Accounting Management Control Systems PDF

The Nature of Management Control Systems  Basic Concepts What does Control mean? Press the accelerator, and your car goes faster. Rotate the steering wheel, and it changes direction. Press the brake pedal, and the car slows or stops. With these devices, you control speed an...

The Nature of Management Control Systems  Basic Concepts What does Control mean? Press the accelerator, and your car goes faster. Rotate the steering wheel, and it changes direction. Press the brake pedal, and the car slows or stops. With these devices, you control speed and direction; if any of them is inoperative, The car does not do what you want it to. In other words, it is out of control  Basic Concepts An organization must also be controlled; that is, devices must be in place to ensure that its strategic intentions are achieved. But controlling an organization is much more complicated than controlling a car. We will begin by describing the control process in simpler systems. Elements of a Control System Every control system has at least four elements: 1. A detector 2. An assessor 3. An effector 4. A communications network  The four „control” elements 1. A detector or sensor a device that measures what is actually happening in the process being controlled. 2. An assessor a device that determines the significance of what is actually happening by comparing it with some standard or expectation of what should happen. 3. An effector a device (often called “feedback”) that alters behavior if the assessor indicates the need to do so. 4. A Communications network devices that transmit information between the detector and the assessor and between the assessor and the effector.  Example: You are driving a car 6 Detectors: Assessor: Effector: Communication network:  Your eyes (detectors) measure actual speed by 7 observing the speedometer. Your brain (assessor) compares actual speed with desired speed (standard: the highest speed is e.g. 90 km/hour) to detect a deviation from standard. Your brain (assessor) directs your foot (effector) to ease up the accelerator if actual speed (100 km/hour) is faster than the standard speed (90 km/hour), press down the accelerator if the actual speed (80 km/hour) is slower than standard speed (90 km/hour). And, your nerves (communication network) form the communication system that transmits information from eyes (detectors) to brain (assessor) and from brain (assessor) to foot (effector). Elements of the control process  Management An organization consists of a group of people who work together to achieve certain common goals in a business organization a major goal is to earn a satisfactory profit  Hierarchy of managers Organizations are led by a hierarchy of managers, with the chief executive officer (CEO) at the top, and the managers of business units, departments, functions,  and other subunits ranked below him or her in the organizational chart.  Hierarchy in the organization The complexity of the organization determines the number of layers in the hierarchy. All managers other than the CEO are both superiors and subordinates: they supervise the people in their own units, and they are supervised by the managers to whom they report The management control process The CEO (or a team of senior managers) decides on the overall strategies that will enable the organization to meet its goals. With the approval of the CEO, the leaders of the various business units formulate additional strategies that will enable their respective units to advance these goals. The management control process is the process by which managers at all levels ensure that the people they supervise implement their intended strategies  Contrast with Simpler Control Processes The control process used by managers contains the same elements as those in the simpler control systems described earlier:  detectors, assessors, effectors, and communications system Contrast with Simpler Control Processes Detectors report what is happening throughout the organization; Assessors compare this information with the desired state; Effectors take corrective action once a significant difference between the actual state and the desired state has been perceived; Communications system Tells managers what is happening and how that compares to the desired state Differences There are significant differences between the management control process and the simpler processes (car driving, temperature measurement):  Differences (1) 1. Unlike in the thermostat or body temperature systems, in the businesses the standard is not preset rather, it is a result of a conscious planning process. 2. The management decides what the organization should be doing, and part of the control process is a comparison of actual accomplishments with these plans. 3. The control process in an organization involves planning. 4. In many situations, planning and control can be viewed as two separate activities BUT 5. In management control involves both planning and control.  Differences (2) Like controlling an automobile management control is not automatic. Some detectors in an organization may be mechanical, but the manager often detects important information with her own eyes, ears, and other senses so if it necessary he/she could make alter in organization’s behavior Management Control involves human beings, the manager must contact with at least one other person to effect change  Differences (3) Unlike controlling an automobile, where a function performed by a single individual, management control requires coordination among individuals An organization consists of many separate parts, management control must ensure that each part works in harmony with the others  Differences (4) The term black box describes an operation whose exact nature cannot be observed Unlike the thermostat or the automobile driver, a management control system is a black box. We cannot know what action a given manager will take when there is a significant difference between actual and expected performance, nor what action others will take in response to the manager’s signal  Differences (5) Much management control is self-control; control is maintained not by an external regulating device like the thermostat, But by managers who are using their own judgment rather than following instructions from a superior. Systems  Definition A system is a prescribed and usually repetitious way of carrying out an activity or a set of activities Systems are characterized by a more or less rhythmic, coordinated, and recurring series of steps intended to accomplish a specified purpose.  Management actions Many management actions are unsystematic. Managers regularly meet situations for which the rules are not well defined and thus must use their best judgment in deciding what actions to take. The effectiveness of their actions is determined by their skill in dealing with people, not by a rule specific to the system (though the system may suggest the general nature of the appropriate response) If all systems ensured the correct action for all situations, there would be no need for human managers  Boundaries of Management Control  Planning and Control we define management control and distinguish it from two other systems— or activities—that also require both planning and control: strategy formulation task control  Management Control Management control fits between strategy formulation and task control in several respects Strategy formulation is the least systematic of the three, Task control is the most systematic, and Management control lies in between  Management Control Strategy formulation focuses on the long run, Task control focuses on short-run activities, and Management control is in between.  Management Control Strategy formulation uses rough approximations of the future, Task control uses current accurate data, Management control is in between. Each activity involves both planning and control, but the emphasis varies with the type of activity  Management Control The planning process is much more important in strategy formulation, the control process is much more important in task control, and planning and control are of approximately equal importance in management control. General relationships among planning and control  Management Control Activities Planning what the organization should do. Coordinating the activities of several parts of the organization. Communicating information. Evaluating information. Deciding what, if any, action should be taken. Influencing people to change their behavior.  