Management Control System (2007)

Q1) what is Goal Congruence? What are the informal factors that
influence Goal Congruence?
Solu:Goal Congruence is a Central purpose of a management control
system, then, it is to ensure a high level of what is called Goal Congruence.
In a goal congruence process, the actions people are lead to take in
accordance with their perceived self-interest are also in the best interest of
the organization. Perfect congruence between individual goals and
organizational goals does not exist.
Informal factors that Influence Goal Congruence:Both formal systems and the informal process influence human
behaviour in organizations. They affect the degree to which goal congruence
can be achieved. The formal control system consists of Strategic plans,
budgets and reports. But it is important for the designer of the formal
systems to take into account informal process such as work ethic,
management style and culture. In order to implement the organization
strategies effectively the formal mechanism must be consistent with the
informal ones.
The factors are as follows:1) External Factors:
External factors are norms of desirable behaviours that exist in the society of
which the organization is a part. These norms includes a set of attitudes,
often collectively referred to as the work ethic which is manifested in
employees loyalties to the organization, their diligence, their spirit, their
pride in doing a good job. Some of these attitudes are local i.e. city or rest on
specific. Other attitudes and norms are industry specific.
Example: Silicon Valleya stretch of Northern California about 30 miles
long and 10 miles wideis one of the major source of new business creation
and wealth in American economy.
2) Internal Factors:
A. Culture:
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The most important internal factor is organisations own culturethe
common beliefs, shared values norms of behavior, and a assumptions that
are implicitly accepted and explicitly manifested throughout the
organization. Cultural norms are extremely important since they explain why
two organizations, with two identical formal management control systems,
may vary in terms of actual control
Example: Johnson & Johnson has a strong corporate culture, as exemplified
by the companys credo. One cannot fully understand the effect of J&Js.
Formal control system without considering the influence of their credo on the
behaviour of its employees. This was demonstrated during the Tylenol crisis
in 1982. After taking poisoned Tylenol capsules, 7 people died. J&J withdrew
all Tylenol capsules from the US Market, even though all the poisoned
capsules were sold in Chicago, the tampering occurred outside J&J premises,
and the individual responsible was not the J&J employee. The steps were
taken by the company to prevent such tampering in future.
B. Management Style:
The internal factor that probably has the strongest impact on management
control is management style. Usually, subordinates attitudes reflect what
they perceive their superiors attitudes to be, and their superiors attitudes
ultimately stem from the CEO.
Managers come in all shapes and sizes. Some are charismatic and outgoing;
others are less ebullient. Some spent much time looking and talking to
people; other relies more heavily on written reports.
C. The Informal Organization:
The lines on organization chart depict the formal relation -- the official
authority and responsibilities of each manager. But in the course of fulfilling
his responsibilities a manager interacts with many other people in the
organization as well as other managers, support units, head quarters staff
and those who are friends and acquaintances. This constitutes the informal
organization. A manager sometimes may pay no head to the order from the
formal boss because of this informal organization particularly if he is
evaluated on the basis of functional efficiency.

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D. Perceptions & Communications:
In working towards the goals of the organization operating managers must
know what the goals are and what action they are supposed to take in order
to achieve them. They receive this information through various channels
both formal and informal. Despite this range of channels, it is not always
clear what senior management wants done.
An organization is a
complicated entity and the actions that should be taken by any one part to
further the goals cannot be stated with absolute clarity.

Q2) Briefly define Discretionary Expense Centers, Engineered Expense

Center, and Profit Center & Investment Center? How is budget prepared in
Discretionary Expense Center? How is performance of the manager
evaluated in a Discretionary Expense Center?

ANS)

Discretionary

Expense

Centers

including

general

and

administrative (G&A) departments, such as finance, human resources, and

legal; research and development (R&D) departments; and marketing units
such as those performing advertising and promotion, are usually treated as
discretionary expense centers. The output from these units is not easily
measured in monetary terms, and the relationship between the resources
they expend (inputs) and the outcomes they produce is weak. Companies
control these discretionary expense centers by negotiating and eventually
authorizing an annual budget and then monitoring whether their actual
spending remains within the budgeted amounts.

Engineered Expense Center: Engineered Expense Centers are usually

found in manufacturing operations. Their input can be measured in monetary
term. Their output can be measured in physical terms. The optimum dollar
amount of input required to produce one unit of output can be determined.
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Manager of Engineered Expense Centers may be responsible for activities
such as training & employee development that are not related to current
production; their performance review should include an appraisal of how well
they carry out their responsibilities.

