What Key Factors Should Risk Officers Consider When Using Generative AI
Mba 518
1. Punjab Technical University
World over distance Education is fast growing mode of education because of the unique benefits
it provides to the learners. Universities are now able to reach the community which has for so
long been deprived or higher education due to various reasons including social, economic and
geographical considerations. Distance Education provides them a second chance to upgrade their
technical skills and qualifications.
Some of the important considerations in initiating distance education in a country like India, has
been the concern of the government in increasing access and reach of higher education to a larger
student community. As such, only 6-8% of students in India take up higher education and more
than 92% drop out before reaching 10+2 level. Further, avenues for upgrading qualifications,
while at work, is limited and also modular programs for gaining latest skills through continuing
education programs is extremely poor. In such a system, distance education programs provide
the much needed avenue for:
z Increasing access and reach of higher education:
z Equity and affordability of higher education to weaker and disadvantaged sections of the
society;
z Increased opportunity for upgrading, retraining and personal enrichment of latest
knowledge and know-how;
z Capacity building for national interests.
One of use important aspects of any distance education program is the learning resources.
Learning material provided to the learner must be innovative, thought provoking,
comprehensive and must be tailor-made for self-learning. It has been a continuous process for the
University in improving the quality of the learning material through well designed course
materials in the SIM format (self-instructional material). While designing the material, the
university has researched the methods and process of some of the best institutions in the world
imparting distance education.
About the University
Punjab Technical University (PTU) was set up by the Government of Punjab in 1997 through a
state Legislative ACT. PTU started with a modest beginning in 1997, when University had only
nine Engineering and thirteen Management colleges affiliated to it. PTU now has affiliated 43
2. Engineering colleges, 56 colleges imparting Management and Computer Application courses, 20
institutions imparting pharmacy education, 6 Architecture institutions, 2 Hotel Management and
12 Regional Centres for imparting M. Tech and Ph. D Programs in different branches of
Engineering and Management. During a short span of nine years, the University has undertaken
many innovative programs. The major development during this period is that University has
restructured its degree program and upgraded syllabi of the course in such a way as to increase
the employability of the student and also to make them self-reliant by imparting Higher
Technical Education. We at Punjab Technical University are propelled by the vision and wisdom
of our leaders and are striving hard to discharge our duties for the overall improvement of
quality of education that we provide.
During a short span of nine years, the University has faced various challenges but has always
kept the interest of students as the paramount concern. During the past couple of years, the
University has undertaken many new initiatives to revitalize the educational programs imparted
with the colleges and Regional centers.
Though knowledge and skills are the key factors in increasing the employability and competitive
edge of students in the emerging global environment, an environment of economic growth and
opportunity is necessary to promote the demand for such trained and professional manpower.
The University is participating in the process of technological growth and development in
shaping the human resource for economic development of the nation.
Keeping the above facts in mind Punjab Technical University, initiated the distance education
program and started offering various job oriented technical courses in disciplines like information
technology, management, Hotel Management, paramedical, Media Technologies and Fashion
Technology since July 2001. The program was initiated with the aim of fulfilling the mandate of
the ACT for providing continuing education to the disadvantaged economically backward
sections of society as well as working professionals for skill up-gradation.
The University has over the years initiated various quality improvement initiatives in running its
distance education program to deliver quality education with a flexible approach of education
delivery. This program also takes care of the overall personality development of the students.
Presently, PTU has more than 60 courses under distance education stream in more than 700
learning centers across the country.
3. About Distance Education Program of PTU
Over the past few years, the distance education program of PTU has gained wide publicity and
acceptance due to certain quality features which were introduced to increase the effectiveness of
learning methodologies. The last comprehensive syllabus review was carried out in the year 2004-
05 and the new revised syllabus was implemented from September 2005. The syllabus once
reviewed is frozen for a period of 3 years and changes, if any, shall be taken up in the year 2008.
Various innovative initiatives have been taken, which has increased the popularity of the
program. Some of these initiatives are enumerated below:
1. Making a pyramid system for almost all courses, in which a student gets flexibility of
continuing higher education in his own pace and per his convenience. Suitable credits are
imparted for courses taken during re-entry into the pyramid as a lateral entry student.
2. Relaxed entry qualifications ensure that students get enough freedom to choose their
course and the basics necessary for completing the course is taught at the first semester
level.
3. A comprehensive course on „Communications and Soft Skills‰ is compulsory for all
students, which ensures that students learn some basic skills for increasing their
employability and competing in the globalized environment.
4. Learning materials and books have been remodeled in the self-Instructional Material
format, which ensures easy dissemination of skills and self-learning. These SIMs are given
in addition to the class notes, work modules and weekly quizzes.
5. Students are allowed to take a minimum of 240 hours of instruction during the semester,
which includes small group interaction with faculty and teaching practical skills in a
personalized manner.
6. Minimum standards have been laid out for the learning centers, and a full time counselor
and core faculty is available to help the student anytime.
7. There is a wide network of Regional Learning and Facilitation Centers (RLFC) catering to
each zone, which is available for student queries, placement support, examination related
queries and day-to-day logistic support. Students need not visit the University for any of
their problems and they can approach the RLFC for taking care of their needs.
8. Various facilities like Free Waiver for physically challenged students, Scholarship scheme
by the government for SC/ST candidates, free bus passes for PRTC buses are available to
students of the University.
The university continuously aims for higher objectives to achieve and the success always gears us
for achieving the improbable. The PTU distance education fraternity has grown more than 200%
during the past two years and the students have now started moving all across the country and
abroad after completing their skill training with us.
We wish you a marvelous learning experience in the next few years of association with us!
DR. R. P. SINGH
Dean
Distance Education
4. Dr. S. K. Salwan
Vice Chancellor
Dr. S. K. Salwan is an eminent scientist, visionary and an experienced administrator. He is a
doctorate in mechanical engineering from the IIT, Mumbai. Dr. Salwan brings with him 14 years
of teaching and research experience. He is credited with establishing the Department of Design
Engineering at the institute of Armament Technology, Pune. He was the founder-member of the
integrated guided missile programme of defence research under His Excellency Honorable Dr.
A.P.J. Abdul Kalam. He also established the high technology missile center, RCI at Hyderabad.
He has been instrumental in implementing the Rs 1000-crore National Range for Testing Missiles
and Weapon Systems at Chandipore, Balance in a record time of three years. He was director of
the Armament Research and Development Establishment, Pune. Dr. Salwan has been part of
many high level defence delegations to various countries. He was Advisor (Strategic project) and
Emeritus Scientist at the DRDO. Dr. Salwan has won various awards, including the Scientist of
the Year 1994; the Rajiv Ratan Award, 1995, and a Vashisht Sewa Medal 1996, the Technology
Assimilation and Transfer Trophy, 1997 and the Punj Pani Award in Punjab for 2006.
Dr. R.P. Singh
Dean, Distance Education
Dr. R.P. Singh is a doctorate in physics from Canada and has been a gold medallist of Banaras
Hindu University in M.Sc. Dr. Singh took over the Department of Distance Education in
November 2004 and since then the University has embarked on various innovations in Distance
Education.
Due to combined efforts of the department, the RLFCÊs and Centers, and with active support of
the Distance Education Council headed by Dr. O.P. Bajpai, Director University College of
Engineering Kurukshetra University the distance education program of PTU is now a structured
system which empowers the learner with requisite skills and knowledge which can enhance their
employability in the global market. Dr. R. P. Singh is promoting distance education at the
national level also and is a founder member of Education Promotion Society of India and is
member of various committees which explores innovative ways of learning for the disadvantages
sections of society. The basic aim of the distance education programs has been to assimilate all
sections of society including women by increasing the access. Reach, equity and affordability of
higher education in the country.
5. MANAGEMENT CONTROL
SYSTEM
MBA – 518
This SIM has been prepared exclusively under the guidance of Punjab Technical University (PTU)
and reviewed by experts and approved by the concerned statutory Board of Studies (BOS). It
conforms to the syllabi and contents as approved by the BOS of PTU.
7. PTU DEP SYLLABI-BOOK MAPPING TABLE
MBA – 518 MANAGEMENT CONTROL SYSTEM
Syllabi Mapping in Book
Section I
Management Control System: Basic concepts, nature and scope.
Control environment – Concept of goals and strategies.
Behavioral considerations.
Responsibility Centers: Revenue and expense centers, Profit
centers, Investment centers.
Section II
Transfer Pricing: Objectives and methods.
Budgeting: Budget preparation, Types of budgets. Behavioral
aspects of budgets.
Section III
Variance analysis and reporting. Performance analysis and
measurement. Impact on management compensation.
Modern Control Methods: JIT, TQM and DSS. Control in service
organisations.
