the
             contribution per unit is different for different products. If the business unit has
             a ‘richer’ mix (i.e., a higher proportion of products with a high contribution
             margin), the actual profit will be higher than the budgeted. Mix variances and
             volume variances can also be calculated separately.
             Mix variance: The following equation is used to calculate the mix variance
             for each product.




                                                                   09
             Mix variance = [(Total actual volume of sales x Budgeted proportion) -




                                                               20
             (Actual volume of sales)] x Budgeted unit contribution.
             Volume variance: Volume variance is calculated using the following formula:

                                                          of
             Volume variance = [(Total actual volume of sales) x Budgeted percentage)] -
                                                       s
             [(Budgeted sales) x (Budgeted unit contribution)]
                                                    s
                                                 la

             Market penetration and industry volume
                                              C


             One extension of revenue analysis is to separate the mix and volume variance
                                       y




             into the amount caused by the differences in market share and the amount
                                     nl




             caused by differences in industry volume. This is because while the business
                                    O




             unit managers are responsible for market share, they are not responsible for
                              se




             industry volume as state of the economy decides the industry volume. For this
             purpose, the industry sales data is also needed to exactly represent the
                           U




             performance of a business unit.
                        S




             Market share variance and industry volume variance are calculated using the
                     B
                   rI




             following equations.
             Fo




             Market share variance = [(Actual sales) - (Industry volume) x Budgeted
             market penetration] x Budgeted unit contribution.
             Industry volume variance = [(Actual industry volume-Budgeted industry
             volume) x Budgeted market penetration] x Budgeted contribution per unit.
             The variance for each product is calculated separately, and the sum of
             variances of all the products gives the total variance.
             Sales budget variances
             Sales budgets are prone to variances because actual sales usually differ from
             budgeted sales. It is the duty of the concerned managers to analyze and
             understand the factors that have caused the deviation. In most organizations
             three principal reasons are responsible for deviations in sales budgets:
             (i)   The actual price realized is different from the price envisaged at the
                   time of budget formulation.

132
                                                       Budget as an Instrument of Control

            (ii)     The actual volume of product sold is different from the planned volume
                     of sales.
            (iii)    The actual sales mix is different from the budgeted sales mix.
            Variance in the sales budget is categorized as a price variance and volume
            variance. Volume variance is analyzed in terms of a sales-mix variance and a
            quantity variance. The same approach is used to analyze a territory-wise sales
            performance report. If a sales district projects a high variance, then it is
            necessary to analyze and understand the reasons for the high variance.
            Corrective measures must be initiated accordingly.

Expense Variances
            Expenses are divided into fixed costs and variable costs. The variance between
            the actual and budgeted fixed costs is obtained simply by subtraction, as these
            costs are not influenced by market sales or volume of production. But variable
            costs vary directly and proportionately with the volume.




                                                                       09
            Material budget variances




                                                                 20
            The material budget variance is categorized as material yield variance and

                                                            of
            material usage variance. Material yield variance occurs due to differences
            between the actual yield and the standard yield. These differences are caused
                                                        s
            by abnormal loss sustained in different processes of production. Thus, yield
                                                       s
                                                    la

            variance represents the portion of usage variance that is due to the difference
            between the standard yield specified and the actual yield obtained.
                                                C



            Material usage variance occurs due to the difference between the standard
                                         y
                                       nl




            quantity specified and the actual quantity used. Material usage variance occurs
            due to the following reasons.
                                      O




            i       Careless handling of materials
                                se




            ii      Wastage, spoilage, scrap, theft, pilferage, etc.
                             U




            iii     Changes in product design, labor, performance, etc.
                         S
                      B




            iv      Use of inferior materials
                    rI




            v       Defective tools and materials
            Fo




            vi      Setting of improper standards
            Labor budget variance
            Labor budget variance occurs due to the following two factors:
            i       Differences between actual wage rate and budgeted wage rate
            ii      Differences between actual labor hours and budgeted labor hours for a
                    particular activity.
            The labor budget variance includes wage rates variance and labor efficiency
            variance. Wage rates are determined through negotiations between union and
            management. This wage rate variance is controllable at the supervisor level.
            The labor efficiency variance is the difference between the standard labor
            hours specified and the actual hours spent on work. Labor efficiency depends
            on the skill levels of the workers, the volume of work hours put in by each
            worker, and the wage rate. Labor efficiency variance occurs due to the
            following factors.
                                                                                        133
 Principles of Management Control Systems


             i     Lack of supervision
             ii    Poor working conditions in the factory
             iii   Use of sub-standard materials
             iv    Inefficiency of workers due to inadequate training.
             v     Lack of proper tools, equipment, and machinery
             vi    Higher labor turnover
             Manufacturing overhead variance
             Manufacturing overhead variances are the most complicated to compute in the
             variance analysis. Fixed overhead variance refers to all items of expenditure
             that are more or less constant, irrespective of fluctuations in the level of the
             output. This variance represents the difference between the actual cost and the
             fixed overhead cost. Variable overhead variance represents the difference
             between the budgeted and the actual variable overheads.




                                                                   09
Summary of Variances




                                                              20
             There are several ways in which variances can be summarized in a report. The

                                                         of
             different methods of calculating variances are: time period of comparison,
             focus on gross margin, evaluation standards, full-cost systems, and amount of
                                                      s
             detail information. These approaches are described below.
                                                    s
                                                 la

             Time period of comparison
                                              C


             Some companies use performance for the year to date as the basis for
                                       y




             comparison. They use the budgeted and actual amounts for the six months
                                     nl




             ending June 30, rather than the amounts for the month June. Other companies
                                    O




             compare the budget for the whole year. The actual amounts are taken for the
             first six months and the estimates of revenues and expenses are taken for the
                              se




             next six months.
                            U




             A comparison of the annual budget with current expectation of actual
                        S




             performance for the whole year shows how closely the business unit manager
                     B




             expects to meet the annual profit target. If the performance for the year to date
                   rI




             is worse than the budget for the year to date, the deficit is likely to be
             Fo




             overcome in the remaining months. However, the forces that caused the actual
             performance to be below budget for the year to date are expected to continue
             for the remaining part of the year, and this is likely to make the final figure
             significantly different from the budgeted amount.
             Focus on gross margin
             Though selling prices are assumed to be constant throughout the year, in
             practice, changes in costs and other factors make it difficult to maintain the
             same selling price. So, the marketing manager must try to achieve a budgeted
             gross margin, that is, a constant spread between costs and selling prices. To do
             so, the ‘gross margin’ variance must be considered. The gross margin is the
             difference between the actual selling prices and manufacturing costs.
             Evaluation standards
             Three types of standards are used for evaluating reports of actual activities: (1)
             Predetermined standards (2) Historical standards (3) External standards.

134
                                                    Budget as an Instrument of Control

             Predetermined standards
             Predetermined standards (also called budgets) if carefully planned, and
             coordinated can be excellent standards. Most companies compare actual
             performance against predetermined standards. But if the budgeted numbers are
             collected in a haphazard manner then this will not provide a reliable basis for
             comparison.
             Historical standards
             These are records of past actual performance. Results for the current month
             are compared with results for the last month, or with results for the same
             month a year ago. There are two disadvantages of using these type of
             standards: conditions may be different in the two periods (this invalidates the
             comparison), and the prior periods' performance may not have been
             considered acceptable performance. Despite these inherent weaknesses, these
             standards are used by companies where valid predetermined standards are not




                                                                 09
             available.




                                                             20
             External standards
             These standards are derived from the performance of other responsibility

                                                        of
             centers or of other companies. The performance of one branch sales office
             may be compared with the performance of other branch sales offices. Such a
                                                   s s
             comparison may provide an acceptable basis for evaluation if the conditions in
                                                la

             the responsibility centers are similar.
                                             C


             Full-cost systems
                                       y
                                     nl




             In a full-cost system, the manufacturing cost of a product includes both
             variable costs and fixed costs. Companies under the full-cost system may not
                                    O




             be able to make such a separation, or even if they do it, they have to identify
                              se




             the variance in manufacturing costs that result from the difference between
             actual and standard production volume. A ‘Production volume variance’ is
                           U




             developed when actual volume is different from standard volume.
                       S
                   B




             Amount of detail information
                 rI




             Revenue variances can be analyzed at various levels: in total; then by volume,
             Fo




             mix, price; analysis of volume and mix variance is done by industry volume
             and market share. At each level, the variances of individual products are
             analyzed. The process of analyzing the variance from one level to another is
             called "peeling the onion." Similarly, additional ‘sales and marketing
             variances’ can be calculated, by ‘sales territories,' by ‘individual sales
             persons,' by ‘sales originating from direct mail,' by ‘customer calls from other
             resources’, by ‘sales to individual countries.' Additional information for
             manufacturing costs can be developed by calculating variances with specific
             input factors, such as wage rents and material prices. These layers of variances
             correspond to the hierarchy of the responsibility center managers.

Limitations of Variance Analysis
             Variance analysis identifies the occurrence of variance, but it does not tell
             ‘why’ the variance occurred. When using variance analysis, it is difficult to
             decide whether a variance is significant or not. Another limitation of variance

                                                                                         135
 Principles of Management Control Systems


             analysis is that, as the performance reports become more highly aggregated,
             offsetting variances might mislead the reader. For example, a manager might
             notice that the business unit manufacturing cost performance was as budgeted.
             However, this may be because good performance at one plant is offsetting
             poor performance at another plant.
             If a variance is significant, but uncontrollable (such as unexpected inflation),
             there may be no point in investigating it. Performance reports show only what
             has happened, they do not show the future effects of actions that the manager
             has taken. For example, reducing the budget for employee training increases
             the current profitability, but may result in adverse consequences later. Since
             variance analysis is limited to those events that are recorded in the accounts,
             many important effects of those events are not reflected in current accounting
             transactions.

SUMMARY




                                                                 09
                                                             20
             Budgets are formal, quantitative statements of resources for carrying out
             planned activities over a given period of time. Budgeting plays an important

                                                        of
             role in coordinating the activities of responsibility centers. The master budget
             is the overall budget for an organization. It represents the overall plan of the
                                                     s
             organization. The principal steps in the preparation of the master budget are:
                                                   s
             preparation of the operating budget, preparation of the budgeted income
                                                la

             statement and preparation of the financial statement.
                                             C



             The budget process and control encompasses the budget preparation process,
                                      y




             budgetary control and behavioral dimensions of budgeting. The budget
                                    nl




             preparation process involves the organization of a budget department, the
                                   O




             establishment of a budget committee and the issuance of the guidelines for
                              se




             developing budgets. Budgets may undergo frequent modifications because of
             changes in external factors, and changes in internal policies. Top management
                           U




             is responsible for administering and reviewing the budget. Zero base
                       S




             budgeting, performance budgeting and participative budgeting can be used to
                   B




             appraise actual performance. Zero based budgeting starts with the premise that
                 rI




             each activity is being performed for the first time and that the costs are zero.
             The manager is held responsible for identifying the resources and has to
             Fo




             justify the reason for spending money on a particular activity.
             Budgetary control focuses attention on deviation from budget standards and
             points out where corrective action is necessary. The important steps for
             achieving effective budgetary control are setting up a budget center,
             documenting a manual, appointing a budget controller and the budget
             committee. The budget period and the key variables must also be decided on.
             The budget is responsible for budgetary control. A budget committee is
             established to assist the budget controller.
             A budget is an important control mechanism. When actual results do not tally
             with the budget; a variance is said to have occurred. Variance analysis thus
             provides managers with useful information for measuring efficiency and
             improving performance. The overall performance of a business unit is divided
             into revenue variance and expense variance. The different types of variances
             that occur in budgets are sales budget variance, material budget variance,
             labor budget variance and manufacturing overhead variance.
136
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                of
                s
                s
             la

           PART IV:
           C



MANAGEMENT CONTROL TOOLS
            y
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         O
      se
     U
     S
  B
rI
Fo
Chapter 10




                                                 09
Reward Systems
                                            20
                                            of
                                      ss
                                   la
                                   C


In this chapter we will discuss:
•
                         y



    Purpose of Reward Systems
                       nl




•   Components of Incentive Compensation Plans
                      O




•   CEO Compensation
                 se




•   Incentives for Business Unit Managers
              U




•   Balanced Scorecard
           S




•   Design Considerations
       B
     rI




•   Agency Theory
Fo
Principles of Management Control Systems


             Between 1981 and 1991, Bausch & Lomb was a highly successful company.
             Its sales and earnings had tripled to $1.5 billion and $150 million, respectively
             and its shares value witnessed a five fold increase. The compensation of Dan
             Gill, the CEO of Bausch & Lomb had soared from $362,000 in 1981 to $6.5
             million by 1991. An aggressive culture and an emphasis on performance and
             rewards drove the organization too far, too fast. The sole aim of the company
             was to achieve double-digit annual growth irrespective of the means used. In
             19941, the SEC and the shareholders, who filed a class suit accused the
             company of misleading investors by falsely inflating sales and earnings.
             Rewards and incentives are clearly important, but organizations also need to
             set boundaries when deciding the rewards. The more the culture and rewards
             drive ambition and goal-seeking behavior, the more the need for a system of
             boundaries and constraints. At Bausch & Lomb, the boundaries were set rather
             late. Only after the SEC investigation began in December 1994, did Gill and
             his top executives adopt more conservative practices, reduce distributor
             inventories, and change bonus guidelines to incorporate broader, long term




                                                                           09
             goals.




                                                                      20
PURPOSE OF REWARD SYSTEMS

                                                                of
             Reward systems are a major motivational tool to secure the participation of
                                                         s  s
             individuals to achieve organizational goals. It is a common notion that only
                                                      la

             the employees of an organization are entitled to rewards. Organizations
                                                   C


             however, also reward their stakeholders -customers, stockholders, creditors,
             and the public for their contribution.
                                          y
                                        nl




             Reward systems are an important source of communication and feedback.
                                       O




             They communicate what the firm values of an individual. Rewards create a
             sense of belonging which makes an individual feel more committed towards
                                 se




             his work. Reward systems harmonize the interests of stakeholders and
                              U




             managers.
                           S
                    B




COMPONENTS OF INCENTIVE COMPENSATION PLANS
                  rI




             A manager’s total compensation package is made up of three components:
            Fo




             •    Salary
             •    Benefits
             • Incentives
             Salaries are usually paid every month. Employees progress through a clearly
             defined career hierarchy based on factors such as age, qualifications,
             experience and performance. Factors which affect the administration of
             salaries in various organizations are as follows:
             •    Remuneration in comparable industries
             •    Firm’s ability to pay


             1
                 Picken, Joseph C.; Dess, Gregory G. “Out of (strategic) control,” Organizational Dynamics,
                 Summer 97, Vol. 26 Issue 1, p35.
140
                                                             Reward Systems


•   Cost of living
•   Productivity
•   Union pressure and strategies
• Government legislation
Salary administration must follow a systematic approach to ensure that
employees are paid in a logical, equitable and fair manner. The objectives of
salary administration are:
•   To acquire qualified and competent personnel
•   To retain present employees
•   To reinforce desired behavior-good performance, loyalty, willingness to
    take additional responsibilities etc.
• To pay the employees in accordance with their efforts and merit
Benefits help employees to deal with certain contingencies and meet certain




                                                    09
social obligations. They satisfy an employee’s economic, social and




                                                20
psychological needs. Benefits include safety measures, health benefits,
pension, perquisites etc. In short, benefits lessen the economic problems of the

                                           of
employee. The objectives of providing benefits are:
•   To boost employee morale
                                      s s
•   To improve the quality of the work environment and work life
                                   la

•   To motivate employees by identifying and satisfying their needs
                                C



•   To create a sense of belonging among employees and retain them
                          y
                        nl




• To protect the health of employees and to ensure their safety
                       O




It is the duty of the senior management to devise the best incentive plan
                   se




possible for its employees. Incentive plans should be approved by the board
of directors before they are implemented. Corporate by-laws and security
              U




regulators also make it mandatory for all organization’s to get their incentive
          S




plans approved by their shareholders.
      B




Incentive compensation plans can be classified as:
    rI




(a) Short-term incentive plans
Fo




(b) Long-term incentive plans
Short-term incentive plans are usually based on the performance of employees
in the current year, while long-term incentive plans relate compensation to
long-term accomplishments. A manager can earn a bonus under both the
plans. In short- term incentive plans, bonus is paid in cash while in long term
incentive plans, the employees are provided with an option of buying the
company's common stock.
Short-term incentive plans
The total bonus pool
Bonus pool refers to a system wherein shareholders vote on the formula to be
used for deciding the total amount of bonus to be paid in a given year.
One simple method is to calculate it as a set percentage of the profits.
However, this method is not always acceptable because a company will have

                                                                            141
Principles of Management Control Systems


             to pay bonus even if the profits are low. Further, this method does not give a
             true picture of additional investments. Additional investments can result in
             increased profits and thus increased bonuses even when the performance of
             the company has been static or has been deteriorating. Many companies
             therefore use formulas according to which bonuses are paid only after a
             specified return has been earned on the capital. One method of accomplishing
             this is to base the bonus on a percentage of earnings per share after a
             predetermined level of earnings per share has been attained. This method,
             however, fails to take into account increases in investment from reinvested
             earnings. This drawback can be overcome by increasing the minimum
             earnings per share each year by a percentage of the annual increase in retained
             earnings.
             Another method is to calculate it as a percentage of the profit before deducting
             taxes and interest on long-term debt minus a capital charge on the total of
             shareholder equity and long-term debt.
             The fourth method is to define capital as equal to shareholder equity.




                                                                 09
             However, the problem with the third and the fourth methods is that a loss in a




                                                             20
             year reduces the shareholders’ equity and thereby increases the amount of
             bonus to be paid in profitable years.

                                                        of
             There are some companies which calculate the bonus on basis of increase in
             profitability in the current year as compared to the previous year. One major
                                                   s s
             drawback of this method is that a good performance in a year is not rewarded
                                                la

             if it follows an excellent one. Bonuses can also be calculated by comparing the
                                             C


             company profitability with industry profitability. However, it is sometimes
             difficult to collect the industrial data as only a few companies adopt the same
                                      y




             product mix or employ identical accounting systems. As a result, a company
                                    nl




             may end up paying a higher bonus in a year in which performance was
                                   O




             mediocre simply because one or more of its industry competitors performed
                              se




             badly.
             It should be noted that while calculating bonuses using any of the above
                           U




             mentioned methods, adjustments need to be made in the net income and
                       S




             shareholder equity. While determining the bonus, it is also important to
                   B




             exclude certain gains and losses from discontinued operations.
                 rI




             Carryovers
            Fo




             This refers to an annual carryover of a part of the amount determined by the
             bonus formula to the bonus pool instead of paying the total amount in the
             bonus pool. The board of directors decides the percentage to be carried every
             year. The board of directors also decides the amount of accumulated carryover
             is to be used if the bonuses paid in a particular year are low. This method is
             flexible as the payment of bonus is not determined by any formula. In a good
             year, the committee might pay only a portion of the bonus to its employees
             while in a poor year, it may pay more than the amount warranted by the year’s
             performance by drawing from the carryover bonus. However, the
             disadvantage of this method is that the bonus calculated is less related to the
             current performance of employees.
             Deferred payments
             Under this system, the amount of bonus is calculated annually, but the
             employees receive the payments over a period of years, usually five.
142
                                                             Reward Systems

Employees receive only one fifth of their bonus in the year in which it was
earned. The remaining part (four fifths) is paid equally over the next four
years. Thus, after five years, employees receive one-fifth of the bonus for the
current year plus one-fifth of each bonus for the preceding four years. One
advantage of the deferred payment method is that employees can estimate
their cash income for the coming year. Another advantage is that it guarantees
bonus to those employees who retire, as the payment of bonus is spread out
for a fixed year. But this method also has its drawbacks. One major
disadvantage is that the deferred amount is not available to the employees the
year it is earned. Moreover, an employee loses the deferred amount, if he
leaves the company.
Long-term incentive plans
Long-term incentive plans are designed to reward the performance of an
employee over a longer period. The types and characteristics of long-term
incentive plans have become increasingly complex over the past several years.
Organizations today design and implement plans that are responsive to the




                                                     09
needs of both the enterprise as well as their employees. The different types of




                                                 20
long-term incentive plans are discussed below.


                                            of
Stock options
A stock option gives the employee the right to buy a certain number of shares
                                         s
in the company at a fixed price for a certain number of years. Stock options
                                      s
                                   la

give the employees the right to buy a number of shares of stock at or after a
                                C


given date in the future. The manager who obtains stock gains if he sells the
stock at a price that exceeds the price paid for it. Managers can retain equity
                         y




even if they leave the company. They can sell the stock whenever they decide
                       nl




to do so. However, managers are not permitted to sell the stock for a specified
                      O




period after it has been acquired. A major advantage of this plan is that
                 se




managers are motivated to direct their energies toward the long-term
performance of the company as it is designed to create an employee ownership
                U




culture.
          S




Stock appreciation rights
      B
    rI




This incentive plan gives employees the right to receive cash payments based
on the increase in the value of stock from the time of the award until a
Fo




specified future date. The amount of bonus received due to the increase in the
value of stock is a function of the market price of the company’s stock.
Phantom stock plans
This plan awards managers a number of shares of stock-either in the form of
cash or shares. At a specified event in future, such as retirement or termination
of employment, the employee is entitled to receive an amount measured by the
fair market value of phantom shares credited to the employee’s account. There
are two types of phantom stock plans, namely “growth” and “basic”. Under
the growth plan, at redemption, employees receive an amount equal only to
the appreciation in the market value of share. Under a “basic” plan, employees
receive the original value of the shares as well as the amount appreciated.
Performance shares
Under this incentive plan, employees are awarded a specified number of
shares when they meet specific long-term goals. This plan aims at achieving
                                                                             143
Principles of Management Control Systems


             certain percentage growth in earnings per share over a period of three to five
             years. The advantage of performance shares over stock options and phantom
             shares is that they are given on the basis of performance. Moreover, they are
             not affected by increase or decrease in stock price. However, one major
             drawback of this incentive plan is that it is based on accounting measures of
             performance. In certain circumstances, actions that corporate executives take
             to improve earnings per share may not contribute directly to the economic
             worth of the firm.

CEO COMPENSATION

             The compensation of the Chief Executive Officer (CEO) is decided after a
             discussion by the board of directors. This takes place after the CEO has
             recommended the incentives to be paid to his subordinates. The percentage of
             incentive compensation decided by the CEO for his subordinates, can be taken




                                                                       09
             as the basis for determining his/her compensation. Most people believe that
             CEO compensation is much higher as compared to other employees in the




                                                                  20
             organization. In most cases, CEOs are paid extraordinary bonuses, lavish
             perquisites that are not related to the profits of the organization. However,

                                                             of
             directors of most firms feel that the compensation the CEOs receive is very
             little as compared to the profits they bring to the organization. However, of
                                                       s  s
             late, the exorbitant salaries being paid to the CEOs have come under scrutiny.
                                                    la

             The recent scandals in Global Crossing, Computer Associates, Xerox have
                                                 C


             highlighted this issue further.
                                         y



             According to some analysts, high CEO compensation is the root cause for
                                       nl




             collusive practices. In 2000, CEOs in the US, were paid 458 times the salary
                                      O




             of an average worker. The problem lies not only with the pay the CEOs
             receive, but also with the methods they adopt to raise the stock price up in
                                se




             time to cash in their options. Emphasizing on the need to restrict such
             practices; writes Warren Buffet2: “To clean up their act on these fronts, CEOs
                             U




             don’t need “independent” directors, oversight committees or auditors
                         S




             absolutely free of conflicts of interest. They simply need to do what’s right.”
                    B




             Also, the policy making process should ensure that better representation is
                  rI




             given to the investors.
            Fo




             The family run businesses in India also pay exceptionally high salaries to their
             CEOs especially in the manufacturing sector where profits and stock prices
             have increased continuously. The CEOs award themselves with high salaries
             by manipulating shareholder meetings and share prices. The CEO
             compensation which has to be decided by the board of directors now seems to
             be just a farce with industrialists and professional managers rewarding one
             another through cross directorships on company boards.

INCENTIVES FOR BUSINESS UNIT MANAGERS

             Incentives for business unit managers include financial incentives,
             psychological incentives and social incentives. Financial incentives are
             offered in the form of salary increases, bonuses, benefits and perquisites.

             2
                 Warren E. Buffett “Who Really Cooks the Books?” New York Times, July 24, 2002
144
                                                                             Reward Systems

                Psychological and social incentives are provided in the form of promotions,
                increased responsibilities, increased autonomy, better location, participation in
                executive development programs etc.

Size of Bonus Relative to Salary
                There are two schools of thought on designing the mix between the fixed
                (salary and benefits) and variable (incentive bonus) portions of a manager’s
                total compensation. One school states that it is important to recruit good
                people, pay them well and expect good performance from them. This school
                emphasizes on salary and not on incentive bonus. The emphasis of this school
                of thought is on the fixed pay system. In this type of compensation
                performance is not related to pay. However, this type of compensation raises
                an important question- what happens if a person does not perform as
                expected? The other school of thought believes that compensation should be
                based on performance. Thus, the emphasis is on incentive bonus and not
                salary. These two philosophies have different implications for business unit




                                                                     09
                managers. While the first philosophy assures employees’ monthly salary it




                                                                 20
                rarely encourages employees to perform efficiently. Whereas the second
                philosophy encourages managers to put greater effort and perform to the best

                                                            of
                of their ability. Most organizations emphasize on incentive bonuses for
                business unit managers.
                                                      s  s
                                                   la

Cutoff Levels
                                                C


                Another aspect that has to be considered when deciding compensation plans is
                                          y



                the cutoff level for bonuses. The upper cutoff indicates the level of
                                        nl




                performance at which maximum bonus can be earned whereas the level below
                                       O




                which there will be no bonus is referred to as the lower cutoff level. When
                employees realize that the maximum performance level has been attained and
                                 se




                they will not be paid any bonus, they may not be motivated to perform well
                              U




                and achieve organizational goals.
                          S




Bonus Basis
                      B
                    rI




                The bonus for a business unit manager can be based on the total profits of the
                Fo




                company or solely on the performance of the individual business unit or a
                combination of both. It is important to base bonus on the performance of the
                individual business unit as the decisions and actions of the manager have a
                direct impact on the performance of that unit. But such an approach can have a
                negative impact on the inter unit cooperation. To encourage cooperation
                among the various units, the managers ability to foster cooperation should also
                be given due consideration.