Management Control Activities Management control does not 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  Management Control Activities If these circumstances have changed at the time of implementation, the actions dictated by the plan may no longer be appropriate (suitable). While a thermostat responds to the actual temperature in a room, management control involves calculating future conditions to ensure that the organization’s objectives are realized.  Management Control Activities If a manager discovers a better approach one more likely than the predetermined plan to achieve the organization’s goals— the management control system should not obstruct its implementation. In other words, conforming to a budget is not necessarily good, and departure from a budget is not necessarily bad.  Goal Congruence Although systematic, the management control process is by no means mechanical; it involves interactions among individuals, which cannot be described in mechanical ways. Managers have personal as well as organizational goals.  Goal Congruence The central control problem is to influence them to act in pursuit of their personal goals in ways that will help reach the organization’s goals as well. Goal congruence means that, the goals of an organization’s individual members should be consistent with the goals of the organization itself. The management control system should be designed and operated with the principle of goal congruence in mind.  Tool for Implementing Strategy  Management Control systems help managers move an organization toward its strategic objectives.  Thus, management control focuses primarily on strategy execution.  Management Controls are only one of the tools managers use in implementing desired strategies.  Strategies are also implemented through the organization’s structure, its management of human resources, and its particular culture. Framework for strategy implementation  Framework for strategy implementation Organizational structure specifies the roles, reporting relationships, and division of responsibilities that shape decision- making within an organization. Human resource management is the selection, training, evaluation, promotion, and termination of employees so as to develop the knowledge and skills required to execute organizational strategy. Culture refers to the set of common beliefs, attitudes, and norms that explicitly or implicitly guide managerial actions. Financial and Nonfinancial Emphasis  Management control systems contains both financial and nonfinancial performance measures.  The financial dimension focuses on the monetary “bottom line”— net income, return on equity, and so forth.  virtually all organizational subunits have nonfinancial objectives— product quality, market share, customer satisfaction, on-time delivery, and employee morale. Aid in Developing New Strategies - interactive control the primary role of management control is to ensure the execution of chosen strategies. In industries that are subject to rapid environmental changes, management control information, especially of a nonfinancial nature can also provide the basis for considering new strategies Interactive control  Interactive control Interactive control calls management’s attention to developments both negative (e.g., loss of market share, customer complaints) and positive (e.g., the opening up of a new market as a result of the elimination o f certain government regulations) that indicate the need for new strategic initiatives. Interactive Controls are an integral part of the management control system.  Strategy Formulation is the process of deciding on the goals of the organization and the strategies for attaining these goals Goals are timeless; they exist until they are changed, and they are changed only rarely  Strategy Formulation For many businesses, earning a satisfactory return on investment is an important goal; for others, attaining a large market share is equally important. Nonprofit organizations also have goals; they seek to provide the maximum services possible with available funding.  Strategies Strategies are big plans, important plans. They state in a general way the direction in which senior management wants the organization to move. E.g. A decision by an automobile manufacturer to produce and sell an electric automobile would be a strategic decision  Strategies The need for formulating strategies usually arises in response to a perceived threat (e.g., market attacks by competitors, a shift in consumer tastes, or new government regulations) or opportunity (e.g., technological innovations, new perceptions of customer behavior, or the development of new applications for existing products). Strategies A new CEO, especially one brought in from the outside, usually perceives both threats and opportunities differently from how his or her predecessor did. Thus, changes in strategies often occur when a new CEO takes over  Strategies Strategies to address a threat or opportunity can arise from anywhere in an organization and at any time New ideas do not emanate solely from the research and development team or the headquarters staff. Virtually anyone might come up with a “bright idea,” which, after analysis and discussion, can form the basis for a new strategy. strategy formulation  Complete responsibility for strategy formulation  should never be assigned to a particular person or organizational unit.  Providing a means of bringing worthwhile ideas directly to the attention of senior management  without allowing them to be blocked at lower levels is important Distinctions between Strategy Formulation and Management Control Strategy formulation is the process of deciding on new strategies; Management control Is the process of implementing those strategies. From the standpoint of systems design, the most important distinction between strategy formulation and management control is that strategy formulation is essentially unsystematic strategic decisions  Threats, opportunities, and new ideas  do not occur at regular intervals;  thus,  strategic decisions may be made at any time Strategic analysis  the analysis of a proposed strategy varies with the nature of the strategy.  Strategic analysis involves  much judgment,  the numbers used in the process are usually rough estimates  the management control process involves  a series of steps that occur in a predictable sequence according to a more-or-less fixed timetable  and with reliable estimates Strategy vs. management control  Analysis of a proposed strategy usually involves relatively few people  The sponsor of the idea, headquarters staff, and senior management.  the management control process involves  managers and their staffs  at all levels in the organization Task Control  Task control is the process  of ensuring that specified tasks are carried out effectively and efficiently  it is transaction-oriented  it involves the performance of individual tasks according to rules established in the management control process Task Control  Task control often consists of seeing that these rules are followed,  A function that in some cases does not  even require the presence of human beings  Numerically controlled machine tools,  process control computers,  and robots  are mechanical task control devices Task Control  Their function involves humans only  when the latter prove less expensive or more reliable;  this is likely to happen only if  unusual events occur so frequently that programming a computer  with rules for dealing with these events is not worthwhile Task Control  Many task control activities are scientific  the optimal decision or the appropriate action  for bringing an out-of-control condition back to the desired state is predictable within acceptable limits.  