Unit 1: Introduction to
Management Control System
(Page 3-14)
Unit 2: Responsibility Centres
(Page 15-29)
Unit 3: Transfer Pricing
(Page 33-37)
Unit 4: Budgeting
(Page 39-68)
Unit 5: Variance Analysis
and Reporting
(Page 71-92)
Unit 6: Modern
Control Methods
(Page 93-105)
9. Contents
Section-I
UNIT 1 INTRODUCTION TO MANAGEMENT CONTROL SYSTEM 3
Introduction
Basic Concepts
Characteristics of a Management Control System (MCS)
Nature of Management Control
Scope of MCS
Control Environment
Behavioural Considerations
Summary
Keywords
Review Questions
Further Readings
UNIT 2 RESPONSIBILITY CENTRES 15
Introduction
Expense Centre
Cost Centre
Profit Centres
Investment Centre
Residual Income (RI)
Summary
Keywords
Review Questions
Further Readings
Section-II
UNIT 3 TRANSFER PRICING 33
Introduction
Objectives of Transfer Pricing
Methods of Transfer Pricing
Summary
Keywords
Review Questions
Further Readings
UNIT 4 BUDGETING 39
Introduction
Process of Budget Preparation
Classification of Budget
Sales Budget
10. Sales Overhead Budget
Cash Budget
Factory Overheads Budget
Flexible Budget
Zero-base Budgeting
Behavioural Aspects of Budgeting
Summary
Keywords
Review Questions
Further Readings
Section-III
UNIT 5 VARIANCE ANALYSIS AND REPORTING 71
Introduction
Variance Analysis
Material Cost Variance (MCV)
Material Price Variance
Overhead Variance
Sales Variance
Reporting
The Budget
Summary
Keywords
Review Questions
Further Readings
UNIT 6 MODERN CONTROL METHODS 93
Introduction
JIT
Total Quality Management
Decision Support System (DSS)
Summary
Keywords
Review Questions
Further Readings
11. SECTION-I
Unit 1
Introduction to Management Control System
Unit 2
Responsibility Centres
12. Introduction to
Management Control System
Notes
Punjab Technical University 3
Unit 1 Introduction to
Management
Control System
Unit Structure
• Introduction
• Basic Concepts
• Characteristics of a Management Control System (MCS)
• Nature of Management Control
• Scope of MCS
• Control Environment
• Behavioural Considerations
• Summary
• Keywords
• Review Questions
• Further Readings
Learning Objectives
At the conclusion of this unit you should be able to:
• Define management control system.
• Describe features, nature and areas of management control
• Know what are the goals and strategies of effective control system
• Discuss the behavioural aspects of management control system
Introduction
Management controls are used daily by managers and employees to accomplish the
identified objectives of an organization. Simply put, management controls are the
operational methods that enable work to proceed as expected. Most controls can be
classified as preventive or detective. Preventive controls are designed to discourage
errors or irregularities. For example:
z A manager's review of purchases prior to approval prevents inappropriate
expenditures of office funds.
z A computer program which asks for a password prevents unauthorized
access to information.
Detective controls are designed to identify an error or irregularity after it has
occurred. Examples include the following:
z An exception report that detects and lists incorrect or incomplete transactions.
z A manager's review of long distance telephone charges will detect improper
or personal calls that should not have been charged to the account.
Often, management controls are documented in terms of policies and procedures.
However, sometimes as an organization undergoes structural and functional changes,
13. Management Control System
Notes
4 Self-Instructional Material
people within the organization create or adopt ways of ensuring that work proceeds
normally. Many times, these methods (controls) are not documented. The purpose of
a Management Control Review (MCR) is to evaluate the entire system or management
controls to help your unit operate more efficiently and effectively, and to provide a
reasonable level of assurance that the process and products for which you are
responsible are adequately protected.
A MCR provides a variety of benefits which promote sound management, including
the following:
z Ensuring that administrative, financial, and programmatic risks have been
adequately addressed.
z Eliminating excessive controls that may have accumulated over the years,
allowing for more efficient operations.
z Increased confidence that responsibilities are being carried out according to
plan.
Basic Concepts
Management Control is a process of assuming that resources are obtained and used
effectively and efficiently in the accomplishment of the organisationÊs objectives.
Some leading definitions of managing control are as follows:
„Management Control seeks to compel events to conform to plans.‰
·Billy, E. Goaz
„Some sort of systematic effort to compare current performance to a predetermined plan or
objective, presumably in order to take any remedial action required.‰
·William Travers Jerome
Control, in its managerial sense, can be defined as, „the presence of that force in a business
which guides it to a predetermined objective by means of predetermined policies and
decisions.‰
·Mc Farland, D.E.
„Control is that function of the system which provides direction in conformance to the plans.‰
·Rosen, J.K.
The above definitions indicate very clearly that management control has to do with
the outgoing operation of the business. Control is a fundamental necessity for the
success of a business. It is the function of the management that helps realisation of the
business objectives. From time to time current performance of the various operations
is compared to a predetermined standards or ideal performance and in case of
variance remedial measures are adopted to conform operations to the set plan or
policy.
Characteristics of a Management Control System
(MCS)
The main characteristics of Management Control are the following:
1. A Total System: Management Control System is a total system as it covers all
aspects of the companyÊs operations. It is an overall process of the enterprise
to fit together the separate plans for various segments so as to assure that
each harmonises with one another and that the aggregate effect of all of them
on the whole enterprise is satisfactory.
14. Introduction to
Management Control System
Notes
Punjab Technical University 5
2. Monetary Standards: Barring some exceptions, the MCS is built around a
financial structure and all the resources and outputs are expressed in terms of
money. The results of each responsibility centre, in respect to production and
resources, are expressed in terms of the common denominator of money.
3. Definite Pattern: The management control process follows a definite pattern
and timetable. The whole operational activity is regular and rhythmic. It is a
continuous process even if the plans are changed in the light of experience or
change in technology.
4. Coordinated System: Management Control System is fully coordinated and
integrated system. For instance, if the information for one purpose varies
from that collected for another purpose, the data reconcile with one another.
It is, therefore, more feasible to consider the interlocking sub-processes as a
single set for achieving the objectives of the enterprise.
5. Line Managers: Figures themselves are nothing more than marks on pieces of
paper. Anything that the business accomplishes is the result of the actions of
the people. Information collected from various sources has to be properly
organised. The line managers are the focal points in management control
system who alone can influence others to improve the performance. Business
budgets are prepared on their advice and suggestion. They can encourage
persons to work efficiently in the interests of the enterprise as to achieve the
objectives set forth.
6. Emphasis: Management control emphasises on search for planning as well as
control. Both should go hand in hand to achieve the best results. It has an
organisational aspect also inasmuch as lines of communication are required
for the collection and transmission of control information.
Nature of Management Control
It is through control that the management assures itself that what the organisation
does conform to management plans and policies. Accounting information is used in
control as a means of communication of motivation and of appraisal. It is not
managementÊs job to work personally but it sees to it that the work gets done by
others. Control is an important element of the process of managing. In managerial
terminology, control is ensuring work accomplishment according to plans. It is the
process that guides and controls operations towards some predetermined goods.
According to Prof. R.N. Anthony „Management control is the process by which
managers assure that resources are obtained and used effectively and efficiently in the
accomplishment of an organisationÊs objectives.‰ It seeks to compel events to conform
to plans. It is a process by which the people in the organisation are made to work
properly and most efficiently with a view to attain the best results. It is concerned
with measuring and evaluating performance so as to secure the best results under the
circumstances. An effort is made to compare the current performance to a
predetermined objective or plan. Thus control is a fundamental function of the
management to ensure work accomplishment according to predetermined plans and
standards.
Other Characteristics of control are as follows:
1. Control is an essential function of every manager: Managers at every level
have to focus attention towards future operational and accounting data taking
into consideration past performance, present trends and anticipated economic
and technological changes. The nature, scope and level of control will be
governed by the level of manager exercising it.
15. Management Control System
Notes
6 Self-Instructional Material
2. Control implies the existence of goals and plans: Without predetermined
goals and plans management control is not possible. These two provide a link
between such future anticipations and actual performance, as the future gets
converted into present and past with the passage of time. Managers quantify
their hopes and ambitions of the future on a realistic basis and to use them
later as standards for measurement of actual performance. In the absence of
objections and goals the results are likely to be different from what desired.
Plans complement objectives which can be attained on the basis of proper
plans. Policy sets the intention while control looks and ascertains how far the
objectives are attained.
3. Control is forward looking: Planning is the process of deciding what action
should be taken in the future. One cannot change the events that have
happened in the past. The nature of managerial control is forward looking. It
is on the basis of evaluation of past performance that the future plans or
guidelines can be laid down. Management control involves managing the
overall activity of the enterprise for the future. It prevents deviations in
operational goals.
4. Management Control a continuous process: Control is a continuous process
over the human and material resources. It demands eternal vigilance of every
step. Regulating the activities of people associated in the common task of
attaining the objectives of the organisation is the primary aim of management
control which requires strict and careful vigilance. Success can be achieved
only when the management controls the men and circumstances around him
on a regular basis. Business conditions are always changing so management
must be always adapting itself to the changed circumstances. Therefore,
management control is a continuing activity.