Performance Criteria
                The bonus of a business unit manager can be decided on the basis of the
                factors mentioned below.
                Controllable factors
                Managers should be rewarded on the basis of variables which values are under
                their control and influence. Such a reward system can be considered fair. On

                                                                                             145
Principles of Management Control Systems


             the other hand, when rewards are based on variables that are outside the
             control of managers, the reward system becomes more arbitrary.
             Uncontrollable factors
             Sometimes corporate managers hold the subordinates responsible for variables
             that are out of their control. These include effects of losses due to earthquakes
             and floods and accidents not caused by the negligence of the manager.
             Another uncontrollable factor is the result of decisions made by the executives
             above the business unit level. These uncontrollable factors have to be taken
             into account while deciding on the reward systems.
             Financial criteria
             In case of a profit center, the choice of financial criteria for the business unit
             manager are decided on the basis of the unit’s contribution margin, direct
             business unit profit, income before taxes and net income. However, before
             considering these factors, it is important to have a clear understanding of the




                                                                   09
             definition of profit, and investment and also the choice between return on
             investment and residual income.




                                                               20
             Short term financial targets

                                                          of
             Linking business managers’ bonus to short term financial targets results in
             managers looking for ways to perform existing operations more creatively and
                                                    s  s
             innovatively. However, this can sometimes cause several dysfunctional
                                                 la

             problems. Managers can encourage short term actions that are not in the long
                                              C


             term interests of the company. They could also discourage investments, that
             promise benefit in the long term but do not contribute to short term financial
                                       y




             results. Managers could manipulate data to meet current period targets.
                                     nl
                                    O




             Overcoming short-term bias
                              se




             These can be overcome by determining the manager's bonus on multiyear
             performance. But having such a reward system has its own disadvantages. If
                           U




             the bonus is based on multiyear performance, managers would have difficulty
                        S




             in perceiving the relationship between their rewards and effort. This would
                   B




             reduce the motivational effect of such rewards. Secondly it would be difficult
                 rI




             to implement such a reward system in case of transfers. Senior management
            Fo




             can thus use non financial criteria like sales growth, market share, customer
             satisfaction, personal development etc. However, the best alternative would be
             to have a judicious mix of financial and non financial criteria.
             Non financial
             For an effective and efficient control system key variables should be
             qualitative. These kinds of key success factors include cycle time, measures of
             quality, on-time delivery, complaints from customers, new product
             introductions, supplier defects and so on.

Benchmarks for Comparison
             The performance of a business unit manager can also be evaluated by
             comparing the actual budgets with profit budgets, its past performance or even
             with its competitor's performance. However, when using the profit budget as a
             motivational tool, it is important for the business unit to set attainable targets.

146
                                                                            Reward Systems


BALANCED SCORECARD

        In this rapidly changing world of business, the traditional measures of
        performance appraisal are insufficient for making decisions. The emphasis is
        not only on measuring financial performance, but also on measuring non
        financial performance. The growing international competition, the TQM
        movement have all widened the growing importance of non-financial
        measures of performance. Thus, it has become important to take into
        consideration both financial and non-financial measures of performance. A
        number of studies have been conducted to include both financial and non-
        financial measure of performance. The balanced scorecard (BSC) developed
        by Robert Kaplan and David Norton takes into account financial and non-
        financial measures, short-term and long-term goals, external goals, internal
        improvements, past outputs and ongoing requirements, as indicators of future
        performance. BSC3 acts a strategic planning and communicating device by:
        •   Directing managers’ attention towards the strategic goals of the




                                                                   09
            organization.




                                                              20
        •   Identifying the links between the lagging and leading indicators of
            performance.
                                                         of
        According to Kaplan and Norton, by using a BSC, managers can effectively
                                                     s
        utilize the potential and specific knowledge of the organization’s personnel to
                                                  s
                                               la

        achieve long-term goals. BSC measures performance from four important
        perspectives:
                                            C



        • Financial perspective that involves the strategy for growth, profitability,
                                    y




             and risk viewed from the shareholder's perspective.
                                  nl




        •   Customer strategy that concentrates on creating value and differentiation
                                 O




            from that of the competitors.
                           se




        •    Internal business processes perspective that focuses on various strategic
                        U




             priorities for various business processes that result in customers’ and
             shareholders’ satisfaction.
                    S
               B




        • Learning and growth perspective determines priorities to create a climate
             rI




             that supports organizational change, innovation and growth.
        Fo




        BSC plays an important role in strategy implementation and performance
        measurement. The measures of performance should be accurate, objective and
        verifiable. Performance measurement should motivate employees to improve
        in the key areas of competition like customer satisfaction, productivity, etc. If
        performance is not measured accurately, managers may manipulate
        performances, and thus the credibility of the system may be lost. The target
        performance level should be challenging and, at the same time, attainable.
        However, having          too many performance measures may reflect the
        complexity of the organization’s task. Employees’ commitment to achieving
        goals can be enhanced by linking BSC to well understood rewards and
        penalties. An organization’s BSC will be effective if it is linked with best
        rewards and appropriate penalties. An effective management control device

        3
            Mary A Malina and Frank H Selto “Communicating and Controlling Strategy: An
            Empirical Study of the Effectiveness of the Balanced Scorecard” Journal of Management
            Accounting Research, 2001.
                                                                                             147
Principles of Management Control Systems


                that promotes desired organizational output should have the following
                attributes:
                •   Performance variables should linked to the strategic goals of the
                    organization.
                •   Goals should be accurate, objective and attainable, and should effectively
                    guide managers towards achieving the strategic objectives of the
                    organization.
                •   To promote positive motivation, an effective management control system
                    should have:
                •   Performance measures that are helpful in measuring the manager's actions
                    by relative performance appraisal measures.
                •   Targets that are challenging, but should be attainable.
                • Achieving targets should be followed by rewards.
                Feedback is a powerful tool and helps the management to measure and reward




                                                                      09
                performances. Feedback can be both formal and informal. Rewards and




                                                                  20
                penalties help an employee to understand the expectations of the management
                and work towards the achievement of the goals.

DESIGN CONSIDERATIONS                                        of
                                                        ss
                                                     la

                The design considerations for developing reward systems follow certain
                criteria. These criteria whether formal or informal are powerful motivators of
                                                 C



                people.
                                          y
                                        nl




                •   Integrating rewards with MSSM
                                       O




                •   Attainability
                                    se




                •   Identifying the formal rewards
                              U




                •   Identifying the informal rewards
                           S




Rewards Integrated with MSSM (Mutually Supportive Systems Model)
                      B
                    rI




                The MSSM (Mutually Supporting Systems Model) which consists of
                Fo




                infrastructure, management sytle and culture, formal control process, rewards
                and coordination and integration has the ability to produce incentives or
                disincentives depending upon its design and performance variables. For
                example, autonomy may be considered an incentive for a manager. A sense of
                authority over the organizational resources will motivate him to perform
                better.
                The incentives and disincentives are strongly influenced by the values and
                culture of an organization. Communication and integration structures are
                strong motivators. Employee participation in decision-making and problem-
                solving, which is usually highly valued by the employees is considered to be a
                powerful incentive.

Attainability
                It is important to set targets which are challenging but attainable. Targets that
                can be easily achieved are poor motivators as they do not give individuals the
148
                                                                        Reward Systems


            scope to grow. At the same time, targets which are impossible to achieve can
            be demotivating.

Formal Rewards
            Formal rewards are specified by the definition of goals, responsibilities,
            performance measures and a number of criteria should be followed by setting
            formal rewards.
            •    Performance measures which are designed to measure reward systems
                 should be congruent with the goals and objectives of the organization.
            •    Performance of the managers has to be evaluated based on the variables
                 over which they have significant amount of control.
            •    Performance should be objectively measured and these standards should
                 be challenging but attainable.
            •    Rewards should encourage competition and should be simple to




                                                                09
                 understand and administer.




                                                            20
Informal Rewards

                                                       of
            Informal relationships among employees give rise to informal rewards.
            Informal rewards are usually meant to satisfy the psychological needs of the
                                                    s
            employees. These rewards promote self-respect, reinforce the values of the
                                                 s
                                              la

            organization and encourage self-learning. The reward and recognition
            dynamics of formal and informal reward systems is shown in Exhibit 10.1.
                                            C



            The left side of the exhibit indicates the formal rewards like merit increases
                                     y




            and bonus programs. Before motivating an individual, these rewards pass
                                   nl




            through cultural values, past training etc., The right side represents the
                                  O




            informal activities which also passes through cultural activities. When these
                             se




            two loops positively reinforce the employee then he is motivated to perform.
                          U




AGENCY THEORY
                       S
                   B
                 rI




            The agency theory describes the factors that should be considered while
            designing incentives and shows how these incentives can be used to motivate
            Fo




            individuals. This theory usually uses mathematical models to describe the
            incentives. Here, we only discuss the main concepts of agency theory and not
            the mathematical models. The term ‘incentive contract’ has been used here
            instead of incentive compensation. The theory reestablishes the importance of
            incentives and self interest in organizational thinking.

Concepts of Agency Theory
            According to the theory, a relationship is formed when party ‘the principal’
            hires another party ‘the agent’, to undertake some service. In an organization,
            many such relationships exist. For example, shareholders are considered to be
            the principals with the chief executive officer as their agent. Similarly, the
            CEO is the principal while the managers of specific business units are agents.
            The agency theory assumes that the principals and agents possess divergent
            preferences and objectives. This divergence in preferences can be reduced
            through incentive contracts.
                                                                                       149
Principles of Management Control Systems



                                            Exhibit 10.1
                                  CEO Compensation in India
      In India, CEO compensation is becoming a highly debatable issue. Family run
      businesses are awarding the CEOs hefty salaries. The late Dhirubhai Ambani, former
      chairman and founder of Reliance Industries was paid $1.83 million in 2002. Hero
      Honda, promoted by the Munjal family in partnership with Honda, paid Rs 29.75 crore
      (Rs 297 million) to its top four executives. Hero Honda's promoters, Brijmohan Lal
      Munjal, Pawan Kant Munjal, and Honda executives Matsuo Yamasaki and Kazumi
      Yanagida, took home around Rs 7.50 crore (Rs 75 million) each during 2002. The
      aggregate salaries of the top five executives of RIL were Rs 27.23 crore (Rs 272
      million), Mukesh Ambani and Anil Ambani being paid Rs 7.21 crore (Rs 72 million)
      each. Nikhil R Meswani and Hital R Meswani was paid Rs 1.93 crore (Rs 19 million)
      each. Apart from these, Hindustan Lever, the Aditya Birla Group, ITC, Wipro and
      ICICI have high pay packets that have attracted attention. The compensation is not
      performance based and industrialists and professional managers reward one another




                                                                      09
      through cross-directorships on company boards.




                                                                 20
      Source: BS Research Bureau, October 17th, 2002 and Sucheta Dalal, “Operation Clean-up In

                                                            of
      The US”, The Financial Express May 27, 2002.         s
                                                       s
                Divergent objectives of principals and agents
                                                    la

                The agency theory assumes that financial compensation alone cannot satisfy
                                                 C


                the agents. Perquisites like greater amount of leisure time, attractive working
                                          y



                conditions, flexibility in working hours etc. are also needed. Some agents
                                        nl




                prefer leisure to hard work (effort) and the preference for leisure over effort is
                                       O




                termed as work aversion. Sometimes, agents deliberately try to evade
                responsibility which is termed as shirking.
                                 se




                Another assumption of the agency theory is that although managers prefer
                              U




                more compensation to less, but satisfaction decreases with the accumulation of
                           S




                more and more wealth. The compensation made to managers is usually based
                      B




                on the performance of the firm. Agents try to avert risk when much of their
                    rI




                wealth is dependent on the company. On the other hand, owners reduce their
                risk by diversifying their wealth and becoming owners in many companies.
               Fo




                Nonobservability of agent’s actions
                The principal should monitor the actions of the agents in order to avoid
                divergence in preferences (between the principals and agents) and to satisfy
                the agents by offering the best compensation and perquisites. However, due to
                the lack of adequate information about the activities of agents, the principal
                cannot ascertain the agent’s contribution to the performance of a firm. This
                situation is referred to as ‘information asymmetry.’ Sometimes, the agent may
                have more information about the task assigned to him than the principal. The
                additional information that the agent may have about performing a particular
                task is termed ‘private information’.
                The agent may sometimes misinterpret information to the principal, either due
                to divergence of preferences or due to the private information available with
                him. Such a situation is termed as moral hazard.


150
                                                                       Reward Systems


          Control mechanisms
          There are two ways of dealing with the problems of information asymmetry
          and divergence in preferences, namely monitoring and incentive contracting.
          Monitoring: The principal can design control systems that monitor the actions
          of its agents. One example of a monitoring system is the auditing of the
          financial statements. These statements help generate reports about the
          company’s performance. These financial reports are audited by a third party
          and then sent back to the owners. Monitoring becomes easy when the task
          assigned to the agent is well defined and the information used is accurate.
          Incentive contracting: Incentive contracts are established to limit divergence
          in preference. Performance measures should be set to measure the rewards
          granted to the agents. The more the reward depends on performance measures,
          the more incentive there is for the agent to improve the measures. The
          principal should define the performance measure in such a way that it furthers
          his or her interest. The ability to accomplish this is known as ‘goal




                                                              09
          congruence’. If the agent, to whom the contract is given, is motivated to work
          in the best interest of the principal, then the contract is said to be goal




                                                          20
          congruent.
          A compensation scheme that does not have an incentive contract is
                                                     of
          demotivating. The CEO who is paid a straight salary, is likely to be less
                                                  s
          motivated to work diligently than the CEO who gets a bonus along with the
                                                s
          salary. This would motivate the CEO to work hard and the organization earns
                                             la

          higher profits. Thus, the incentive contract is beneficial for both agents and
                                          C


          principals. Contracts help in aligning the interests of the two parties.
                                   y




          The asymmetry of information, differences in risk preference between the two
                                 nl




          parties, costs of monitoring, etc. sometimes make incentive contracts
                                O




          ineffective. These can lead to additional costs. Even an efficient system of
          incentives can lead to divergence of preferences. This divergence is referred to
                           se




          as ‘residual loss’. The additional costs of incentive compensation, the costs of
                        U




          monitoring and the residual loss is termed as ‘agency costs’.
                    S
                B




SUMMARY
              rI
          Fo




          This chapter examined the usefulness of reward systems as a control
          mechanism that encourages and motivates managers to achieve organizational
          objectives. The reward system is a major tool for communication and
          feedback. Reward systems help align the interests of stakeholders with that of
          managers. The important components of incentive compensation plans are:
          salary, benefits and incentive compensation. CEO salaries have soared very
          high and is causing serious concern.
          Short-term incentive plans are based on performance of employees in the
          current year while long-term incentive plans are based on performance over a
          longer period. The balanced scorecard can be used for comparing
          performances of individuals within an organization. It provides the
          management with the information that may help to prevent control failures or
          at least identify them early. The control system is designed to ensure:
          safeguarding of assets, reliability of information. Feedback is an important
          motivational tool that helps in assessing the performance of individuals in
          organizations. The chapter concludes with a description of the agency theory.
                                                                                      151
 Chapter 11

 Management Control of



                                                09
 Operations

                                                20
                                         of
                                      ss
In this chapter we will discuss:
                                   la

•   Information Used in Control of Operations
                                   C



•   Just-in-Time Techniques
                         y
                       nl




•   Total Quality Management
                      O




•   Computer Integrated Manufacturing
                 se




•   Decision Support Systems
              U
           S
       B
     rI
Fo
                                                    Management Control of Operations


            Operations management is one of the most important managerial functions. In
            order to bring about efficiency in operations, there is a need to develop
            techniques that help a manager to establish control. As management control of
            operations involves working through others, managers should have the right
            kind of information to understand the different activities that directly or
            indirectly influence control. This control can be discussed in two sections. The
            first section is concerned with the information that managers require to carry
            out the different activities that directly or indirectly influence control and the
            second section deals with techniques that are useful in management control of
            operations.

INFORMATION USED IN CONTROL OF OPERATIONS

            A manager is responsible for selecting the work force, ensuring that they are
            adequately trained, deciding where they fit best in the organization, providing




                                                                  09
            advice and suggestions, solving problems and ensuring that the environment




                                                             20
            in the work place is satisfactory. Managers also need to interact with other
            managers to obtain their cooperation and resolve problems when their

                                                        of
            activities impede the work of the responsibility center. Thus, a primary motive
            of a manager is to create a climate that induces employees to work efficiently
                                                     s
            and effectively.
                                                   s
                                                la

            In order to carry out these activities, managers require information. Hence, it
                                             C


            is necessary to discuss the different types of information required in
                                      y



            management control of operations.
                                    nl
                                   O




Informal Information
                             se




            Information that managers receive in organizations is mostly informal in
                          U




            nature. It is obtained through observation, face-to-face conversations,
            telephonic conversations, and meetings. ‘Management by walking around’
                       S




            (MBWA) has gained a lot of importance in the present day business world
                  B




            indicating the importance of informal information. By ‘walking around’, the
                rI




            manager tries to understand the problems of the workers. The information
            Fo




            received through this process is informal and cannot be categorized.

Formal Information
            In formal information, the manager relies principally on the formal reports.
            This includes task control information, budget reports, budget signals and
            internal audit.
            Task control information
            Task control information constitutes most of the formal information that flows
            through an organization in its daily operations (production or other activities).
            A production control system is one that schedules the flow of material, labor
            and other resources to ensure that both quality and productivity are
            maintained. An organization also has systems that control procurement,

                                                                                          153
 Principles of Management Control Systems


              payroll, storage and other activities. Management control information is
              nothing but a summary of task control information. The emergence of
              technology has made it easier for managers to acquire day-to-day information.
              However, the main issue is not of acquiring the information but deciding what
              information is really useful for them.

              Budget reports
              Approved budget is a financial tool which helps in controlling the activities of
              the managers and comparing actual expenses with budgeted amounts. The
              budget report serves as an important guide for the manager. The manager is
              expected to operate in accordance with the budget to get a clear idea of the
              financial position of the responsibility centers. However, the manager is free
              to depart from the budget if he feels there is a better way of achieving the
              objectives of the organization.




                                                                   09
              Budget signals




                                                               20
              Budget signals help the operating manager to determine the amount of money

                                                          of
              that has to be spent on various activities. These activities can be grouped
              under Ceilings and Floors. Ceiling includes activities such as advertising,
                                                       s
              entertainment expenses on which no more than the budgeted amount should
                                                    s
                                                 la

              be spent. Floors include activities like training and the manager is expected to
              spend the amount assigned for a particular activity. Though the expenses are
                                              C



              stated in the budget, the manager should be in a position to decide the amount
                                       y




              that has to be spent on each activity based on the requirement of the
                                     nl




              department.
                                    O
                               se




              The main emphasis for managers is to achieve the bottomline, and hence,
              adjustments can be made in the individual revenue and expense items on the
                            U




              income statement. With the exception of floor amounts, spending exceeding
                        S




              the budget amount for one item is not criticized if the spending is
                    B




              compensated for other items.
                  rI




              Internal audit
             Fo




              If too much emphasis is placed on the budget, there is always a danger of
              managers manipulating numbers to report the attainment of the budgeted
              profitability in the current period. One way of doing this is to record goods
              that have, not been shipped to customers during that period. On the other
              hand, if performance greatly exceeds the budget, the apprehension that
              reporting a high profit may lead to an increase in the budget amount or a
              decrease in the following year, may prevent a manager from reporting certain
              revenue transactions.
              The internal audit reports help detect such behavior while the audit committee
              activities ensures that appropriate action is taken on internal audit reports and
              that there are adequate controls to minimize theft and defalcation. As these
              activities generally involve high level managers it becomes difficult as well as
              sensitive task.

154
                                                       Management Control of Operations


Non Financial Information
               For management control systems to be effective in controlling operations,
               there is a need for non-financial information. It is reported as a supplement to
               the financial information. Non financial information includes the identification
               of key variables and the steps that have to be taken to achieve competency in
               these key variables. While financial performance shows the end result of an
               organization's performance, non financial information shows the means to
               achieve the ends. The relationship between financial and non-financial
               information in an organization is illustrated in Figure 11.1. The exhibit
               illustrates that at the lower levels of organizational hierarchy, non financial
               measures are given greater importance. The emphasis on financial measures is
               likely to increase with hierarchical levels.

        Figure 11.1: Hierarchical Levels and Types of Performance Measures




                                                                     09
       Hierarchical        Importance of          Importance of       Level of




                                                                  20
          level            financial               nonfinancial       aggregation
                           measures                 measures          of measures


        Corporate              Higher                Lower   of        Higher
                                                      s s
        executive
                                                   la
                                                C


        Business
        unit
                                           y




        manager
                                         nl
                                        O




        Functional
                                se




        department
        manager
                             U
                          S
                       B




        Subunits
        within
                     rI




        functional
              Fo




        departments


        Work centers             Lower              Higher             Lower

  Source: Joseph A Maciariello and Calvin J. Kirby, Management Control Systems, (USA: Prentice
  Hall of Inc, Second Edition) 431.

JUST-IN-TIME TECHNIQUES

               Just-in-time is a Japanese philosophy that is used for managing all types of
               inventory, purchase and production functions in an organization. The main
               purpose of this philosophy is to reduce inefficiency and unproductive time in
               the production process.


                                                                                             155
 Principles of Management Control Systems


Advantages of Just-in-Time Techniques
              There are a number of strategic advantages for an organization using just-in-
              time systems. They form an integral part of the corporate strategy by
              focussing on cutting cycle time, improving inventory turnover and increasing
              labor productivity. Some of the advantages have been discussed below:
              Reduces buffer inventory
              The main aim of just-in-time is to ensure the delivery of raw materials at the
              right time and in the right quantity and reduce buffer inventory. The need for
              buffer inventory arises when machines break down or they produce defective
              parts. The amount of buffer inventory can be reduced if steps are taken to
              minimize machine breakdown and improvise quality of the inventory. The
              need for buffer inventory also arises because of bottlenecks in the workplace.
              These problems can be minimized by taking immediate action whenever a
              problem arises.




                                                                   09
              Decreases set-up costs




                                                               20
              The amount spent on set-up costs is reduced with the introduction of

                                                          of
              numerically controlled machine tools. Traditionally when a machine was
              discontinued a sizable production of each part became obsolete and these
                                                       s
              awaited replacements. With numerically controlled machine tools, the need
                                                    s
              for this inventory is greatly reduced and orders for obsolete parts can be filled
                                                 la

              by simply inserting a proper computer program.
                                              C
                                       y



              Decreasing procurement costs
                                     nl




              Traditionally, procurement involved a long process of first inviting bids, then
                                    O




              analyzing these bids, and placing an order with the best vendor, followed by
                               se




              an inspection of the incoming goods. This process was time consuming as
              well as expensive. To avoid this, companies are now establishing relationship
                            U




              with one or two vendors who are expected to inspect the quality of the
                        S




              incoming goods before delivering them. Moreover, with the advent of
                    B




              information technology, orders are being transmitted electronically in many
                  rI




              companies. This can help companies to curtail procurement.
             Fo




              Relationship with customers
              Manufacturers use systems through which sales persons can automatically
              place orders from retailers or other customers. These systems help in
              providing fast and accurate information to managers and also build strong
              relationship between the customer and manufacturer. .

Implications for Management Control
              Before implementing just-in-time systems a manager has to understand the
              following aspects. Work-in-process inventory becomes insignificant because
              of just-in-time systems and can be disregarded. In such cases inventories exist
              only for raw materials and finished goods, therefore reducing record keeping
              considerably.
              In addition to the traditional focus on cost, a just-in-time system focuses
              management attention on time. A reduction in cycle time may result in
156
                                                       Management Control of Operations


             reduction of costs. The progress of just-in-time systems can be effectively
             monitored through the following ratio:


             Processing time
                Cycle time
             This ratio should ideally be equal to 1. The just-in-time system is an
             evolutionary system, that seeks to improve the manufacturing process
             continually. Keeping this ratio in mind, the management can establish targets
             and monitor progress against the targets.

TOTAL QUALITY MANAGEMENT

             Total quality management (TQM) is a management concept that directs the




                                                                     09
             collective efforts of all managers and employees towards satisfying customer
             expectations by continually improving operations management processes and




                                                                20
             products. TQM emphasizes three important aspects: customer satisfaction,
             employee involvement and quality improvement. The Japanese have set an

                                                           of
             example for other countries paying considerable attention to quality. Quality
             efforts initiated by the Japanese have now been adopted by several American
                                                     s  s
             companies.
                                                  la
                                               C


Consequences of Poor Quality
                                        y




             The quality of a product can be decided either on the basis of design or its
                                      nl




             conformance to customer requirements. Design quality can be described as the
                                     O




             value that the consumer places on the product. A product is said to achieve
                               se




             conformance quality, if it adheres to the specification of manufacturing the
             product. If a product does not meet the specifications, than it implies
                             U




             nonconformance to quality. This nonconformance is measured by the number
                        S




             of defective products. Total quality management emphasizes manufacturing
                   B




             products with zero defects. Emphasis is also laid on detecting the problem at
                 rI




             the initial stage because if the defect is detected at a later stage, then it results
             in cost penalty for the organization, which at times can damage the reputation
            Fo




             of the firm. Therefore, the earlier a defect is detected; the lower will be the
             cost penalty.

Total Quality Management Approach
             The total quality management approach can be looked at from three aspects:
             responsibility for quality, product design and relationship with suppliers.
             Responsibility for quality
             The traditional view held that most defects occurred at the factory floor and
             that workers were primarily responsible for them. Hence, the quality control in
             the traditional method involved inspecting the quality of the products. This
             was a tedious process and entailed setting up a quality control department.
             This led to a frequent conflict between the manufacturing department and the
             quality control department. The main objective of the manufacturing

                                                                                              157
 Principles of Management Control Systems


              department was to maximize output; the quality control department was
              responsible for detecting problems. Thus, coordination among the various
              departments became a major problem for the management. This problem was
              eliminated to a large extent by using the total quality approach. According to
              the total quality control approach, the responsibility for quality should be
              shared by all departments as quality is the responsibility of every single
              department. According to this view, most quality problems occur even before
              the product reaches the factory floor.
              According to Edward E. Deming, “Quality is the responsibility of the
              management and not the workers and management must foster an environment
              for detecting and solving quality problems.” The production process in an
              organization can be divided into two parts: the system that is under the control
              of the management and workers who are under their control. Of the quality
              problems that arise in an organization, 85 percent can be attributed to the
              former while 15 percent to the latter. The system that is under the control of




                                                                   09
              management can be faulty due to several reasons like ineffective
              manufacturing processes, inferior raw materials, poor working conditions etc.