the rules for economic order quantity  determine the amount and timing of purchase orders Task Control  Most of the information in an organization is task control information:  The number of items ordered by customers,  the pounds of material and units of components used in the manufacture of products,  The number of hours employees work,  the amount of cash disbursed Task Control  Many of an organization’s central activities  including procurement, scheduling, order entry, logistics, quality control, and cash management  are task control systems  Some of them, though mechanical, can be extremely complicated Distinctions between Task Control and Management Control Many task control systems are scientific, whereas management control can never be reduced to a science. Management control involves the behavior of managers, and this cannot be expressed by equations Examples of Decisions  Distinctions between Task Control and Management Control Serious errors may be made when principles developed by management scientists for task control situations are applied to management control situations In management control, managers interact with other managers; In task control, either human beings are not involved at all (as in some automated production processes), or the interaction is between a manager and a nonmanager  Distinctions between Task Control and Management Control In management control the focus is on organizational units; In task control the focus is on specific tasks performed by these organizational units (e.g.,Manufacturing job no. 59268, or ordering 100 units of part no. 3642…)  Distinctions between Task Control and Management Control Management control is concerned with the broadly defined activities of managers deciding what is to be done within the general constraints of strategies. Task control relates to specified tasks, most of which require little or no judgment to perform. Impact of the Internet on Management Control The pace of the information revolution accelerated with the invention of computers, gaining tremendous momentum in the 1990s with the advent of the Internet  The Internet provides major benefits, such as: Instant access Multi-targeted communication Costless communication Ability to display images Shifting power and control to the individual  Impact of the Internet With these advantages the Internet has changed the rules of the game in the business-to-individual consumer sector The Internet has also changed business- to-business commerce The impact of the Internet on the world of business has been significant  The Internet’s impact on Management Controls  Management control systems involve information, and organizations require an infrastructure to process that information.  The Internet provides that infrastructure, making the processing of information easier and faster, with fewer errors.  On the Web, a manager can collect huge amounts of data, store that data, analyze it in different forms, and send it to anyone in the organization.  Managers can also use this information to customize and personalize their reports  The Internet’s impact on Management Controls The Internet facilitates coordination and control through the efficient and effective processing of information, but the Internet cannot substitute for the fundamental processes that are involved in management control. This is because implementing strategies through management Controls is essentially a social and behavioral process and thus cannot be fully automated  The Internet’s impact on Management Controls Although the Internet has vastly improved information processing, the fundamental elements of management control what information to collect and how to use it are essentially behavioral in nature and thus not amenable to a formula approach COST AND THEIR IMPORTANCE 1ST SEMINAR  OVERVIEW OF COST CATEGORIES FOR A MANUFACTURING FIRM  All costs incurred by the firm must be accounted for in its financial statements MANUFACTURING COSTS Direct Materials (DM) Direct Labor (DL) Overhead (OH) Indirect Materials Indirect Labor Other NON-MANUFACTURING COSTS Marketing or Selling Costs Administrative Costs MANUFACTURING COSTS 1. Direct Materials (DM)  Materials that are consumed in the manufacturing process and physically incorporated in the finished product  Materials whose cost is sufficiently large to justify the record keeping expenses necessary to trace the costs to individual products MANUFACTURING COSTS 2. Direct Labor (DL)  Labor time that is physically traceable to the products being manufactured  Labor time whose cost is sufficiently large to justify the record keeping expenses necessary to trace the costs to individual products Example: Direct labor for manufacturing Honda Accords  Line workers, robot operators, painters, assembly workers Any labor probably not included in direct labor?  Factory janitors, factory supervisors, factory secretaries KEY ISSUES IN DETERMINING DIRECT LABOR Is idle time generally considered as direct labor? Why or why not?  Usually not. It is not usually due to one product, hence it is not traceable What are the typical fringe benefits an assembly line worker receives?  Health insurance, pension plan, disability insurance Is the cost of fringe benefits for the assembly line workers generally considered direct labor?  Usually yes, the costs can be traced  KEY ISSUES IN DETERMINING DIRECT LABOR When an assembly line worker works overtime, he/she is paid a regular wage plus an overtime premium. Would most companies treat his/her regular wage as a direct labor cost?  Yes, the amount of time an employee works can be traced to the products. What about the overtime premium?  Treated as Overhead (OH), cannot be traced to a specific product. MANUFACTURING COSTS 3. Manufacturing Overhead (OH) All of costs of manufacturing excluding direct materials and direct labor a. Indirect Materials (IM) – Materials, used in the manufacturing of products, which are difficult to trace to particular products in an economical way  Glue, nails, cleaning supplies b. Indirect Labor (IL) – Labor, used in the manufacturing of products, which is difficult to trace to particular products in an economical way  Wages for maintenance workers, factory supervisor’s salary, idle time MANUFACTURING COSTS c. All other types of manufacturing overhead  Depreciation on machinery, depreciation on factory building, factory insurance, utilities for factory NON-MANUFACTURING COSTS 1. Marketing or Selling Costs – Costs incurred in securing orders from customers and providing customers with the finished product  Sales commissions, costs of shipping products to customers, storage of finished goods, depreciation of selling equipment (cash register) 2. Administrative Costs – Executive, organizational, and clerical costs that are not related to manufacturing or marketing  CEO’s salary, cost of controller’s office, depreciation on administrative building. CLASSIFICATION EXERCISE Classify the following cost items  Depreciation on factory building  Other OH  Depreciation on office equipment  NMC (marketing or adminstrative?)  Property tax on finished goods warehouse  Marketing or selling cost  Wages paid to forklift operator in finished goods warehouse  Marketing or selling cost  Wages paid to forklift operator in factory  Indirect Labor IL  Wages paid to welders when welding equipment is not working  IL  Paper used in textbook production  DM  Paper used in central office computer  Administrative costs  Wages paid to assembly line workers  DL  Maintenance cost for machines  Manufacturing OH IL OTHER COST CONCEPTS Product Costs or Inventoriable Costs – costs assigned to products that were either purchased for resale (merchandising firm or retailer) or manufactured for sale (manufacturing firm)  When products are sold, product costs are recognized as an expense (cost of goods sold or COGS). The costs of unsold products remain in inventory and are not expensed (i.e. not deducted from revenue in calculating net income) Period Costs – costs that are not product costs and that are associated with the period in which they are incurred  Period costs such as selling and administrative costs are expensed (i.e. deducted from revenue in calculating net income) in the period they are incurred PRODUCT COSTS VERSUS PERIOD COSTS Product costs include Period costs are not direct materials, direct included in product labor, and costs. They are manufacturing expensed on the overhead. income statement. Cost of Inventory Goods Sold Expense Sale Balance Income Income Sheet Statement Statement QUICK CHECK  WHICH OF THE FOLLOWING COSTS WOULD BE CONSIDERED A PERIOD RATHER THAN A PRODUCT COST IN A MANUFACTURING COMPANY? A. Manufacturing equipment depreciation. Product cost B. Property taxes on corporate headquarters. Period cost C. Direct materials costs. Product cost D. Electrical costs to light the production facility. Product cost E. Sales commissions. Period cost COSTS RELATED TO DECISION MAKING Opportunity Costs - costs when taking one action requires giving up the opportunity to earn profits from a different action  Nike Inc. has limited production capacity. What would be Nike’s opportunity cost of accepting a special order from the military for combat boots? If Nike accepts the special order, they may not be able to