5. People oriented: Management control is significant to internal control system
as its approach is people oriented. People assume a new role, attitudes, and
motivations under a sound management. Control is attained through people
and not lifeless materials. It is the managers, engineers and operators who
implement the ideas and objectives of the management. It is people who
make or mar a thing. The coordination of the main divisions of a concern
makes for smoother operation and less friction which results in the
achievement of predetermined objectives.
Scope of MCS
Managerial Control, as we know, is an important process in which accounting
information is used as to accomplish the organisationÊs objectives. Therefore, the
scope of control is very wide that covers a broad range of management activities.
According to Holden, Fish and Smith the main areas of control are as follows:
1. Policies Control: The success of a business hangs on formulation of sound
policies and their proper implementation. There is a great need of control
over policies.
2. Control over Organisation: For the control over organisation the
management uses organisationÊs manual and organisational chart. Designing
and organising various departments for the smooth running of the business is
very essential. If any problem or conflict arises the management control
attempts to remove the causes of such frictions and rationalise the
organisational structure as to ensure its efficient working.
3. Control over Personnel: Anything that the business accomplishes is the result
of the action of those people who work in the organisation. It is the people,
16. Introduction to
Management Control System
Notes
Punjab Technical University 7
not figures, that get things done. The personnel manager is responsible to
draw a control plan for having control over the personnel of the concern.
4. Control over Wages and Salaries: Control over wages and salaries is
sometimes assigned to the personnel department or a specially constituted
wage and salary committee.
5. Control over Costs: The cost accountant who is responsible to control costs
sets cost standards, labour material and overheads. He makes comparisons of
actual cost data with standard cost. Cost control is a delicate task and is
supplemented by budgetary control systems.
6. Control over Techniques: It implies the use of best methods and techniques so
as to eliminate all wastage in time, energy and material. The task is
accomplished by periodic analysis and checking of activities of each
department with a view to avoid and eliminate all non-essential motions,
functions and methods.
7. Control over Capital Expenditure: Various projects entailing huge amounts
require control. This is exercised through a system of evaluation of projects in
terms of capital. Capital budget is prepared for the whole concern. Every
project is evaluated in terms of the advantages accruing to the firm. For this
purpose capital budgeting, project analysis, breakeven analysis, study of cost
of capital etc. are carried on extensively.
8. Production Control: The function of production control is to plan, organise,
direct and control the necessary activities to provide products and services.
Once the production system is designed and activated the problems arise in
the areas of production, planning and control. Market needs and attitudes of
consumers are studied minutely for revision in product lines and their
rationalising. Routing, scheduling, dispatching, follow up, Inventory control,
Quality control are the various techniques of production control.
9. Overall Control: A master plan is prepared for overall control and all the
concerned departments are made to involve in this procedure.
10. Control over External Relations: Public relations department should always
be alert in improving external relations. It may also prescribe norms and
measures for other operating departments to insist on cordial relations with
all the parties.
11. Control over Research and Development: Research activities, being technical
in nature, cannot be controlled directly. But it should be seen that all facilities
are provided to the research staff to improve their ability and keeping in
touch with the up-to-date techniques and devices. Training facilities should
also be provided by having a research budget in the business.
Process of Control
1. Well-defined Objectives and Goals: The objectives and goals of the
organisation should be crystal clear and well-defined in the process of
control. The organisational goals should be split into sub-goals at
departmental level. The operation of the various functions and their
coordination should be vested in the hands of the executives who are armed
with sufficient authority or power to fulfil their responsibility. The planned
goals of the enterprise or of a particular department serve as a standard for
performance measurement.
2. Determination of Strategic Point of Control: The responsibility centres and
strategic points of control should be selected and fixed. To make the control
17. Management Control System
Notes
8 Self-Instructional Material
process effective, the management should concentrate upon strategic points
only.
3. Establishment of Control Standards: These standards are established criteria
against which actual performance can be compared and measured in terms of
money, time, physical units or some other index. The object of predetermined
standards is that comparison between actual performance and targets
performance is made possible. Continuous comparison is very necessary. This
requires tabulating the targets framed, collecting and collating data regarding
actual performance and reporting variations periodically to the controlling
authorities. It is obvious that control is not possible unless actual performance
and the standard against which it is being measured are comparable.
4. Determination of Controllable Costs and Control Period: Optimum control
does not mean excessive control. Sometimes good results are achieved only if
critical points are identified. Secret of good control is to establish strategic
points where corrective actions will be the cheapest and most effective.
5. Strengthening the Organisation: The complete framework of control is aimed
at strengthening the organisation. Planning is a prerequisite. Control should
be tailored to fit the organisation. There should be a system of checks on the
managerial activity of subordinates. The organisation should be strengthened
first to overcome the weaknesses of deviations. Controls should incorporate
sufficient flexibility in them so as to remain effective despite the failure of
plan.
6. Measurement of Performance: It is not only a process of comparison of actual
performance with the objectives, but to initiate steps to achieve the objective.
This is done without encroaching upon the authority and scope of authority
of the manager concerned. The evaluation of performance is very necessary. It
involves the measurement of performance in respect of work and in terms of
control standards. In the opinion of Peter F. Drucker, the measurement of
performance must be clear, simple, rational, relevant and reliable. The
effectiveness of a control system depends upon the prompt reporting of past
results to the persons who have power to produce changes. The next step is to
compare the performance with the planned standards. It is important to
determine the limits within which the variations can be held and still to be
regarded within control when performance is measured accurately. The
management is not only required to find out the extent of variations but the
causes of variations must also be ascertained correctly. The manager should
be able to distinguish between minor and unimportant variation and
variations indicating need for immediate correction. To assess whether actual
performance is in accordance with the target comparison with the standard
has to be made and the variation is properly analysed to understand the
reason for the variation. The comparison should be done at frequent intervals
so that immediate corrective action could be taken.
7. Control Period: The proper control period is the shortest period of time in
which management can usefully intervene and in which significant changes
in performance are likely. The period is different for different responsibility
centres and for different items within responsibility centres. Spoilage rates in
a production operation may be measured hourly or often. The key cost
element of the centre may be measured daily. Reports on overall
performance, particularly those going to the levels of management are often
on a monthly basis and sometimes for quarterly or longer intervals, since top
management does not have either the time or the inclination to explore the
local temporary problems.
18. Introduction to
Management Control System
Notes
Punjab Technical University 9
Adequate or Effective Control System
Management control is that function of the managers, next in line to top level, by
which they ensure that the objectives of the organisation are achieved. It is not only a
process of comparison of actual performance with the objectives but to initiate steps
to achieve the object, if not achieved. This is done without encroaching upon the
autonomy and scope of authority of the manager concerned. This involves the
assessment of a managerÊs performance in quantitative terms and at the same time
not to lay too much emphasis on quantitative data. In fact, some of the objectives
themselves cannot be exactly quantified, for instance, objectives in respect of research
and development, industrial relations etc. Thus management control is the process by
which managers assume that resources are obtained and used effectively, and
efficiently in the accomplishment of organisationÊs objectives.
„Since Management control involves the behaviour of human beings, the relevant
principles are those drawn from such disciplines as social psychology and
organisational behaviour rather than from Economics, Mathematics or any
discipline.‰ The following are important requirements for making any control system
effective in application :
1. Control by Objectives: The control must be goal-oriented and by objectives.
As objectives classify the expected results in meaningful and realistic terms,
they provide the control standards by which actual performance can be
measured. The control system should be according to the nature and needs of
organisation.
2. Direct Control: Control should be exercised on people who work on
machines and materials. Thus, it should be employee-oriented rather than
work-oriented. It is people who resent control and not the inanimate articles.
It is, therefore, necessary to alter the attitude of personnel who oppose control
measures. An attempt should be made to understand the attitude of the
people by proper education.
3. Forward Looking Control: Control should always be forward looking. It
should bring out the deviation in light as soon as possible. It must focus on
strategic points with exception.
4. Managerial Self-Control: Control should be enforced through managerial
positions in the organisational structure. Each Manager must be vested with
adequate authority for exercising control and taking decisions. Alleviation of
duties and responsibilities goes a long way towards securing effective control
in the organisation.
5. Simple and Balanced Control: To be effective control must be simple and
well-balanced. Any control device which is not intelligible cannot be put in
practice. So, control lines must-be simple and intelligible both to the controller
and the controlled.
6. Flexibility: There should be nothing like rigidity in control. Even the best
plans and other predetermined criteria need to be charged from time to time
to meet a particular situation. However, an effective control system should
retain its basic structure.
7. Economy: A simple control system is bound to be economical. It should not be
cumbersome and expensive. Economy is the basic requirement of any good
control system.
8. Feedback: Feedback is the process of adjusting future actions based upon
information about past performance. Recently this concept of feedback has
19. Management Control System
Notes
10 Self-Instructional Material
received considerable attention. It proves the worth and utility of control
process.