                                                               20
              The total quality management approach thus, emphasizes ensuring quality
              while the product is being manufactured rather than inspecting it for quality
                                                          of
              after it has been manufactured. Most of the quality problems can be avoided
                                                       s
              by identifying the errors at an early stage. Exhibit 11.1 illustrates the quality
                                                    s
              control process implemented at Toyota. Employees in every department
                                                 la

              should ensure that they do not pass on a defective product to the next stage of
                                              C


              production. Also, the function of the quality control department should not
                                       y



              just be related to inspecting the product after it has been manufactured but
                                     nl




              inspecting and monitoring the production process. This will eliminate most of
                                    O




              the defects.
                               se




              Product design
                            U




              Most of the quality problems arise in the early stages mainly during the
                        S




              designing of the product. These problems occur when the designers do not
                    B




              work closely with the production people, who are familiar with manufacturing
                  rI




              problems. Under total quality control, there is an effort to coordinate the
             Fo




              activities of designers and the production engineers. While designing a
              product, the preference of the customers should be given due consideration.
              For this it is important that the marketing department and design department
              work in close coordination.
              Relationship with suppliers
              In the traditional method, contracts were awarded to those suppliers who
              placed the lowest bid. But in total quality management, the supplier is selected
              not just on the basis price but also the quality, and its timely delivery of the
              product. Thus, instead of having many suppliers, one or two suppliers are
              selected and a long term relationship is established with them.
Implications for Management Control
              The management can ensure the quality of its products by focusing on two
              aspects-the financial and non financial.

158
                                                 Management Control of Operations



                                     Exhibit 11.1
                             Quality Control at Toyota
The cornerstone of Toyota’s quality control system is the role of the team members
in the production process. The team members in the Toyota plant are encouraged to
play an active role in quality control. Employees’ ideas and opinions are utilized in
the production processes, and they are encouraged to practice “kaizen’ — striving for
constant improvement. Every team member in the Toyota plant treats the other
member as a customer. This way they ensure that no defective product is passed on
to the other team members. If a team member finds a problem with a part or the
automobile, the team member stops the line and corrects the problem before the
vehicle goes any farther down the line.

•   The planning stage is an important stage where the employees emphasize on
    manufacturing defect free products. Quality is designed in the automobile with




                                                               09
    the help of advanced design techniques like computer-aided design that helps in
    improving the quality. This stage also emphasizes developing a product that is




                                                          20
    defect free. Quality control involves close cooperation of many production
    departments.
•
                                                     of
    Toyota’s quality control during production ensures that the correct materials and
                                                  s
    parts are used and fitted with precision and accuracy. This effort is combined
                                                s
    with thousands of rigorous inspections performed by team members during the
                                             la

    production process. The team members are responsible for any defects in the
                                          C


    products they use as they are the inspectors of the products they use. To ensure
                                   y



    that the product is defect free a quality audit is done that ensures that the product
                                 nl




    is manufactured as per quality standards.
                                O




•   Encouraging and rewarding people form an important system in quality control.
    Members in Toyota are rewarded for providing suggestions. Through Quality
                           se




    Circles and a suggestion system that rewards employees for ideas, team members
                       U




    strive to achieve the Toyota principle of kaizen, or continuous improvement. At
    any time during the production process, any team member who spots a problem
                   S
               B




    can stop production by pulling the “and on cord” located next to the assembly
             rI




    line. “And on cord” lets supervisors know the location of the problem with a
    blinking light and a distinct musical tone.
        Fo




Source: www.toyotageorgetown.com


        Financial measures
        In the financial measures, the costs of doing things wrong are estimated and
        aggregated. There are certain costs associated with quality management:
        prevention, appraisal, internal failure costs and external failure costs. The
        total cost of quality for a firm is the sum of the four costs described below:
        Preventive costs
        These are costs incurred to make products defect free the first time they are
        manufactured. It includes quality engineering, receiving inspection, preventive
        maintenance, the estimated fraction of manufacturing engineering and design

                                                                                       159
 Principles of Management Control Systems


              engineering. All these ensure prevention of defects and encourage quality
              training.
              Appraisal costs
              These are costs incurred in assessing the level of quality in the manufacturing
              system. It includes technical services laboratory, design analysis and actual
              inspection costs.
              Internal failure costs
              They fall into two major categories: yield losses (if a defective item has to be
              scrapped) and rework costs (if an item is routed to previous operations).
              External failure costs
              These arise when a defect is discovered after a customer has received a
              product or service. The costs include cost of returns, marketing expenses
              dealing with returns, repair costs etc.,




                                                                  09
              Total cost of quality and reporting can provide several benefits for an
              organization.




                                                              20
              •   It helps the management to analyze the costs that are incurred as a result

                                                          of
                  of poor quality. If these costs form a high percentage of total profits, the
                  management would need to take corrective actions and adopt total quality
                                                      s
                  control at the earliest.
                                                    s
                                                 la

              •   These reports can help the management to understand the relationship
                                              C


                  between preventive and failure costs. Specific programs to improve
                  quality can thus be designed.
                                          y
                                        nl




              •   These reports guide the workers and also the management to work
                                       O




                  towards quality goals.
                                se




              Nonfinancial measures
                            U




              These relate to collecting nonfinancial information about the number of
              defective units delivered by each supplier, number and frequency of late
                        S
                    B




              deliveries, number of customer complaints, warranty claims, machine
                  rI




              breakdowns, number and frequency of product returns. The major advantages
              of non financial measures are:
             Fo




              •   They can be reported on a daily basis
              • Corrective actions can be taken everyday.
              Thus non financial measures are important to provide continuous feedback to
              managers and workers improve quality.

COMPUTER INTEGRATED MANUFACTURING

              It is a term used for the total integration of product design and engineering,
              process planning and manufacturing by means of complex computer systems.
              Expensive computer systems are used to link various stages of production.
              These systems automatically schedule manufacturing tasks, and keep track of
              the availability labor. Then they send instructions to computer screens at
              various workstations along the assembly line. The implications of such
              systems for management control are:
160
                                                    Management Control of Operations


             •   They increase the task control for managers as these systems convert
                 certain production activities that once required management control to
                 task control. Hence, managers no longer have to supervise the work of
                 their employees. They are required to handle only unusual situations.
             •   The information provided by these systems is accurate and detailed.
                 However, the designers are sometimes overloaded with information and
                 have difficulty in deciding the amount of information they should report to
                 managers. The solution to such a situation is to provide a small quantity of
                 information routinely and permit the manager to access a large database
                 for other information.
             •   Some systems are built around work teams that are responsible for all
                 operations. Employees are rewarded on the basis of their contribution to
                 the work team in terms of achieving the quality and quantity.
             •   In team approaches, the business unit controller is primarily responsible
                 for assisting the business unit manager in planning and controlling the




                                                                 09
                 unit's operations.




                                                             20
DECISION SUPPORT SYSTEMS

                                                        of
                                                     s
             The term decision support system is broadly used for systems that aid
                                                   s
             decision-making by providing the answers to a series of “what-if” questions.
                                                la

             Decision support systems include expert systems, natural language systems,
                                             C


             artificial intelligence systems, and knowledge-based systems.
                                      y
                                    nl




Nature of Decision Support Systems
                                   O




             “If-then” rules or decision rules that show how an expert in the area would
                              se




             solve a problem, given a certain set of facts, make up a decision support
             system. The relevant information is provided by a series of questions
                           U




             answered by the decision maker. These questions are asked in plain English
                       S




             and does not require any knowledge of computer programming. That is why
                   B




             they are called “natural language” programs. A course of action is then
                 rI




             suggested by the computer. Decision support systems are so called because
             they help the decision maker to arrive at a decision. The decision maker,
            Fo




             however, is free to reject the computer’s recommendation, or to modify it.

Implications for Management Control
             With the use of decision support systems, the need for managers may be
             reduced as they can convert management control activities into task control
             activities. Managers may also be able to spend a larger fraction of their time
             on other problems.
             On the one hand, decision support systems can increase the quality of
             decisions and reduce (or even eliminate, in some cases) the time that is
             required to take them. On the other hand, they permit many types of decisions
             to be made by the computer or by lower-level personnel. Decision support
             systems thus, reduce the level of expertise required and, in some cases,
             eliminate jobs entirely.


                                                                                         161
 Principles of Management Control Systems


SUMMARY

              Operations management is being increasingly recognized, at the strategic
              level, as a potentially rich source from which competitive advantage may be
              leveraged. To control such a process and make it work effectively, managers
              use various types of information. The simplest is “management by walking
              around.”
              Formal methods through which a manager controls performance include task
              control information, budget reports and signals. Internal audit is an important
              method to assess whether the manager is performing as expected by the
              organization. Apart from financial information, a manager should also have an
              idea about the non-financial information that is necessary to achieve the
              organizational goals.
              Recent developments in operations management have helped companies to
              increase quality at lower costs. Just-in-time is one philosophy that is used to




                                                                  09
              reduce inefficiency and unproductive time in the production process.




                                                              20
              Total quality management is a management concept that has gained
              tremendous importance in continually improving operations management

                                                         of
              processes and products. The other developments include computer integrated
              manufacturing and decision support systems.
                                                   s  s
                                                la
                                              C
                                       y
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                                    O
                               se
                            U
                        S
                    B
                  rI
             Fo




162
Chapter 12

Continuous Process



                                              09
Improvement Methods
                                          20
                                      of
                                     ss
                                   la

In this chapter we will discuss:
                             C



 •   Target Costing
                       y
                     nl




 •   Benchtrending and Benchmarking
                    O




 •   Quality Improvement: Process Quality Teaming
              se




 •   Activity Based Costing
            U
        S
       B
     rI
Fo
 Principles of Management Control Systems


              With more and more companies focussing on quality management and
              customer satisfaction, Continuous Process Improvement (CPI) methods have
              assumed great importance. Continuous Process Improvement (CPI) is the
              philosophy of running business in such a way that every member of the
              organization is encouraged to continuously strive to serve the customer more
              efficiently.
              The objective of CPI is to sustain continuous improvement within an
              organization and align improvement activities to support strategic objectives.
              This is done through modification in all processes, procedures and task
              content. Efforts are also made to enhance product quality while maintaining
              time schedules.
              However, as a methodology for achieving long-term objectives CPI has some
              limitations. As it does not lead to major technical breakthroughs or
              innovations, companies which excessively depend on CPI are likely to lose to
              other companies which are more innovative. Conversely, companies that rely




                                                                    09
              only on technical innovations may soon lose to other companies that may take
              to innovation and then continue to refine products and reduce costs through




                                                             20
              CPI.
              ‘Innovation’ and ‘CPI’ require different approaches and therefore, have
                                                         of
              different requirements. While, innovation relies heavily on technical staff,
                                                     s
              business and investment plans, CPI requires a supportive culture, extensive
                                                   s
              training and continuous managerial support.
                                                la

              To ensure success, the management should introduce various tools and
                                             C


              techniques to facilitate CPI. It should focus upon improvement in the quality
                                        y




              of processes, the cost of operations, and the strategic planning process.
                                      nl




              The management must concentrate on three improvement methods: target
                                     O




              costing, benchmarking and benchtrending, and process quality teaming. The
                              se




              successful implementation of these methods requires a reasonable
              understanding of the philosophy, focus and techniques of total quality
                            U




              management and an analysis of the entire business environment. Activity
                        S




              based costing and the balanced scorecard can also be useful for CPI.
                    B
                  rI




TARGET COSTING
             Fo




              Target cost is the maximum manufacturing cost of a product. Target costing is
              done to encourage various design and production departments to find less
              expensive ways of achieving similar or better product features and quality. It
              is decided after analyzing market niches, assessing customer requirements,
              understanding cost drivers, determining elasticity of demand, and analyzing
              volume-cost relationships. It is calculated by subtracting the expected market
              price from the required margin on sales.
              Target costing goes through three stages. They are:
              •   Planning stage
              •   Development stage
              •   Production stage


164
                                          Continuous Process Implementation Methods


Planning Stage
             Traditionally, after determining the type of product to be manufactured, the
             management assigned its development to the Product Design Department
             (PDD). After finalizing the design, it was sent to the costing department for
             assessing its costs. The costing department often found it expensive to
             produce. The ‘design’ then came back to the design department with
             instructions to reduce costs, usually by compromising on the quality of the
             product. The product design was sent back and forth between the costing and
             design department till both the departments arrived at a consensus. The
             product was then sent to the manufacturing department and the manufacturing
             department also often declared that it was impossible to manufacture the
             product as proposed. It was then sent back to the design department. Because
             of these long procedures, lot of time, money and effort were wasted. All this
             had a negative impact on the productivity and profitability of the organization.
             Target costing helps eliminate such problems.




                                                                   09
             Before establishing a reasonable target cost, a market research is conducted to




                                                              20
             determine what the competitors are doing. Their products are analyzed with
             regard to price, quality, service and support, promotion, work culture and

                                                         of
             technology. Once this is done, the important features of the product are
             finalized by conducting surveys and identifying consumer preferences.
                                                    s s
             The researcher should then determine the significance of various features of
                                                 la

             the product manufactured by the company so as to, locate a niche market
                                              C


             where it may have some competitive advantage. Once, this is done, a target
             cost is set that is close to that of competitors' products.
                                       y
                                     nl




Development Stage
                                    O
                              se




             After an in-depth study of the competitor’s products and the market has been
             done, the design department takes care of the design aspects of the product by
                           U




             analyzing the best possible designs. Thus, the company identifies the cost
                        S




             associated with the best possible design as per the internal cost structure of the
                     B




             company. The company also tries to reduce the internal costs by analyzing the
                   rI




             internal cost structure of its own products and comparing it with the cost
             structure of its competitors. The activity based costing (ABC) approach is
            Fo




             generally used to estimate the cost structure. Under this approach, the
             activities related to the product are identified and costs are estimated using
             multiple cost drivers. Once the cost information is available, the product
             development team can generate cost estimates under different situations. The
             designers, manufacturers, marketers, and engineers should conduct a
             brainstorming session to generate ideas on how to substantially reduce costs or
             add different features to the product without increasing target costs. Finally,
             they come up with a complete model of the product, to be manufactured.

Production Stage
             Planned production schedules, Just-In-Time (JIT) techniques are helpful in the
             production phase of target costing. Target costing becomes a tool for reducing
             costs of existing products if production is carried out with perfect planning
             and optimal cost-effective processes that are planned are followed carefully.

                                                                                           165
 Principles of Management Control Systems


              This makes it easier for the organization to produce the product at a relatively
              low and desired price. Target costing ensures less expensive means of
              production with an even flow of goods.

Benefits of Target Costing
              The benefits of target costing are:
              a) Target costing provides detailed information on the costs involved in
                  producing a new product. It is a better way of estimating different cost
                  scenarios by using activity based costing.
              b) Target costing reduces the development cycle of a product by reducing the
                  wastage of time and resources and identifying the additional costs at an
                  early stage of product development.
              c) Target costing provides an excellent understanding of the dynamics of
                  production costs by using activity based costing and it suggests different
                  ways of reducing non-value added activities, and simplifying the




                                                                   09
                  production process and costing procedures.




                                                              20
              d) Target costing increases the profitability of new products, by reducing
                  manufacturing costs and improving quality. Through the use of surveys

                                                         of
                  the preferences of consumers are identified and products are manufactured
                  according to consumers’ requirement.
                                                      ss
              e) Target costing forecasts the future costs and motivates the management
                                                    la

                  and the employees to meet the future cost goals.
                                               C


              f) Target costing helps in controlling the costs even before the company has
                                        y




                  incurred any production cost. Thus, a great deal of time and money is
                                      nl




                  saved during the design phase.
                                     O




              However, estimating target the target cost for complex products (that may
                               se




              require subassemblies) becomes difficult.
                             U
                         S




BENCHMARKING AND BENCHTRENDING
                    B
                  rI




              Benchmarking is a continuous process of comparing products and operations
             Fo




              against the best practices in the industry. The general benchmarking process is
              shown in the Exhibit 12.1
              The process of benchmarking consists of four sub-processes:
              (a) Planning the variables to be benchmarked.
              (b) Analyzing the current and projected gap in performance.
              (c) Communicating the benchmark standards to operating personnel and
                  establishing internal goals.
              (d) Developing implementation plans.
              All these processes are carried out in two phases, namely: the planning phase
              and the analysis phase.
Planning Phase
              The first step in planning is to identify the products or services that the unit
              provides. The next step is to identify companies whose performance
166
                                            Continuous Process Implementation Methods


                                           Exhibit 12.1
                                  Generic Benchmarking Process
                                        Benchmarking Process



             Benchmark                                                         Benchmark
              Practices                                                         Practices




                                                                       How to Close the Gap
          Benchmark Gap                                                •   Improved Knowledge
          •   How Much                                                 •   Improved Practices
          •   Where                                                    •   Improved Processes




                                                                     09
          •   When




                                                                20
                                                            of
                                                      s s
                                        Management Commitment
                                                   la
                                                C
                                         y



                                     Organization Communication
                                       nl
                                      O
                                se




                                       Employee Participation
                             U
                          S
                     B




                                       Superior Performance
                   rI




    Source: Joseph A Maciariello and Calvin J Kirby, Management Control Systems, (USA: Prentice Hall
              Fo




    Inc, Second edition) 498.

               constitutes the best practices for a product or service. The best practices can be
               identified through internal and external sources, professional associations,
               libraries, journals, universities, and consultants from related industries.

Analysis Phase
               The purpose of conducting an analysis is to determine the current gap in
               performance between the internal operations currently being followed and the
               best practices. This helps the management to project the gap in the future.
               Benchmarking studies provide useful information about the gaps in
               competitiveness for an operation or process at the time the study was
               conducted.



                                                                                             167
 Principles of Management Control Systems


Benchtrending
              The techniques involved in benchtrending are similar to the ones used in
              benchmarking. The only difference is that benchmarking has a new structural
              dimension. The study of benchtrending includes a projection of the critical
              market conditions and the consumer preference variables. These studies
              identify consumer preferences, new entrants, innovation threats, and other
              market critical variables for the long-run success of the firm.
              By the time the performance gaps have been bridged by a company,
              competition will move forward, creating new gaps in other areas.
              Overshooting the gaps in anticipation of improved competitor performance
              can bring in new problems that can affect competitiveness in different ways.
              This can be avoided by identifying important trends in the process and
              evaluating their impact through the process of benchtrending.
              Strategic benchtrending




                                                                  09
              These methods are used to give a direction for a business unit and set long-
              term goals and objectives. A study team is formed with representatives from




                                                              20
              marketing, business development, and engineering department.
              The process of strategic bench trending comprises of the following steps:
                                                         of
              1) Firstly, the market is defined by determining its size, customer
                                                      s
                  preferences, competitors and relative business position of the company
                                                   s
                  within the market.
                                                la
                                              C


              2) The industry direction, technology shifts, geopolitical changes, consumer
                  changes, and potential threats from outside sources are assessed.
                                       y
                                     nl




              3) The strongest current and potential competitors are then determined by
                                    O




                  evaluating the trends in the industry.
              4) Data on the performance of competitors is gathered and the current and
                               se




                  future performance of the business unit is compared with that of its
                            U




                  competitor.
                        S




              5) A performance baseline for the business units is then established, and
                    B




                  estimate relative performance for the current and projected competition.
                  rI




              6) A set of initiatives which form the basis of an improvement plan are
             Fo




                  identified to maintain strengths while reducing projected gaps.

Process Benchtrending
              If a company wants to improve a specific function or process, process
              benchtrending methods are used. For example, a unit that produces electronic
              circuit boards might want to improve its quality testing process. This involves
              a process benchtrending study.
              A typical process oriented unit would use the following steps:
              1) Understanding the requirements of the process that is to be bench trended.
              2) Understanding the process flow. For a clearer understanding, flow charts,
                 procedures and quality control parameters can be used.
              3) Identifying and evaluating the specific objectives of the benchtrending
                 project.

168
                                     Continuous Process Implementation Methods

         4) Identifying the benchtrending methods being adopted by different
            companies and studying companies that could pose a threat in future.
         5) Choosing practices that would be best suited for the organization.
         6) Determining specific process gaps.
         Communication and integration

         Benchmarking and benchtrending programs can be sustained only through a
         formal and informal communication. Formal methods are used to acquaint the
         employees of the organization with the logic of the goals and its competitive
         necessity. Benchmark findings must be communicated to the people so that
         they consider themselves a part of the organization and are motivated to
         perform better. Informal networks should also be established to share the
         examples of successes, to discuss problems, and to provide assistance in
         attaining goals. Rewards and informal recognition programs should be
         instituted to encourage employee communication and integration.




                                                              09
         Implementation




                                                         20
         In the implementation stage, action plans are designed to attain the desired
         goals. Teams are formed and responsibilities are assigned; tasks are specified
                                                     of
         & sequenced, resources are allocated, and results are monitored.
                                                 s
         The organization can follow either line organization or project organization to
                                               s
                                            la

         implement benchmarked goals.
                                         C
                                   y



QUALITY IMPROVEMENTS: PROCESS QUALITY TEAMING
                                 nl
                                O




         Traditionally, superior quality has been associated with higher costs.
                          se




         Managements spend heavily to achieve high quality, but they virtually do
         nothing to cut down their costs. Now, the paradigm for improving quality has
                        U




         changed. “Process Quality Teaming” has become a popular concept, as it
                    S




         combines several successful total quality techniques into a cybernetic control
                B




         system with features like feedback loops, action plans, and environmental
              rI




         scanning.
         Fo




         Given the general structure of process quality teaming, it can be applied, with
         minor modifications, to various situations. This method is effective in
         improving organizational yields as long as customer and suppliers are satisfied
         with the management. In the generalized structure of a quality process, as
         shown in Exhibit 12.2, the control loop involves:
         i)   Sensing the environment-either the customer or the current yields.
         ii) Detecting the gap between expectations and results.
         iii) Performing an analysis to determine appropriate action.
         iv) Assigning actions.
         v) Returning to step (i) by sensing the customer's needs or observing the
            yields.
         This cycle is repeated several times and each time an improvement results.
         This structure is applicable to almost any service, production, or support

                                                                                    169
 Principles of Management Control Systems



                                             Exhibit 12.2
                      Quality Process Team Cybernetic Decision Structure
                                                                  Goals
        Environment                                           Process Limits
        Customer                                              Improvement
        Needs                                                   Objectives
                                                               Expectations



                                        Perception               Comparator
       Feedback                       Team Reviews               Cause/Effect
                                                                  Analysis

              Sensor




                                                                       09
          Process Control                                      Action List
              Charts




                                                                   20
                                                               Due Dates
              Yields                                           Actions to


                                                              of
                                                          s  Maintain Control

           Effector
                                                       s
                                                    la

      Source: Joseph A Maciariello and Calvin J Kirby, Management Control Systems, (USA: Prentice-
                                                 C


      Hall Inc, Second edition) 511.
                                          y
                                        nl




               process. The key is to focus on improving processes that are used to produce
                                       O




               the output.
                                 se




               We shall take a manufacturing unit as an example to discuss the
               implementation of a process quality teaming. Process quality teaming in a
                              U




               manufacturing unit involves coordination of the efforts of the management,
                            S




               support personnel, and workers.
                     B




               The steps involved in this process are:
                   rI




               a) The management selects a unit, say, a manufacturing department, within
              Fo




                  which quality improvement teams are formed, the output to be improved
                  is determined and based on this inputs to the process are added.
               b) A team of people from all key departments of the firm is formed.
               c) The responsibility of each department is clarified. The responsibility of
                  ensuring quality should lie with the production supervisors and workers
                  who are directly involved in manufacturing the product.
               The next four steps together constitute a closed-loop corrective action system.
               The team tries to identify specific customer requirements. In some cases,
               maintaining high quality may be critical, while in other cases, reliability is
               extremely important.
               The further steps in this process are the following:
               a) Making a flow chart the process. At each step, critical control parameters
                  and associated measurements are noted.

170
                                          Continuous Process Implementation Methods

             b) Establishing appropriate process control limits for each step in the
                process.
             c) Running the process normally, and calculating the output after the
                completion of the major steps
             d) Performing a cause and effect analysis of the major problems, and
                determining a specific corrective action. Comparing the current yields to
                the Process Control Limits (PCL).
             The implementation of effective CPI methods may be difficult. It requires
             many other quality tools. Each of these tools may have its own limitations.
             Therefore, the management should have a good understanding of the various
             tools.

ACTIVITY-BASED COSTING




                                                                   09
             In the last few decades, there has been a number of changes in the collection
             and utilization of cost information because of increased computerization and




                                                              20
             automation in factories. Traditionally, costs were allocated to products, based
             on the direct labor hours. But today, companies presently are emphasizing on
                                                         of
             separating material-related costs from other manufacturing costs. The
                                                      s
             manufacturing costs are collected separately for individual departments and
                                                   s
             individual machines which perform a series of operations that are finally
                                                la

             integrated to get the final product. Here, the direct labor cost is added to the
                                              C


             other costs which results in conversion costs. Conversion costs is constituted
                                       y



             of the factory and labor overhead costs of converting raw materials into
                                     nl




             finished goods. The newer cost systems also include the administrative
                                    O




             expenses, R&D expenses and marketing costs. These systems use multiple
             allocation bases. Here the word ‘activity’ is used to represent “cost center”
                              se




             and “cost driver,” and not the basis of resource allocation. Hence, this cost
                           U




             system is termed as activity-based cost system. (ABC).
                       S




             As a strategic planning tool, ABC helps in understanding the effectiveness and
                   B




             efficiency of products. It has a number of strategic and tactical uses in an
                 rI




             organization. It helps to:
             Fo




             •   Identify the values of the organization’s activities, business segments, etc.,
                 through a comprehensive understanding of costs and related dynamics to
                 help organization's focus attention on target outcomes;
             •   Identify opportunities to effectively use delivery channels to enhance
                 outputs;
             •   Differentiate between activities provided to different customer segments
             •   Identify incremental operating expenses in order to support growth
             •   Identify cost management opportunities
             •   Provide information to improve process efficiency.