produce enough product for other sales. So, Nike would lose the profit from the other sale. COSTS RELATED TO DECISION MAKING Incremental Costs or Differential Costs – additional costs incurred when choosing a certain course of action over another (Note that incremental costs can include opportunity costs)  What would be Macy’s incremental costs of expanding its fragrance department and shrinking its accessories department? The costs of stocking and staffing the new fragrance area, opportunity costs of lost profit from the decrease in sales of accessories COSTS RELATED TO DECISION MAKING Incremental Benefits or Differential Benefits – additional benefits reaped when choosing a certain course of action over another  What would be Macy’s incremental benefits of expanding its fragrance department and shrinking its accessories department? Profits Macy’s expects to earn on the new fragrances it displays/stocks Sunk Costs – Costs that have been incurred and that are not affected by any current/future action  What would be considered sunk cost if Macy’s decides to expand its fragrance department and shrink its accessories department? Depreciation on the building, cost of the building  COST FLOWS IN A MANUFACTURING COMPANY 3. Inputs such as labor and capital equipment are also incurred to make the product. The costs of all the inputs used in the manufacturing facilities are recorded in WORK IN PROCESS INVENTORY 4. As products are finished, they are moved to finished goods warehouse and their costs are recorded in FINISHED GOODS (FG) INVENTORY  COST FLOWS IN A MANUFACTURING COMPANY RAW MATERIALS INVENTORY Beg. Bal. - RM Materials used in Production (DM) Materials Purchased End. Bal. - RM WORK IN PROCESS INVENTORY Beg. Bal. - WIP Cost of Goods Manufactured DM (COGM) DL OH End. Bal. - WIP FINISHED GOODS INVENTORY Beg. Bal. - FG Cost of Goods Sold (COGS) COGM End. Bal. - FG THE INVENTORY EQUATION Beginning Inventory Ending Inventory + = + Additions to Inventory Items Removed from Inventory  The inventory equation allows us to put together the following schedules: Schedule of Total Manufacturing Costs Schedule of Cost of Goods Manufactured (of the period) QUICK CHECK  If your inventory balance at the beginning of the month was $1,000, you bought $100 during the month, and sold $300 during the month, what would be the balance at the end of the month? A. $1,000. $1,000 + $100 = $1,100 B. $ 800. $1,100 - $300 = $800 C. $1,200. D. $ 200. QUICK CHECK  Beginning raw materials inventory was $32,000. During the month, $276,000 of raw material was purchased. A count at the end of the month revealed that $28,000 of raw material was still present. What is the cost of direct material used? A. $276,000 B. $272,000 C. $280,000 D. $ 2,000 QUICK CHECK  Beginning work in process was $125,000. Manufacturing costs incurred for the month were $835,000. There were $200,000 of partially finished goods remaining in work in process inventory at the end of the month. What was the cost of goods manufactured during the month? A. $1,160,000 B. $ 910,000 C. $ 760,000 D. Cannot be determined. VARIABLE AND FIXED COSTS Activity – a quantitative measure of a firm’s output of goods or services  Number of Chrysler vans  Pairs of Nike shoes  Tons of cement produced Variable Costs – costs that change proportionately (in total) with the activity level within a relevant range of activity Fixed Costs – costs that do not change in total as activity level changes within a relevant range of activity Example: Publishing a magazine Variable costs Fixed Costs Cost of paper Rent on building Cost of ink Salaries to reporters Sales Commissions Depreciation on printing equipment Cost of lubricants for machine Cost of operating press TOTAL VARIABLE AND FIXED COSTS Total Variable Cost Total Fixed Cost Number of units Number of units VARIABLE AND FIXED COSTS PER UNIT Per Unit Variable Cost Per Unit Fixed Cost Number of units Number of units  RELEVANT RANGE The range of activity within which the firm’s cost structure (i.e. variable cost per unit and total fixed cost) remains unchanged  Publishing a small number of magazines (cost structure of a small publisher) Total Variable Cost Total Fixed Cost Relevant Range Number of units Relevant Range Number of units  TOTAL COSTS To get total costs you need to add variable costs and fixed costs Total Cost Fixed costs The Slope is the variable cost per unit Number of units Chapter 3 Behavior in Organizations Management controll systems (MCS) influence the human behavior. Good MCS influence behavior in a goal congruent manner So they ensure that individual actions taken to achive the personal goals Also help to achieve the organization’s goals. 3.1. Goal Congruence The central purpose of a MCS is to ensure a high level of what is called „ GOAL CONGRUENCE” In a goal of congruent process the actions people are led to take accordance with their percieved self-interest are also in the best interest of the organizations. The Formal Controll Process Source: Anthony & Govindarajan, 2007 3.2. Types of Organization 3.2. Types of Organization A) Functional Organization 3.2. Types of Organization A) Functional Organization 3.2. Types of Organization 3.2. Types of Organization B)Business Unit Organizations 3.2. Types of Organization C) Matrix Organizations 3.2. Types of Organization C) Matrix Organizations 3.2. Types of Organization  3.3. Functions of the Controller The person who is responsible for the designing and operating the MCS is the CONTROLLER. Actually in many organizations, the title of this person (controller) is chief financial officer (CFO)  3.3. Functions of the Controller 1 Designing and operating information and controll systems. Preparing financial statements and financial report for shareholders and other externals parties. Preparing and analyzing performance reports, interpreting this reports for managers, and analyzing program and budget proposals for various segments of the company and consolidating them into an overall annual budget. 3.3. Functions of the Controller 2 Supervising internal audit and accounting controll procedures to ensure the validity of information, establishing adequate safeguards against theft and fraud and performing operational audits. Developing personnel (employees) in the controller origanization and participating in the education of management personnel in matters relating to the controller functions. 3.3. The functions of the financial controller The financial controller is the professional responsible for the company’s financial control, his/her position in the company being linked to control and supervision and thus providing a bridge between management and accounting.  This position’s functions vary significantly depending on whether the company is a single company or a subsidiary or whether it is a parent organization of a company of a certain size.  3.3.1.The financial controller of a medium- sized company or subsidiary 1 In a company of these characteristics, the financial controller’s functions are basically operational, the main and most common being:  Contribution at a basic level to the supervision of the preparation of the annual accounts of the company.  Guaranteeing compliance with both accounting and tax obligations.  Verification of compliance with tax objectives and the organization's standards and procedures.  Detection of errors, deviations and areas for improvementfrom a financial perspective.  Implementation of methodological and IT tools to control activity. 3.3.1.The financial controller of a medium- sized company or subsidiary 2  Optimization of information systems.  Treasury management and supervision of the level of funds needed for common costs and investments.  Training and motivation of the financial and accounting teams under his/her responsibility.  Sending of reports to the Senior Management of the company, subsidiary or, if applicable, Financial Director of the central or parent company.  Occasionally being responsible for maintaining the relationship with the external auditors and responding to their demands.  3.3.1.The financial controller in the central company 1 The role of financial controller is significantly modified in the case of large companies with a parent company and various subsidiaries. In the event that this professional controls the central company, his/her role will be less operational and more focused on such issues as: The supervision of the preparation of the individual and consolidated annual accounts as well as the financial statements of the whole Group. Development and implementation of internal control. Definition of the standards and procedures of the whole company.  