Control should not be negative. It should be positive, constructive and helpful.
Control is not a command; it is guidance. The system is really concerned with
arrangements for implementing the decisions made in strategic planning.
Control Environment
The COSO framework describes the control environment as setting the tone of an
organization and influencing the control consciousness of its people. An effective
control environment supports and strengthens the other control elements, whereas a
weak control environment undermines the other elements, rendering them useless. In
an effective control environment, employees know that doing the right thing is
expected and will be supported by upper level management, even if it hurts the
bottom line. In a weak environment, control procedures are frequently overridden or
ignored, providing an opportunity for fraud.
Traditionally, auditors' assessments of the control environment have included issuing
a questionnaire to senior management to determine whether management policies
and procedures, such as a code of ethics, have been implemented. The problem with
this approach is that it measures management's efforts to create a sound environment,
not its effectiveness in doing so. A more direct method of evaluating whether
management has created an environment in which ethical behavior is encouraged is
for internal auditors to survey the people who work in that environment. The focus of
the assessment should not be on the message management thinks it is sending, but on
the message employees are actually receiving.
The control environment is one of the key components of an entity's internal control;
it sets the tone of an entity, influences the control consciousness of people within all
organization and is the foundation for all other components of the internal control
system.
Management is responsible for evaluating and reporting on a company's controls. The
external auditors are responsible for auditing management's assertion and
independently coming to their own conclusions about the company's internal control
effectiveness. They must evaluate management's assessment and also perform their
own, independent tests in many areas, including the control environment.
z The control environment has a pervasive structure that affects many business
process activities. It includes elements such as management's integrity and
ethical values, operating philosophy and commitment to organizational
competence.
z Adding to the difficulty of the task is the fact that the control environment is
not transaction-oriented. Tests of controls that auditors are accustomed to
performing, such as walk-through or the re-performance of the control for a
sample of items, will not be possible. And focusing solely on activity-level
controls is inappropriate.
z Tests of the Control Environment will consist of a combination of procedures,
including a review of relevant documentation of the design, inquiries of
management and employees and direct observation.
z Auditors will have to probe for understanding and awareness and try to
understand the company's attitude toward internal control over financial
reporting. They also should ask management for a self-assessment.
20. Introduction to
Management Control System
Notes
Punjab Technical University 11
Practical Tips to Remember
z Don't focus your internal control tests exclusively on activity-level controls.
You have to evaluate and test the control environment, too.
z Establish a benchmark, such as the internal control reliability model, that will
be used to gauge internal control effectiveness. Use this model to design your
tests of the control environment.
z Use several different testing techniques to gather information about the
control environment from a broad range of entity personnel.
Student Activity
„Environmental surveillance on an ongoing basis, for understanding the nature
and implications of the emerging developments and their implications for the
effective control system, is imperative.‰ Describe the statement with suitable
examples.
Concept of Goals and Strategy
A strategy invariably indicates the long-term goals toward which all efforts are
directed. For example, long-term goals might be to Âdominate the market, to be the
technology leader or to be the premium quality firmÊ. Such enduring goals help
employees give their best in a unified manner and enable the firm to specify its
competitive position very clearly to its rivals.
Strategy is the overall plan of a firm deploying its resources to establish a favourable
position and compete successfully against its rivals. Strategy describes a framework
for charting a course of action. It explicates an approach for the company that builds
on its strengths and is a good fit with the firmÊs external environment. It is basically
intended to help firms achieve competitive advantage. Competitive advantage allows
a firm to gain an edge over rivals when competing. Competitive advantage comes
from a firmÊs unique ability to perform activities more distinctively and more
effectively than rivals. A firmÊs distinctive competence or unique ability here implies,
those special capabilities, skills, technologies or resources that enable a firm to
distinguish itself from its rivals and create competitive advantage (such as superior
quality, design skills, low-cost manufacturing, superior distribution etc.). The term
ÂterrainÊ is highly relevant in explaining the concept of strategy more clearly. From a
business sense, terrain refers to markets, segments and products used to win over
customers. The essence of strategy is to match strengths and distinctive competence
with terrain in such a way that oneÊs own business enjoys a competitive advantage
over rivals competing in the same terrain. The basic premise of strategy, as things
stand now, is that an adversary can defeat a rival–even a larger, more powerful one–if
it can maneuver a battle or engagement onto a terrain favourable to its own
capabilities. The term ÂcapabilityÊ refers to the ability or capacity of a bundle of
resources deployed by a firm to perform an activity (Pitts and Lie).
Elements of a Strategy
Any coherent strategy (as the above expert opinions reveal) should have four
important elements (Saloner et al):
a. Goals: A strategy invariably indicates the long-term goals toward which all
efforts are directed. For example long-term goals might be to Âdominate the
market, to be the technology leader or to be the premium quality firmÊ. Such
enduring goals help employees give their best in a unified manner and enable
the firm to specify its competitive position very clearly to its rivals. A recent
21. Management Control System
Notes
12 Self-Instructional Material
advertisement from Maruti Suzuki for example, claims: „we donÊt just sell
more cars than No.2. We sell more cars than the entire competition put
together‰. MarutiÊs commitment to being number one (sales, distribution
network, lowest cost producer, highest resale value, one stop solution
provider etc) or two in the markets it serves, sends clear signals to its rivals in
more than one way.
b. Scope: A strategy defines the scope of the firm that is, the kind of products the
firm will offer, the markets (geographies, technologies, processes) it will
pursue and the broad areas of activity it will undertake. It will, at the same
time, throw light on the activities the firm will not undertake.
c. Competitive Advantage: A strategy also contains a clear statement of what
competitive advantages the firm will pursue and sustain. Competitive
advantage arises when a firm is able to perform an activity that is distinct or
different from that of its rivals. Firms build competitive advantage when they
take steps that help them gain an edge over their rivals in attracting buyers.
These steps vary, for example, making the highest quality product, offering
the best customer service, producing at the lowest cost or focusing resources
on a specific segment or niche of the industry.
d. Logic: This is the most important element of strategy. For example, a firmÊs
strategy is to dominate the market for inexpensive detergents by being the
low-cost, mass-market producer. Here the goal is to dominate the detergent
market. The scope is to produce low-cost detergent powder for the Indian
mass market. The competitive advantage is the firmÊs low cost. Yet this
example does not explain why this strategy will work. Why the firm will get
ahead of others by limiting its scope and by being the low cost producer
(competitive advantage) in the detergent industry. The ÂwhyÊ is the logic of
the strategy. To see how logic is the core of a strategy, consider the following
expanded version of a strategy: Âour strategy is to dominate the Indian market
for inexpensive detergent powder by being the low cost producer selling
through mass-market channels. Our low price will generate high volumes.
This, in turn, will makes us a high volume, low-cost producer. The economies
of scale would help us improve our bottom-line even with a low price‰.
Student Activity
„The purpose of strategy is to define the nature of relationship between a firm and
its environment.‰ Critically examine the statement.
Behavioural Considerations
A control system is necessary in any organization in which the activities of different
divisions, departments, sections, and so on need to be coordinated and controlled.
Most control systems are past-action-oriented and consequently are inefficient or fail.
For example, there is little an employee can do today to correct the results of actions
completed two weeks ago.
Steering controls, on the other hand, are future-oriented and allow adjustments to be
made to get back on course before the control period ends. They therefore establish a
more motivating climate for the employee.
What's more, although many standards or controls are simply estimates of what
should occur if certain assumptions are correct, they take on a precision in today's
control systems that leaves little or no margin for error. Managers would be better off
establishing a range rather than a precise number and changing standards as time
passes and assumptions prove erroneous. This would be fairer and would positively
22. Introduction to
Management Control System
Notes
Punjab Technical University 13
motivate employees. There are three fundamental beliefs underlying most successful
control systems.
z First, planning and control are the two most closely interrelated management
functions.
z Second, the human side of the control process needs to be stressed as much
as, if not more than, the tasks or 'numbers crunching' side.
z Finally, evaluating, coaching, and rewarding are more effective in the long
term than measuring, comparing, and pressuring or penalizing.
This is perhaps because the task side of control is noticed and the behavioral or
human side is largely overlooked. But as previously noted, managers should carefully
consider the behavioral aspects of the process when designing a control system if
employees are to be motivated to accomplish assigned tasks.
The evaluate focus of most organizational control systems is on the management of
the institutionÊs financial resources. However, controlling on only one aspect of
institutional performance often results in dysfunctional decisions [Caplan, 1971;
Dalton and Lawrence, 1917]. Therefore, important managerial accounting problems
found in both are private and public sectors are (1) how to select non-monetary
performance measures and (2) how to integrate them into the organizational control
system.
Conceptually, the problems are straightforward. The accountant must select one of
the established financial accounting systems and modify it so that submit
performance as it affects non-financial performance evaluation also is reflected in the
financial accounting system. A financial accounting system available for such
modification is the cost allocation system, in particular the allocation of joint costs.