Traditional Costing vs. Activity Based Costing (ABC)
             The differences between traditional costing and activity-based costing are the
             following:
                                                                                           171
 Principles of Management Control Systems



                                               Exhibit 12.3
                                      Contrast in Product Costing

           A. Traditional Costing

                                                                                 Product Cost
               Direct
               material
                                                                             Direct material


           Direct Labor
                                                                                 Direct labor


                                       Production cost




                                                                      09
           Factory overhead
           cost centers                centers (few in                     Factory overhead




                                                                  20
                                       number)


                                                            of
                                                    s    s
                                                         Allocated on basis of
                                                 la

                                                         direct labor or
                                              C


                                                         machine hours
                                       y
                                     nl




        Source: Robert N Anthony and Vijay Govindarajan, Management Control Systems (Irwin
        Publications, Eighth edition) 333.
                                    O
                               se




              The traditional cost management systems allocate service overhead costs to
              services or departments, primarily to distribute the overhead cost for financial
                              U




              reporting purposes. Costs are allocated by a single step process, with the costs
                          S




              per service or customers as the basis. Such methods often produce inaccurate
                    B




              and misleading information. Traditional costing systems take a general view
                  rI




              of the costs incurred by all the departments. They fail to understand that costs
             Fo




              for each department are marked by unique characteristics. Exhibits 12.3 and
              12.4 represent the differences between traditional and activity- based costing.
              ABC systems focus on the activities performed by each department and
              allocate costs on the basis of this. An ABC system can gauge the amount of
              resources that are consumed by individual cost centers and customers, and by
              the activities and processes that deliver the products and provide services to
              customers. ABC identifies activities undertaken in an organization, and
              determines their cost and performance. Let us take an example to clearly
              understand the difference between traditional costing and ABC.
              Consider a college, where the major activities of the student administration
              department involve looking after the administrative activities of the students.
              The costs of students passing out is at Rs. 50,000 pa, paying salaries
              (Rs.35,000), spending on occupancy (Rs.10,000) and others (Rs. 5,000).
              During the year in which 500 international students graduated, the number of

172
                                 Continuous Process Implementation Methods


                                   Exhibit 12.4
                              Activity-Based Costing

                                                               Production cost
        Material
                                                                  Material

     Direct Labor



                                  Production               Conversion (labor and
                                  cost centers             overhead)
  Factory activities                (many)




                                                         09
                                                     20
                                   Many bases
                                  of allocation

                                                   of
                                  (cost drivers)             Non-manufacturing
 Non-manufacturing
                                            s    s
     activities
                                         la
                                     C


                       (Design R&D, G&A Marketing,
                                Distribution
                              y
                            nl




Source: Source: Robert N Anthony and Vijay Govindarajan, Management Control Systems
                           O




(Irwin Publications, Eighth edition) 333.
                       se




     undergraduate was 300, that of industry funded graduates was 100,
                       U




     postgraduate students who paid the regular fees were 100 in number. A
                   S




     traditional costing approach would have failed to capture the cost of the
            B




     activity (Rs 50,000) understand the activity cost driver (the number of
          rI




     graduates), highlight the unit true cost of the activity (Rs 100 per graduate),
     Fo




     accurately assign this cost to the various types of student and understand
     which type of students being served by this activity.
     Traditional cost accounting vs Activity-based Costing

     Traditional cost accounting

      Salaries                                                     Rs 2,00,000
      On costs                                                          20,000
      Consumables                                                       80,000
      Travel                                                            20,000
      Depreciation                                                      80,000
      Total                                                        Rs.4,00,000



                                                                                 173
 Principles of Management Control Systems


               Activity based costing

               Enrolling students                                           Rs. 1,00,000
               Designing a new course                                             50,000
               Teaching Subjects (specific)                                     1,50,000
               Tutoring students                                                  20,000
               Assessing students                                                 30,000
               Graduating students                                                50,000
               Total                                                         Rs.4,00,000


SUMMARY

              Continuous improvements in performance is increasingly being emphasized in




                                                                  09
              most organizations. Continuous process improvement (CPI) is the philosophy
              of running business, and striving for perfection. The objective of CPI is to




                                                              20
              align the improvement activities to support the strategic objectives, to serve
              the customer more efficiently. There are three CPI methods- target costing,
                                                         of
              benchmarking and benchtrending, and process quality teaming.
                                                      s
              Target costing aims at reducing the costs of a product over its life cycle,
                                                    s
                                                 la

              especially design-related costs. It is a market-driven design methodology. It is
              carried out in three phases-planning, development and production.
                                              C


              Benchmarking is a continuous process of comparing a company's products
                                        y




              and operations against the best practices in the industry. This can only be done
                                      nl




              with proper planning and analysis. In benchtrending, a projection of the
                                     O




              critical market and consumer structural variables are made, if a company
                               se




              wants to improve a specific function or process. To bring about overall
              improvement, ‘process quality teaming’ is undertaken. The implementation of
                            U




              effective CPI methods may be complex. The management should have a good
                        S




              understanding of the total improvement process, a support culture, and
                    B




              providing abundant personnel support.
                  rI




              There have been a number of changes in the methods for collection and for
             Fo




              use of cost information because of increased computerization and automation
              in factories. Activity-based costing is one such method that helps to prioritize
              and quantify improvement methods. It is suitable for today’s companies.




174
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                of
                s
           PART V:
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     MANAGERIAL COSTING
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      se
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     S
  B
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Fo
Chapter 13




                                               09
Strategic Cost Management
                                             20
                                       of
                                     ss
                                   la

In this chapter we will discuss:
                              C



•
                       y



    Evolution of Strategic Cost Management
                     nl




•   Three Key Themes of Strategic Cost Management
                    O




•   Strategic Management and Strategic Cost Analysis
               se
            U
         S
      B
    rI
Fo
Principles of Management Control Systems

             Amazon.com, US-based internet retailing major, is known for its low costs
             and excellent customer service. It not only created a new business model but
             also made sure that the model worked. While many firms that had adopted a
             similar internet-based retailing model perished, Amazon.com made sure it
             survived. There were two main reasons for its survival: comparatively low
             cost and excellent customer service.
             To survive in the market, a company has to provide excellent service at a
             comparatively low cost. The internal accounting department of a company
             plays a vital role in cost management. It provides all cost information on a
             timely basis. This information forms the basis for the company’s future
             strategies. Companies have started using cost management as a strategic tool.
             The focus of cost management has shifted from product costing and financial
             reporting to the development of cost information to help management achieve
             strategic goals. Hence, cost information is vital not just for achieving
             operational efficiencies but also for the long term growth of the company.




                                                                 09
             The application of costing information to the development and
             implementation of a firm’s strategy is called strategic cost management




                                                             20
             (SCM). In a broader sense, SCM can be defined as the, “managerial use of
             cost information explicitly directed at one or more stages of the strategic

                                                        of
             management cycle.” The four stages of the strategic management cycle are:
             formulation of strategies, the communication of those strategies throughout
                                                   s s
             the organization, the implementation of those strategies, and the evaluation
                                                la

             and control of the strategies that have been implemented.
                                             C
                                      y




EVOLUTION OF STRATEGIC COST MANAGEMENT
                                    nl
                                   O




             The change in business processes has made it imperative for companies to
                              se




             change the focus of their costing systems. Initially, costing was done mainly to
             account for product costs and other overheads. Costing was thus like a control
                           U




             measure that enabled line managers to keep costs under control at the
                       S




             departmental level. Rapid changes in the business environment and
                   B




             corresponding changes in product and manufacturing processes forced
                 rI




             companies to adopt a more proactive and strategic approach towards costing.
             Fo




             They realized that costing systems should be flexible enough to support
             changes in the business environment and help management take better
             strategic decisions.

Strategic Measures of Success
             Strategic cost management systems produce financial as well as non-financial
             information. Financial information includes figures pertaining to sales, cash
             flow and stock price. Non-financial information consists of details such as
             market share, product quality, customer satisfaction and growth opportunities.
             Financial information indicates a firm’s current financial position, whereas
             non-financial information indicates a firm’s competitive position. The
             competitive position is assessed on the basis of customer satisfaction, internal
             business processes and innovation and learning. Financial and non-financial
             measures together constitute Critical Success Factors. These factors are
             essential for a firm's growth and success.

178
                                                               Strategic Cost Management


                                         Exhibit 13.1
                               Harnessing the Value Chain
    Manufacturers such as Boeing and General Electric also use the value-chain concept to
    find profits downstream. For example, Boeing offers a number of products and
    services in addition to the aircraft it manufactures: financing, local parts supply,
    ground maintenance, logistics management, and pilot training. In the cyclical industry
    in which it operates, Boeing can earn profits from them during the slack
    manufacturing times.
    General Electric has connected its locomotive manufacturing business to its financing
    unit, GE Capital, to provide customer financing for not only locomotives but also
    boxcars and other rail assets. Other GE units profit by refurbishing and reselling
    boxcars and by developing advanced rail tracking systems. In effect, GE finds
    providing a broad range of services to the locomotive customer more profitable than
    only manufacturing.




                                                                    09
                                                               20
     Source: Orit Gadiesh and James L. Gilbert, “Profit Pools: A Fresh Look at Strategy,”
     Harvard Business Review, May–June 1998, pp. 139–47;

THREE KEY THEMES OF STRATEGIC COST MANAGEMENT              of
                                                      s s
                                                   la

              Strategic cost management combines three strategic management themes. The
                                               C


              three themes are:
                                        y




              •   Value chain analysis
                                      nl




              •
                                     O




                  Cost driver analysis
              •   Strategic positioning analysis
                               se




              In the following sections we will discuss all the three themes in detail.
                            U
                         S




Value Chain Analysis
                    B
                  rI




              Value chain analysis is a strategic analysis tool that can be used to identify
              areas in which value can be enhanced for customers or costs can be reduced.
              Fo




              Value chain analysis thus helps a firm gain competitive advantage (Refer
              Table 13.1 for the value chain of the computer manufacturing industry).
              According to Michael Porter, the value chain of a company is the linked set of
              value-creating activities, all the way from basic raw material sources for
              component suppliers through to the ultimate end product delivered into the
              final consumers’ hands. The Value chain of a manufacturing firm differs from
              the value chain of a services firm. The value chain of a manufacturing firm
              includes activities like design and acquisition of raw materials, manufacturing,
              assembling, testing, packaging, warehousing, distribution, retail sales and
              customer service. Every firm can split its operations into a number of
              activities to analyze its value chain and to identify areas that require
              improvement.
              Value chain analysis is centered around a product or service and encompasses
              all the activities taken up for delivering it. An individual firm positions itself
              at some point in the value chain, depending upon the competitive advantage it
                                                                                            179
Principles of Management Control Systems



      Table 13.1: Value Chain for Computer Manufacturing Industry
      Step in the Value Chain             Activities                          Expected Output of
                                                                              Activities
      Step 1: Design                      Performing research and             Completed product design
                                          development
      Step 2: Raw materials               Mining, development and             Silicon, plastic, various
      acquisition                         refining                            metals
      Step 3: Materials assembled Converting raw materials                    Desired components and
      into components             into components and parts                   parts
                                  used to manufacture the
                                  computer
      Stage 1:                            Converting, assembling              Chips processors other
                                                                              basic components




                                                                                  09
      Stage 2:                            Finishing testing and               Motherboards and higher




                                                                             20
                                          grading                             level components
      Step 4: Computer                    Final assembling,                   Completed computers
      manufacturing                       packaging and shipping
                                                                       of
                                                                   s
                                          the final product
                                                               s
      Step 5: Wholesaling                 Moving products to retail
                                                            la

                                                                              Rail truck and air
      warehousing and                     locations and warehouses            shipments
                                                         C


      distribution                        as needed
                                                y
                                              nl




      Step 6: Retail Sales                Making retail sale                  Cash receipts
                                             O




      Step 7: Customer service            Processing returns,                 Serviced and restocked
                                          inquiries and repairs               computers
                                      se




       Source: higheredmcgrawhill.com
                                  U
                              S




                 can have over other firms. For example, in the computer hardware industry,
                        B




                 there are a number of players who occupy different positions in the value
                      rI




                 chain depending on their core competency. Texas Instruments manufactures
                 chips, Intel manufactures processors, Seagate manufactures hard drives, IBM
                 Fo




                 purchases manufactured components, assembles them and sells them.
                 Value chain analysis consists of three steps:
                 Step1: Identifying value chain activities
                 Step2: Identifying the cost driver(s) at each value activity
                 Step3: Developing a competitive advantage by reducing cost or adding value
                 Identifying value chain activities
                 In the first step of value chain analysis, a firm identifies all the activities in its
                 value chain1. The value activities differ from industry to industry. For
                 example, in the service industry the focus is on operations, advertising and
                 promotion rather than purchasing raw materials and manufacturing. All the

                 1
                     The activities that are necessary to convert raw materials into final products are called value
                     activities.
180
                                                                         Strategic Cost Management

             value activities should be identified and differentiated from other activities to
             such an extent that they can be regarded as separate business activities.
             Identifying cost drivers at each value activity
             Any factor that changes the level of total cost of a product or service is called
             a cost driver2. In this step, those activities that have potential for cost
             reduction are identified. For example, in an insurance company the costs of
             data entry and recording can be reduced. Insurance companies can find ways
             to reduce costs in this area. They can also outsource this activity to someone
             who can provide the service at a lower cost.
             Developing a competitive advantage by reducing cost or adding value
             In the final step, firms conduct a detailed study of the value activities and cost
             drivers that have been identified earlier to determine the nature of current and
             potential competitive advantage. This helps the firm improve its strategic
             positioning. In addition, analysis of value activities also enables the firm to




                                                                               09
             identify areas in which the company can provide greater value. For example,
             Wal-Mart uses high-end computer technology to coordinate with its suppliers




                                                                         20
             to quickly restock its stores. This enables it to maintain optimum stocks of all
             products and thereby reduce inventory costs. Companies like Sony, Compaq
                                                                   of
             and Cisco have tied up with Flextronics International Ltd, Solectron Corp. and
                                                               s
             SCI Inc. respectively for supply of various computer parts and subassemblies.
                                                           s
             These companies realized that outsourcing some of the manufacturing would
                                                        la

             reduce costs and improve speed and competitiveness.
                                                     C
                                            y



Cost Driver Analysis
                                          nl




             Every activity in the value chain is associated with a cost. During value chain
                                         O




             analysis, companies try to identify various activities for reducing costs. Cost
                                  se




             driver analysis is used to quantify the cost of poor quality and determining the
             root causes of poor quality or high costs. It is a useful technique that integrates
                              U




             the problem-solving and analytical tools for quality and process improvement.
                          S




             Cost driver analysis combines these tools and techniques to generate
                       B




             information needed to reduce costs and improve the overall financial
                     rI




             performance.
             Fo




             Daniel Riley3 has categorized cost drivers into two types: structural cost
             drivers and executional cost drivers.
             Structural cost drivers
             There are five structural cost drivers: scale, scope, experience, complexity,
             and technology. Refer Table 13.2 for the various structural cost drivers, their
             implications, and the ways in which a company can control these cost drivers.




             2
                 A cost driver is a factor that causally affects costs. For variable costs, a change in the level
                 of activity or volume would result in a proportional change in cost. Fixed costs have no
                 short run cost driver but may have a long run cost driver.
             3   “
                  Competitive Cost Based Investment Strategies for Industrial Companies,” manufacturing
                 Issues (Booz, Allen, Hamilton, New York, 1987).
                                                                                                            181
Principles of Management Control Systems


      Table 13.2: Structural Cost Drivers
      Cost Driver       Implications                          Controlling structural cost
                                                              drivers
      Scale             Take       decisions       concerning Develop scale economies to
                        investments in manufacturing, control costs
                        R&D and marketing
      Scope             Decide on the degree of vertical Enhance vertical integration;
                        integration needed                    otherwise outsource
      Experience        Identify the repetitive tasks         Enhance employee learning
                                                              and experience
      Complexity        Decide about product line and Find sharing opportunities
                        number of products                    with other business units in
                                                              the enterprise
      Technology        Take decisions pertaining to Optimize               the   use   of




                                                                      09
                        technologies to be used at every technology between value
                        stage of value chain                  chain activities




                                                                 20
      Source: ICFAI Center for Management Research.

                Executional cost drivers                      of
                                                       s s
                Executional cost drivers determine a firm’s cost position, which in turn
                                                    la

                depends on the firm’s ability to execute value activities successfully. Some of
                                                 C


                the basic executional drivers are:
                                          y




                •   Commitment of workforce to continuous improvement
                                        nl




                •   Management’s attitudes towards quality
                                       O




                •   Cycle time for getting new products to market
                                  se




                •   Firm’s utilization of existing capacity
                              U




                •   Proper design of internal business processes
                           S
                      B




                •   Management’s ability to work efficiently with suppliers and/or customers
                    rI




                    to reduce costs
               Fo




Strategic Positioning Analysis
                The third important theme of strategic cost management is strategic
                positioning or strategic competitive analysis. Michael Porter, in his book
                Competitive Strategy, states that a firm can choose to compete in the market
                either on the basis of cost or differentiation. This means that in order to remain
                competitive, a firm has to offer its products either at a lower cost or with a
                greater number of features.
                Cost leadership
                If a firm produces its products or services at a cost lower than its competitors,
                then the firm is said to be following a cost leadership strategy for gaining
                competitive advantage. To make sustainable profits, such a firm depends on
                high sales. A company that follows cost leadership strategy has a large market

182
                                                        Strategic Cost Management

       share and uses its price advantage to attract customers. Such a firm limits the
       growth of profit margins within the industry. A company can afford to adopt a
       cost leadership strategy only when its productivity is high and its
       manufacturing processes run smoothly. In addition, its selling and distribution
       costs must be low and its administration expenses should be minimum.
       Examples of companies that practice cost leadership are: Texas Instruments,
       Wal-Mart and Compaq (before its merger with HP). Companies that adopt this
       strategy often do not spend much of R&D. As a result, their products may
       become obsolete.
       Differentiation
       Firms that adopt a differentiation strategy try to make their customers feel that
       their products are different, qualitatively superior and have a greater number
       of features than the competitors’ products. This strategy allows a firm to
       charge a higher price for its products and thereby make profits without major
       cost cutting. Most firms in the automobile, telecom, and consumer electronics




                                                            09
       industry use a differentiation strategy. Some of the companies that have




                                                        20
       adopted this strategy are Rolex, Bentley, Tiffany and Mercedes-Benz. Firms
       that follow this strategy tend to undermine the importance of cost reduction. If

                                                     of
       customers do not perceive a great difference between a lower cost product and
       the firm's product, the firm may lose market share. Table 13.3 shows the
                                                s
       differences between cost leadership and product differentiation in terms of
                                              s
                                           la

       strategic emphasis and control.
                                        C
                                 y



Table 13.3: Conventional Management Accounting Versus Strategic Cost
                               nl




Management
                              O




                              Conventional            Strategic Cost Management
                           se




                               Management                      Paradigm
                           Accounting Paradigm
                      U




Which is the best way      In terms of products,      In terms of various stages in
                  S




of analyzing costs?        customers         and      the value chain. It has an
              B




                           functions. It has a        external focus and value
            rI




                           strong internal focus      added concept is supposed to
       Fo




                           and believes in value      be a narrow concept.
                           added concept.
What is the objective of   The objectives are         Apart from these objectives,
cost analysis?             scorekeeping, attention    the SCM system changes
                           directing and problem      depending on the basis of
                           solving                    strategic positioning
How      should     one    Cost is a function of      Cost is a function of strategic
understand          cost   output volume. It is       choices. It’s mainly to do
behavior?                  cumulative figure of       with managerial skills needed
                           variable cost, fixed       in executing choices i.e.
                           cost, step cost and        Structural costs drivers and
                           mixed cost.                executional cost drivers.

Source: John K.Shank, Strategic cost Management: New Wine, or Just New Bottles, Journal
of Management Accounting and Research, Fall 1989.
                                                                                     183
Principles of Management Control Systems

STRATEGIC MANAGEMENT AND STRATEGIC COST ANALYSIS

             As already discussed, strategic cost management combines three strategic
             management themes: value chain analysis, cost driver analysis and strategic
             positioning analysis. These themes can be used by managers as tools for
             gaining competitive advantage. For each of these themes, conventional
             management accounting does not provide the needed financial analysis
             support for successful implementation of strategies.
             Strategic cost management evolved because conventional management
             accounting was not able to cater to the information needs of top managers.
             When costing techniques were used along with strategic management tools, a
             paradigm shift took place in the field of strategic management.
             Management accounting and Strategic Cost Management differ in three ways.
             First, in the way costs are analyzed; second, in the objective behind
             conducting cost analysis; and third, in the way cost behavior is understood




                                                                  09
             (Refer table 13.3 for differences between management accounting and SCM).




                                                              20
SUMMARY
                                                         of
                                                      s
             The application of costing information for developing and implementing
                                                   s
             strategies in firms is called strategic cost management. Strategic cost
                                                la

             management combines three strategic management themes: value chain
                                             C


             analysis, cost driver analysis, and strategic positioning analysis. Value chain
                                      y



             analysis is a strategic analysis tool that can be used to identify areas in which
                                    nl




             value can be enhanced for customers or costs can be reduced. All the activities
                                   O




             of a value chain have costs associated with them. The process of driving up or
             down the cost of value chain activities is called cost driver analysis. Cost
                              se




             drivers can be of two types: structural cost drivers and executional cost
                           U




             drivers. There are five structural cost drivers: scale, scope, experience,
             complexity, and technology. Executional cost drivers are those drivers that
                       S
                   B




             determine a company's ability to execute value activities. Strategic positioning
                 rI




             refers to the way in which a firm positions itself against its competitors in the
             market. A firm can choose to compete in the market either on the basis of cost
            Fo




             or differentiation. Management accounting and Strategic Cost Management
             differ in three ways. First, in the way costs are analyzed; second, in the
             objective behind conducting cost analysis; and third, in the way cost behavior
             is understood.




184
Chapter 14

Auditing



                                           09
                                           20
                                     of
In this chapter we will discuss:   s
 •   Benefits of Audit
                                   s
 •
                                la

     Limitations of Audit
                             C


 •   Timing of an Audit
                         y



 •   Audit Process
                       nl




 •   Audit Tools and Techniques
                      O




 •   Management Audit
              se




 •   Internal Audit
            U




 •   Financial and Cost Audit
        S
       B




 •   Social Audit
     rI




 •   Audit Evidence
Fo




 •   Auditing for Continuous Improvement
Principles of Management Control Systems


             Audit is the examination and verification of records and other evidences by an
             individual or a body of persons so as to confirm whether the records and other
             evidences present a true and fair picture of whatever they are supposed to
             reflect.
             Audits can be categorized basically into two types- Financial audit and non-
             financial audit. Financial audit is a statutory audit that helps in monitoring the
             financial performance of the company. Non-financial audit is non-statutory
             and serves two purposes. Firstly, it checks a company’s compliance to
             standards and secondly, determines whether a product or service satisfies
             customers' demands in terms of features and quality. Table 14.1 shows the
             differences between financial and non-financial audits. Though financial and
             non-financial audits differ greatly, there are some similarities, too. Both the
             audits are conducted to measure compliance to a set of standards. Both
             generate performance data that can be used for benchmarking and
             performance analysis and both identify opportunities for performance




                                                                   09
             improvement.




                                                              20
BENEFITS OF AUDIT
                                                         of
             Audit yields multiple benefits. Some of these benefits are the following:
                                                    s s
                                                 la

Identify Opportunities for Improvement
                                              C


             Audits can help managers identify job priorities by showing which changes
                                       y



             would have the highest impact on overall performance. Audit can be used as a
                                     nl




             tool for identifying the gap between the desired and actual performance and
                                    O




             help the management take steps for the improvement of performance.
                               se




Reality Check
                           U




             Companies prepare formal plans before executing them, but in many cases
                        S




             these plans do not get executed as supposed because the assumptions made by
                   B




             the executives may not have been correct. Systematic collection of data and
                 rI




             comparing reality with manager's assumption help companies to be more
             Fo




             resilient when faced with change.

Identify Outdated Strategies
             When there is a change in the organization's strategy, processes that support
             the strategy do not evolve automatically. Regular audits of management
             processes help managers understand when the strategy becomes outdated and
             needs to be changed.

Increase Management’s Ability to Address Concerns
             The compilation of audit information increases the management’s ability to
             address issues arising from increasing regulation and litigation, and to clarify
             queries by outside stakeholders in the business. Auditing is a systematic way
             of clarifying and prioritizing the information.


186
                                                                                       Auditing



Table 14.1: Financial versus Non-financial Audit
              Financial Audits                    Non Financial Audits
                                      Relies primarily on standards set internally
 Relies primarily on standards set externally
                                      on the basis of customer and competitor
 (by government or by professional standards
 groups).                             information.
 Procedures are formalized and consistent
                                      Procedures are fluid and should be adapted
 from company to company. Compliance  by each company. Measures should be
 with procedures adds credibility to the audit.
                                      created that suit the company’s needs.
                                      Standards should change as performance
 Standards are essentially the same from audit
 to audit                             improves.
                                      Focus is on exceeding standards set
 Focus is on complying with standards set by
 external groups                      internally or by industry competitors.
                                      Audience is generally internal, with data
 Audience is often primarily external, with




                                                                           09
                                      being
 audit standards used as a way of building      used      primarily   to     improve




                                                                      20
 credibility                          performance.
 Generally conducted yearly           Conducted, on average, every 18 to 24

                                                                 of
                                      months.                s
 Focuses on measures that affect only Focuses on a broad range of functions that
                                                           s
 financial performance.               contribute to the success or failure of a
                                                        la

                                      particular process.
                                                     C


Source: ‘The Company audit guide’, Strategic Direction publishers Ltd., Switzerland.
                                             y
                                           nl




 Enhances Teamwork
                                          O




                  Systematic collection and sharing of audit information enhances the ability of
                                     se




                  the various segments of an organization to work in coordination. The breaking
                                  U




                  of barriers between the different parts of an organization enables a company to
                  respond more quickly and effectively to the demands of customers and other
                              S




                  stakeholders.
                         B
                       rI




 Increase Commitment to Change
                  Fo




                  The audit process increases the commitment of the employees of an
                  organization to change. Audit results may succeed in convincing the
                  management about the need to re-order its priorities.

 LIMITATIONS OF AUDIT

                  Audit has its limitations, too. It is not a cure for all kinds of management
                  problems. Given here are some of the issues that cannot be solved through
                  audit.
                  •    An audit can neither help in prioritizing changes nor in allocating
                       resources. At the most, it can provide certain clues regarding changes that
                       are most important.
                  •    Audit cannot mobilize people to take action. Though audit identifies

                                                                                              187
Principles of Management Control Systems


                 various problems that exist in the organizational systems and processes, it
                 cannot help the management bring about changes to solve these problems.
                 In order to bring about such changes, there is need for commitment and
                 support from all the people within the organization.
             •   Audit cannot generate better data than the measures used to gather those.
                 For example, if a questionnaire used during audit for collecting data has a
                 flaw, then the results of the audit will also be faulty. Hence, it is important
                 to plan on proper audit tools to be used in the audit.
             •   An audit, by itself, cannot improve performance. Since an audit brings out
                 the weaknesses in the system and identifies opportunities for
                 improvement, it should not be conducted unless there is a strong
                 commitment to improve or strengthen the process being studied.
             •   Audit should not be used for wrongful purposes. It should not be used for
                 personal indictment and to justify improper actions.