3.3.1.The financial controller in the central company 2 Organization and analysis of the reporting system. Coordination of the Group or organization’s transversal projects, which may relate to strategy, IT, finance or accounting. Control of the company’s overall financial objectives: budgets, investments, funding, etc. Participation in the definition of the company’s general business plan.  Responsibility Centers: Revenue and Expense Centers  4.1. Responsibility center A responsibility center is an organization unit that is headed by a manager who is responsible for its activities In a sense, a company is a collection of responsibility centers, each of which is represented by a box on the organization chart!  Hierarchy These responsibility centers form a hierarchy At the lowest level are the centers for sections, work shifts, and other small organization units. Departments or business units comprising several of these smaller units are higher in the hierarchy  4.1.1. Nature of Responsibility Centers A responsibility center exists to accomplish one or more purposes, termed its objectives. The company as a whole has goals, and senior management decides on a set of strategies to accomplish these goals. The objectives of the company’s various responsibility centers are to help implement these strategies  Core operation of responsibility centers Responsibility centers receive inputs, in the form of materials, labor, and services. Using working capital (e.g., inventory, receivables), equipment, and other assets, the responsibility center performs its particular function, with the ultimate objective of transforming its inputs into outputs, either tangible (i.e., goods) or intangible (i.e., services). In a production plant, the outputs are goods. In staff units, such as human resources, transportation, engineering, accounting, and administration, the outputs are services. Operation of responsibility centers  Operation of responsibility centers The products (i.e., goods and services) produced by a responsibility center may be furnished either to another responsibility center, where they are inputs, or to the outside marketplace.  4.1.2 Relation between Inputs and Outputs Management is responsible for ensuring the optimum relationship between inputs (resources) and outputs (goods and services). In some centers, the relationship is causal and direct, as in a production department, where the inputs of raw material become a physical part of the finished goods. The control focuses on using in this case the minimum input necessary to produce the required output according to the correct specifications and quality standards, at the time requested, and in the quantities desired.  Relation between Inputs and Outputs In many situations, inputs are not directly related to outputs. Advertising expense is an input that is intended to increase sales revenue; but since revenue is affected by many factors other than advertising, is rarely demonstrable. In R&D even more …  4.1.3 Measuring Inputs and Outputs Much of the input that responsibility centers use can be stated as physical measurements: hours of labor, quarts of oil, reams of paper, and kilowatt-hours of electricity. In a management control system these quantitative amounts are translated into monetary terms  Cost The monetary value of a given input is ordinarily calculated by multiplying a physical quantity by a price per unit (e.g., hours of labor times a rate per hour). The resulting monetary sum is called “cost”; this is the way a responsibility center’s input is commonly expressed. Cost is a monetary measure of the amount of resources used by a responsibility center  4.1.4 Efficiency and Effectiveness The concepts of input, output, and cost can be used to explain the meaning of efficiency and effectiveness, which are the two criteria by which the performance of a responsibility center is judged These terms are almost always used in a comparative, rather than an absolute sense. *  Efficiency Efficiency is the ratio of outputs to inputs, or the amount of output per unit of input. Responsibility Center A is more efficient than Responsibility Center B (1) if it uses fewer resources than Responsibility Center B but produces the same output or (2) if it uses the same amount of resources but produces a greater output  Efficiency In many responsibility centers efficiency is measured by comparing actual costs with some standard of what those costs should have been at the measured output. Though this method can be somewhat useful, it has two major flaws (bias): (1) Recorded costs are not precise measures of the resources actually consumed, (2) the standard is merely an approximation of what ideally should have happened under the prevailing circumstances*  Efficiency vs. effectiveness In contrast to efficiency, which is determined by the relationship between input and output, effectiveness is determined by the relationship between a responsibility center’s output and its objectives. The more this output contributes to the objectives, the more effective the unit. Both objectives and outputs are difficult to quantify, so effectiveness tends to be expressed in subjective, nonanalytical terms*  Efficiency and effectiveness Efficiency and effectiveness are not mutually exclusive; every responsibility center ought to be both efficient and effective in which case, the organization ought to be meeting its goals in an optimum manner.  Efficient vs. effective A responsibility center, which carries out its charge with the lowest possible consumption of resources, may be efficient, but if its output fails to contribute adequately to the attainment of the organizations’ goals, it is not effective! a responsibility center is efficient if it does things right, and it is effective if it does the right things.  The Role of Profit A major objective of any profit-oriented organization is to earn a satisfactory profit Thus, profit is an important measure of effectiveness, since profit is the difference between revenue (a measure of output) and expense (a measure of input), it is also a measure of efficiency (profit measures both effectiveness and efficiency)  4.1.5 Types of Responsibility Centers  Four types of responsibility centers classified according to the nature of the monetary inputs and/or outputs that are measured for control purposes: ▪ expense centers, ▪ revenue centers, ▪ profit centers, ▪ investment centers Types of responsibility centers - Expense center Types of responsibility centers - Revenue center Types of responsibility centers -Profit center Types of responsibility centers -Investment center  Responsibility centers In revenue centers, Output is measured in monetary terms; in expense centers, inputs are so measured; in profit centers, both revenues (output) and expenses (input) are measured; and in investment centers, the relationship between profit and investment is measured Each type of responsibility center requires a different planning and control system  4.2. Revenue Centers Output (i.e., revenue) is measured in monetary terms, but isn’t made to relate input (i.e., expense or cost) to output (If expense was matched with revenue, the unit would be a profit center.)  Revenue Centers Typically revenue centers are marketing/sales units that do not have authority to set selling prices and are not charged for the cost of the goods they market Actual sales or orders booked are measured against budgets or quotas, and the manager is held accountable for the expenses incurred directly within the unit, but the primary measurement her/his job is the revenue (Chapter 5)  4.3. Expense Centers Expense centers are responsibility centers whose inputs are measured in monetary terms, but whose outputs are not (measured in monetary terms). There are two general types of expense centers: 1. engineered and 2. discretionary. These labels relate to two types of cost.  