The accountant may view cost allocation from the standpoint of providing
management control data and/or expense measurement [Vatter, 1945]. These
perspectives may conflict. As a consequence, selection of cost allocation criteria and,
hence, selection of the based by which costs may be allocated should be approached
with concern for the motivational dimension present in any allocation which affects
financial performance.
Behavioral accounting is the application of social science concepts to some areas of
accounting research such as budgeting, decision making, control and finance
reporting. The newly emerging sub-discipline attempts to focus on the "human
element" in what has essentially been a quantitative subject area.
Summary
Management control system primarily deals with the outgoing operations of the
business. It is concerned with all types of forecasts. It is a continuous exercise and
even as the work proceeds, plans are changed in the light of the experience gained.
One of the basic concepts of management control system is that it works on the basis
of continuously collected information. Because large number of people are involved
in collecting the information, therefore, the flow of information has to be properly
organised and channelled. Thus, management control is that function through which
it has been ensured that resources are obtained and used effectively to achieve the
organisationÊs objects. The control system emphasises simultaneously on both
planning and control.
Keywords
Management Control System: It is the process of comparing actual performance with
standards and taking any necessary corrective action.
23. Management Control System
Notes
14 Self-Instructional Material
Control Environment: It is one of the key component of an entity is internal control; it
sets the tone of an entity, influences the control consciousness of people within all
organization and is the foundation for all other components of the internal control
system.
Strategy: It is the overall plan of a firm deploying its resources to establish a
favourable position and complete successfully against its rivals.
Review Questions
1. Discuss the concept of Management Control. Give the essential elements of a
Management Control System.
2. Explain the concept of Management Control and discuss the necessity of such
control.
3. „Control is a fundamental management function that ensures work
accomplishment according to plans.‰ Analyse the statement describing the
importance of control and the steps involved in the control function.
4. What are the elements of an adequate or effective control system?
Further Readings
D.K. Sinha, Management Control System, Excel Books, 2008
Ravindhra Vadapalli, Management Control System, Excel Books, 2008
Rober N. Anthony and V. Govindarajan, Management Control Systems, McGraw
Hill/Irwin, 2000
Keneth Merchant, Wim Van der Stede, Management Control Systems, Pearson
Education, 2007
24. Responsibility Centres
Notes
Punjab Technical University 15
Unit 2 Responsibility
Centres
Unit Structure
• Introduction
• Expense Centre
• Cost Centre
• Profit Centres
• Investment Centre
• Residual Income (RI)
• Summary
• Keywords
• Review Questions
• Further Readings
Learning Objectives
At the conclusion of this unit you should be able to:
• Describe meaning and features of responsibility centres
• Discuss revenue and expense centres
• Point out the advantages of profit centres
• Distinguish between different types of profit centres
• Know the meaning, features and performance management of investment centres
Introduction
The entire organization should be divided into various responsibility centres. Each
responsibility centre is led by a manager or the head of the centre who has been
assigned the responsibility.
Organisation
Marketing Finance R & D Production HRD
Marketing
Manager
Finance
Manager
R&D
Manager
Production
Manager
HRD
Manager
Marketing
Budget
Finance
Budget
R&D
Budget
Production
Budget
HRD
Budget
25. Management Control System
Notes
16 Self-Instructional Material
From the given Diagram, it is clearly understood that every organization is normally
classified into various responsibility centres to the tune of different functions viz.
Marketing, Finance, Research & Development, Production and Human Resources.
These responsibility centres are headed by the responsibility managers.
The responsibility centre is the department, which is headed by the responsible
person i.e. the manager of that particular function. It is a part of the organization,
through which information is processed and communicated at every position. The
decision of the responsibility centre is taken by the head, by considering the positional
responsibilities. The responsibility centre is classified into various categories:
Revenue and Expense Centre, Profit Centre, Investment Centre, etc.
Student Activity
Highlight the corporate examples in fixing the responsibility on the managerial
positions.
Expense Centre
The responsibility centre which incurs only expenses, and measures them, is known
as expense centre. The expense centres of the organization are mostly the service
centres which only usually incur expenses.
The contribution of service department and office & administration department to the
company cannot be denominated in monetary terms, but instead in terms of quality of
services to assist the entire organization.
The output of the sales/production departments are denominated in monetary terms
unlike others.
Cost Centre
Cost centres are divisions that add to the cost of the organization, but only indirectly
add to the profit of the company. Typical examples include Research and
Development, Marketing and Customer service.
Companies may choose to classify business units as cost centres, profit centres, or
investment centres. There are some significant advantages to classifying simple,
straightforward divisions as cost centres, since cost is easy to measure. However, cost
centres create incentives for managers to under fund their units in order to benefit
themselves, and this under funding may result in adverse consequences for the
company as a whole (reduced sales because of bad customer service experiences, for
example).
Because the cost centre has a negative impact on profit (at least on the surface) it is a
likely target for rollbacks and layoffs when budgets are cut. Operational decisions in a
contact centre, for example, are typically driven by cost considerations. Financial
investments in new equipment, technology and staff are often difficult to justify to
management because indirect profitability is hard to translate to bottom-line figures.
Business metrics are sometimes employed to quantify the benefits of a cost centre and
relate costs and benefits to those of the organization as a whole. In a contact centre, for
example, metrics such as average handle time, service level and cost per call are used
in conjunction with other calculations to justify current or improved funding.
When the manager is held accountable only for costs incurred in a responsibility
centre, it is called a cost centre. More precisely, it is the inputs and not outputs that are
measured in terms of money. In a cost centre of responsibility, the accounting system
26. Responsibility Centres
Notes
Punjab Technical University 17
records only costs incurred by the centre/unit/division, but the revenues earned
(output) are excluded from the purview. This only means that a cost centre is a
segment whose financial performance is measured in terms of cost. The costs are the
planning and control data in cost centres, since managers are not made responsible
for profits and investments in assets. The performance of the managers is evaluated
by comparing the costs incurred with the budgeted costs. The management focuses on
the cost variances for ensuring proper control. The performance of a cost centre is
measured by cost alone, without taking into consideration, its attainments in terms of
„output‰.
A cost centre does not serve the purpose of measuring the performance of the
responsibility centre, since it ignores the output (revenues) measured in terms of
money.
Profit Centres
Situational Requirements for Successful Implementation
When profit is used to express expectations for a responsibility unit and for
evaluating its performance, that responsibility unit is known as a profit centre and its
manager has the responsibility for attaining a certain level of profit. If he or she is to
be evaluated on the basis of profit performance, the profit centre manager must have
sufficient authority to make whatever decisions are necessary to ensure an adequate
profit. Joel Dean details three situational characteristics of profit centres as follows
(Dean, 1955, p. 67):
1. Operational Independence: Each profit centre manager must have the
authority to make most if not all of the key operating decisions that affect his
profits, subject to broad policy directions from the top. The areas where
independence cannot exist should properly be considered to be service
centres.
2. Access to sources and markets: The profit centre manager must have control
over all source and market decisions and be free to buy and sell in alternative
markets. This freedom to trade dissolves alibis and helps establish
responsibility.
3. Quantifiable costs and revenues: A profit centre must be able to identify its
true costs and establish a reasonable price for its product. Otherwise,
measurement by profit is questionable.
The characteristics necessary for effective operation of a profit centre indicate that
before a responsibility unit can be considered to be a profit centre, its manager must
have the power to generate revenues and control sources of supply and other costs.
Identifying a responsibility unit whose revenues and costs can both be controlled by
the manager is not sufficient to conclude that the unit can be planned and controlled
as a profit centre. At least three additional conditions must also be present.
1. Top management must be committed to decentralization: A profit centre
system must have the wholehearted commitment of top management. They
must be willing to relinquish some of their intimate knowledge of day-to-day
operations and also some of their authority to subordinates. Top management
must allow the profit centre manager to make the key operating decisions.
Although it may be difficult especially in a company with only one major
business but they must do so if the system is to work effectively.
2. Adequate staff and information systems: The cost of implementing a profit
centre system may be quite high. Most likely a new management information
27. Management Control System
Notes
18 Self-Instructional Material
system will be necessary in order to provide top management with the data it
needs to control decentralized operations. Further, each profit centre manager
will now need information to make decisions. Accounting reports will be the
primary source of information about a unitÊs performance, so top
management must provide these reports and must also know how to use
them.
3. Capable profit centre managers: A company using a profit centre system must
have managers capable of heading them. The implementation of profit centres
requires a great deal of education to train managers up and down the line to
understand and think in terms of profits. They must be made to understand
that their performance is now being measured by their contribution to
company profits and that they must now make decisions based on profit
contribution. Each profit centre manager must be made aware of the key
variables of the organization as a whole, the managerÊs strategic variables,
and the relationship between these, so that he or she will not make decisions
to maximize his or her own welfare at the expense of the organization as a
whole.