                                                                   09
TIMING OF AN AUDIT




                                                               20
                                                          of
             The timing of an audit depends on the type of audit. Financial audits are
             conducted once in every year whereas non-financial audits may be conducted
                                                       s
             once in every two years. Before deciding on the timing of the audit, the
                                                     s
             management has to answer the following questions:
                                                  la
                                              C


             •   How important is the audit process to the achievement of the company’s
                 strategy?
                                       y
                                     nl




             •   How does the company fare when compared to its competitors in terms of
                                    O




                 the efficiency of its systems and processes?
                              se




             •   What are the types of resources needed for conducting an audit? Does the
                 company have enough human resources to form a separate team for
                           U




                 conducting audits?
                       S




             •   Has the company diligently implemented the previous audit report
                   B




                 recommendations?
                 rI
            Fo




AUDIT PROCESS

             An audit process consists of following stages:
             •   Staffing the audit team
             •   Creating an audit project plan
             •   Laying the groundwork for the audit
             •   Analyzing audit results
             •   Sharing audit results
             •   Writing audit reports
             •   Dealing with resistance to audit recommendations
             •   Building an ongoing audit program

188
                                                                                  Auditing


Staffing the Audit Team
             The audit team usually consists of three to four people. The number of people
             may be higher, depending on the volume of data required and the number of
             customers or employees to be interviewed. The audit team reports either to the
             CEO or some other senior executive. Quality of an audit report is directly
             related to the competence of the audit team members. Hence an audit team
             should consist of people who have substantial knowledge of systems and
             processes within the company. An audit team should consist of people who
             have knowledge in diverse areas. Some other aspects that should be
             considered are:
             The team should consist of newcomers as well as experienced people.
             Importance is given to people with prior experience in auditing. In case a
             particular function is being audited, then functional experts should be included
             in the audit team. If it is a process that is being audited, then people who are
             closely associated with that process should be included in the audit team.




                                                                 09
             Team members should possess strong analytical and interpersonal skills. They
             should be able to communicate well with their peers and establish strong




                                                             20
             working relationships. They should also possess facilitation and interviewing

                                                        of
             skills. Finally, they should have an understanding of a company's overall
             strategy and its goals and objectives.
                                                     s
             The audit team leader is selected from among the audit team members. He
                                                   s
                                                la

             plays an important role in data gathering and is responsible for the overall
                                             C


             success of the audit. As the team leader plays a very important role in the
             audit, the selection should be done after careful consideration. The following
                                      y




             are the qualities required in an audit team leader: Excellent interpersonal
                                    nl




             skills, good relationship with the CEO and other senior executives, strong
                                   O




             analytical skills, ability to assimilate and process large amounts of complex
                              se




             data quickly, some knowledge of the function being audited and extensive
             knowledge of the type of process being audited.
                           U
                       S




Creating an Audit Project Plan
                   B
                 rI




             Before starting an audit, it is necessary to prepare plan that explains how an
             audit is to be conducted in a step-by-step manner. An audit plan helps in better
             Fo




             allocation of resources, especially if the resources are scarce. It makes sure
             that audit tasks are completed on time. It also ensures accountability and
             responsibility of the management by clearly stating what is to be done, who is
             responsible for which task and when the audit should be completed.

Laying the Ground Work for the Audit
             After preparing the audit plan, the next step is to gather support from the
             employees for the audit. The following steps will help an audit run smoothly:
             Garnering executive support
             There are two benefits of gathering the executives’ support for the audit.
             Firstly, those involved in the area being audited will cooperate with those who
             are gathering data and secondly, it ensures executive support for the area
             being audited and shows a commitment to improve performance in this area.

                                                                                         189
Principles of Management Control Systems


               The executive sponsor of the audit introduces the audit by means of a memo
               which explains the purpose of the audit and asks for support from everyone in
               the area being audited.
               Make arrangements with the area being audited
               The audit team leader should check with the manager in charge of the process
               or site being audited if arrangements have been made for on-site visits,
               interviewing, surveys etc. The manager, and the team leader together should
               ensure that audit does not affect the normal workflow in the company. Before
               commencing the audit, the team leader should hold discussions with
               employees regarding the timing of the audit, the methods of data collection,
               the availability of required data, etc.
               Develop a checklist
               A checklist is used to outline all the issues that are central to the audit. It can
               help in organizing the audit work. It helps in performing tasks systematically




                                                                     09
               and maintaining a record of those tasks. Exhibit 14.1 shows a sample financial
               audit checklist.




                                                                 20
                                                            of
                                         Exhibit 14.1    s
                              Sample Financial Audit Checklist
                                                      s
                                                   la

Collect all accounting materials.
                                                C


Receipts
Deposit slips
                                         y




Invoices
                                       nl




Cancelled Checks
                                      O




Bank Statements
                                se




Check Registers
Note lost or Illegible material
                             U




Last Annual Financial Report
                          S




Monthly Financial Reports
                     B




Review Accounts Used.
                   rI




Income Accounts (Should have separate account for each income type)
              Fo




Are all deposits recorded as to income type?
Are all deposits reconciled to bank statements?
Expense Accounts (Should have separate account for each expense type)
Are all expenditures recorded as to expense type?
Are all checks reconciled to bank statements?
Verify the following:
Starting Balance
Receipt for every expenditure
The officers of the chapter approved all expenditures
An approved budget exists for each expense type
All expenditures are within approved budget
All individual account's starting and ending balances match the chapter's ledger
The annual ending balance matches the chapter's ledger

Source:/www.ssq.org


190
                                                                                    Auditing


Analyzing Audit Results
             When the audit is completed, the gaps between a company's targets and its
             actual performance can be identified. These gaps usually pertain to specific
             areas in the various functions of the management. The audit results identify
             the opportunities for improvement, but arranging the areas in terms of
             importance is a difficult task. Apart from this, due to limited resources,
             choices must be made about which options are more important.

Sharing Audit Results
             The audit results are presented before the members of the executive team, the
             managers who work in the area covered by the audit, the audit team members
             and anyone else who is affected by the audit or is interested in the results, in a
             feedback meeting. The audit team's objective during the meeting is to present
             a clear and simple picture of the current situation, as revealed by the audit.
             The following structure can be followed for conducting a feedback meeting:




                                                                   09
             •   Introduce the meeting and preview its agenda




                                                              20
             •   Present the audit findings

                                                         of
             •   Present audit recommendations
             •
                                                      s
                 Ask others to react to the data
                                                      s
             •   Develop preliminary action plans
                                                   la
                                              C


Writing Audit Reports
                                       y
                                     nl




             After the audit work is completed, the whole process of auditing, the resultant
                                    O




             findings and recommendations are written in a formal report called an audit
             report. An audit report may be a plain summary of the audit. But such a report
                              se




             is not recommended because the probability of taking action in this case is
                           U




             less. An audit report may supplement a feedback meeting and provide useful
             guidelines to those who attended the meeting, for future action. An audit
                        S




             report serves as a baseline document for measuring improvement in
                   B




             performance possible in future audits.
                 rI




Dealing with Resistance to Audit Recommendations
            Fo




             The audit team gives its recommendations when the audit is completed. These
             recommendations may not be always accepted, especially when they require
             people to change their way of working. Change is usually resisted because it
             requires a great deal of energy and effort. Employees’ resistance to change
             usually inhibits auditors from making recommendations that require
             transformational changes.
             Direct resistance to audit recommendations
             Resistance to audit recommendations can take two forms-direct and indirect.
             Direct resistance to audit recommendations is easy to identify and address.
             Direct resistance usually comes from the management in the form of doubts
             about the implementation of the audit team's recommendations. During the
             meeting between the audit team members and the management, some people
             may wish to voice their concerns over these recommendations. It is necessary

                                                                                           191
Principles of Management Control Systems


Table 14.2: Differences Between Surveys, Questionnaires and Interviews
           Surveys                     Questionnaires                       Interviews
 Completed by respondents, May be computed with or Involve the presence of a
 independent of researcher without researcher      researcher, either face-to-
                                                   face or on the telephone
 Highly structured              May be structured or              Usually highly unstructured
                                unstructured

 Require      absence    of May or may not capitalize on Capitalizes on the interaction
 interaction        between the   interaction  between between researcher          and
 researcher and respondent researcher and respondent respondent

 May be difficult to ensure Rate of response depends on Ensuring a high response rate




                                                                        09
 a high response rate       whether the questionnaire is is usually quite easy
                            used like a survey or like an




                                                                    20
                            interview


                                                               of
 Results can be generalized Results can usually not be Results can generally not be
 to a larger population     generalized to a larger generalized to a larger
                                                           s
                            population                 population
                                                        s
                                                     la

 Allow     researchers   to Allow     more    researcher Researchers    have    little
                                                  C


 exercise high control over control than an unstructured control over content of the
                                           y



 content of the response    interview, but less control response
                                         nl




                            than a survey
                                        O




 Results are quite easy to Ease of tabulating results Results are not easy to
                                  se




 tabulate                  depends     on     type of tabulate
                           questionnaire used
                               U
                            S




 Source: ‘The Company audit guide’, Strategic Direction Publishers Ltd., Switzerland.
                       B
                     rI




                for the audit team members to allow people to do. There should be no attempt
                Fo




                to suppress their views. At the same time, audit team members should not
                become too defensive when someone is vociferous in his/her objections.
                Some of the ways in which one can deal with direct resistance to audit
                recommendations are the following:
                •    Prioritize the concerns raised by the management. Deal with the serious
                     ones immediately.
                •    These concerns should be summarized and the management should be
                     convinced that their concerns would be taken care of.
                •    Deal with differences in opinion through free and fair dialogue with an
                     aim of arriving at a resolution.




192
                                                                                  Auditing


            Indirect resistance to audit recommendations
            Indirect resistance to audit recommendations is subtle and difficult to identify.
            Peter Block has named some specific forms of indirect resistance that come up
            during meetings between audit team members and managers.
            Managers during an audit meeting show indirect resistance by frequently
            asking for more details or by providing unnecessary details to questions. They
            may also say that there is not sufficient time to implement the audit team’s
            recommendations. They may question the authenticity of the methods used by
            the audit team. They may, at times act times pretend to be confused or remain
            silent, indicating that they are uninterested in audit recommendations. In such
            a situation, audit team members should encourage those people to write down
            what they feel about the recommendations and why they are resisting them.
            Making people talk often solves a lot of problems. Hence, the audit team
            should encourage people to frankly air their opinions. They should identify
            people who have reservations against the audit teams recommendations and




                                                                 09
            work with them to address their concerns.




                                                             20
Building an Ongoing Audit Program

                                                        of
            With the increasing pace of changes, organizations need to continuously
                                                     s
            increase their efficiency and effectiveness. In order to accomplish this,
                                                  s
            organizations must adopt ongoing audit programs. Ongoing audit programs
                                               la

            help in monitoring improvement in performance over a specific period of
                                            C


            time. They help in systematically monitoring the changes taking place in the
            company's work environment and also help managers deal with resistance to
                                     y
                                   nl




            change.
                                  O
                             se




AUDIT TOOLS AND TECHNIQUES
                          U




            Collection of accurate and comprehensive data is one of the keys to effective
                      S




            audit. Data for an audit can be collected through surveys, questionnaires,
                  B




            interviews, focus groups, and direct observation. The selection of a research
                rI




            method for data collection depends on several factors:
            Fo




Budget
            In many cases, the funds available for conducting the research is the most
            important factor in the selection of the research type. When the budget is tight,
            qualitative research (any method the results of which cannot be communicated
            or presented to a larger population) is advisable rather than quantitative
            research (surveys), because it usually involves lower costs.

Timing
            Timing, too, has an important role to play in the selection of a research
            method. Compared to other methods, preparation time and analysis time for
            surveys is longer. Questionnaires, focus groups and interviews require lesser
            time for preparation or analysis. While a survey may take several weeks to be
            completed, there are some methods that can be completed almost immediately.

                                                                                         193
Principles of Management Control Systems


Projectability
                 If the goal of a project is to determine the attitudes or behavior of a large
                 group then the only effective method is to conduct a survey. While a fairly
                 comprehensive picture can be obtained from focus groups, interviews and
                 questionnaires, the results cannot be accurately generalized and presented to
                 the larger population in statistical terms.

Geography
                 All the sources of data for a project may be found at one location, or may be
                 widely dispersed. This factor tells upon the cost of a research project, both in
                 terms of time and money. Consider the problems related to traveling to
                 various locations, surveys done through mail or telephone seem to be rather
                 cost effective and convenient.

Surveys




                                                                     09
                 Surveys help in collecting information regarding five variables-background




                                                                 20
                 data (age, education and income), behavioral data (buying habits, etc.) data
                 about attitudes and beliefs, data about opinions, and data about the knowledge
                 of the products offered by a company.
                                                            of
                                                       s s
                 Types of surveys
                                                    la
                                                 C


                 Surveys are of two types-written survey questionnaires and telephone surveys
                 using a written questionnaire. The difference between a written survey
                                          y
                                        nl




                 questionnaire and a telephone survey using a written questionnaire is that in
                 the former case, the questionnaire is answered by the individual respondent,
                                       O




                 whereas in case of the latter, the questionnaire is filled in by the interviewer
                                  se




                 himself. Written survey questionnaires, which are sent to respondents by
                               U




                 direct mail, have the lowest response rate and are likely to provide unreliable
                 data because the researchers have no control over who responds to the survey.
                           S




                 Telephone surveys serve are a fast means for collecting data. A telephone
                       B




                 survey includes forced choice, scaled questions and open-ended questions.
                     rI
             Fo




                 The risks of survey research
                 Because surveys are somewhat superficial, there is no way of probing people's
                 responses to determine why they answered in the way they did. Also,
                 respondents’ answers may be based on what is socially or politically
                 acceptable, rather than on the basis of their own attitude, opinions, or
                 behavior.
                 Surveys can be used most effectively when auditors are aware of the following
                 limitations of survey:
                 •   A survey assumes that the researcher knows in advance what the
                     important organizational issues are, and thus, what questions should be
                     asked.
                 •   Surveys assume that people use the same language when they discuss
                     similar issues and interpret survey questions in the same way.

194
                                                                                    Auditing


               •   Although surveys can provide precise statistical information, they usually
                   reveal only superficial information that is incomplete at best.
               •   A survey distorts the political reality of the organization by aggregating
                   responses and implying that all opinions carry equal weight.
               •   The use of random samples in a survey assumes that the required
                   information is distributed evenly across the organization or customer
                   group. This can lead to the researcher developing a distorted picture of the
                   company or its customer base.
               •   The very process of the survey affects the responses which depend on
                   when and by whom the question is asked.
               •   Surveys assume that people have independent opinions, but in reality,
                   these often end up controlling people to give an opinion which they do not
                   hold, because the close-ended questions in a survey impose a response
                   framework on the respondents.




                                                                    09
Questionnaires




                                                               20
               In terms of the applications for which they are best suited, questionnaires fall

                                                          of
               midway between surveys and interviews.  s
               Structure of a questionnaire
                                                     s
               The most common problem with questionnaire research is the design of the
                                                  la

               questionnaire. Since the use of vague and ambiguous terms is the major
                                               C


               problem in questionnaire design, Michael Patton, in his book “Practical
                                        y



               Interviewing” (1982), suggests the following questions as a guide for framing
                                      nl




               clear-cut questions.
                                     O




               1. What do we want to find out?
                                se




               2. Why do we want to find that out?
                             U




               3. When do we need the information?
                         S




               4. Who has that information?
                     B




               The purpose of the questionnaire and the topic it covers governs the structure
                   rI




               to be used in designing the questionnaire. In most cases, the relatively general
            Fo




               questions should be placed in the beginning of the questionnaire and the most
               specific ones follow them. This enables the respondents to warm up to the
               issues and prepares them to provide specific data.
               The use of open-ended or close-ended questions is another important choice to
               be made in questionnaire design.
               Effective questionnaires should use easily understandable language, avoid
               ambiguity, avoid expressing point of view that are likely to make the
               respondents biased and use short sentences, and avoid using jargons.

Focus Groups
               Focus groups serve as yet another approach to data collection. It allows for the
               collection of more information and the involvement of more people than is
               possible in one-on-one interviews. The participants in focus groups, at the
               same time, can be asked to provide more depth than can be obtained from

                                                                                           195
Principles of Management Control Systems


             survey respondents. The dynamics of a focus group may also allow the
             expression of ideas which might otherwise go unstated. A focus group may
             have four to ten participants, and the session may last for about two hours.
             A successful focus group usually has a skilled facilitator, who is responsible
             for guiding the research and managing group dynamics. The role of a
             facilitator of a focus group is different role from that of an interviewer. The
             primary responsibility of a facilitator is to manage the information flow
             between group members rather than asking questions and documenting
             responses.

Interviews
             Interviewing is a technique to gather data from a conversation with a
             respondent. It is a highly flexible research tool. Also, it is an effective way of
             collecting data about sensitive subjects, as skilled interviewers can establish a
             relationship of trust with the respondent. Moreover, the interviewer probes




                                                                   09
             these responses and elicits information that might otherwise be overlooked. As
             the rate of responses to interviews is considerably high they are often used in




                                                              20
             audits.
             Types of interviews
                                                          of
                                                    s s
             There are three basic types of interviews:
                                                 la

             Structured interviews
                                              C
                                        y



             Structured interviews are an interactive approach to surveys or questionnaires.
                                      nl




             Interviewees have a set of formalized questions that do not allow for great
                                     O




             flexibility in terms of responses.
                              se




             Semi-structured interviews
                           U




             These provide a somewhat formalized approach to the question and answer
                        S




             procedure and make use of a protocol format.
                   B
                 rI




             Unstructured interviews
             Fo




             In unstructured interviews, the researcher initiates the interview with a set of
             basic questions, and then allows the rest of its course to be guided by the
             responses of the interviewees.

Direct Observation
             For decades, direct observation has been a favorite research tool of
             anthropologists. However, it has evolved into a sophisticated research method
             now. Direct observation finds many applications in corporate environments,
             particularly in the audit process.
             Direct observation techniques
             There are several direct observation research techniques. These include the
             following:

196
                                                                                 Auditing


            Participant observation
            This technique involves the full participation of the researcher in an activity,
            and requires him to make mental notes of the dynamics of and feelings
            involved in participating.
            Field observation
            Here, an observer closely watches the interaction of a group without being
            directly involved in it. The detachment of the observer from the group activity
            makes it difficult for him to understand any particular situation during the
            interaction from a participant’s point of view.

MANAGEMENT AUDIT
            With the continuous growth of firms, the importance of control has increased.
            Decentralization in organizations is responsible for the fact that control has




                                                                09
            assumed more importance. The growth of organizations should not lead to




                                                            20
            laxity in controls. An efficient manager understands the need for an impartial
            analysis of the firm’s operations and conducts a “management audit.” A

                                                       of
            management audit is defined as “an examination of the conditions and a
            diagnosis of deficiencies with recommendations for correcting them.”
                                                    s
            According to John C Burton, “In a management audit, the auditor will see
                                                  s
                                               la

            whether management is getting information relevant to the decisions and
            actions which it must take. This will require a much more intensive analysis of
                                            C


            information needs and the efficiency of the existing system in meeting them.
                                     y




            The auditor will not have to decide whether management is making the right
                                   nl




            strategic and operative decisions but rather whether management has available
                                  O




            to it and is using the relevant information and techniques necessary to evaluate
                             se




            rationally the various alternatives that exist.”
                          U




Objective of a Management Audit
                      S




            The main aim of conducting a management audit is to critically analyze and
                  B




            evaluate management performance. Apart from this, it is conducted to detect
                rI




            and overcome existing managerial deficiencies and resulting operational
            Fo




            problems. Management audit helps to evaluate the methods and processes
            used by the management to accomplish its organizational objectives; it helps
            to determine the effectiveness of management in planning, organizing,
            directing, and controlling the organization’s activities. It also helps to
            ascertain the appropriateness of the management's decisions for achieving the
            organization objectives.

Development of Management Audit
            The very concept of management audit came into being due to the limitations
            of financial audit. Theo Haimann in his book ‘Professional management’,
            writes about the need for independent appraisal of management performance.
            He discusses the importance of management audit and how it can help in
            overcoming the limitations of financial audit. He was of the opinion that
            management audit can help in assessing the operations of an enterprise from

                                                                                        197
Principles of Management Control Systems


             multiple angles. According to Haimann, management audit would become
             compulsory like the financial audit due to three major reasons.
             •   Increasing number of professional managers
             •   Increasing separation between management and owners
             •   Wider distribution of stockholders

Benefits of Management Audits
             •   As the approach to management auditing is proactive, it provides an early-
                 warning signal of managerial problems and related operational difficulties.
             •   It can be used as a source of information in assisting the organization to
                 accomplish the desired objectives.
             •   It helps to objectively and impartially evaluate organizational plans,
                 structure, and the directions that management gives in the form of




                                                                 09
                 strategies and management processes in planning, organizing, directing
                 and controlling the organizational resources.




                                                             20
Types of Management Audit
                                                        of
             Management audit can be categorized into six types:
                                                  s   s
             •   Complete management audit
                                               la

             •   Compliance management audit
                                             C



             •   Program management audit
                                       y
                                     nl




             •   Functional management audit
                                    O




             •   Efficiency audit
                              se




             •   Propriety Audit
                           U




             Complete management audit
                       S
                   B




             Complete management audit evaluates the firm’s current activities, and
                 rI




             measures the gaps between its existing policies and objectives, and its actual
            Fo




             activities. In case its actual practice does not conform to the firm’s policies
             corrective action is proposed. If the auditor comes across some weaknesses in
             the policies and objectives, he may suggest changes in them, regardless of the
             degree of conformation. Complete management audit is however, not
             designed to punish the inefficient or reprimand people who make honest
             mistakes. Complete management audit is conducted from a positive, and not a
             negative viewpoint, that is when weaknesses in operations or people are
             uncovered, non-vindictive suggestions are given with the hope of improving
             operational performance and the productivity of the personnel concerned.
             Compliance management audit
             According to compliance audit, auditors are asked to identify the gaps
             between the company’s existing policies and objectives, and its actual
             practice. However, in this case, the auditors do not make any
             recommendations for improvements. They simply present their observations

198
                                                                                    Auditing


            to the top management. The top management consults its personnel to decide
            whether, what, or how corrective action should be taken. This type of audit
            eliminates the fear of directives being imposed on the firm by an outside party.
            However, the disadvantage of this type of audit is that it fails to utilize the
            knowledge and experience of the auditors. It also does not avail of the possible
            benefits of observations made by the trained specialists from outside the
            organization.
            Program management audit
            Program management audit is similar to complete management audit and
            compliance audit; the only difference being the fact that it focusses on a
            specific program. Program management audit is designed to appraise
            performance within a specified program and it does not disturb other
            operations of the firm.
            Functional management audit




                                                                   09
            Functional audit measures the difference between the actual performance of an




                                                               20
            organization and its objectives, with emphasis on a particular function. For
            example, manufacturing firms may regularly hold an audit of their quality
                                                          of
            control function. Such an audit will help the firm to regularly check the
                                                      s
            efficiency of internal controls over the quality of its products.
                                                   s
                                                la

            Efficiency audit
                                              C


            Efficiency audit is conducted to ensure that money is so utilized as to generate
                                      y




            handsome returns. The objectives of efficiency audit are:
                                    nl




            •   To invest the capital in areas that generate optimum returns
                                   O




            •   To plan and invest judiciously in various functions
                               se




            Propriety audit
                           U
                       S




            Propriety audit is conducted to examine the effect of the management's
                  B




            decisions and actions on the society and public. While conducting this audit,
                rI




            the auditor examines all transactions of the company to find out whether any
            Fo




            of the transactions has negatively affected public interests. The audit of public
            sector companies conducted by the Comptroller and Auditor General of India
            is a type of propriety audit. The objective of this kind of audit is to identify the
            loopholes in administrative rules and regulations, and to suggest methods for
            improving the execution of future plans and projects.

Organizing the Management Audit
            The management's approval is essential for establishment of a general
            program for management audit. If the proposal does not receive the total
            support of the management, it may face enormous difficulties at later stages.
            Devising the statement of policy
            The management’s support should be reflected clearly and categorically in the
            company's highest policy statement. The statement should be specific in
            nature. It should clearly describe the scope and status of the

                                                                                            199
Principles of Management Control Systems


             management/operational auditing within the enterprise, its authority to hold
             audits, issue reports, make recommendations, and evaluate corrective action.
             The statement of policy should lay down very clearly the scope of activities to
             be undertaken by the management auditor. The statement must give the
             auditor the extent of authority he needs, but it should not assign to him any
             task that he cannot conceivably take care of. The statement must categorically
             state that the management auditor is authorized to review administrative and
             management controls on any activity within the company.
             Depending upon the size and nature of their business, organizations set up a
             separate audit department, the head of which reports directly to the top
             executive. In certain cases, the audit group may be a part of the management
             the administrative control department or some other unit of the organizations.
             However, some analysts feel that the audit function should be free from
             pressures of various groups in the enterprise. The greater its independence, the
             greater is its capability to function to work effectively. Therefore, it is
             necessary to place the audit department in a considerably high position in the




                                                                 09
             organization. The auditing unit should report only to an officer whose status is




                                                             20
             such that he can command prompt and proper consideration of the auditor's
             opinion and recommendations. The management auditor's goal therefore, is to

                                                        of
             attain such a level of operational independence, which will prevent him from
             having to compromise with his audit objectives.
                                                   s s
             Allocation of personnel
                                                la
                                             C


             Everyone placed in the audit unit should have good understanding of the
             theory of auditing, thorough knowledge of the fundamentals of both the
                                      y
                                    nl




             organization and the management, the principles and effective methods of
             control, and requirements for scientific appraisal. The management auditor is
                                   O




             expected to evaluate operational performance and non-monetary operational
                              se




             controls. He should possess basic knowledge of the technology and
             commercial practices of the enterprise, an inquisitive, analytical, pragmatic
                           U




             and imaginative approach and thorough understanding of the control system.
                       S




             The management auditor should also have basic knowledge of commerce, law,
                   B




             taxation, cost accounting, economics, quantitative methods and EDP systems.
                 rI




             Those who have a sound background in accounting along with knowledge of
            Fo




             other relevant disciplines are best suited for this job.
             The individuals to whom this job is assigned should have an inclination
             towards analysis, a high degree of imagination and an ability to write and
             express themselves clearly and logically.
             Staff training program
             A continuous training program is necessary to achieve quality in performing
             audit assignments. An effective training program enables the staff to assume
             additional responsibilities in the organization. Training programs act as an
             incentive for drawing capable people into the department and retaining them.
             Time and other aspects
             The time required to complete a management audit varies, depending upon the
             extent and nature of the assignment. The time and cost will vary for each
             assignment, depending upon the nature of the assignment, the number of

200
                                                                                 Auditing


            auditors assigned to perform the work, and whether more specialists in a
            particular field are required.
            Frequency
            The frequency of conducting audits depends on the organization. When the
            organization is subject to rapid change or the total resources utilized are
            expensive, the frequency of management auditing should be greater than when
            it does not undergo rapid changes or the resources employed are not high in
            value. In essence, management audits should be conducted often enough to
            provide protection against growing problems. On the other hand, they should
            not be so frequent as to lead to repetitious results.