Two types of cost Engineered costs are those for which the “right” or “proper” amount can be estimated with reasonable reliability for example, a factory’s costs for direct labor, direct material, components, supplies, and utilities. Discretionary costs (also called managed costs) are those for which no such engineered estimate is feasible the costs incurred depend on management’s judgment as to the appropriate amount under the circumstances  4.3.1 Engineered Expense Centers - characteristics Their input can be measured in monetary terms. Their output can be measured in physical terms. The optimum dollar (monetary unit) amount of input required to produce one unit of output can be determined  Engineered expense centers-examples Engineered expense centers are usually found in manufacturing operations. But warehousing, distribution, trucking, and similar units within the marketing organization may also be engineered expense centers, as may certain responsibility centers within administrative and support departments: accounts receivable, accounts payable, and payroll sections in the controller department; personnel records and the cafeteria in the human resources department; shareholder records in the corporate secretary department; the company motor pool – corporate vehicles* 4.3.2 Discretionary Expense Centers They include administrative and support units (e.g., accounting, legal, industrial relations, public relations, human resources), research and development operations, and most marketing activities The output of these centers cannot be measured in monetary terms  Discretionary Expense Centers The term discretionary does not imply that management’s judgment as to optimum cost is capricious or haphazard. It reflects management’s decisions regarding certain policies: ▪ whether to match or exceed the marketing efforts of competitors; ▪ the level of service the company should provide to its customers; ▪ and the appropriate amounts to spend for R&D, financial planning, public relations, and a host of other activities 4.3.3 General Control Characteristics A. Budget Preparation B. Cost Variability C. Type of Financial Control D. Measurement of Performance  A. Budget Preparation Management makes budgetary decisions for discretionary expense centers that differ from those for engineered expense centers. - Engineered expense center decides whether the proposed operating budget represents the unit cost of performing its task efficiently. - by contrast Management formulates the budget for a discretionary expense center by determining the magnitude of the job that needs to be done!  A. Budget Preparation The work done by discretionary expense centers falls into two general categories: Continuing work is done consistently from year to year, such as the preparation of financial statements by the controller’s office Special work is a “one-shot” project for example, developing and installing a profit- budgeting system in a newly acquired division  A. Budget Preparation Management by Objectives (MbO) The MbO technique is often used in preparing a discretionary expense center’s budget. This is a formal process in which a budgetee proposes to accomplish specific jobs and suggests the measurement to be used in performance evaluation.  B. Cost Variability Unlike costs in engineered expense centers, which are strongly affected by shortrun volume changes, costs in discretionary expense centers are comparatively insulated from such short-term fluctuations.  B. Cost Variability This difference stems from the fact that in preparing the budgets for discretionary expense centers, management tends to approve changes that correspond to anticipated changes in sales volume for example, allowing for additional personnel when volume is expected to increase, and for layoffs or attrition when volume is expected to decrease. B. Cost Variability - Personnel costs Personnel and personnel-related costs are by far the largest expense items in most discretionary expense centers; thus, the annual budgets for these centers therefore tend to be a constant percentage of budgeted sales volume.  C. Type of Financial Control Financial control (as an activity) in a discretionary expense center is quite different from that in an engineered expense center. A) In the engineered expense center: the objective is to become cost competitive by setting a standard and measuring actual costs compare this standard.  C. Financial Control B) The main purpose of a discretionary expense budget is to control the costs by allowing the manager to participate in the planning, sharing in the discussion of what tasks should be undertaken, and what level of effort is appropriate for each. Thus, in a discretionary expense center, financial control is primarily exercised at the planning stage before the costs are incurred.  D. Measurement of Performance The primary job of a discretionary expense center’s manager is to obtain the desired output. Spending an amount that is “on budget” to do this is considered satisfactory; but spending more than that is cause for concern (makes worry ) in the organizations; and spending less may indicate that the planned work is not being done. D. Financial performance report In discretionary centers, -as opposed to engineered expense centers,- the financial performance report is not a means of valuating the efficiency of the manager. 4.4. Administrative and Support Centers  Administrative centers Administrative centers include senior corporate management and business unit management, along with the managers of supporting staff units. Support centers are units that provide services to other responsibility centers.  4.4.1. Control Problems The control of administrative expense is especially difficult because of (1) the problems inherent in measuring output and (2) the frequent lack of congruence between the goals of departmental staff and of the company as a whole  Difficulty in Measuring Output Some staff activities, such as payroll accounting, are so routinized that their units are, in fact, engineered expense centers. In other activities, however, the principal output is advice and service functions that are virtually impossible to quantify, much less evaluate  Difficulty in Measuring Output Since output cannot be measured, it is not possible to set cost standards against which to measure financial performance. Thus, a budget variance cannot be interpreted as representing either efficient or inefficient performance  Lack of Goal Congruence Managers of administrative staff offices strive for functional excellence. Superficially, this desire would seem to be congruent with company goals; in fact, much depends on how one defines excellence. Although a staff office may want to develop the “ideal” system, program, or function, the ideal may be too costly relative to the additional profits that perfection may generate.  Lack of Goal Congruence E.g.: the “perfect” legal staff, for example, will not approve any contract that contains even the slightest flaw; but the cost of maintaining a staff large enough to guarantee this level of assurance may outweigh (exceed) the potential loss from minor flaws. At worst, a striving for “excellence” can lead to “empire building” or to “safeguarding one’s position” without regard to the welfare of the company  Lack of Goal Congruence The severity of these two problems ▪ the difficulty of measuring output and ▪ the lack of goal congruence is directly related to the size and prosperity of the company. In small and medium-sized businesses, senior management is in close personal contact with staff units and can determine from personal observation what they are doing and whether a unit is worth its cost  4.4.2. Budget for an administrative or support center It usually consists of a list of expense items, with the proposed (next period) budget being compared with the current period’s – current year’s actual expenses. Some companies request a more elaborate presentation, which may include some or all of the following components*: ▪ A section covering the basic costs of the center ▪ A section covering the discretionary activities of the center ▪ A section fully explaining all proposed increases in the budget (other than those related to inflation)  4.5. Research and Development Centers  4.5.1 Control Problems The control of research and development centers presents its own characteristic difficulties, in particular, difficulty in relating results to inputs and lack of goal congruence  Difficulty in Relating Results to Inputs The results of research and development activities are difficult to measure quantitatively. In contrast to administrative activities, R&D usually has at least a semitangible output in the form of patents, new products, or new processes; but the relationship of output to input is difficult to appraise on an annual basis because the completed “product” of an R&D group may involve several years of effort. Inputs as stated in an annual budget may be unrelated to outputs  Lack of Goal Congruence The goal congruence problem in R&D centers is similar to that in administrative centers. The research manager typically wants to build the best research organization money can buy, even though that may be more expensive than the company can afford. A further problem is that research people often do not have sufficient knowledge of (or interest in) the business to determine the optimum direction of the research efforts.  