The Benefits of Profit Centres
Treating responsibility units as profit centres is one way to realize the benefits of
decentralization. Successful decentralization brings with it the following benefits:
A way of managing large entities: In large organizations it is difficult for one manager
or a small group of managers to understand every aspect of the business. Sheer size
prohibits management by face-to-face contact and informal or interpersonal methods.
Large organizations must, therefore, forego some of the benefits of integration by
decomposing themselves into more manageable operating units.
Better decisions: When a large organization is divided into smaller, more manageable
units it achieves many of the advantages of a small company. Because the decision-makers
responsible for each unit are closer to the problems in their environment, they
are better able to make the relevant revenue/costs decisions. Because decision making
can also be speeded up, a decentralized organization can be more responsive to
environmental change. Furthermore, because they are held responsible for all their
activities, managers are far more aware of their ultimate impact and are extremely
sensitive to what they are doing for the company.
Motivation: If responsibility is motivating, and monetary measures are one means of
establishing responsibility, then the manager who is responsible for revenues and
revenue/cost trade-offs will probably be more committed than a manager who is
responsible for costs alone. Profit measures allow managers to focus on a familiar,
well-understood goal, and give them the feeling of being in business for themselves.
Frees Top Management: By definition, decentralization frees top management. When
profit centres are established, top management no longer needs to get involved in the
day-to-day operations of each unit. Top management can devote its time to more
important issues, such as strategic planning or coordinating the efforts of a number of
profit centres. Because they do not have to concentrate on all elements of their
business, they can practice management by attending to those areas where a strong
influence will be most beneficial. If one profit centre begins to experience difficulty,
management can then spend its time helping this centre to correct its problems.
Thus it appears that management can achieve many of the benefits of decentralization
through profit centres. When decentralized operating units are made into profit
centres, each manager has a common goal·profit. Decentralized units can be planned
and controlled according to their contribution to organizational profitability.
Complete responsibility can be assigned because profit is a comprehensive measure of
28. Responsibility Centres
Notes
Punjab Technical University 19
all activity, and each manager can then be judged on his or her ability to manage a
complete operating unit as a separate and distinct business.
At the same time, central management can realize the benefits of a large
organizationÊs economies by maintaining central staff functions such as economic
planning, forecasting, technical analysis, accounting, and perhaps management
information systems. These services can be provided to the profit centres on a charge
basis to ensure that they are used efficiently.
Types of Profit Centres
An effective planning and control system for managers is one that motivates them to
act in their best interests while simultaneously achieving what is best for the
organization as a whole. Using this as the criterion for evaluation, let us examine two
types of profit centres in order to determine the effectiveness of the profit measure as
a basis for planning and control.
Independent (natural) profit centres: If a responsibility unit operates independently of
the other units in the organization, that is, if it is effectively in its own business, then a
manager who maximizes his or her own profits is also automatically maximizing the
profits of the organization as a whole. The manager has discretion over sourcing of
inputs and revenues to be charged. Decisions can be based on meaningful values
derived from market-based, armÊs-length transactions. Profit is a clear measure of
efficiency and performance.
This type of responsibility unit is termed a natural or independent profit centre.
Interdependent (artificial) profit centres: Many organizational structures do not lend
themselves to decomposition into natural profit centres. Because of their size,
however, these organizations may still require some form of decentralization and may
want to realize the benefits of a profit centre system. For example, in a functionally
organized automobile company (e.g., Ford, Case 4.1) the engine division or the chassis
division may transfer parts to the assembly division. In an integrated oil company, the
exploration and production division discovers oil and transports it to the
manufacturing division which, in turn, ships it to marketing for disposal to the
consumer market. But to be a profit centre an organizational unit must act both as a
seller, with the discretion to set prices and output volumes, and as a buyer, with
discretion on how much to consume at various price levels. It must also be able to
choose whether to deal with a unit inside the company or with one outside.
Organizations such as the automobile and oil companies described above do not meet
the criteria for profit centre systems. Can units within the same organization that deal
with each other regularly nevertheless be decentralized as profit centres? Many
organizations do just this. Artificial or interdependent profit centres are responsibility
units which are considered to be profit centres, even though they do not satisfy the
usual criteria. The automobile assembly division is a good example. It can be
considered to buy components from other divisions, assemble the car, and then sell it
to a sales division. But clearly the assembly division manager is not free to buy and
sell at will. In the absence of a free market, how his prices are going to be determined?
Two Styles of Profit Centre Management
One way is to establish specific performance expectations and to enforce firm
commitment to their accomplishment. Alternatively, initially formulated expectations
may serve only as guidelines; performance is later evaluated in light of the actual
conditions and constraints in effect at the time of performance.
29. Management Control System
Notes
20 Self-Instructional Material
Profit as a Specific Performance Objective
Establishing a specific profit goal and attempting to obtain rigid commitment to this
goal can have many dysfunctional consequences. Yet the benefits of ensuring that
managers are sensitive to the effect of their activities on profits still makes the profit
measure extremely useful. How, then, can its potentially dysfunctional consequences
be averted?
One way is to adopt a management by objectives approach to commitment and
evaluation and to apply this approach over short time spans of discretion. First, a
level of profit is negotiated and agreed upon, and a short performance evaluation
interval is set. The profit centre manager also agrees to discuss all major decisions
affecting profits with top management before they are finalized.
Frequent communication and short evaluation periods may seem strange
prescriptions for a profit centre system, since they appear to negate the benefits of
decentralization. However, when considered in the overall management by objective
approach, whose aims are to achieve initial commitment, periodically review
performance, and coach the subordinate to achieve the objectives he or she has
specified, these methods can help overcome the adverse effects of performance
evaluation. Evaluation is not merely a period-based measure of profitability; rather, it
is an ongoing process that examines the quality of the decisions reached as well as
their eventual results. The strength of this method is involvement and
communication; if it is properly applied, it can achieve many of the motivational
benefits of a management by objectives system.
Profit as a Guiding Objective
A second approach to profit centre management is to use profit expectations merely
as general objectives or guidelines. In this approach expectations are used for
planning and orientation and are considered to be initial targets only. They are the
best estimates that can be made at the time, and can be revised radically later on if
necessary. This approach lessens the pressure on a profit centre manager to maximize
short-term performance. It permits him or her a greater amount of discretion.
However, appropriate time spans for evaluation must still be established; too long a
time interval also carries with it the risks and costs of inappropriate behaviour.
If profit is used only as a general guide and performance is evaluated over a longer
period of time, the following conditions must also apply. First, each profit centre must
be supported by an adequate information system. Detailed analyses and
reconciliations of past performance to expectation must be continually provided to
top management to demonstrate that the profit centre manager understands what is
going on. This reporting keeps top management aware of the quality of decision-making
and performance. But any formal information system, regardless of how
efficiently computerized it is, is still too slow to perform an early warning function for
management. Continual communication between profit centre managers and
corporate staff is necessary. Hence, the second requirement of this approach is that an
appropriate climate for free and open communication be established.
This style of management may require the involvement of advisory staff groups,
top-management committees, and perhaps a group vice president. Informal channels
of communication are the real key to predicting problems in a profit centre and its
ability to handle them.
Student Activity
Discuss the organisational structures and/or types of responsibility centre that are
most likely to be planned and controlled as profit centre.
30. Responsibility Centres
Notes
Punjab Technical University 21
Investment Centre
It is the responsibility centre at which the manager is responsible for the effective
utility of assets in order to earn the best rate of return out of the investments or assets
employed. The exact volume of assets employed cannot be easily assessed for single
department or responsibility centre. The difficulty in the assessment on the volume of
assets is only due to the utility of the assets, which is not only in one responsibility
centre but also in more than one.
When the manager is held responsibility for costs and revenues as well as for the
investment in assets of a responsibility centre, it is called an Investment Centre. In an
investment centre, the performance is measured not by profit alone, but it is related to
investments effected, since the manager of an investment centre is always interested
to earn a satisfactory return. The return on investment which is usually referred to as
ROI, serves as a criterion for the performance evaluation of the manager of an
investment centre. Viewed from this angle, investment centres may be considered as
separate entities wherein the managers are entrusted with the overall responsibility of
managing inputs, outputs and investment. This only represents an extension of the
responsibility idea.
Return on Investment (ROI)
A company is decentralized with respect to profit responsibility when each
responsibility unit manager is accountable for achieving some level of profit. The
assets employed in generating this profit form the asset base of the unit.
Responsibility unit managers who are responsible for their investment base as well as
their profitability are known as investment centre managers. The most commonly
used investment-based measure of performance is return on investment (ROI), the
ratio of profit to investment.
The use of ROI for financial planning and control of decentralized units, originated by
the Du Pont Corporation, grew from its need to plan and evaluate the performance of
the independent entities making up its diversified operations. The use of ROI solved
the problem of motivating managers, ensuring consistent decision-making, and
controlling decentralized divisions.
