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process even if the plans are changed in the light of experience or change in
technology.
4. Coordinated system : A management control system is a fully coordinated and
integrated system. Even if the information for one purpose varied from that collected
for another purpose, the data reconciles with one another. It is, therefore, more
plausible to consider the interlocking sub – processes as a single set for achieving the
objectives of the enterprise.
5. Line manager : Information collected from various sources is organized by the line
managers. The line managers are the focal points in the management control system.
Line managers motivate the employees to improve their performance and thereby
achieve the organizational goal. Business budgets are prepared based on their advice
and suggestions.
All the above are the features of the ideal management control system.
Q.2 What is concept of free cash flow as applied to an organization? Explain process of
computation.
Ans. Free cash flow is a cash flow acrually available for distribution to investors after
the company has made all the investment in fixed assets and working capital necessary to
sustain ongoing operations.
In addition to identifying sources and uses of cash, investors are interested in measuring
free cash flow. This concept focuses on the cash generated from operations in excess of that
needed for reinvestment. Some measures of free cash flow can be determined directly from
the cash flow statement.
Free cash flow is an important concept for valuation. Analysts frequently value firms
based on the present value of expected future free cash flow. If a firm is not expected to
generate free cash flow in the future, it is unlikely to be valuable.
The measure of free cash flow depends on the perspective of the investor doing the
measuring. Free cash flow available to the firm represents cash flow available to both debt
and equity holders. Free cash flow to equity is what remains after debt holders have received
their contractually obligated payments – namely interest.
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- Changes In Working Prior & Current Balance Sheets: Current Assets and Liability
Capital accounts
It is important to note that negative free cash flow is not bad in itself. If free cash flow is
negative, it could be a sign that a company is making large investments. If these investments
earn a high return, the strategy has the potential to pay off in the long run.
A measure of financial performance that expresses the net amount of cash that is
generated for the firm, consisting of expenses, taxes and changes in net working capital and
investments.
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Calculated as:
This is a measurement of a company's profitability after all expenses and reinvestments. It's
one of the many benchmarks used to compare and analyze financial health.
A positive value would indicate that the firm has cash left after expenses. A negative value,
on the other hand, would indicate that the firm has not generated enough revenue to cover its
costs and investment activities. In that instance, an investor should dig deeper to assess why
this is happening - it could be a sign that the company may have some deeper problems.
The FCFE is the cash flow left for equity shareholders after the firm has covered its capital
expenditure and working capital needs and met all its obligations toward lenders and
preference shareholders. It is defined as follows:
Ans. Goals means broad statement of what organization intends to achieve in general without
time reference. Thereafter management decides what set of action the organization should
take in order to achieve its goals. These are the strategies which are determined by top
management.
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Every organization function to attain its goals. Organization may be profit oriented
business unit or a non-profit organization providing services to the community. Profit or
profitability is the principle goal of a business. Earning a satisfactory return on investment is
not the only economic goal of an organization. It has other goals also such as market share,
new product line, new business, optimizing shareholder’s value, etc. Besides, every big
business house has its social responsibilities also.
Thus the different organizational goals are:
1. Economic Goals.
2. Social Goals.
1. Economic Goals:
Economic goals are:
a) Profit and Profitability.
b) Earning per share.
c) Shareholder’s Value.
d) Market Share.
e) New products and product line.
f) Adding new business.
Thus, it is an evident that all of the elements in the above equations are related to each
other, and any action on one without considering the effect on the other will be wrong. The
only measure that takes into account the net effect of movements in all the elements is return
on investment. Hence, the later should be considered as the most important indicator of
profitability of any business unit.
Profitability refers to profits in the long run, rather than in current year or current
quarter, because some of the current expenses such as advertising and sales promotion,
research and development, employees training programme and similar other expenses
reduces current profits, but increase profits in the long run. In the short period, profit may be
lower, but would give profit at much higher rate in the subsequent period.
has been my policy to force the price of the car down as fast as production would permit and
give the benefit to the user and labourers, with resulting surprisingly enormous benefit to
ourselves.”
Other goals such as adding new products, or product-line or new business actually
indicate normal organizational growth.
2. Social Goals:
Every organization has its share of responsibility towards the local community where
it is situated, and the public at large. It is very difficult to incorporate in Management Control
System such goals as taking pride in the organization which cares for the society and renders
service to the public. Any concrete structural programme indicating its operational expenses,
methods of providing service, personnel involved in rendering service and the nature of the
service in details, however can be mentioned through an appropriate system.