Conditions for Successful Management Audit
            A major aspect of a management audit, is related to the selection of the audit
            personnel. The auditors must be competent, have clear idea about the subject,
            experience, and professional ability. In addition, they must possess an ability




                                                                09
            to deal successfully with human relations issues. They must be able to
            objectively appraise other's actions without generating undue suspicion.




                                                            20
            Almost every employee's attitude towards an audit is defensive. This attitude
            must be avoided. For this to happen, auditors should establish a pre-audit
                                                       of
            condition, expressing their willingness to discuss their observation with the
                                                    s
            affected personnel before it is reported to the top management. In many cases,
                                                  s
            this will evolve into a negotiation-discussion process, whereby those
                                               la

            concerned begin to view audit as a way in which weaknesses of the system
                                            C


            may be pinpointed and their performance be improved. Finally, the
                                     y



            willingness of the firm’s employees to accept change is essential for the
                                   nl




            success of an audit. Several people in managerial positions, particularly those
                                  O




            who have risen through many ranks, feel that the current way of running
            business is good enough. They may be allowed to retain this belief only if the
                             se




            audit supplements it with facts. However, this is rarely the case. The “good
            enough syndrome” would eventually destroy all desires for continual
                          U




            improvement. Audits are meant to highlight the strengths and weaknesses of
                      S




            the firm’s operations. It is up to the management at all levels to reward
                  B




            employees or to take corrective action. If no action is taken in response to the
                rI




            auditor's findings, then his effort is wasted.
            Fo




INTERNAL AUDIT
            Internal audit can be viewed from two different perspectives-the traditional
            perspective and the modern perspective.             Viewed from a traditional
            perspective, internal audit is found to play the following roles:
            •   Check whether the existing controls are effective and adequate
            •  Check whether the financial reports and other records show the actual
               results of the company
            • Check whether the sub-units of the organization are following the policies
               and procedures laid down by the management.
            The traditional concept of internal auditing has a narrow scope whereas the
            modern concept has wider scope. The fact that the modern internal auditing is
            wider is reflected in the new definition of internal auditing given by the

                                                                                        201
Principles of Management Control Systems


             Institute of Internal Auditors, "An independent appraisal function established
             within an organization to examine and evaluate its activities as a service to the
             organization. The objective of internal auditing is to assist members of the
             organization in the effective discharge of their responsibilities. To this end,
             internal audit furnishes them with analyses, appraisals, recommendations,
             counsel and information concerning the activities reviewed." This definition
             implies that an internal auditor has to go beyond checking the books of
             account and related records. He has to appraise the various operational
             functions of an organization and provide recommendations about these. Thus,
             according to the modern concept of internal auditing, the internal auditor is
             involved in conducting a review of operations, and internal audit and
             operational audit are almost synonymous.

Need for Internal Auditing
             The need for an internal audit is determined by the increasing size and
             complexity of organizational operations. Many organizations operate in a




                                                                   09
             number of countries and therefore have a large number of employees. In order




                                                              20
             to avoid discrepancies from creeping into their systems, processes, and
             operations, such organizations appoint a team of specialists called internal

                                                         of
             auditors to monitor, track and report such discrepancies, inefficiencies of
             personnel in the concerned departments.
                                                    s s
                                                 la

FINANCIAL AND COST AUDIT
                                              C
                                       y




             Financial audit is defined as “an exploratory critical review by an independent
                                     nl




             public accountant of the underlying controls and accounting records of a
                                    O




             business enterprise that leads to an opinion of the propriety of the financial
                              se




             statements of the enterprise.” It is conducted to examine the correctness of
             financial statements, and to establish whether they present a true and fair
                           U




             picture of the company's financial position on a particular date. Financial audit
                        S




             is a statutory audit and should be definitely conducted by an independent
                   B




             statutory auditor at the end of every financial year. The statutory auditor has to
                 rI




             certify that financial statements have been prepared without violating the
             accounting rules and principles of accounting.
             Fo




             Cost audit is also a statutory audit conducted to report the cost of production
             of a particular product to the government. A cost and works accountant
             performs a cost audit of routine operations. A cost audit report follows a
             prescribed format, and does not offer the much needed flexibility to the
             professionals to use it as control mechanism.

SOCIAL AUDIT

             Companies should not focus only on increasing profitability and improving
             financial stability, but also on social welfare and uplift of the society. The
             inadequate reflection of the social performance of the organization has given
             rise to the concept of social accounting and social auditing. Social accounting
             and social auditing help in evaluating the contributions made by the company
             to the society. Social accounting is defined as “systematic accounting and

202
                                                                                      Auditing


                 reporting of those parts of a company's activities that have a social impact.”
                 Social accounting, unlike financial accounting lacks an accounting structure.
                 Social accounting is rather an approach that can be used for reporting social
                 performance of organizations. Some of the companies that publish social
                 performance reports are Body Shop (See Exhibit 14.2), BP Amoco, Novo
                 Nordisk and British Telecom. A social accounting report contains the
                 following information:
                 •   Details of financial performance against the stated objectives of the
                     company
                 •   An assessment of the impact of the company's operations on the local
                     community
                 •   A report on the company's environmental performance
                 •   A report on the company's compliance with statutory and voluntary




                                                                          09
                                               Exhibit 14.2




                                                                      20
                              Social Audit Statement of Body Shop

                                                               of
Statements                  Main characteristics                      Foundations
Environmental               Environment protection is the main        The European Union Eco
                                                          s   s
Statement (1992).           theme of the statement;                   management    and Audit
                                                       la

                            • Products-focus approach, rather         Regulation (EMAS)
                                                     C


                                than stakeholder-focus approach
                                             y



The Values Report           • The report comprised of three           •   Mission Statement
                                           nl




1995, published in              statements on the company’s           •   Trading Chart
                                          O




January     1996.    It         performance on environmental,         •   Managers’ and
contains three separate         animal protection and social
                                    se




                                                                          Employees Handbooks
statements                      issues;                               •   Community Trade
                                 U




concerning:                 • Each statement has an element               Programme
• Performance on
                             S




                                of independent verification in
                        B




     environmental              line with established best
                      rI




     issues                     practice;
• Animal protection         • Included in the publication a
                Fo




• Social issues                 paper     “The       Body     Shop
                                Approach to Ethical Auditing”
                                describing        the     methods
                                underpinning the three reports;
                            • A         verification     statement
                                indicating        an       external
                                verification process.
The Values Report           • Single statement covering these         •   Mission Statement
1997, published in              three aspects: environmental          •   Trading Chart
January 1998                    performance; animal protection;       •   Managers’ and
                                and social issues.                        Employees Handbooks
                                                                      •   Community Trade
                                                                          Programme
Source: http://intranet.bexhillcollege.ac.uk

                                                                                            203
Principles of Management Control Systems


                    quality and procedural standards
              •     Views of stakeholders about the objectives and values of the company.

Social Accounting versus Social Audit
              Often the phrases, ‘social accounting’ and ‘social auditing’ are used
              interchangeably, which is not correct. The main reason for this confusion is
              that both social accounting and social audit lead to the compilation of social
              reports. Audit starts where accounting ends. The social accounting report is
              prepared by accountants working in a company. Social audit is conducted by
              an independent auditor who reviews the information given in the social
              accounting report. Hence, social audit can be conducted only after the social
              accounting report has been prepared.

Definition of Social Audit
              Blake, Fredrick and Myers in their book 'Social Auditing' define social audit




                                                                        09
              as systematic attempt to identify, analyze, measure, evaluate and monitor the




                                                                    20
              effect of an organization's operations on society. Turnbull (1995) defines
              social audit as “the process whereby an enterprise measures and reports on its

                                                               of
              performance in meeting its declared social, community or environmental
              objectives.” The word 'social audit' has been often used wrongly to mean
                                                           s
              activities pertaining to a company's social programs, social surveys, etc. For
                                                        s
                                                     la

              example, in India, the MAOCARO1 report given by the company's auditor
              was wrongly taken as a social audit report.
                                                  C
                                           y




Features of Social Audit
                                         nl
                                        O




              •     Social audits adhere to the specified norms. These norms may pertain to
                    the government's standards of social performance, standards established
                                  se




                    by the organization and norms set by outside agencies.
                               U




              •     The aim of conducting a social audit is to influence the policies, objectives
                           S




                    and actions of the concerned organization to improve its social
                      B




                    performance.
                    rI




              •     Social audit is conducted by professionals who have knowledge about the
             Fo




                    social area being audited.

Approaches to Social Audit
              Any one of the following approaches can be adopted to conduct a social audit.
              Inventory approach
              It is a simple listing and short description of programs which the firm has
              developed to deal with social problems.




              1
                  MAOCARO stands for Manufacturing and Other Companies Auditor’s Report Order.
204
                                                                                     Auditing


             Program management approach
             It is a more systematic effort to measure costs, benefits and achievements of
             an organization. It is “an extension of a traditional management audit to social
             programs.”
             Cost-benefit approach
             This is an attempt to list all social costs and benefits incurred by an
             organization in terms of money.
             Social indicator approach
             This pertains to utilizing social criteria (e.g., suitable housing, good health, job
             opportunities) to clarify community needs and then evaluating corporate
             activities in the light of these community indicators.

Types of Social Audit




                                                                    09
             Fredrick, Myers and Blake have identified six types of social audit. These




                                                                20
             audits mainly differ in terms of their scope and coverage.
             Social balance sheet and income statement
                                                           of
                                                       s
             This kind of audit requires quantification of social costs and income. It is
                                                    s
             conducted to reduce social costs in terms of money.
                                                 la
                                               C


             Social performance audit
                                       y




             This audit is conducted to assess the performance of companies with respect to
                                     nl




             some area of social or public concern. For example, this audit can assume the
                                    O




             form of research-based appraisal, that is conducted to find out the extent of
                               se




             pollution caused by cement and steel industries.
                            U




             Macro-micro social indicator audit
                        S




             This type of audit is conducted to evaluate a company's social performance in
                   B




             terms of social indicators that signify public interest. It evaluates the
                 rI




             contribution of the company to the well being of the local community.
             Fo




             Constituency group attitudes audit
             This kind of audit is conducted to ascertain how corporate actions affect
             employees or the general public in different ways. Depending on the findings
             of the audit, the policies or actions of companies are modified.
             Government mandated audits
             This type of audit is conducted by authorized government agencies to study a
             firm's performance in areas of social concern. The focus of agencies that
             conduct this audit is environment protection and equal employment
             opportunity.
             Social process or program audit
             This audit is limited to specific processes and programs of an organization that
             may have social implications. It aims to appraise a program which has already
             been initiated by the company.
                                                                                             205
Principles of Management Control Systems


AUDIT EVIDENCE

             Audit evidence is any kind of information used by the auditor to determine
             whether the financial statements being audited are in accordance with the
             established rules and regulations. For audit evidence to be useful for the
             auditor, it must possess the following four characteristics:
             •   Persuasive
             •   Relevant
             •   Unbiased
             •   Objective
Persuasive
             Evidence is persuasive if it is sufficient in quantity and quality so that the
             auditor is able to arrive at a conclusion.




                                                                  09
Relevant




                                                             20
              Evidence must pertain to the objective or assertion that is under observation
             (e.g. being tested).
                                                        of
                                                       s
Unbiased
                                                     s
                                                  la

             To be unbiased, evidence should not unduly influence one alternative over
                                             C


             another. Bias can result either from the characteristics of the evidence or from
                                      y



             the auditor’s sample selection of items that are to be examined.
                                    nl




Objective
                                   O
                              se




             The ability to reach a similar conclusion that another auditor would find in the
             same circumstances.
                             U
                       S




AUDITING FOR CONTINUOUS IMPROVEMENT
                   B
                 rI
             Fo




             Managers can use audit as a continuous improvement tool. Initiatives for
             continuous improvement should be undertaken to achieve long-term goals
             rather than making short term improvements. In order to maximize the
             benefits of an audit, companies should:
             •   Make the most of audit results
             •   Achieve competitive advantage through frequent auditing
             •   Identify improvement trigger points
             •   Lay down action plans

SUMMARY

             Audit involves examination and verification of records and evidences by an
             independent person or body of persons so as to express an opinion about

206
                                                                    Auditing


whether the company's records and other evidences present a true and fair
view of what they are supposed to reflect. Audits are of two types: financial
audits and non-financial audits. An audit is conducted for various purposes,
some of which are to identify opportunities for improvement, as a reality
check, to identify outdated strategies, to measure performance improvements,
to increase management’s ability to address concerns, enhance teamwork, to
change mind-set and increase acceptance to change. An audit process consists
of these stages-staffing the audit team, creating the audit plan, laying the
ground plan, analyzing audit results, sharing audit results, writing audit
reports, dealing with resistance to audit recommendations and building an
ongoing audit program. For collecting data during an audit, auditors use
various audit tools- surveys, questionnaires, interviews, focus group methods,
the direct observation techniques and the field observation technique. The tool
is selected on the basis of budget, timing, projectability and geography of the
audit. With the continuous growth of firms, the importance and complexity of
control has increased. At this point, an efficient manager acknowledges the
need for an impartial analysis of the firm’s operations and conducts a




                                                    09
management audit. Management audit is defined as an examination of




                                                20
conditions and a diagnosis of deficiencies of an organization with
recommendations for correcting them. It is basically constructive and

                                           of
objective in its approach. It has one purpose-that of helping the management
to enhance the position of the company. In short, the main aim of conducting a
                                        s
management audit is to critically analyze and evaluate management
                                     s
                                  la

performance. Management audits can be categorized into six types-complete
                               C


management audit, compliance management audit, program management
audit, functional management audit, efficiency audit and propriety audit.
                         y




Setting up a general program for management audit requires the
                       nl




management’s approval and support. The management's support must be
                      O




reflected clearly and categorically in the company's highest policy statement.
                 se




Apart from this, management should allocate personnel, train them and decide
on the timing and frequency of audits. Internal audit is conducted for
              U




systematically examining the records, systems, procedures and operations of
          S




an organization. Financial audit is another type of audit conducted to examine
      B




and verify the correctness of a company's financial statements. Cost audit is a
    rI




statutory audit, conducted to report the cost of production of a particular
product. Social audit is a systematic attempt to identify, analyze, measure,
Fo




evaluate and monitor the effect of an organization's operations on the society.
There are four approaches of social audit- the inventory approach, the program
management approach, the cost-benefit approach and the social indicator
approach. There are six types of social audit audit-social balance sheet and
income statement, social performance audit, macro-micro social indicator
audit, constituency group attitudes audit, government mandated audits and
social process or program audit. Audit evidence is any kind of information
that is used by the auditor to determine whether the financial statements being
audited are in accordance with the rules and regulations of the company. Audit
evidence should necessarily possess four characteristics- persuasive, relevant,
unbiased and objective.




                                                                           207
Chapter 15

Audit of Management



                                               09
Functions
                                          20
                                      of
                                  s s
                               la

In this chapter we will discuss:
                             C


 •   Audit of Purchasing Function
                      y




 •   Human Resource Audit
                    nl
                   O




 •   Research & Development Activities Audit
 •
              se




     Production Audit
 •   Marketing Audit
           U




 •
        S




     Sales Audit
       B
     rI
Fo
                                                         Audit of Management Functions

             In order to conduct business properly, activities pertaining to a particular
             domain are clubbed under specific functions of management. For example, all
             activities related to people come under the personnel function. Similarly, all
             activities that are performed as a part of manufacturing fall under the
             production function. Over a period of time, an organization may not be able to
             perform these activities efficiently due to systemic problems and human
             inefficiencies and this may affect the performance of the organization. Hence,
             it is necessary to regularly conduct audits of these functions.

AUDIT OF THE PURCHASING FUNCTION

             Purchasing is an important function of the management especially in the case
             of manufacturing firms. In manufacturing firms, material costs form 50 to
             60% of the total cost. If a firm can reduce its purchasing costs, it would lower
             the material cost as well as the cost of production, thereby earning higher




                                                                   09
             profits. In most of the big companies there is a centralized purchase




                                                               20
             department that takes care of purchasing needs of other departments. The user
             departments forward the list of items they need along with the quantity desired

                                                          of
             and specifications, if any. The purchase department is responsible for
             negotiating a price and buying items at the lowest possible rate without
                                                     ss
             compromising on quality. If there is some technical help needed, the purchase
                                                  la

             department can hire technical experts from outside or get them from other
                                              C


             departments within the company.
                                        y
                                      nl




Purchasing Procedure
                                     O




             In most companies, the purchasing department performs the following
                              se




             functions:
                           U




             •   Verifying purchase requisition
                       S




             •   Inviting Quotations, tenders, etc.
                   B




             •   Negotiating price
                 rI




             •   Selecting the source of supply
             Fo




             •   Settling delivery date, mode of dispatch, payment terms etc.
             •   Following-up delivery
             •   Securing evidence of receipt of materials/services
             •   Negotiating adjustments with suppliers
             •   Checking invoices
             •   Serving as a source of information for user departments.
             •   Maintaining the register of suppliers, vendor files etc.,

Characteristics of an Effective Purchase Department
             The characteristics of purchasing department determine whether it is
             innovative or not. The following are the important characteristics of
             purchasing department:
                                                                                         209
Principles of Management Control Systems

             •   Maintaining the continuity of supply of raw materials in support of the
                 production schedule.
             •   Purchasing material at the least available price
             •   Adhering to the standards of quality while buying goods
             •   Formulating and implementing plans for reducing costs through value
                 analysis programs
             •   Keeping all the relevant people informed about its activities, market
                 developments, availability of substitutes etc.

Purchase Audit Areas
             While conducting an audit of purchase functions, an auditor should look into
             the following aspects before giving his approval.
             As a first step, the auditor should determine whether the organization has a




                                                                    09
             system for collecting information pertaining to purchases. If a system exists,
             he should analyze all the documents that trigger the purchase activity. During




                                                              20
             investigation, the auditor should look at the adequacy, format and correctness
             of those documents. He should conduct a critical review of the purchase

                                                         of
             procedure of the company. After the review, the auditor has the freedom to
             comment whether the purchase department is playing an innovative role in the
                                                   s  s
             organization or not. The auditor should look for failures, if any, on the part of
                                                la

             the purchase department to get valid competitive quotations. It should check
                                             C


             that there are no loopholes in the quality control measures adopted by the
             purchase department. An effective purchase department should compare the
                                      y
                                    nl




             prices of the market quotations with the prices obtained from new sources of
             supplies. If there is any discrepancy, it should look for alternative sources of
                                   O




             supply.
                              se
                           U




HUMAN RESOURCE AUDIT
                       S
                   B




             The Human Resource (HR) Audit is the process of examining policies,
                 rI




             procedures, documentation, systems, and practices with respect to an
            Fo




             organization’s HR functions. The purpose of an HR audit is to reveal the
             strengths and weaknesses of the human resources system, and identify any
             issues which need to be resolved. The main purpose of an audit should be to
             analyze and improve the HR function in the organization.
             Some other objectives of an HR audit would include:
             •   Examining a company’s compliance with established employment laws
                 and regulations.
             •   Determining how to serve the relevant needs of stakeholders,
                 management, employees and customers better.
             •   Streamlining company practices and procedures used in carrying out
                 recruitment, wage & salary administration, managing leaves of absence,
                 benefits, training, discipline & termination, etc.
             •   Establishing an “early warning system” to spot problems or identify issues
                 before they become crises

210
                                                               Audit of Management Functions

Conducting an HR Audit
            An HR audit is conducted by an audit team comprising a cross-section of the
            organization’s staff, including the line staff, middle and upper management,
            and the department responsible for HR functions. Using a questionnaire, the
            team collects information for a number of categories. For example, a
            questionnaire to collect information pertaining to recruitment would have the
            following questions.
            •    How did the work force increase to its current size?
            •    What are the future needs of personnel in your organization?
            •    What are the procedures, for hiring in your organization?
            •    What are the recruitment sources used? (e.g., advertisements, referrals
                 from other agencies, personal contacts)
            •    Are the current employees given appropriate consideration for promotion




                                                                          09
                 or lateral position changes?
            •




                                                                     20
                 By whom is the preliminary screening of candidates done?
            •    Who selects candidates for interviews?
            •
                                                                of
                 Is training provided to those who conduct interviews?
                                                            s
            •    How is the recruitment, screening, and selection process documented?
                                                        s
                                                     la

            •    What is the interview process that is used (e.g., individual, sequential,
                                                  C


                 panel)?
                                          y




            •    Who holds the final authority to hire?
                                        nl




            •    Who checks references?
                                       O




            •    How are the reference checks documented?
                                se




            •    Who makes the offer of employment?
                             U




            •    Where is the hiring paperwork generated?
                        S
                   B




            •    Who negotiates compensation packages?
                 rI




            •    What is the turnover rate (percent of employees leaving each year) in your
           Fo




                 organization? Has this changed over time?
            •    Who gives references for former employees?
            By seeking an answer to these questions one can gain considerable insight into
            the recruitment activities of the organization.
            Caution for the HR auditor
            Conducting an HR audit is not an easy task. An auditor1 should bear the
            following points in mind while conducting an HR audit.
            •    It is difficult to quantify the human contributions to the success or failure
                 of an organization.


            1
                If the HR audit is conducted by an outside consultancy, then the auditor is a senior agency
                who has experience in conducting the audit. If the audit is conducted internally, then a
                senior manager would play the role of auditor.
                                                                                                      211
Principles of Management Control Systems

             •   It is difficult to develop a yardstick to measure the performance of
                 workers.
             •   It is difficult to assess the contribution of workers to the work as they are
                 influenced by fellow workers and their industrial background.
             •   It is necessary to have a proper understanding of human behavior in order
                 to keep the workforce motivated to achieve organizational goals.
                 Therefore, the auditor should assess whether the supervisors and managers
                 have leadership qualities to motivate the employees or not.
             •   It is not easy to assess the impact of training programs on workers ability.
             •   It is necessary for the auditor to understand the importance of the
                 personnel function and its role in optimum utilization of resources
                 available in a firm.




                                                                   09
RESEARCH AND DEVELOPMENT ACTIVITIES AUDIT




                                                              20
             Due to the tremendous technological progress most of the existing

                                                         of
             technologies become obsolete within no time. Thus it becomes imperative for
                                                      s
             companies to come out with innovative concepts, products and procedures so
                                                    s
             that they can survive. If a company has to constantly innovate, it has to invest
                                                 la

             heavily in research and development. The following guidelines will help a
                                              C


             company monitor its research and development in a better way:
                                       y




             •   Set a definite R&D goal
                                     nl
                                    O




             •   Set aside an R&D budget every year
                              se




             •   Decide the extent of R&D required for a young company.
                           U




             •   Select broad research concepts which an organization is capable of
                 developing.
                       S
                   B




             •   Form a consensus on the research project being undertaken.
                 rI




             •   Conduct a pilot project before starting the research project on full scale.
             Fo




Evaluation of R&D Activities
             While conducting an R&D audit, the auditor should look into the following
             aspects.
             •   The auditor should make sure that the company has allocated a specified
                 amount as R&D budget based on detailed report of each project.
             •   The auditor should make sure that the details of expenses of each project
                 are maintained separately and systematically.
             •   The auditor should make sure that there is control in material requisition
                 and consumption.
             •   The auditor should make sure that R&D personnel are recruited on the
                 basis of merit and competency.

212
                                                         Audit of Management Functions

             •   Every R&D project may not prove to be commercially viable. The auditor
                 should see to it that the company does not incur unnecessary expenses on
                 projects which are not commercially viable.
             •   R&D projects can be successful only if the R&D activities are well
                 coordinated and within the overall objectives of the company.
             •   The R&D development center should have a well stocked library and
                 necessary equipments for conducting the research. A team of experts
                 should make sure that books and equipments are available and properly
                 maintained.


PRODUCTION AUDIT

             The production audit also referred as manufacturing audit is conducted to




                                                                   09
             measure the effectiveness and efficiency of all production facilities and
             processes. It is conducted for the primary production activities as well as




                                                              20
             support activities like maintenance, stock keeping etc. Production audit may
             include an extensive plant tour utilizing a number of checklists developed
                                                         of
             specifically for that plant. The plant tour helps the auditor get a general
                                                      s
             understanding of the manufacturing processes and their inherent problems.
                                                   s
                                                la

             Some of the major reasons for conducting a production audit are:
                                              C


             •   To make sure that actual production procedures are in conformance with
                                       y



                 standard production procedures
                                     nl




             •   To study consistency of a process on a day to day basis
                                    O




             •   To demonstrate a proactive approach to process improvement; and
                              se




                 encourage ongoing corrective action
                           U




Characteristics of a Good Manufacturing Audit
                       S
                   B




             A good manufacturing audit has the following characteristics:
                 rI




             •
            Fo




                 A manufacturing audit is not supposed to be a fault finding exercise. It is
                 rather meant to help people do things more efficiently through evaluation
                 and feedback.
             •   It should use rating schemes to classify problems discovered. A rating
                 scheme helps in ranking problems in order of priority so that corrective
                 actions can be undertaken accordingly.
             •   It not only helps in discovering problems but also aid in taking corrective
                 actions.
             •   It is necessary for the auditor to be familiar with the area he is auditing as
                 well as auditing techniques.
             •   It is more than just walking into a work area and looking for trouble.
                 Rather it should be a proactive process wherein problems are identified
                 and eliminated.

                                                                                           213
Principles of Management Control Systems

MARKETING AUDIT

             Marketing audit is a comprehensive, systematic, independent and periodic
             examination of a company's or business unit's marketing environment,
             objectives, strategies and activities. A marketing audit is conducted to
             determine problem areas and opportunities and recommend an action plan to
             improve the company's marketing performance.