As used by Du Pont, return on investment is the quotient of the accounted profit
earned by a unit divided by the investment assigned to the unit. The investment is
made up of both fixed assets, such as machinery and equipment, and working capital
items, such as inventory, receivables, and cash. ROI allows the measurement and
evaluation of each responsibility centre manager according to how productively he or
she uses the assets entrusted to him or her. It allows managers the latitude to make
trade-off decisions between investments, revenues, and operating costs, and then to
be evaluated on these decisions by one comprehensive performance figure. Planning
and controlling the operations of decentralized investment centres by ROI have all the
benefits of a profit centre approach, and in addition can be used to measure the
productivity of the assets employed.
Calculation of the Investment Base
Two critical procedures in the computation of ROI are specifying the investment base
to be used for productivity measurements, and separating it into its controllable and
non-controllable components for evaluation. In discussion of alternative methods of
measuring an investment base, Solomon (1968) raises the following questions:
1. Should investment be interpreted to mean all assets, net assets (total assets-liabilities),
or fixed assets plus net current assets?
31. Management Control System
Notes
22 Self-Instructional Material
2. How investment is defined and how should it be measured? Should fixed
assets be included at cost, net book value (i.e., deducting accumulated
depreciation), or at appraised value?
3. How should assets which are either shared or controlled centrally be
computed in the return on investment? That is, when a responsibility unit
does not hold separate cash balances or if it does not control its own
receivables, how should these be allocated?
4. When inventories are valued on a LIFO basis, is any adjustment necessary
when the investment base is computed?
5. When should the investment base be measured·at the beginning or at the
end of the period, or should the average over the period be used?
After an extensive analysis of the implications of each of these alternatives, Solomon
concludes that for calculating returns and for evaluating performance, investment
should be defined as follows:
1. Total investment is best defined as total assets. Measures of productivity
should be based on the total amount of capital committed, irrespective of how
it was financed, because differences in financing strategies are irrelevant to
the way assets are used, and also because financing decisions are usually
made centrally rather than by the investment centre manager. However, to
determine controllable investment, a deduction should be made for
controllable liabilities. Changing these also changes net controllable
investment, which should be the basis of the ROI figure used for evaluation.
2. Fixed assets should be included at gross cost. No deduction should be made
for accumulated depreciation because such arbitrary deductions, and the
resulting net book values, may bear no relationship to the productivity of the
assets involved. ROI, based on net book value, increases as accumulated
depreciation increases and net book value decreases. To negate the effects of
changing price levels and to establish a basis of comparison between
investment centres acquiring assets at different times, index number
adjustments may be used.
3. Fixed assets held under corporate control (e.g., a research laboratory or
computer centre) should be allocated to investment centres only if there exists
a reasonable basis to do so. An alternative is to rely on a charge for services
rendered, although this method involves all the difficulties of a transfer
pricing scheme. The allocation of centrally controlled working capital is
appropriate if a basis can be found that reflects incremental demands for such
capital; for example, centrally held bank balances can be allocated on the basis
of incremental cash demands while receivables can be allocated on the basis
of sales. Allocated assets form part of a divisionÊs total investment, but not
part of its controllable investment.
4. Investment in inventory is generally controllable and should be valued on a
FIFO basis to approximate replacement cost on the balance sheet and avoid
the distortions of LIFO.
5. The point in time at which the investment base should be measured depends
on the length of the period considered and the time it takes for changes in
assets to have an effect on profits. In calculating the rate of return for a period
shorter than a quarter, the investment at the beginning of the period is a
suitable base. For a longer interval, however, average investment should be
used.
The five questions cited above are not an exhaustive coverage of all aspects of
investment-based measurement, but they do demonstrate the types of choices to be
32. Responsibility Centres
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made. A review of SolomonÊs recommendations and his underlying reasoning reveals
how arbitrary these measurements of the investment base really are. In considering
the alternatives, Solomons appears to have assessed the implications of each kind of
measurement according to what appears most „correct‰ from the standpoint of
economic productivity and performance. There is, therefore, a significant amount of
subjectivity in his choices. One could argue that productivity measures would be
better based on the appraised value of assets, not historical costs, or that index
number adjustments to only a part of a companyÊs assets produce misleading
information. But debates on the „correctness‰ of alternative investment-based
measurements could (and probably will) go on forever. As in many other accounting-related
areas of contention, there are no „right‰ answers.
In deciding among alternative ways to compute an investment base, a system
designer must consider how these measures are to be used. If their purpose is to
motivate the investment centre manager to behave in certain desired ways (e.g., to
keep minimal levels of inventory), then they should stress the controllable
components of investment. If, on the other hand, the measures are to be used as aids
for decision-making, they should stress economic reality. In sum, like most
components of a planning and control system, how the components of an investment
base should be measured depends on the characteristics of the situation and on the
behaviour that the measures are intended to influence.
Advantages of ROI
In addition to all the benefits of profit measures, ROI has two more advantages. The
first and foremost of these is that it provides a single, comprehensive, financial
measure of performance. It not only reflects the increment to wealth, such as the profit
measure, but it also relates profit to the assets employed in generating it. Second,
because it is expressed as a ratio, ROI is an excellent way of comparing operations of
different sizes and types.
Disadvantages of ROI
When ROI was first introduced by Du Pont to control its decentralized operations, it
was far superior to other methods. Since then, however, numerous flaws have been
uncovered in the ROI measure. Return on investment was originally intended to
guide the planning and decision-making of unit managers and to give top
management a basis by which to control and evaluate performance. However, from
both of these perspectives ROI has several defects.
First, ROI suffers from all the defects of conventional accounting measures, it suffers
even more from the arbitrariness of accounting conventions. For example, many
expenditures which benefit the firm for more than a single accounting period, are
expensed rather than capitalized, such as research and development expenditures and
advertising outlays. And the historical costs at which assets are measured do not
reflect their true economic value at any time subsequent to initial acquisition.
Depreciation reduces book values and so increases ROI artificially. Book values are
not adjusted for the changing value of the dollar, so that in times of inflation a
substantial part of the reported profits may actually result from holding and using
older assets while pricing products at current market levels, rather than from normal
operations.
A second set of problems results from using ROI as a performance measure. As such,
it should be controllable by the unit manager. However, many if not all of the assets
entrusted to him are acquired through a host of past decisions outside his control.
Nevertheless, these decisions are almost unavoidably reflected in any measure of
performance, so that the use of ROI for evaluation may lead to distortion after all. As
33. Management Control System
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24 Self-Instructional Material
a measure of performance, ROI suffers not only from all the dysfunctional
consequences associated with improper use of the profit measure, but it may
encourage other undesirable behavior as well. Assume that the objective of an
investment centre manager is to maximize or at least to maintain his or her current
ROI level. The manager may do so not only by improving profit performance, but also
by minimizing his or her investment. For instance, minimizing assets by leasing, as
opposed to buying, will have an immediate effect on ROI performance.
Pressure to achieve a specific ROI level may lead to incongruent decisions about asset
replacement and disposal. In ROI performance measurement, asset replacement
decisions are a function of the book value of an asset, not salvage values.
Furthermore, ROI can be increased by scrapping assets which are earning less than
the current ROI, thereby increasing the overall average. Scrapping unused assets
increases ROI because these assets no longer are depreciated, nor do they appear in
the asset base. Therefore, retaining idle assets is entirely undesirable. Also, because
ROI is an overall measure of the use of assets, in some cases it can be increased by any
action that reduces the asset base; and such decisions, while productive in the short
run, may not be so in the long run.
Because ROI increases simply with the passage of time and depreciation (especially
accelerated depreciation), it may also discourage new investments. The older the asset
base of an organization, the higher is its ROI, and therefore, the higher is the return
required on new investments in order to maintain or improve this average. Thus there
may be a tendency to keep older equipment operating as long as possible in order to
show high ROI rates, even when replacement would be better in the long run.
It is important to recognize that ROI is simply the quotient of profit over investment,
and may differ from an organizationÊs cost of capital. It is also a single-year
measurement, not a rate of return computed over the life cycle of an entire project.
Hence while it may provide an appropriate criterion for short-term current operating
decisions, it is certainly no guide for capital investments. ROI is based on current
performance using existing assets, and does not reflect the cost of financing additional
investments. Thus it is improper to use ROI as a decision criterion or hurdle rate
against which to evaluate new investment proposals.
Investments should be made if their return exceeds the cost of making them. It is well
known that different types of financing have different costs. For example, cash can be
borrowed from a bank, acquired through the issuance of securities, or obtained by
liquidating fixed assets. Each source of an organizationÊs financing, be it debt or
equity, carries a separate implicit or explicit cost. The weighted average of an
organizationÊs financing costs is known as its cost of capital. It provides the decision
criteria that the organization should use. If a new investment earns an amount greater
than its costs, there is a net positive increment to the organizationÊs overall worth.
Therefore, if an organizationÊs objective is to maximize the net present value of its
current shareholders, then it is in the shareholdersÊ best interest to undertake any
investment whose return exceeds the organizationÊs current cost of capital.