Profit Center: Many operating unit managers have responsibility and

authority for both production and sales. They make decisions about what
products and services to produce, how to produce them, their quality level,
price, sales and distribution systems. But these managers may not have the
authority to determine the level of capital investment in their facilities. In
these cases, operating profit may be the single best (short term)
performance measure for how well the managers are creating value from the
resources the company has put at their disposal. Such a unit, in which the
manager has almost complete operational decision-making responsibility and
is evaluated by a straight forward profit measure, is called a profit center.

Investment Center: When a local manager has all the responsibilities

described above as well as the responsibility and authority for his or her
centers working capital and physical assets, the manager is running an
investment center. The performance of such a unit is best measured with a
metric that relates profits earned to the level of physical and financial assets
employed in the center. Investment center managers are evaluated with
metrics as return on investment (ROI) and economic value-added.

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Budget prepared in Discretionary Expense Center:

Management makes budgetary decisions for Discretionary Expense Centers

that differ from those for engineered expense centers. Management
formulates the budget for Discretionary Expense Center by determining the
magnitude of the job that needs to be done. The work done by Discretionary
Expense Centers falls into two general categories: continuing & special.
Continuing work is done consistently from year to year, such as the
preparation of financial statements by the controllers office. Special work is
a one-shot projecteg. Developing & installing a profit budgeting system
in a newly acquired division.
A technique often used in preparing a Discretionary Expense Centers budget
is Management by Objectives, a formal process in which a budgeted
proposes to accomplish specific jobs & suggests the measurement to be
used in performance evaluation. The planning function for Discretionary
Expense Centers is usually carried out in one of two ways: incremental
budgeting or zero-base review.

Performance of the manager evaluated in a Discretionary Expense Center:

The primary job of a Discretionary Expense Centers manager is to obtain the

desired output. Spending an amount that is on budget to do this is
satisfactory; spending more than that is cause for concern; & spending less
may indicate that the planned work is not done. In Discretionary Expense
Centers the financial report is not a means of evaluating the efficiency of the
manager.
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Total control over Discretionary Expense Centers is achieved primarily

through no financial performance measures. E.g. the best indication of the
quality of service for some Discretionary Expense Centers may be the
opinion of their users.

Q3) Every SBU is a profit center but every profit center is not a SBU? What
are the conditions that should be fulfilled for an organization unit to be
converted into a profit center? What are the different ways to measure the
performance of profit center? Discuss their relative merits & demerits?
ANS) Strategic Business Unit or SBU is understood as a business unit within
the overall corporate identity which is distinguishable from other business
because it serves a defined external market where management can conduct
strategic planning in relation to products and markets. When companies
become really large, they are best thought of as being composed of a
number of businesses (or SBUs).
These organizational entities are large enough and homogeneous enough to
exercise control over most strategic factors affecting their performance. They
are managed as self contained planning units for which discrete business
strategies can be developed. A Strategic Business Unit can encompass an
entire company, or can simply be a smaller part of a company set up to
perform a specific task. The SBU has its own business strategy, objectives
and competitors and these will often be different from those of the parent
company
Profit Centres are parts of a Corporation that directly add to its Profit. A
profit center manager is held accountable for both revenues, and costs
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(expenses), and therefore, profits. What this means in terms of managerial
responsibilities is that the manager has to drive the sales revenue generating
activities which leads to cash inflows and at the same time control the cost
(cash outflows) causing activities.
Profit center management is equivalent to running an independent business
because a profit center business unit or department is treated as a distinct
entity enabling revenues and expenses to be determined and its profitability
to be measured. Business organizations may be organized in terms of profit
centers where the profit center's revenues and expenses are held separate
from the main company's in order to determine their profitability. Usually
different profit centers are separated for Accounting purposes so that the
management can follow how much profit each center makes and compare
their relative efficiency and profit.
After learning about the profit center & SBU, hence we can say that every
SBU is a profit center but every profit center is not a SBU.
The conditions that should be fulfilled for an organization unit to be
converted into a profit center are:
The manager should have access to the relevant information needed
for making such a decision.
There should be some way to measure the effectiveness of the tradeoffs the manager has made.
There are 2 types of measuring the performance of the profit center they are:
The measure of Management Performance, which focuses on how
well the manager is doing. This measure is used for planning,
coordinating, & controlling the profit centers day-to-day activities & as
a device for providing the proper motivation for its manager.
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The measure of Economic Performance, which focuses on how well
the profit center is doing as an economic entity. 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 the profit center). The performance
of the profit center manager, however, may be evaluated by 5 different
measures of profitability & they are:
1. Contribution Margin,
2. Direct profit,
3. Controllable Profit,
4. Income before Income Taxes, or
5. Net Income.