Characteristics of Marketing Audit
             There are four main characteristics of marketing audit. They are:
             Comprehensiveness
             A marketing audit is conducted to cover all the marketing activities of a
             business. If the audit covers only some activities that form a part of the




                                                                 09
             marketing function such as sales force, pricing etc, then it is called a




                                                             20
             functional audit. Functional audits do not give a fair picture, and can
             sometimes mislead the management. For example, excess sales force turnover

                                                        of
             may not always be due to poor training or compensation but due to weak
             products and poor promotion by company. Thus a comprehensive marketing
                                                     s
             audit is more effective in locating the real problem.
                                                  s
                                               la

             Systematic
                                             C



             A marketing audit is an orderly examination of both the macro and micro
                                      y
                                    nl




             marketing environments, the marketing objectives and strategies, of an
             organization. The audit shows the areas where improvement is required. The
                                   O




             improvements are made with the help of both short run and long run plans.
                              se




             Independent
                           U




             A marketing audit can be conducted in various ways. It can be a self-audit,
                        S




             audit from across, audit from above, company task force audit, outsider audit
                   B




             etc. Self-audits are conducted by marketing managers themselves by using a
                 rI




             checklist to rate their own operations. Self-audit has a number of
             Fo




             disadvantages. A self audit lacks objectivity and independence. Hence, it may
             not reflect the actual performance of the marketing function. To avoid this, it
             is always better to go for an external agency for conducting a marketing audit.
             Periodic
             Marketing audits are usually initiated when there is a deterioration in sales.
             Conducting a marketing audit after encountering a problem is not of much
             help. Hence, it is better to conduct a periodic audit both during good times as
             well as bad times.
             Marketing audit checklist
             A marketing audit checklist is a tool used by auditors to conduct internal
             marketing audits. The checklist gives a list of situations each having three to
             four options. This checklist is given to all the people within the marketing
             department to know their views regarding the company's products, price,
214
                                                             Audit of Management Functions

              promotion activities etc. The data collected gives the management an insight
              into the marketing efforts and strategies and ways and means of improving
              them. In exhibit 15.1, a list of situations pertaining mainly to a company’s
              products and pricing strategy are given in the form of a checklist.

SALES AUDIT

              Competitive environment, increasing consumerism and advent of the internet
              has made it imperative for companies to monitor their sales closely. Sales
              audit is the process of examining and assessing the current state of sales, the
              sales environment and the sales objectives, strategies and activities.

Approaches to Sales Audit
              For conducting a sales audit, an auditor can use two approaches.




                                                                       09
              •    Separate approach




                                                                  20
              •    Collective approach


                                             Exhibit 15.1    of
                                                       s  s
                                     Marketing Audit Checklist
                                                    la

       Agree                              Disagree                             Uncertain
                                                 C


       Company has sometimes failed to meet production targets
                                          y




       Suppliers are very reliable
                                        nl




       The majority of our sales are in one product
                                       O




       We do not introduce new products as often as our competitors
                                 se




       Our product range matches customer wants
                              U




       We monitor new product development in the industry
                          S




       We are aware and comply with current legislation
                     B




       We are aware of how our customers perceive our products
                   rI




       We do have a system of quality control
              Fo




       We monitor the quality of incoming supplies
       Level of sales returns is negligible
       Level of purchase returns is negligible
       Company collects feedback from after sales complaints
       Company uses feedback from sales to influence new products
       Markets are sensitive to price changes
       Prices are in line with the competition
       Profit margins are wide enough to meet price competition
       Credit terms and discounts are in line with competitors
       An increase in credit sales will lead to cash-flow problems
       Company follows competitors in pricing the product/services

      Adapted from Marketing Audit Questionnaire, Strathclyde European Partnership Project, Glasgow.


                                                                                                215
Principles of Management Control Systems

               Separate approach
               In a separate approach, individual sales executives are interviewed to find out
               their personal sales experiences and views regarding the existing sales process
               and ways of improving them.
               Collective approach
               On the other hand, when views of a group of sales executives are sought then
               it is known as the collective approach. For example, if the regional sales
               manager wants to know the views of all the sales executives in a regional
               meeting he can use this approach. Questionnaires are generally used for
               collecting data.

Conducting a Sales Audit
               A sales audit can be conducted in-house by the sales manager or by an outside




                                                                       09
               consultant. It is always better to appoint an outside consultant for the sake of
               objectivity. Before conducting a sales audit, the company should make sure




                                                               20
               that it has a strong sales foundation and excellent sales relationship (Refer
               Exhibit 15.2). In the absence of these, the sales audit may not prove to be
                                                           of
               successful and hence, the purpose of conducting it may be lost.
                                                     s s
Characteristics of a Sales Auditor
                                                  la
                                               C


               The main characteristics of a good sales auditor are:
                                         y




               •   He must be detail oriented. He should pay specific attention to the
                                       nl




                   different product aspects when counting inventory and recording
                                      O




                   information. He should always cross-check to make sure that all sales
                                se




                                           Exhibit 15.2
                             U




                           Pre-requisite for Conducting Sales Audit
                          S
                     B




      The Five Foundations of Sales
                   rI




      Attention – Possibly through advertising, the potential customer needs to be attracted.
               Fo




      Interest – Generate their interest in the product.
      Desire – Show off your product; make the customer want it.
      Conviction – Prove that your product is the best. Tell them about your competition
      and give them stories from satisfied customers.
      Action – Persuade customers to decide. If they have any doubts, address those
      concerns.
      Establishing Selling Relationships
      Sales people who are honest and show an actual interest in the client develop the best
      type of customer-salesperson relationship.
      To keep these relationships strong, a company has to maintain contacts with the
      clients and keep several channels of communication open.


       Source:www.consultomc.com

216
                                                          Audit of Management Functions

                 invoices have been retrieved for the audit period. If an invoice appears to
                 be missing, the auditor should make every effort to retrieve the missing
                 invoice from the stores manager.
             •   An effective sales auditor will always give importance to collecting
                 invoices from a stores manager, and never assume that all the invoices
                 were handed over to him or her.
             •   Sales auditors must have exposure to store management while they are
                 doing their job. Auditors not only act as data collectors but also as
                 representatives of the service providing firm. For this reason, they must
                 interact with stores manager and plan store visits in such a manner that
                 they do not disturb the stores manager's schedule.

Process of Collecting Data During Sales Audit
             During a sales audit, data is usually collected from sales representatives




                                                                  09
             through questionnaires. The questionnaire may have questions pertaining to




                                                              20
             different aspects of sales like sales strategy, sales planning, territory
             allocation, motivating salespersons, performance modeling of salespersons,

                                                          of
             sales analysis and control etc. For example, some of the questions pertaining
             to sales control that can be incorporated in the questionnaire are:
                                                   s s
             •   What is the Sales Control (SC) system is used?
                                                la


             •
                                             C


                 Which sales activities are controlled?
                                      y



             •   Who sets the sales standards? How?
                                    nl




             •   Who uses or gets to see the sales figures?
                                   O




             •   When variances occur, who takes care of these variances?
                              se




             The data collected provides great insight into the sales management function
                           U




             and can help to improve sales processes.
                       S
                   B




   SUMMARY
                 rI
             Fo




             Organizations club activities pertaining to a particular domain under a specific
             management functions. In order to prevent functional activities form
             becoming inefficient, organizations conduct functional audit. An audit of the
             purchase activities is referred as purchase audit. It is conducted to control
             purchase costs and to identify loopholes, if any, in the purchase function. The
             Human Resources (HR) audit is a process of examining policies, procedures,
             documentation, systems, and practices with respect to an organization’s HR
             functions. The purpose of an HR audit is to reveal the strengths and
             weaknesses of the human resources system. In order to remain competitive, it
             has become imperative for companies to develop innovative concepts,
             products and procedures. For achieving this, companies need to invest heavily
             in R&D. R&D investment may prove to be a waste if the R&D activities are
             not monitored and controlled. Therefore, organizations conduct R&D audits to
             ensure that their R&D efforts are fruitful and not simply a waste of money and
             resources. The production audit is conducted to measure the effectiveness and
             efficiency of all production facilities and processes.
                                                                                         217
Principles of Management Control Systems

             A marketing audit is a comprehensive, systematic, independent and periodic
             examination of a company's or business unit's marketing environment,
             objectives, strategies, and activities. This is done to identify the problem areas
             as well as opportunities. An action plan is then recommended to improve the
             company's marketing performance. Sales audit is the process of examining
             and assessing current state of sales, the sales environment, and sales
             objectives, strategies and activities.




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                        S
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                 rI
            Fo




218
                       09
                    20
                 of
           PART VII:
                s
                s
             la

 MANAGEMENT CONTROL AND
            C



     EMERGING AREAS
            y
          nl
         O
      se
     U
     S
  B
rI
Fo
Chapter 16

Control in Multinational



                                              09
Corporations
                                          20
                                        of
                                   s s
                                la
                             C


 In this chapter we will discuss:
                      y




 •   Types of Controls Used by MNCs
                    nl




 •   Concept of Strategic Control
                   O




 •   Factors Affecting Control Systems in MNCs
              se




 •   Analysis of Foreign Investment Projects by MNCs
            U




 •   Transfer Pricing in MNCs
        S
    B




 •   Control of Foreign Affiliates
  rI




 •   Budgeting for Foreign Affiliates
Fo
Principles of Management Control Systems

             In the last few decades, companies have grown across borders at a tremendous
             pace. This growth in business has made it imperative for managers to increase
             their awareness in relation to the important issues involved in cross-border
             investments, subsidiary control, global benchmarking practices and cultural
             diversities of countries. Multinational Corporations (MNCs) have to adapt
             various control practices used in their home countries (headquarters) to suit
             the requirements of the host countries (subsidiaries). Improper adaptation of
             control systems used in the home country for subsidiaries, works against the
             interests of the organization. As control is one of the most important issues for
             an MNC, we will discuss the ways and means by which the headquarters
             exercises control over its subsidiaries.

TYPES OF CONTROLS USED BY MNCs

             MNCs use different types of controls to monitor and improve the performance




                                                                  09
             of their subsidiaries. Some of the controls are:




                                                              20
             •    Personal controls
             •    Output controls
             •    Cultural controls                      of
                                                      s
             •
                                                   s
                  Result controls
                                                la

             •    Bureaucratic controls
                                             C
                                         y



Personal Controls
                                       nl




             Personal control is exercised through informal meetings that take place at all
                                      O




             levels between the officials of the headquarters and the subsidiary. These
                               se




             meetings help them to establish greater coordination and communication
             between the headquarters and the subsidiary.
                            U
                        S




Output Controls
                    B
                  rI




             Output control relates to the performance of a subsidiary in quantitative and
             Fo




             qualitative terms. Performance measures can be established to determine
             profitability, productivity, quality of the product and market share of a
             subsidiary. The headquarters often set stiff targets for the subsidiaries
             especially in terms of profitability and productivity. These targets act as
             controls for the subsidiary.

Cultural Controls
             Cultural controls are exercised by an MNC directly or indirectly in order to
             uphold, manage and improve the work culture in its subsidiaries. These
             controls help in regulating the behavior of employees at the subsidiary.

Result Controls
             Controls that are used for rewarding individuals or groups for generating good
             results are called result controls. One of the best examples of result control is

222
                                                 Control in Multinational Corporations


             the “pay for performance” system used in the US. In this system, employees
             are paid on the basis of their performance rather than the number of hours they
             have worked. A similar system is often used in MNC subsidiaries in order to
             control performance.

Bureaucratic Controls
             Bureaucratic controls take the form of rules, norms and regulations imposed
             by the headquarters on the subsidiaries so that the business is conducted
             properly. For example, a company may have rule that restricts subsidiaries
             from spending more than 10% of their allocated budget on business-related
             travel.

CONCEPT OF STRATEGIC CONTROL




                                                                 09
             Strategic control is defined by Prahlad and Doz as “the extent of influence that
             a head office has over a subsidiary concerning decisions that affect subsidiary




                                                             20
             strategy”. In many multi-business, multinational companies, more than 50% of
             the assets, sales and profits come from overseas operations. As MNCs grow

                                                        of
             and as their operations become more complex, the headquarters has to devise
             and implement strategies to control subsidiaries effectively. However, the
                                                   s s
             controls should not hamper the growth of the subsidiaries. Some of the factors
                                                la

             that determine the kind of influence the headquarters has over the subsidiary
                                             C


             are:
                                      y
                                    nl




Headquarters-Subsidiary Environment
                                   O




             Earlier, MNCs used to invest and consolidate their position only in their home
                              se




             countries. But with better growth prospects in foreign markets compared to the
             domestic markets, MNCs have started to invest and create a stronger asset
                           U




             base for their foreign subsidiaries too. For this reason, the headquarters of a
                        S




             company has to exercise greater strategic control over its subsidiaries.
                   B
                 rI




Impact of Global Competition
            Fo




             Over the last few decades, competition between players in a wide range of
             industries has intensified. Industries like automobiles, chemicals, and
             consumer electronics have experienced intense competition. In order to
             compete in the global market, an MNC should surpass the boundaries of
             national markets and prepare a global strategy. In order to do so, it has to
             constantly review and change its sourcing patterns, pricing strategies, product
             designs, etc. This has led the headquarters of MNCs to exercise greater control
             over their subsidiaries.

Impact of Host Government Demands
             Often, the host government (i.e. the government of the country in which the
             subsidiary of the MNC operates) intervenes in the operations of an MNC.
             Host governments are averse to centralization and may penalize the MNC for
             excessive controls. Hence, MNCs find themselves in a tricky situation where,

                                                                                         223
Principles of Management Control Systems

             on the one hand, the government demands greater autonomy for the
             subsidiaries, and on the other hand, the government itself intervenes in their
             functioning. Strategic control by the headquarters has gained importance for
             this reason.

Impact of Joint Ventures
             In order to gain entry into certain foreign markets, an MNC may form a joint
             venture with a local company because the host government restricts the direct
             entry of MNCs. In recent years, many joint ventures have not proved
             successful in the long term because of lack of coordination and conflicting
             interests between the MNC and the local company. Due to lack of
             coordination and communication between the MNC and the local company,
             the subsidiary cannot operate properly. The MNC cannot exercise excessive
             control because it fears that the joint venture may be called off and it may be
             deprived of a prospective market. Here, established control systems for the




                                                                   09
             subsidiary are useful.




                                                               20
FACTORS AFFECTING CONTROL SYSTEMS IN MNCs

                                                          of
             MNCs need to adapt the control systems practices prevalent in their home
                                                    s  s
             country to the conditions prevalent in the foreign country. These control
                                                 la

             systems should be evaluated on a continuous basis and should be modified
                                              C


             when required. Control systems need modification or changes because they
             are affected by a number of factors such as:
                                       y
                                     nl




             •   Cultural Differences Across Countries
                                    O




             •   Differences in Business Environment
                               se




Cultural Differences Across Countries
                           U
                        S




             Culture and traditions vary from country to country. MNCs need to be
                   B




             sensitive to these differences when designing control systems for their
                 rI




             subsidiaries. Culture has a great effect on management control systems
             (MCSs) because a number of control problems are in fact behavioral
             Fo




             problems. A number of studies have been conducted to study the implications
             of various aspects of culture for MCSs. Geert Hofstede, in his landmark study,
             identified four types of cultural dimensions, which have distinct implications
             for control systems. According to Hofstede, the four cultural dimensions are:
             •   Individualism
             •   Power distance
             •   Uncertainty avoidance
             •   Masculinity
             Individualism
             Individualism is a cultural dimension, which determines how an individual
             sees himself, i.e. as an individual entity or as a part of a larger group. Cultures
             that are highly individualistic consist of people who give priority to their self-
             interest rather than that of the group. When the culture is collectivist, people
224
                                                  Control in Multinational Corporations


             give more importance to the group interest rather than the individual’s interest.
             This dimension of culture is important for designing the reward system in an
             organization- an integral part of MCSs. For example if the culture is highly
             individualistic, organizations use individual incentives for motivating their
             employees. If the culture is collectivist, it gives incentives based on group
             performance.
             Power distance
             In an organization different people are vested with different degrees of power
             and authority. This often creates a feeling of inequality. Power distance means
             the extent to which employees understand and accept this unequal distribution
             of power. In the context of MCSs, employees who score high on power
             distance always prefer centralization and do not like to delegate authority.
             Employees who score low on power distance prefer greater decentralization
             and participation.
             Uncertainty avoidance




                                                                  09
             Uncertainty avoidance is a cultural dimension seen in employees who avoid




                                                              20
             taking risks. Employees who favor uncertainty avoidance, do not take quick
             decisions and feel uncomfortable when confronted with difficult situations. If

                                                         of
             an organization has a large number of employees who are averse to risk
             taking, then it must have clear rules and guidelines for every action. It has to
                                                      s
             do things in a planned and systematic manner so that employees know
                                                     s
                                                  la

             beforehand what they have to do in unfamiliar situations.
                                             C


             Masculinity
                                      y




             ‘Masculinity’ is defined here as a strong drive for achievement. Employees
                                    nl




             with this attribute are highly assertive and are often entrusted with responsible
                                   O




             roles. They take decisions quickly and are not worried about the results. The
                              se




             implication for MCSs is that such employees demand more autonomy and
             freedom at the workplace. They do not like excessive controls and cannot
                             U




             perform well in a highly centralized organization. They also prefer
                         S




             performance-based rewards.
                   B
                 rI




Differences in Business Environment
            Fo




             Business environment is dynamic and differs across countries. Organizations
             need to learn to adapt to these changes in environment in order to survive and
             prosper. Some of the elements of business environment that have an effect on
             control systems are:
             •   Inflation
             •   Business risk and uncertainty
             •   Labor availability and quality
             Inflation
             Inflation refers to a sustained increase in the general price level in an
             economy. As the rate of inflation increases, the value and purchasing power of
             money decreases. Rates of inflation vary widely across countries. MNCs need
             to evaluate the impending financial risk due to fluctuations in inflation rates.
             An MNC operating in a country which has a high rate of inflation, may

                                                                                          225
Principles of Management Control Systems

             experience an erosion in the value of its assets. High inflation can also
             adversely affect the compensation of employees. As the prices of goods
             increase, there should be a corresponding increase in salaries. This would in
             turn mean that the management has to make changes in its rewards system --
             an integral part of the control system.
             Business risk and uncertainty
             MNCs operating in different countries are exposed to different types of risks
             and uncertainty. Business risk and uncertainty is lower in countries which are
             economically and politically stable than in countries which are politically and
             economically unstable. Risk also differs across countries depending on the
             extent of economic development. Companies in economically underdeveloped
             countries may not have strong and well-developed control systems. A poor
             and undeveloped MCS is characterized by a poor accounting system, an
             ineffective information system, limited computerization and excessively
             subjective performance reviews. A company’s growth strategy also affects the
             way an organization manages risk. Companies may grow organically (i.e.




                                                                  09
             gradual growth due to increase in profit or returns) or by acquiring other firms.




                                                              20
             When companies grow by acquiring other firms, they encounter variations in
             control systems. A company that can adopt the best control system for all its

                                                         of
             acquisitions will be more adept at managing risks.
                                                      s
             Labor availability and quality
                                                   s
                                                la

             MNCs operating in underdeveloped countries find it difficult to hire skilled
                                             C


             labor due to the lack of quality education and vocational training. This forces
             the management to have a highly centralized structure and to exercise a high
                                      y




             degree of control. Even at the managerial level, there is a marked difference in
                                    nl




             the quality of managers across the countries. An MNC needs to consider all
                                   O




             these factors before designing the control systems for its subsidiaries.
                               se
                            U




ANALYSIS OF FOREIGN INVESTMENT PROJECTS BY MNCs
                        S
                   B




             MNCs often invest in different countries by taking up a number of projects.
                 rI




             They use various methods like Net Present Value (NPV), Pay back period, or
             Accounting rate of return, for assessing the profitability and viability of a
            Fo




             project. They also conduct risk-benefit analysis before initiating a project.
             There are a number of other issues that should be considered by an MNC
             before embarking on projects in foreign countries. Some of them are:
             •   Taxes on income from foreign investment projects
             •   Political risks
             •   Economic risks
             •   Exchange rate risks
             •   Different types of exchange rate exposure

Taxes on Income from Foreign Investment Projects
             All over the world, host countries levy taxes on MNCs on the income they
             earn in the host countries. Taxes are levied not only on the income earned but
             also on the income repatriated to the home country of the MNC in the form of
226
                                                  Control in Multinational Corporations


              dividends. The rate of taxation differs from country to country. At times, an
              MNC may get tax concessions due to the nature of the project or its location.
              It may also get concessions because of the employment opportunities the
              project generates for the local people. MNCs should have a transparent and
              efficient accounting system in order to avoid complications that may arise due
              to the incorrect assessment of tax to be paid.

Political Risks
              The most extreme form of risk an MNC faces in its overseas operations is the
              risk of expropriation of the business by the host country due to policy changes.
              Expropriation can take the form of seizure of property or assets of an MNC.
              For example, in 1970 in Chile, the government took control of companies like
              Anaconda, Ford and AT&T as part of its nationalization policy.

Economic Risks




                                                                  09
              Economic risk can be divided into exchange rate risk and inflation. As we




                                                              20
              have already discussed inflation in the previous section, here we will discuss
              exchange rate risk in detail. Political risk has a strong bearing on economic

                                                         of
              risk. Frequent political changes in a country can adversely affect the economy
              of the country and the operations of MNCs.
                                                    s s
                                                 la

Exchange Rate Risk
                                              C


              Exchange rate is the value of one currency in terms of another. The value of
                                       y




              one US dollar can be quoted in terms of another currency like the Euro. The
                                     nl




              exchange rate of a currency is governed by the laws of demand and supply.
                                    O




              The demand and supply of a currency is influenced by many factors including
                               se




              interest rate differentials, relative inflation, export competitiveness and
              economic growth. Exchange rate fluctuations influence the cash flows of an
                            U




              MNC because they may be denominated in several currencies and the value of
                        S




              each currency relative to the dollar is different at different times. This
                    B




              complicates the problem of measuring the performance of subsidiaries. Apart
                  rI




              from this, exchange rate changes also affect costs. If a country’s currency has
              Fo




              depreciated, there will be an increase in the prices of raw materials imported
              from other countries. Moreover, since domestic inflation often accompanies
              depreciation/devaluation of the currency, prices of raw materials purchased
              locally will also rise. As costs and prices rise, so will wages. Therefore, if
              there are risks of exchange rate changes, these risks should get reflected in
              estimates of project costs and revenues.
              Different types of exchange rate exposure
              The sensitivity of a firm’s cash flows to changes in exchange rates is called
              exposure. MNCs face different types of exchange rate exposures.
              Some of them are:
              •   Translation exposure
              •   Transaction exposure, and
              •   Economic exposure
                                                                                          227
Principles of Management Control Systems

             Translation exposure
             Fluctuations in exchange rate affect the income statement and balance sheet of
             companies either positively or negatively. The erosion or appreciation in the
             value of earnings, assets and liabilities is referred to as translation exposure.
             This exposure arises because MNCs maintain their accounts in a single
             currency (usually the currency of parent country) whereas the cash inflows are
             in different currencies. For example, the accounts of a US-based MNC would
             be maintained in US dollars, but its cash inflows would be in different
             currencies. As the value of dollar fluctuates against the value of other
             currencies, the figures in the income statement and balance sheet are affected.
             Transaction exposure
             Transaction exposure indicates the exchange rate exposure that the firm has in
             its cross-border transactions, when such transactions are entered into at the
             present time, but payments to settle the transactions are made at some future
             date. If nominal exchange rates change during the interim period, and the




                                                                          09
             payment or receipt commitments are outstanding, the value of transactions is




                                                                     20
             put at risk. Examples of such transactions are receivables and payables, and
             debt or interest payments outstanding, in foreign currencies.
             Economic exposure
                                                               of
                                                           s
             Economic exposure, also referred to as “operating exposure,” or “competitive
                                                        s
                                                     la

             exposure,” is the exchange rate exposure of the firm’s cash flows to changes
             in the real exchange rate.
                                                  C
                                          y
                                        nl




TRANSFER PRICING IN MNCs
                                       O
                                se




             One of the most controversial and often least understood issues in a
             multinational's operations is transfer pricing1. In chapter 7, we explained the
                             U




             basic concept of transfer pricing and the way it is used by domestic firms to
                         S




             achieve goal congruence. In the following sections we will study transfer
                    B




             pricing from an MNC perspective and the ways in which MNCs manipulate
                  rI




             this system for tax gains.
            Fo




             When one subsidiary of an MNC in one country transfers (read sells) goods,
             services or know-how to another subsidiary in another country, the price
             charged for these goods or services is called the 'transfer price'.
             MNCs can manipulate their income by the use of transfer pricing in following
             ways:
             •   MNCs set high transfer prices for subsidiaries in countries with a
                 relatively high rate of taxation.
             •   MNCs set low transfer prices when goods are subjected to high import
                 duties in a particular country.

             1
                 In order to prevent companies from manipulating their incomes using he transfer pricing
                 mechanism, tax authorities may insist on companies adopting the principle of arms length
                 pricing which means that whenever goods are sold by a foreign affiliate to its parent
                 company or vice versa, the transaction should take place as if the two companies were
                 separate entities.
228
                                                   Control in Multinational Corporations


              •   MNCs set relatively high transfer prices for their subsidiaries in countries
                  experiencing hyperinflation and currency devaluation.
              •   MNCs set high transfer prices for goods and services that are purchased
                  by their subsidiaries situated in countries that restrict repatriation of
                  income.
              We will see in the following paragraphs that the transfer price can be set at a
              level which can reduce or even cancel out the total tax which has to be paid by
              an MNC.
              Let us assume that ABC Automobile Company, based in the UK,
              manufactures and assembles automobile components and exports them all
              over the world. It has its main assembling division in the UK but manufactures
              a number of other parts in its plants in the US. The US subsidiary transfers
              certain automobile parts at a transfer price that is fixed by the parent company
              in the UK. This effectively means that the subsidiary belongs to the parent
              company and ultimately it is the parent company that takes all the decisions




                                                                    09
              for the subsidiary.