It is important to recognize that ROI does not measure the cost of resources to an
organization; it measures only the rate currently being earned on the money already
invested. And so, investment opportunities which earn less than the organizationÊs
ROI rate but more than the organizationÊs cost of capital may be rejected because they
reduce average ROI. This sort of behaviour is undesirable because it foregoes
potential increments to shareholderÊs wealth. Yet once a responsibility centre manager
has committed himself to a specific ROI rate, it is unreasonable to expect him to
propose a capital investment that will earn a lesser rate of return.
Thus it can be seen that the use of ROI as a criterion for investment decisions may
lead a manager to make decisions which are incongruent with and inappropriate for
34. Responsibility Centres
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Punjab Technical University 25
overall organizational objectives. The use of ROI may not always motivate the
manager to behave in a way that benefits himself while simultaneously benefiting the
organization as a whole·the criterion for an effective planning and control system.
Residual Income (RI)
Residual income is another asset-based measure of financial performance. It is used in
an attempt to overcome some of the weaknesses of ROI and to move closer toward the
net present value notion of financial decision-making. The RI of an investment centre
is its current operating profit (revenues – operating expenses) minus a capital charge
for the assets employed in generating this profit. A capital charge is simply the cost to
the firm of each particular type of asset it uses. RI is thus the net income of a
responsibility unit after the cost of the capital used in its operations has been
deducted.
Advantages of RI
One strength of RI is that it counters the need to maintain at least an average rate of
ROI in considering new investment decisions. If an investment has a positive residual
income, it will be undertaken even if its ROI is lower than the current average ROI.
With an RI decision criterion, all investments will be accepted as long as they earn
more than their capital costs. RI, therefore, encourages congruent investment
decision-making, so that each responsibility centre is able to contribute to overall
shareholder welfare by increasing the net present worth of the firm.
A second strength of RI is its use of capital charges in weighing assets. Because RI
employs capital charges, each separate class of assets can be treated in a different
manner, as appropriate. Assets which are more liquid and involve less risk to the firm
or which are more readily available may be costed at rates substantially different from
those which are hard to obtain or especially expensive. Assets which must be
irretrievably committed to a project, and hence involve high risk, may be priced
differently from those that can be recovered easily at full value. By pricing assets
appropriately, an RI system can motivate managers to use assets in the proportions
deemed most suitable from the standpoint of the organization as a whole.
Disadvantages of RI
The residual income measure shares many of the problems of ROI, however. The
same problem of measuring fixed assets still exists, since the capital charges have to
be applied against specific asset amounts and must be classified into controllable and
non-controllable components. Furthermore, RI is measured in absolute dollars, not as
a ratio, making it more difficult to compare responsibility units of different sizes. Like
ROI, RI is a comprehensive financial measurement of performance. But it cannot
include non-financial factors, of course, so many relevant key variables may be
ignored. And finally, although many of the limitations of conventional accounting can
be partly ameliorated, management usually cannot or will not use accounting
techniques such as annuity depreciation and replacement cost accounting that would
make the use of RI more realistic.
Therefore, although residual income is a more helpful formula than ROI for making
decisions about asset acquisitions, it does not overcome the dysfunctional temptation
to reduce assets (so as to minimize capital charges, in this case). In short, although it is
perhaps superior to ROI in some ways, it still must be applied with the greatest of
care.
35. Management Control System
Notes
26 Self-Instructional Material
Effective Use of Investment-Based Performance
Measures
The best information available on the use of RI and ROI comes from a survey
conducted more than a decade ago. Mauriel and Anthony (1966) surveyed 3,525 U.S.
companies with sales of over $20 million. Of the 2,658 companies that responded to
the questionnaire, 60% used either ROI or RI or some combination of both in their
planning and control of decentralized units. Only 3.8% of the total surveyed used
residual income only. A follow-up study conducted by the same researchers revealed
that 60% of their 981 respondents relied solely on ROI as a measure of responsibility
centre performance. The responses indicated that most companies use accounting-based
measures for computing their asset base. Of the companies responding, 93%
measured divisional performance on the basis of either gross book value (18.5%), net
book value (73.2%), or a combination of these two (1.6%). Hence, in spite of the many
deficiencies associated with the use of both ROI and RI, it appears that investment-based
performance measurements are widely used in management practice today.
Investment-based performance measurements present the designer of any planning
and control system with a dilemma. On the one hand it is recognized that both ROI
and RI have many of the drawbacks of a single performance measurement. They do
not lead to correct investment decisions because they fail to mediate effectively
between the short and the long term, and to reflect both the qualitative and
quantitative aspects of any business operation. Furthermore, many non-financial key
variables and intangible considerations (e.g., services) are not reflected in a unitÊs
investment base, and therefore, cannot be accommodated by these types of
measurement. But on the other hand, as the above surveys reveal, these investment-based
performance measurements are in wide use today; and their acceptance by
management is so widespread that it is unrealistic to assume that they will be done
away with in the near future. So ways must be found to use these measures
successfully. This means that if an organization relies heavily on a single performance
measurement, its use ought to be accompanied both by a sharp awareness of the
strengths and weaknesses of the measure, and also by an appropriate management
style.
Both ROI and RI must emphasize trust and open communication if they are to be
effective. They require the specification of appropriate key variables, the
establishment of expectations in terms of these key variables, and finally, a consistent
evaluation of the performance of each responsibility centre manager. These
requirements also hold true when investment-based performance measures are used
in the planning and control system.
If an investment-based criterion is used as a firm measure of expected performance,
the determinants selected for the asset base must motivate the manager to make use
of his or her assets appropriately. Clearly, residual income is superior to ROI in this
respect; if each individual class of assets is properly priced, the encouragement of cost
minimization will automatically ensure congruent actions. As before, performance
can be controlled by establishing firm expectations and then having managers report
to top management at short-time intervals. The constant involvement of top
management will help to avoid the dysfunctional behaviours associated with
investment-based performance measures.
If investment-based performance measures are established simply as guidelines, ROI
or RI measures will serve not as a basis for evaluation but as a diagnostic tool. They
are monitored to detect changes over time and to suggest potential improvements. To
make them more useful for this purpose, accounting practices should be modified as
needed. For example, modifying depreciation schedules and capitalizing
expenditures such as advertising and research and development may be appropriate
36. Responsibility Centres
Notes
Punjab Technical University 27
for internal accounting purposes, although not for external reporting. With this
approach, return on investment must be regarded simply as one of many key
variables that affect performance.
An Alternative Approach to Planning and Controlling
Investment Centres
The use of RI and ROI as measures of investment centre performance implies the
validity of two assumptions: (1) that a single measure combining both profits and
assets can describe efficient and effective behaviour, and (2) that a single-period
measure of performance can guide appropriate behaviour. If these two assumptions
are not valid, an organization must devise alternative means of planning and
controlling investment centres. Specifically, it must answer the following questions:
1. What criteria should be used in making short-run operating decisions?
2. How should expenditures related to managed or discretionary short-run
capacity costs (costs which cannot be associated with output) be planned and
controlled?
3. How should an organization make capital investment decisions, and then
evaluate the productivity of these investments?
To understand the role of investment-based performance measurements in the
planning and control of any decentralized responsibility unit, it is essential to
recognize that three types of decision-making occur. Two of these relate to short-run
decisions and performance evaluation and the third to long-run expenditures.
The first type, current operating decisions, is concerned with the net contribution of
any decision to the organizationÊs profit and overhead. The key criterion of these
decisions is whether or not the benefits exceed the cost over the short run. These
decisions are based solely on differential (incremental) revenues and costs; i.e.,
revenues as well as variable costs and other costs that will differ according to the
alternative selected. All other costs, such as committed or sunk costs, are irrelevant to
these decisions and their inclusion will only confuse the issue at hand. Furthermore,
because of the short interval of time covered the time value of money can be ignored
in these decisions. The cost-volume and contribution margin decision-making
procedures familiar to any student of management accounting are the applicable
techniques. The effective control of operating decision-making is essentially the same
as the process involved in profit budgeting.
The second set of short-run decisions relates to the capacity to carry out business in
the short run. These are the costs needed to do business and involve the fixed or
committed costs needed to support current operations. Many components of these
costs are independent of operating outputs and hence must be managed; i.e., their
amounts are subject to the discretion of management rather than to an input-output
relationship with volume of activity. Managed cost budgets, together with allocation
schemes such as zero-base budgeting and interpersonal schemes such as management
by objectives, are some techniques that will ensure the effective and efficient
allocation of managed resources.
The third type of decision making and performance evaluation for investment centres
relates to long-term expenditures. Capital expenditure decisions must reflect an
organizationÊs cost of capital as well as other decision criteria that reflect a time period
greater than one year, such as payout period, and the relative risk in the project over
its full life cycle. Capital expenditure analysis is the primary means by which an
organization approves acquisition of new assets, major changes from existing
operations, and also the divestment of capital assets. It is the means by which an