4.5.2. Nature of the R&D (The R&D Continuum) The activities conducted by R&D organizations lie along a continuum, with basic research at one extreme and product testing at the other. Basic research has two characteristics: (1) it is unplanned, with management at best specifying just the general area to be explored; (2) there is often a significant time lapse between the initiation of research and the introduction of a successful new product.  The R&D Continuum Because financial control systems have little value in managing basic research activities, alternative procedures are often employed. In some companies, basic research is included as a lump sum (in one amount of money) in the research program and its budget. In others, no specific allowance is made for basic research as such, but there is an understanding that scientists and engineers can devote part of their time (perhaps 15 percent, or one day a week) to exploring in whatever direction they find most interesting subject only to the informal agreement of their supervisor 4.5.3.The content of R&D program There is no scientific way of determining the optimum size of an R&D budget Many companies simply use a percentage of average revenues as a base. The specific percentage applied is determinded in part by a comparison with competitors’ R&D expeditures and in part by the company’s own spending history.  4.5.4. Annual Budgets If a company has decided on a long-range R&D program and has implemented this program with a system of project approval, the preparation of the annual R&D budget is a fairly simple matter, involving mainly the “calendarization” of the expected expenses for the budget period.  Annual Budgets If the budget is in line with the strategic plan (as it should be), approval is routine it primarily serves to assist in cash and personnel planning. Preparation of the budget allows management to take another look at the R&D program with this question in mind: “In view of what we now know, is this the best way to use our resources next year?”  4.5.5. Measurement of Performance At regular intervals, usually monthly or quarterly, most companies compare actual expenses with budgeted expenses for all responsibility centers and ongoing projects. These comparisons are summarized for managers at progressively higher levels to assist the managers of responsibility centers in planning their expenses and to assure their superiors that those expenses are remaining at approved levels.  Measurement of Performance In many companies, management receives two types of financial reports on R&D activities. 1. The first type compares the latest forecast of total cost with the approved amount for each active project. It is prepared periodically for the executives who control research spending, to help them determine whether changes should be made in the list of approved projects  Measurement of Performance 2. The second type of financial report consists of a comparison between budgeted expenses and actual expenses in each responsibility center. Its main purpose is to help research executives anticipate expenses and make sure that expense commitments are being met. Neither type of financial report informs management as to the effectiveness of the research effort! 4.6. Marketing Centers  Marketing Centers In many companies, two very different types of activities are grouped under the heading of marketing, with different Controls being appropriate for each.  Marketing activities One group of activities relates to the filling of orders. Filling or Logistics activities by definition, take place after an order has been received. The other group of activities relates to efforts to obtain orders, and, obviously, take place before an order has been received. These are the true marketing activities, they may also be called order-getting activities.  Logistics Activities Logistics activities are those involved in moving goods from the company to its customers and collecting the amounts due from customers in return. These activities include ▪ transportation to distribution centers, ▪ warehousing, ▪ shipping and delivery, ▪ billing and the related credit function, ▪ the collection of accounts receivable. The responsibility centers that perform these functions are fundamentally similar to the expense centers in manufacturing plants.*  Marketing Activities Marketing activities are those undertaken to obtain orders for company products. These activities include ▪ test marketing; ▪ the establishment, training, and supervision of the sales force; ▪ advertising; ▪ and sales promotion all of which have characteristics that present management control problems.  Marketing Activities While it is possible to measure a marketing organization’s output, evaluating the effectiveness of the marketing effort is much more difficult. This is because changes in factors beyond the marketing department’s control (e.g., economic conditions or the actions of competitors) may invalidate the assumptions on which the sales budgets were based.  Marketing Activities In any case, meeting the budgetary commitment for marketing expenses is not a major criterion in the evaluation process, because the impact of sales volume on profits tends to overshadow cost performance. If a marketing group sells twice as much as its quota, it is unlikely that management will be concerned that it exceeded its budgeted cost by 10 percent to bring in those sales. The sales target, not the expense target, is the critical factor.  Marketing Activities-Summary There are three types of activities within a marketing organization, and, consequently, three types of activity measures. First, there is the order-filling or logistics activity, many of whose costs are engineered expenses. Second, there is the generation of revenue, which is usually evaluated by comparing actual revenue and physical quantities sold with budgeted revenue and budgeted units, respectively. Third, there are order getting costs, which are discretionary because no one knows what the optimum amounts should be and depend of the decisions of the managers. The measurement of efficiency and effectiveness for these costs is highly subjective. Budget Preparation Nature of a Budget Budgets are an important tool for effective short-term planning and control in organizations. An operating budget usually covers one year and states the revenues and expenses planned for that year. The budget has these characteristics: A budget estimates the profit potential of the business unit. It is stated in monetary terms, may be backed up by nonmonetary amounts (e.g., units sold or produced). It generally covers a period of one year. In businesses that are strongly influenced by seasonal factors, there may be two budgets per year— for example, apparel companies typically have a fall budget and a spring budget. It is a management commitment; managers agree to accept responsibility for attaining the budgeted objectives. The budget proposal is reviewed and approved by an authority higher than the budgetee. Once approved, the budget can be changed only under specified conditions. actual financial performance is compared to budget, and variances are analyzed and explained Relation to Strategic Planning Strategic planning, is the process of deciding on the nature and size of the several programs that are to be undertaken in implementing an organization’s strategies. Both strategic planning and budget preparation involve planning, but the types of planning activities are different in the two processes A budget is, a one-year slice of the organization’s strategic plan, although the budgeting process involves more than simply carving out a slice. Contrast with Forecasting A budget is a management plan a forecast is merely a prediction of what will most likely happen From management’s point of view, a financial forecast is exclusively a planning tool, whereas a budget is both a planning tool and a control tool. All budgets include elements of forecasting Use of a Budget Preparation of an operating budget has four principal purposes: (1) to fine-tune the strategic plan; (2) to help coordinate