Eg: Britannia Industries Ltd. has “WE CARE” programme, which is operated in
three/four cities in India looking after the orphans, handicapped and destitutes. This
programme is managed and controlled by the Personnel Manager of the Unit located in the
respective cities.
The meaning of the term “shareholder value” was not always clear, it probably refers
to the market price of the corporation’s stock. However it is believe that achieving
satisfactory profit is a better way of stating a corporation’s goal, for following two reasons:
1. “Maximising” implies that there is a way of finding the maximum amount that a
company can earn. This is not the case. In deciding between two courses of action,
management usually selects the one it believes will increase profitability the most. But
management rarely, if ever, identifies all the possible alternatives and their respective effects
on profitability. Furthermore, profit maximization requires that marginal costs and a demand
curve be calculated, and managers usually do not know what these are. If maximization were
the goal, managers would spend every working hour(and many sleepless nights) thinking
about endless alternatives for increasing profitability; life is generally considered to be too
short to warrant such an effort.
3. Although optimizing shareholder value may be a major goal, it is by no the only goal
for most organizations. Certainly a business that does not earn a profit at least equal to
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its cost of capital is not doing its job; unless it does so, it cannot discharge any other
responsibilities. But economic performance is not the sole responsibility of a
business, nor is shareholder value. Most managers want to behave ethically, and most
feel an obligation to other stakeholders in the organization in additions to
shareholders.
Managers manage differently. Some rely heavily on reports and certain formal documents;
others prefer conversations and informal contacts. Some think in concrete terms; others think
abstractly. Some are analytical; others use trial and error. Some are risk takers; others are risk
averse. Some are process oriented; others are result oriented. Some are people oriented;
others are task oriented. Some are friendly; others are aloof. Some are long-term oriented;
others are short-term oriented. Some dominate decision making (“Theory x”), others
encourage organisation participation in decision making (“Theory Y”). Some emphasize
monetary rewards; others emphasize a broader set of rewards.
The various dimensions of management style significantly influence the operation of the
control systems. Even if the same reports with the same set of data go with the same
frequency to the CEO, two CEOs with different styles would use these reports very
differently to manage the business units. The dramatic shifts in the control process within
General Electric when Jack Welch succeeded Reginald Jones as the CEO.
Style affects the management control process-how the CEO prefers to use the information,
conducts performance review meetings, and so on-which in turn affects how the control
system actually operates, even if the formal structure does not change under a new CEO. In
fact, when CEOs change, subordinates typically infer what the new CEO really wants based
on how he/she interacts during the management control process. (e.g., whether performance
reports or speeches and directives take precedence).
Managers’ attitudes towards formal reports affect the amount of detail they want, the
frequency of these reports, and even their preference for graphs rather than tables of numbers,
and whether they want numerical reports supplemented with written comments. Designers of
management control system need to identify these preferences and accommodate them.
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Tight versus Loose Controls: A manager’s style affects the degree of tight versus loose
control in any situation. The manager of a routine production responsibility center can be
controlled relatively tightly or loosely, and the actual control reflects the style of the
manager’s superior. Thus, the degree of tightness or looseness often is not revealed by the
content of the forms or aspects of the formal control documents, rules, or procedures. It is a
factor of how these formal devices are used.
The degree of looseness tends to increase at successively higher levels in the organisation
hierarchy: higher level managers typically tend to pay less attention to details and more to
overall results (the bottom line, rather than the details of how the results are obtained).
However, this generalization might not apply if a given CEO has a different style.
Example. The classical illustration of this point is IIT under Harold Geneen. One could argue
that IIT, being a conglomerate, should be managed based on monitoring the business unit
bottom line and not through a details evaluation of every aspect of the business unit
operations. This is so since, in a conglomerate, the CEO typically has “capacity limitations”
in understanding the nuts and bolts of various business units operations. In such context, it
was Harold Geneen’s personal style that explains the detailed evaluations hr made of the
business units’ managers.
When Rand Araskog succeeded Harold Geneen at IIT, he altered the detailed and tight
control system since, among other things; Araskog’s personal style was not oriented toward
exercising tight controls.
The style of the CEO has a profound impact on management control. If a new senior
management with a different style takes over, the system tends to change correspondingly. It
might happen that the manager’s style is not a good fit with the organization’s management
control requirements. If the manager recognizes the incongruity and adapts his/her style
accordingly, the problem disappears. If, however, the manager is unwilling or unable to
change, the organisation will experience performance problems. The solution in this case
might be to change the manager.
A market price-based transfer price will induce goal congruence if all the following
conditions exist. Rarely, if ever, will all these conditions exists in practice. The list, therefore,
does not set forth criteria that must be met to have a transfer price. Rather, it suggests a way
of looking at a situation to see what changes should be made to improve the operation of the
transfer price mechanism.