Merits of Profit Centers:

1) The quality of decisions may improve because they are being made
by managers closest to the point of decision.
2) The speed of operating decisions may be increased since they do not
have to be referred to corporate headquarters.
3) Headquarters management, relieved of day-to-day decision-making,
can concentrate on border issues.
4) Managers, subject to fewer corporate restraints, are freer to use their
imagination & initiative.
5) Profit centers provide an excellent training ground for general
management & for managers.
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6) Profit

Consciousness

is

enhanced

since

managers

who

are

responsible for profits will constantly seek ways to increase them.

7) Profit centers provide top management with ready-made information
on the profitability of the companys individual components.
8) As the output is readily measured, profit centers are particularly
responsive to pressures to improve their competitive performance.
Demerits of the Profit Centers:
1) Decentralized decision-making will force top management to rely more
on management control reports than on personal knowledge of an
operation, entailing some loss of control.
2) If headquarters management is more capable or better informed than
the average profit center manager, the quality of decisions made at
the unit level may be reduced.
3) Friction may increase because of arrangement over the appropriate
transfer price, the assignment of common costs, & the credit for
revenues that were formerly generated jointly by two or more business
units working together.
4) Organization units that once cooperated as functional units may now
be in competition with one another. An increase in profits for one
manager may mean a decrease for another. In such situations, a
manager may fail to refer sales leads to another business unit better
qualified to pursue them; may hoard personnel or equipment that,
from the overall company standpoint, would be better off used in
another unit; or may make production decisions that have undesirable
csot consequences for other units.

Management Control System (2007)

5) Divisionalization may impose additional costs because of additional
management. Staff personnel and record keeping required, and may
lead to task redundancies at each profit center.
6) Competent

general

managers

may

not

exist

in

functional

organization because there may not have sufficient opportunities for

them to develop general management competence.
7) There is no completely satisfactory system for ensuring that optimizing
the profits of each individual profit center will optimize the profits of
the company as a whole.
8) There may be too much emphasis on short-run profitability at the
expense of long-run profitability. In the desire to report high current
profits, the profit center manager may skimp on R&D, training prog, or
maintenance. This tendency is especially prevalent when the turnover
of profit center managers is relatively high. In these circumstances,
managers may have good reason to believe that their actions may not
affect profitability until after they have moved to other jobs.

Q4) what are the objectives of Transfer Pricing? What is ideal transfer price
in the situations of: - (a) Limited Market (b) Shortage of capacity in the
industry. When do you use Cost Based Transfer Prices?
ANS) Objectives of Transfer Pricing:
1) It should provide each business unit with the relevant information it
needs to be determined the optimum trade-off between company costs
& revenues.

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2) It should induce Goal Congruent decisions--- that are; the system
should be designed so that decisions that improve business unit profits
will also improve company profits.
3) It should help measure the economic performance of the individual
business units.
4) The system should be simple to understand & easy to administer.
Ideal transfer price in the situations of: - (a) Limited Market:
In the case of limited markets, the transfer price that best satisfies the
requirements of a profit center system is the

competitive

price.

Competitive prices measure the contribution of each profit center to the total
company profits.
Ideal transfer price in the situations of: - (b) Shortage of capacity in the
Industry
In the case of the Shortage of Capacity in the Industry, the transfer price
would be the competitive price, and the other option is to develop Costbased transfer prices.
When to use Cost Based Transfer Prices:
Cost Based Transfer Prices is used, if competitive prices are not available,
transfer prices may be set on the basis of cost plus profit, even though such
transfer prices may be complex to calculate & the results less satisfactory
than a market-based price. Two decisions must be made in a cost-based
transfer price system:
1. How to define cost &
2. How to calculate the profit markup.
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Q8) Write Short notes on:

I.

Zero-based budgeting
Zero based budgeting is a technique of planning and decision-making which
reverses the working process of traditional budgeting. In traditional
incremental budgeting, departmental managers justify only increases over
the previous year budget and what has been already spent is automatically
sanctioned. No reference is made to the previous level of expenditure. By
contrast, in zero-based budgeting, every department function is reviewed
comprehensively and all expenditures must be approved, rather than only
increases. Zero-based budgeting requires the budget request be justified in
complete detail by each division manager starting from the zero-base. The
zero-base is indifferent to whether the total budget is increasing or
decreasing. Zero-based budgeting starts from a zero base and every
function within an organization are analyzed for its needs and costs.