                                                               20
              The finance director of the parent company explains how income can be
              manipulated for tax gains in four different situations. The first situation is one

                                                           of
              in which the MNC pays some tax to the authorities.
                                                       s
Situation 1 – Paying Some Tax
                                                     s
                                                  la

              Assume that the US subsidiary manufactures one of the automobile
                                               C


              components for $100. It transfers the component to the assembly division in
                                        y




              UK at $200 each and hence makes a profit of $100. The parent company in
                                      nl




              UK sells the same component for $300 in turn making a profit of $100 ($300-
                                     O




              $200). The overall profit is thus $100 in the host country and another $100 in
              the home country, a total of $200.
                                se




              However, one has to consider the tax these companies have to pay on their
                            U




              profits. Tax rates (company or corporation tax) are different in the USA and
                         S




              the UK. Assuming the US subsidiary has to pay corporation tax at the rate of
                    B




              20% on profits, the tax amounts to $20 (20% of $100). The parent company in
                  rI




              UK has to pay tax at the rate of 60% on profits which amounts to $60 (60% of
              Fo




              $100). Overall, tax paid is $80 ($20+$60). This reduces the overall profit
              before tax of $200 to profit after tax of $120 ($200-$80). The US subsidiary
              contributed $80 to this profit, while the parent company in UK contributed
              $40. The after-tax profit generated by the parent company in the home
              country, was smaller because of the corporation tax of 60% which is higher
              than the subsidiary’s tax rate of 20%.
              However, the parent company can tell the subsidiary what to charge and can
              fix the transfer price for the subsidiary. The transfer price is arbitrary, and is
              decided by mutual agreement between the parent company and the subsidiary.

Situation 2-Inflating Profits
              Suppose, the US subsidiary manufactures the part for $100 but sets the
              transfer price at $280 on the advice of the parent company. In this situation the
              profit made by the subsidiary is $180. Assuming that the parent company sells
              it for $300, it will make a profit of $20 in the home country. The total profit

                                                                                            229
Principles of Management Control Systems

             before tax is again $200 but as the profits of the parent and the subsidiary have
             changed so will the taxes. Now the tax paid by the subsidiary will amount to
             $36 (20% of $180) whereas the tax paid by the parent company will be $12
             (60% of $20). In total the tax paid is $36+$12= $48. The overall profit after
             tax now stands at $152 ($200-$48=$152) which is much more than the earlier
             profit of $120. Hence by merely manipulating the transfer price, the company
             has been able to inflate its profits by $32.

Situation 3 - Paying No Tax
             Now, assume that the US subsidiary has increased the transfer price to $300
             on the advice of the parent company. Assume that the parent company buys
             the product at $300 and sells it at the same price. One may think that this does
             not make sense at all but in fact the parent company stands to gain a lot from
             this transfer. When the transfer price is $300, subsidiary makes a profit of
             $200 ($300-$100) whereas the parent company neither makes profit nor incurs




                                                                     09
             any loss. The tax paid by the subsidiary would be $40 (20% of $200) and $0
             by the parent company. The total tax paid is only $40. In this scenario, the




                                                                20
             profit after tax becomes $160. The subsidiary contributes $160 to this while
             parent company's contribution is $0. The parent company has successfully
                                                           of
             shifted all the profits to the subsidiary and hence does not pay any tax in the
                                                        s
             home country. The parent company can shift even more of its profits to the
                                                     s
             subsidiary. It can make a loss and get a tax rebate. This is illustrated by
                                                  la

             situation 4.
                                               C
                                        y




Situation 4 - Getting Tax Rebates
                                      nl
                                     O




             Assume that the subsidiary has now set the transfer price at $400. This means
             that it will make a profit of $300, assuming manufacturing cost remains the
                               se




             same at $100. If the parent company cannot sell the component at $400, then
                            U




             effectively it will incur a loss of $100. In this situation the total tax paid by the
             subsidiary would be $60. As the parent company has incurred losses, it
                        S
                   B




             reduces its tax bill by $60, in effect getting a rebate of $60. It can use this loss
                 rI




             to reduce the tax liability on other profitable operations in the home country.
             Hence the overall result is that the MNC pays no tax at all on this transaction,
             Fo




             and its after-tax profit becomes $200.

Tax Avoidance Inflates Profits
             So, by arbitrarily increasing the transfer price, the company almost doubled its
             after-tax profit. This was done by merely changing book entries and not by
             any change in operations.
             In other words, it is possible for a multinational company to minimize its tax
             liability by manipulating transfer price. This is legal until governments
             enforce laws to prevent this practice. However, in the case discussed above,
             the tax paid to the host country increased while the tax paid to the home
             country decreased gradually. In other words, one government's loss was
             another government's gain. So one government may want to enforce
             legislation against unfair transfer pricing practices, while the other
             government may object to such legislation.
230
                                                 Control in Multinational Corporations


Methods of Transfer Pricing
             Basically, there are three methods of transfer pricing used by MNCs. The
             method adopted depends on the market price of goods that are being
             transferred, the tax structure of the country in which the subsidiary operates
             and the position of the affiliate in the industry. The three methods commonly
             used are:
             •   Market price method
             •   Resale price method
             •   Cost method
             Market price method
             Here, MNCs set transfer prices for their affiliates according to the prevailing
             market price of the particular good or service.
             Resale price method




                                                                  09
             Here, MNCs estimate an appropriate transfer price for a product if it becomes




                                                             20
             an input for another product within a reasonable period of time. In this case,
             the transfer price is the difference between further processing cost plus profit
                                                        of
             markup, and the selling price of the product.
                                                   s s
             Cost method
                                                la

             Here, MNCs determine the transfer price on the basis of the costs incurred by
                                             C


             the affiliate in producing the goods. For this method to be successful, MNCs
                                       y



             need to have sound cost accounting practices and access to the cost structure
                                     nl




             of the affiliate.
                                    O
                               se




CONTROL OF FOREIGN AFFILIATES
                           U




             In 1979, Persen and Lessig conducted a survey of the differences between the
                       S




             financial evaluation of domestic firms and foreign affiliates. There were 106
                   B




             respondents to the survey. The differences as conveyed by the respondents
                 rI




             can be broadly can be categorized into the following five types, based on their
            Fo




             cause:
             •   Currency and exchange rate fluctuation
             •   Translation of currencies
             •   Variation in inflation
             •   Variation in financial and economic conditions
             •   Multiplicity of government regulations and controls
             Currency translation was found to be the most important issue that an MNC
             should consider before designing control systems for its foreign affiliates.

Currency Translation
             We shall understand the effect of currency translation on the performance of
             an affiliate with the help of an example. ABC Inc. is a US-based company

                                                                                         231
Principles of Management Control Systems

                 which has a subsidiary in India. The Indian subsidiary produces electric bulbs
                 which are sold only in the Indian market. Suppose the initial exchange rate of
                 the Indian rupee was Rs.50/$
                 Assuming the subsidiary was given the target of selling goods worth Rs.500,
                 with a corresponding profit of Rs.50 (10% of net revenue as profit). Suppose
                 the Indian rupee depreciates by 10% against the dollar over a period of a year
                 (i.e. it now stands at Rs.55/$). Due to the depreciation, the performance of the
                 subsidiary appears poor in dollar terms, although it has achieved its target in
                 rupee terms. From Table 16.1, we can see that although the budgeted and
                 actual revenues were same in terms of rupees, they were different in terms of
                 dollars. This happened on account of the depreciation of the rupee against the
                 dollar. The loss suffered by the parent company is called ‘Translation Loss’.
                 There is little that parent companies can do to control such exchange rate
                 fluctuations.

   Table 16.1 Budgeted and Actuals for Balanced Subsidiary




                                                                      09
                                Budgeted                               Actual




                                                                    20
                          Rs                $                 Rs.                   $
  Revenue                 500              10
                                                            of500                  9.09
                                                         s
  Profit                   50               1                  50                  0.91
                                                        s
                                                     la

      Source: ICFAI Center for Management Research
                                                 C
                                          y



                 In preparing a report for stockholders, a company has to consolidate the
                                        nl




                 accounts of all its foreign subsidiaries with the accounts of the parent. During
                                       O




                 this process of consolidation currencies of subsidiary countries are translated
                 into the currency of the parent company. The performance of the subsidiary
                                  se




                 should not be affected by such translation gains or losses.
                                U




Budgeting for Foreign Affiliates
                            S
                        B




                 One of the best methods of control an MNC can use over its affiliates is
                      rI




                 budgeting. Budgeting data helps in comparing the actual performance against
                 the budgeted, and helps the management to identify the areas in which greater
                 Fo




                 control is needed. Budgeting can also be used to improve coordination
                 between the affiliates and the parent company. The major problem in
                 budgeting for foreign affiliates pertains to exchange rate fluctuations. Some of
                 the issues involved are:
                 1. Which exchange rates should be used for budgetary planning?
                 2. Which exchange rates should be used for reporting performance?
                 3. Should the managers of foreign affiliates be held responsible for the
                    effects of exchange rate fluctuation?
                 These issues can be resolved by establishing goal congruence and better
                 controllability.
                 Goal congruence
                 The main concern for an MNC while designing a control system is the returns
                 it gets in terms of the parent company's currency. If the parent company is

232
                                              Control in Multinational Corporations


          UK-based then it would like to calculate revenues, profits and dividends in the
          local currency i.e. Pound Sterling. In order to avoid complications due to
          fluctuations in exchange rates, the parent company can budget using exchange
          rates projected for the end of the period.
          Controllability
          Exchange rate fluctuations cannot be controlled by the management of local
          subsidiaries. In a survey conducted by Persen and Lessig, it was found that
          most of the firms used projected exchange rates for budgeting whereas they
          used actual rates for reporting the performance. This leads to discrepancy and
          may reflect a poor performance on the part of the subsidiary even though that
          may not be the case. Hence in order to establish better controllability, it is
          recommended that the same exchange rates be used for budgeting as well as
          reporting performance.

SUMMARY




                                                              09
                                                          20
          MNCs need to control their subsidiaries so that the subsidiaries perform better
          and achieve higher profits. MNCs make use of different types of control
                                                     of
          systems. These include personal controls, output controls, cultural controls,
                                                  s
          action controls, result controls and bureaucratic controls. The headquarters of
                                                s
          the company tries to exercise control over the subsidiaries. This is referred to
                                             la

          as strategic control. Some of the factors that determine the influence of the
                                          C


          headquarters over the subsidiary are: the headquarters-subsidiary environment,
                                   y



          host government demands, joint ventures and global competition. Cultural
                                 nl




          differences across countries, differences in the business environment and local
                                O




          institutions also influence control systems used by MNCs. Geert Hofstede’s
          cultural dimension reveals the cultural dimensions affecting control in an
                            se




          organization. Hofstede's cultural dimensions are individualism, power
                        U




          distance, uncertainty avoidance and masculinity. The environmental elements
          that can greatly affect control systems in an organization are inflation,
                    S




          business risk and uncertainty, labor availability and quality. An MNC
                B




          planning to invest in projects in other countries needs to consider a number of
              rI




          factors before starting operations. Some of the factors are taxes on income
          Fo




          from foreign investment projects, political risks and economic risks. MNCs
          use transfer pricing to manipulate their incomes. Some of the methods of
          transfer pricing are cost method, resale price method and market price method.
          Currency translation is an important issue that an MNC should consider before
          designing a control system for its foreign affiliates. Budgeting is an important
          tool that an MNC to exercise control over its affiliates. One of the major
          problems encountered when budgeting for foreign affiliates pertains to
          exchange rate fluctuations. Exchange rate fluctuations can adversely affect the
          performance of foreign affiliates. In order to solve the problems arising out of
          exchange rate fluctuations, MNCs have to achieve goal congruence and ensure
          better controllability.




                                                                                      233
Chapter 17

Control in Nonprofit



                                                09
Organizations
                                            20
                                          of
                                   ss
                                la

 In this chapter we will discuss:
                              C



 •   Mission of Nonprofit Organizations
                       y
                     nl




 •   Key Characteristics of Nonprofit Organizations
                    O




 •   Designing Control Systems for Nonprofit Organizations
               se




 •   Employee Characteristics and Organizational Culture
            U
         S
       B
     rI
Fo
                                                           Control in Non Profit Organizations


         A nonprofit organization1 is defined as “an organization that does not have
         owners who profit when revenues exceed expenses”. A nonprofit organization
         operates in the interests of society. It does not participate in the equity markets
         since it has no shareholders. The sources of funds for nonprofit organizations
         are contributions, grants, and operating surplus. The activities of a nonprofit
         organization uphold the organization’s stated mission, which describes the
         nature of its contribution to society; profits do not form a part of its mission.
         Most nonprofit organizations provide services. They are run professionally, by
         managers who develop objectives, strategies and budgets. Performance
         reviews are conducted for the employees and they are suitably rewarded.
         Controlling employees, systems and processes in a nonprofit organization is
         different from controlling them in profit seeking organizations. In this chapter
         we will discuss the differences between nonprofit and profit-seeking
         organizations and their implications for control systems.




                                                                           09
MISSION OF NONPROFIT ORGANIZATIONS




                                                                      20
                                                                of
         The major difference between profit seeking and nonprofit organizations is
         their mission. The mission of an organization is explained in its mission
                                                            s
         statement. A mission statement is a written statement of purpose that can be
                                                        s
                                                     la

         used to initiate, evaluate and refine all organizational activities. According to
                                                  C


         Peter Drucker, a mission statement should state the following:
                                         y



         •     Opportunities that an organization can exploit or needs that it can meet
                                       nl




         •     Strengths of an organization
                                      O




         •     Beliefs of members of the organization
                               se




         A mission statement serves as a road map that guides an organization to
                            U




         success. Many organizations recognize the need to have a mission statement
                       S




         and to put this powerful tool into action -- especially nonprofit organizations
                 B




         that sincerely attempt to provide quality services. The basic problem that most
               rI




         nonprofit organizations face is that they find it difficult to measure the success
         Fo




         of their mission. But, contemporary research indicates that this can be done.
         For this purpose, they need first to define their mission clearly. Nonprofit
         organizations have three options to help determine the organization’s success
         in terms of its mission. First, the organization can define its mission narrowly
         so that progress can be measured easily. Second, it can invest in research to
         show how its activities help in achieving the objectives stated in its mission.
         Third, it can develop micro-level goals that if achieved, imply success on a
         bigger scale.



         1
             Though there is no perceived difference between nonprofit and not-for-profit organizations,
             the legal definition differentiates between the two. “Not-for-profit” refers to an activity, for
             example, a hobby (like fishing). "Nonprofit" refers to an organization established for
             purposes other than profit-making. For example, a "nonprofit" organization can be an
             association of people who like fishing.

                                                                                                        235
Principles of Management Control Systems



                                        Exhibit 17.1
                          Mission Statement of Ford foundation
Founded in 1936, the Foundation operated as a local philanthropy in the state of Michigan
until 1950, when it expanded to become a national and inter-national foundation. Since its
inception it has been an independent, nonprofit, nongovernmental organization. It has
provided slightly more than $10 billion in grants and loans. These funds derive from an
investment portfolio that began with gifts and bequests of Ford Motor Company stock by
Henry and Edsel Ford. The Foundation no longer owns Ford Motor Company stock, and its
diversified portfolio is managed to provide a perpetual source of support for the
Foundation's programs and operations.
The Trustees of the Foundation set policy and delegate authority to the president and senior
staff for the Foundation's grant making and operations. Program officers in the United
States, Africa, the Middle East, Asia, Latin America and Russia explore opportunities to
pursue the Foundation's goals, formulate strategies and recommend proposals for funding.




                                                                    09
The Ford Foundation is a resource for innovative people and institutions worldwide. Its
goals are to:




                                                                20
•     Strengthen democratic values,
•     Reduce poverty and injustice,
                                                           of
                                                        s
•     Promote international cooperation and
                                                      s
                                                   la

•     Advance human achievement
                                                C


A fundamental challenge facing every society is to create political, economic and social
                                          y



systems that promote peace, human welfare and the sustainability of the environment on
                                        nl




which life depends. Ford Foundation believes that the best way to meet this challenge is to
                                       O




encourage initiatives by those living and working closest to where problems are located; to
promote collaboration among the nonprofit, government and business sectors, and to ensure
                                 se




participation by men and women from diverse communities and at all levels of society. Such
                               U




activities help build common understanding, enhance excellence, enable people to improve
their lives and reinforce their commitment to society.
                           S
                       B




The Ford Foundation is one source of support for these activities. It works mainly by
                     rI




making grants or loans that build knowledge and strengthen organizations and networks.
                Fo




Since its financial resources are modest in comparison to societal needs, it focuses on a
limited number of problem areas and program strategies within their broad goals.

 www.fordfound.org


KEY CHARACTERISTICS OF NONPROFIT ORGANIZATIONS

                 After studying a number of nonprofit organizations, seven key characteristics
                 of these organizations have been identified:
                 •   Atmosphere of “scarcity”
                 •   Bias towards informality, participation and consensus
                 •   Dual bottom lines: mission and financial

236
                                                      Control in Non Profit Organizations


             •   Difficulty in assessing program outcomes
             •   Governing board with both overview and supporting roles
             •   Mixed skill levels of staff
             •   Participation of volunteers

Atmosphere of “Scarcity”
             There are factual and perceptual components to scarcity in nonprofit
             organizations. Most nonprofit leaders are severely constrained by lack of
             resources. In addition, many nonprofit organizations rely on altruism. As a
             result, they often have underdeveloped infrastructures.

Bias towards Informality, Participation and Consensus
             Nonprofit organizations are characterized by informality, participation and
             consensus. They give less importance to hierarchy. Taken too far, informality




                                                                   09
             can limit the appropriate exercise of authority, over-participation can inhibit
             appropriate division of labor, and the tendency toward consensus can bog




                                                              20
             down decision making.

Dual Bottom Lines: Mission and Financial
                                                         of
                                                      s
             Tension between mission and financial results is fundamental for nonprofit
                                                    s
                                                 la

             organizations. (One can debate to what extent this is unique. For-profit
                                               C


             organizations have increasingly focused on the importance of mission, relative
             to the priority of return on investment. Governmental organizations have
                                       y




             increasingly focused on the importance of mission relative to the priority of
                                     nl




             political impact).
                                    O




             Internally, the tension between bottom lines influences many strategic
                              se




             decisions as well as the sense of “how well the organization is doing” at all
             operational levels. Externally, some stakeholders of a nonprofit organization
                           U




             care about both bottom lines (funders, competitors and regulators) while some
                        S




             stakeholders care primarily about mission (clients and community). The
                   B




             complexity of dual bottom lines figures in many consulting engagements.
                 rI
             Fo




Difficulty in Assessing Program Outcomes
             Most nonprofit organizations have limited capacity for program evaluation.
             This is caused partly by the absence of standardized program outcomes in
             most fields. In childcare for example, standards for adult-child ratios exist, but
             little is standardized in terms of the quality of care delivered. Similarly, arts
             groups, advocacy organizations, mental health agencies and community
             development corporations face substantial challenges in measuring their
             effectiveness. Furthermore, most nonprofit organizations do not have the
             benefit of unambiguous market feedback to let them know how well they are
             serving their clients. Nonprofit organizations exist because neither the market
             nor government is providing the service; most are funded in part or completely
             by sources other than the direct beneficiaries of their work. Thus, assessing
             cost-effectiveness and comparing alternative actions is difficult. Also,
             different individuals may make different assumptions about the relationship
             between cost and effectiveness. Some groups essentially ignore the issue
             assuming their efforts are as effective as they can be.
                                                                                           237
Principles of Management Control Systems


Governing Board with both Overview and Supporting Roles
              The governing board of a nonprofit organization has dual roles: it is
              responsible for ensuring that the public interest is served by the organization,
              and, -- unlike private sector boards of directors or government boards and
              commissions -- is expected to help the organization to be successful. The first
              role is analogous to protecting the interest of stockholders or voters. The
              second role complicates the distinction between governance and management
              because, in this role, board members do staff-like work. As helpers, board
              members may raise funds, send mailings, paint buildings, or do the
              bookkeeping. This can lead to confusion about when, and how, it is
              appropriate for board members to be involved in initiatives at work.
              Furthermore, board members are often not experts in either nonprofit
              management or in the organization's field of service. They may either be
              unprepared to make decisions, or may give up their authority inappropriately




                                                                  09
              to staff.




                                                              20
Mixed Skill Levels of Staff

                                                         of
              The individual’s passion for the mission, the limited financial resources of the
                                                      s
              organization, and a shallow pool of candidates often result in nonprofit
                                                    s
              organizations hiring managers with limited management training and program
                                                 la

              staff with little program experience. Though the staff is often composed of
                                              C


              professionals (e.g. social workers, artists and scientists), since most
                                       y




              organizations are small, there is seldom much internal capacity to provide
                                     nl




              training for staff for the particular roles they are playing.
                                    O
                               se




Participation of Volunteers
                            U




              Many nonprofit organizations rely on the active participation of volunteers.
                        S




              Members of the Board of Directors are normally not paid for their work, and
                    B




              individuals contribute considerable time and effort in delivering services and
                  rI




              providing administrative support. The contribution that volunteers make to the
             Fo




              nonprofit sector is significant; indeed without volunteerism, many needed
              social services would not be available to the public. However, volunteers
              usually have to juggle multiple commitments, and the relative priority they
              assign to their volunteer job may have to be balanced with their paid job,
              family responsibilities, and other volunteer commitments. Board meetings are
              therefore often held in the evenings or on weekends. Finally, there may be
              resentment on the part of certain volunteers that some people are being paid
              for work that they are doing for free, and the feeling that everyone should be
              volunteering.


DESIGNING CONTROL SYSTEMS FOR NONPROFIT ORGANIZATIONS

              Designing a control system for a profit seeking organization is different from
              designing a control system for nonprofit organizations. Some of the reasons
              are:
238
                                                  Control in Non Profit Organizations


          •   Absence of profit measure. This makes performance evaluation difficult.
          •   Separate tax and legal status. Nonprofit organizations are exempted from
              taxation and there are no shareholders.
          •   Most nonprofit organizations provide services rather than products. It is
              difficult to measure the quality and quantity of service.
          •   Fragmented governance due to numerous sources of influence.
          •   Excessive constraints in terms of usage of funds.
          •   Differences in senior management.
          •   Traditionally nonprofit organizations have had poor management controls
              because the management consisted of professionals like teachers, priests,
              doctors, etc. These professionals tended to give greater importance to
              professional goals and did not give requisite value to managerial skills.




                                                              09
EMPLOYEE CHARACTERISTICS AND ORGANIZATIONAL CULTURE




                                                          20
          Employees of a nonprofit organization are different from employees of a

                                                     of
          profit seeking organization. This can have positive or negative implications
          for organizational control. Control problems are usually aggravated when
                                                  s
          employees of nonprofit organizations compare themselves with the employees
                                               s
                                            la

          of profit seeking organizations. For example, compensation of employees in
          nonprofit organizations is usually not competitive when compared to
                                          C



          compensation in profit seeking organizations. A positive aspect for control,
                                   y




          seen in nonprofit organizations, is employee commitment. Because of the
                                 nl




          nature of work, which is quite often philanthropic in nature, employees find it
                                O




          easier to identify themselves with the organization and its goals. High
                           se




          commitment minimizes control problems that may arise due to lack of
          motivation and direction.
                        U




          Cultural characteristics of profit seeking and nonprofit organizations also
                    S




          differ. Nonprofit organizations which are dominated by professionals, have
                B




          little regard for management control systems. These people prefer to
              rI




          concentrate on their profession and undermine the value of MCS. Because of
          Fo




          poor compensation, nonprofit organizations do not attract the best of
          managerial talent too. Absence of performance measurement methods
          compounds this problem. This leads to a culture in which there may be poor
          coordination and lack of trust among employees.

Rewards
          Generally, employees working in profit seeking organizations get better
          compensation and rewards when compared to employees in nonprofit
          organizations. In nonprofit organizations, employees feel rewarded when they
          achieve the goals which form a part of the mission statement of the
          organization. For example, employees of a nonprofit organization that is
          working towards preventing the spread of AIDS will feel rewarded when the
          rate at which the disease is spreading decreases. As financial rewards are
          negligible in nonprofit organizations, achieving the goals in the mission
          statement keeps employees motivated. However, there are exceptions to this

                                                                                     239
Principles of Management Control Systems


             generalization. In certain nonprofit organizations like universities and research
             organizations, employee compensation is better than in private sector
             companies.

Performance Measurement
             Measuring performance of nonprofit organizations is difficult and arduous
             because most nonprofit organizations provide services which are measured in
             qualitative terms rather than quantitative terms. Without a quantifiable
             performance indicator, it is difficult: -
             •    to measure organizational performance in light of the overall goals and to
                  use results control at the broad organizational level;
             •    to analyze the benefits of alternative courses of action
             •    to decentralize the organization and hold sub-unit managers responsible
                  for specific areas of performance; and




                                                                    09
             •    to compare the performance of sub-units which are performing dissimilar
                  activities.




                                                               20
             It has been observed that many nonprofit organizations, irrespective of their

                                                          of
             mission, scope and needs, design three types of performance metrics. They
             are:
                                                    s  s
             •    Success in mobilizing resources
                                                 la

             •    Effectiveness of staff on the job
                                              C



             • Progress in fulfilling the mission
                                       y
                                     nl




             The way these metrics can be applied differs from organization to
                                    O




             organization. For example, for a museum, the performance of its staff will be
             rated on basis of the number of people who visited the museum. Of these three
                               se




             metrics, the first two are easy to develop but measuring the success of a
                            U




             nonprofit organization in terms of the achievement of its mission, is difficult.
                        S




Fund Accounting
                    B
                  rI




             “Fund accounting” is an accounting system used by many nonprofit
            Fo




             organizations. In this system, accounts are kept separately for several funds,
             each of which is self-balancing, with the sum of debit balances equaling the
             sum of credit balances.
             Most nonprofit organizations have: (1) a general fund or operating fund,
             which corresponds to the set of operating accounts; (2) a plant fund and an
             endowment fund, which account for contributed capital assets and equities and
             (3) a variety of other funds for special purposes.

Programming and Budget Preparation
             Compared to a typical business, programming is a more important and time-
             consuming process in a nonprofit organization, where a decision has to be
             made on how best to allocate limited resources to worthwhile activities.
             Nonprofit organizations have to work within their budgets and cannot exceed
             the set monetary limits because they do not market their services to increase

240
                                                  Control in Non Profit Organizations


          their revenues. They limit their expenditure and aim to break even at the
          estimated amount of revenue. Hence, the budget is a very important
          management control tool for a nonprofit organization.

SUMMARY

          A nonprofit organization is defined as an organization that does not have
          owners who profit when revenues exceed expenses. Nonprofit organizations
          such as hospitals, government organizations, fraternal organizations and
          religious institutions play a vital role in society. The major difference between
          profit seeking and nonprofit organizations is their mission. Nonprofit
          organizations are passionate about their mission. Their main aim is to achieve
          the goals listed in their mission statement. Controlling employees, systems
          and processes in a nonprofit organization is different from controlling them in
          profit seeking organizations. Nonprofit organizations provide services, not in
          order to create wealth for their shareholders but to meet a felt need. The




                                                               09
          reasons why control systems of a nonprofit organization ha