Competent people: Ideally, managers should be interested in the long-run as well as the
short-run performances of their responsibility centres. Staff people involve in negotiation and
arbitration of transfer price also must be competent.
A market price: The ideal transfer price is based on a well-established, normal market price
for the identical product being transferred-that is, a market price reflecting the same
conditions (quantity, delivery time, and quality) as the product to which the transfer price
applies. The market price may be adjusted downward to reflect savings accruing to the selling
unit from dealing inside the company. For example., there would be no bad debt expense, and
advertising and selling costs would be smaller when products are transferred from one
business unit to another within the company. Although less than ideal, a market price for a
similar, but not identical, product is better than no market price at all.
Freedom too source: Alternatives for sourcing should exist, and managers should be
permitted to choose the alternative that is in their own best interests. The buying managers
should be free to buy from the outside, and the selling manager should be free to sell outside.
In these circumstances, the transfer price policy simply gives the manager of each profit
center the right to deal with either insiders or outsiders at his/her discretion. The market thus
establishes the transfer price.
The decision as to whether to deal inside or outside also made by the marketplace. If buyers
cannot get a satisfactory price from the inside source, they are free to buy from the outside.
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This method is optimum if the selling profit center can sell all of its products to either
insiders or outsiders and if the buying center can obtain all of its requirements from either
outsiders or insiders.
The market price represents the opportunity costs to the seller of selling the product inside.
This is so because if the product were not sold outside. From a company point of view,
therefore, the relevant cost of the product is the market price because that is the amount of
cash that has been forgone by selling inside. The transfer price represents the opportunity cost
to the company.
Full Information: Managers must know about the available alternatives and the relevant
costs and revenues of each.
If all of these conditions are present, a transfer price system based on market prices would
induce goal congruent decisions, with no need for central administration. In the next
subsection, we consider situations in which not all of these conditions are present.
Q8.) MCS designers apparently disagree whether a SINGLE measure to evaluate profit
performance and capital investment performance is preferrable or SEPERATE
measures for each are preferrable?
We totally agree with belief what MCS designers have ,the fact that they disagree
with individually evaluating Profit Performance and Capital Investment Performance is apt.
As we know Profit Performance Evaluation is nothing but calculating the Profit in figures
that we earned for the amount of Sales that took place. And Evaluation of Capital
Investment Performance is reaching to a figure that tells us “How much we earned for the
Capital we Invested.”
DEFINITION : Comparison of the sums to be invested in a project with the earnings
expected over the period of the investment, expressed usually as return-on-investment
(ROI) percentage per accounting period is briefly noted as Capital Investment
Performance.
Most proposals require significant new capital. Techniques for analyzing Capital
Investment Proposals attempt to find either,
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1.) The net Present Value of the project, that is, the excess of the present value of the estimated
cash inflows over the amount of investment required.
OR
2.) The internal rate of return implicit in the relationship between inflows and outflows.
Capital investment decisions that involve the purchase of items such as land, machinery,
buildings, or equipment are among the most important decisions undertaken by the business
manager. These decisions typically involve the commitment of large sums of money, and
they will affect the business over a number of years. Furthermore, the funds to purchase a
capital item must be paid out immediately, whereas the income or benefits accrue over time.
Because the benefits are based on future events and the ability to foresee the future is
imperfect, you should make a considerable effort to evaluate investment alternatives as
thoroughly as possible. The most important task of investment analysis is gathering the
appropriate data. Selecting investments that will improve the financial performance of the
business involves two fundamental tasks:
1) Economic profitability analysis and
2) Financial feasibility analysis.
Economic profitability will show if an alternative is economically profitable.
However, an investment may not be financially feasible: that is, the cash flows may be
insufficient to make the required principal and interest payments.
Three cash flow/discount rate evaluation methods can be used in the financial analysis: the
net operating cash flow method, the net cash flow to investors method, and the net cash flow
to equity holders method. Any of the three methods can be used because the three elements
that must be incorporated in the analysis (risk, financing mix, and debt financing benefits)
can be included in either the cash flows or the discount rate.
Q9.) What are different methods to measure profits of a profit center in Organisations?
Which different messages each type of measure is likely to convey to managers?
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A profit centers economic performance is always measured by net income i.e. the
income remaining after all costs including a fair share of the corporate overhead, have been
allocated to profit center. The performance of the profit center manager, however, may be
evaluated by five different measures of profitability
1) CONTRIBUTION MARGIN:
It reflects the spread between revenue and variable expenses. It is to measure the
performance of profit center managers, that since fixed expenses are beyond their control,
managers should focus their attention on maximizing contribution. The problem with this
argument is that its premises are inaccurate; in fact, almost all fixed expenses are atleast
partially controllable by manager.