Advantages of Zero-Based Budgeting

1. Efficient allocation of resources, as it is based on needs and benefits.
2. Drives managers to find cost effective ways to improve operations.
3. Detects inflated budgets.
4. Municipal planning departments are exempt from this budgeting
practice.
5. Useful for service departments where the output is difficult to identify.
6. Increases

staff

motivation

by

providing

greater

initiative

and

responsibility in decision-making.
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7. Increases communication and coordination within the organization.
8. Identifies and eliminates wasteful and obsolete operations.
9. Identifies opportunities for outsourcing.
10.

Forces cost centers to identify their mission and their relationship

to overall goals.

Disadvantages of Zero-Based Budgeting

1. Difficult to define decision units and decision packages, as it is timeconsuming and exhaustive.
2. Forced to justify every detail related to expenditure. The R&D
department is threatened whereas the production department benefits.
3. Necessary to train managers. Zero-based budgeting must be clearly
understood

by

managers

at

various

levels

to

be

successfully

implemented. Difficult to administer and communicate the budgeting

because more managers are involved in the process.
4. In a large organization, the volume of forms may be so large that no
one person could read it all. Compressing the information down to a
usable size might remove critically important details.
5. Honesty of the managers must be reliable and uniform. Any manager
that exaggerates skews the results.

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II. Free Cash Flow
A measure of financial performance calculated as operating cash flow minus
capital expenditures. Free cash flow (FCF) represents the cash that a
company is able to generate after laying out the money required to maintain
or expand its asset base. Free cash flow is important because it allows a
company to pursue opportunities that enhance shareholder value. Without
cash, it's tough to develop new products, make acquisitions, pay dividends
and reduce debt. FCF is calculated as:

It can also be calculated by taking operating cash flow and subtracting

capital expenditures. If free cash flow is positive then the company has done
a good job of managing its cash. If free cash flow is negative then the
company may have to look for other sources of funding such as issuing
additional shares or debt financing.
If a company has a negative free cash flow and has to issue more equity
shares, this will dilute the profits per share. If the company chooses to seek
debt financing, there will be additional interest expense as a result and the
net income of the company will suffer.
When investing for dividend growth, we can assume that for a company to
continuously grow its dividend there must be positive cash flow.
Free cash flow is one indicator of the ability of a company to return profits to
shareholders

through

debt

reduction,

increasing

dividends,

or

stock
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buybacks. All of these scenarios result in an increased shareholder yield and
a better return on investment. The term Free cash Flow is used because
this cash is free to be paid back to the suppliers of capital.

III. Management Control in Matrix Organization

If members of the project team are employees of the sponsoring
organization, they have 2 bosses, the project manager & the manager of the
functional department to which they are permanently assigned. Such an
arrangement is called Matrix Organization. However, their basic loyalty is to
their functional department. Therefore, project manager has less authority
over personnel than the manager of a production department, whose
employees have an undivided loyalty to that department.
Project managers want full attention given to their projects, while functional
responsibility center managers must take into account all the projects on
which the employees of that center work. This conflict of interest is
inevitable; it creates tension. Hence it is necessary to have a good
management control on this type of organization.
An evolution of organization structure should be in place to handle the work
smoothly. Different types of management personnel & management methods
may be appropriate at different stage of the project. In the planning phase of
a construction project, architects, engineers, schedulers, & cost analysts
predominate. In the execution of the project, the managers are production
managers. In the final stages, the work tapers off, & the principal task may
be to obtain the sponsors acceptance, with marketing skills being a principal
requirement.

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If the project is conducted by an outside contractor, an additional level of
project control is created. In addition to the control exercised by the
contractor who does the work, the sponsoring organization has its own
control responsibilities. The contractor could bring its own control system to
the project, & this system need to be adopted to provide information that the
sponsors needs. This doesnt imply that there are duplicate systems; the
sponsors system should use data from the project system.
IV. Internal Control
Internal control is the process by which managers influence other members
of the organization to implement the organizations strategies. Internal
control involves a variety of activities, including:
Planning what the organization should do.
Coordinating the activities of several parts of the organization.
Communicating information.
Deciding what, if any, action should be taken.
Influencing people to change their behavior.
Internal control doesnt necessarily require that all actions correspond to a
previously determined plan, such as a budget. Such plans are based on
circumstances believed to exist at the time they were formulated. If these
circumstances have changed at the time of implementation, the actions
dictated by the plan may no longer be appropriate.

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