As many expense items are discretionary; i.e. they can be changed at the discretion of profit
center manager. A focus on contribution margin tends to direct attention away from this
responsibility. If an expense such as administrative salaries, cannot be changes in short run,
profit center manager is still responsible for controlling employee’s efficiency and
productivity.
2) DIRECT PROFIT:
This measure reflects a profit center’s contribution to the general overhead and profit
of the corporation. It incorporates all expenses either incurred by or directly traceable to
profit center, regardless of whether or not these items are within profit center manager’s
control.
In practical terms Direct Profit method can be seen as performed by a manager as under :
Expenses incurred at head quarters, however, are not included in calculation. Weakness of
direct profit measure is that it does not recognize the motivational benefit of charging head
quarter’s costs.
3) CONTROLLABLE PROFIT:
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Headquarters expenses can be divided into two categories: controllable and non-
controllable. The former category includes expenses that are controllable, at least to a degree,
by the business unit managers – information technology, services, for e.g: if these costs are
included in the measurement system profit will be what remains after the deduction of all
expenses that may be influenced by profit center manager.
In this measure all corporate overhead is allocated to profit centers based on relative amount
of expense each profit center incurs.Corporate service units have tendencies to increase their
power base and to enhance their own excellence without regard to their effect on company as
a whole. The performance of each profit center will be more realistic and more readily
comparable to the performance of competitors who pay for similar services.If profit centers
are to be charged for a proportion of corporate overhead, this item should be calculated on the
basis of budgeted, rather than actual, costs in which case the “budget” and “actual” columns
in profit centers performance reports will show identical amounts for this particular item.
This ensures that profit center managers will not complain about either the arbitrariness of
the allocation or their lack of control over this cost, since their performance reports will
show no variance in overhead allocation. Allocating corporate overheads cost to profit
centers increases the likelihood that profit center managers will question these costs, thus
serving to keep head office spending in check.
5) NET INCOME:
Here, companies measure the performance of domestic profit centers according to the
bottom line, the amount of net income tax.
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The situations in which the effective income tax rate does vary amoung profit centers.
For e.g. foreign subsidiaries or business units with foreign operation may have different
effective income tax rates. In other cases profit centers may influence income taxes through
their installment credit policies, their decision on acquiring or disposing of equipment, and
there use of other generally accepted accounting procedures to distinguish gross income from
taxable income.
In this situation a manager may be desirable to allocate income tax expenses to profit
centers not only to measure their economic profitability but also to motivate managers to
minimize tax liability.
reason, professional tend to look down on manager. Professional tends to give inadequate
weight to the financial implication of their decision; they want to do the best job they can,
regardless of its cost. This attitude affects the attitude of supports staff and nonprofessional in
the organization; it tends to adequate cost control.
o Output and input measurement:
The output of professional organization can be measured in physical terms, such as
units, tons, or gallons. We can measure the number of hours a lawyer spends on case, but this
measure of input, not output. Output is the effectiveness of the lawyer’s works, and this is not
measured by number of pages in brief or the number of hours in the court room. We can
measure the number of patients a physician treats in a day, even classify this visit by type of
complaint; but this by no means equivalent to measuring the amounts or the quality of service
the physician has provided.
o Small size:
With few exceptions, such as some law firms an accounting firms, professional
organization are relatively small and operate at a single location. Senior management in such
organization can personally observe what is going on and personally motivate employees.
Thus, there is less need for sophisticated management control system, with profit centre and
formal performance reports. Nevertheless, even a small organization needs a budget, a
regular comparison of performance against budget, and away of relating compensation to
performance.
o Marketing:
In manufacturing company there is a clear dividing line between marketing
activities and production activities; only senior management is concerned with both. Such
clean separation does not exist in most professional organization. In some, such as law,
medicine, and accounting, the profession’s ethical code limits the amounts and character of
overt marketing efforts by professionals. Marketing is an essential in almost all organization,
however. If it can not be conducted openly it takes the form of personal contact, speeches,
articles, conversation on golf course, and so on. These marketing activities conducted by the
professionals, usually by the professionals who spend much of their time in production work
– that working for clients.
Q12. Budget versus Actual Comparison for div.Z of Kiran Company is as follows
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(b) What remedial measures, if any, would you suggest based or the analysis?
Ans.:
Particulars Budget Actual
Profit Margin :
b) Turnover of Asset :
c) ROI (aXb)
= 28.57 = 27.86