the activities of the several parts of the organization; (3) to assign responsibility to managers, to authorize the amounts they are permitted to spend, and to inform them of the performance that is expected of them; (4) to obtain a commitment that is a basis for evaluating a manager’s actual performance. Fine-Tuning the Strategic Plan The strategic plan has the following characteristics: it is prepared early in the year, it is developed on the basis of the best information available at that time, its preparation involves relatively few managers, The budget provides an opportunity to use the latest available information and is based on the judgment of managers at all levels throughout the organization. Coordination Every responsibility center manager in the organization participates in the preparation of the budget. Then, when the staff assembles the pieces into an overall plan, inconsistencies may show up. The most common is the possibility that the plans of the production organization are not consistent with the planned sales volume, in total or in certain product lines During the budget preparation process, these inconsistencies are identified and resolved. Assigning Responsibility The approved budget should make clear what each manager is responsible for. The budget also authorizes responsibility center managers to spend specified amounts of money for certain designated purposes without seeking the approval of higher authority Basis for Performance Evaluation The budget represents a commitment by the budgetee to his or her superior. It is therefore a benchmark against which actual performance can be judged. The commitment is subject to change if the assumptions on which it is based change, Content of an Operating Budget Exhibit 9.1 shows the content of a typical operating budget: the strategic plan and the capital budget, the cash budget, and the budgeted balance sheet The amounts are the planned dollar amounts for the year, together with quantitative amounts, such as head counts (i.e., number of employees) and sales in units. Operating Budget Categories In a relatively small organization, especially one that has no business units, the whole budget may fit on one page. In larger organizations, there is a summary page, and other pages contain the details for individual business units, plus research and development, and general and administrative expenses. The revenue item is listed first, because the amount of budgeted revenues influences the amount of many of the other items Revenue Budgets A revenue budget consists of unit sales projection multiplied by expected selling prices. Of all the elements of a profit budget, the revenue budget is the most critical, but it is also the element that is subject to the greatest uncertainty. The degree of uncertainty differs among companies, and within the same company the degree of uncertainty is different at different times Revenue Budgets The revenue budget usually is based on forecasts of some conditions for which the sales manager cannot be held responsible. For example, the state of the economy must be anticipated in preparing a revenue budget, but the marketing manager obviously has no control over it effective advertising, good service, good quality, and well-trained salespeople influence the sales volume, and the marketing manager does control these factors Budgeted Production Cost and Cost of Sales Production managers make plans for obtaining quantities of material and labor, and they may prepare procurement budgets for long-lead-time items. They also develop production schedules to ensure that resources needed to produce the budgeted quantities will be available the cost of sales reported in the summary budget is the standard cost of the products budgeted to be sold. Marketing Expenses Marketing expenses are expenses incurred to obtain sales. A considerable fraction of the amounts included in the budget may have been committed before the year begins. plans for opening or closing offices and for hiring and training new personnel (or for laying off personnel) must be well under way before the year begins. Advertising must be prepared months in advance of its release, and contracts with media also are placed months in advance. Logistics expenses These expenses usually are reported separately from order getting expenses. They include: order entry, warehousing and order picking, transportation to the customer, and collection of accounts receivable. Conceptually, these expenses behave more like production costs than marketing costs; that is, many of them are engineered costs. Nevertheless, many companies include them in the marketing budget, because they tend to be the responsibility of the marketing organization. General and Administrative Expenses These are G&A expenses of staff units, both at headquarters and at business units. Overall, they are discretionary expenses, although some components such as bookkeeping costs in the accounting department are engineered expenses. In budget preparation, much attention is given to these categories; because they are discretionary, the appropriate amount to authorize is subject to much debate Research and Development Expenses The R&D budget uses either of two approaches, or a combination of them. In one approach, total amount is the focus. This may be the current level of spending, adjusted for inflation, or it may be a larger amount, in the belief that more can be spent in good times, if the company expects an increase in sales revenue or if there is a good chance of developing a significantly new product or process. Research and Development Expenses Many companies decide to spend a specified percentage of sales revenue on R&D, but this percentage is based on a long-run average— that is, R&D spending is not geared to short-run changes in sales volume. Income Taxes Although the bottom line is income after income taxes, some companies do not take income taxes into account in preparing the budgets for business units. This is because income tax policies are determined at corporate headquarters Other Budgets Capital Budget The capital budget states the approved capital projects, plus a lump-sum amount for small projects that do not require high-level approval. It is usually prepared separately from the operating budget and by different people. During the year, proposals for capital expenditures are considered at various levels within the organization, and some are finally approved. This is part of the strategic planning process. Budgeted Balance Sheet The budgeted balance sheet shows the balance sheet implications of decisions included in the operating budget and the capital budget. Overall, it is not a management control device, but some parts of it are useful for control. Operating managers who can influence the level of inventories, accounts receivable, or accounts payable are often held responsible for the level of those items Budgeted Cash Flow Statement The budgeted cash flow statement shows how much of the cash needs during the year will be supplied by retained earnings and how much, if any, must be obtained by borrowing or from other outside sources. The cash flow statement shows the inflows and outflows of cash during the year, usually by quarters Budget Preparation Process Organization Budget Department The budget department, which normally reports to the corporate controller, administers the information flow of the budgetary control system. The Budget Committee The budget committee consists of members of senior management, such as the chief executive officer, chief operating officer, and the chief financial officer. In some companies, the chief executive officer decides without a committee. The budget committee performs a vital role. It reviews and either approves or adjusts each of the budgets The budget department performs the following functions: Publishes procedures Coordinates Provides assistance to budgetees Analyzes proposed budgets and makes recommendations Analyzes reported performance against budget, interprets the result, and prepares summary reports for senior management. Issuance of Guidelines If a company has a strategic planning process, the first year of the strategic plan which is usually approved in the summer is the beginning of the budget preparation process. The budget staff develops the guidelines and senior management approves them. In some cases lower-level managers may discuss the guidelines before approval Initial Budget Proposal Using the guidelines, responsibility center managers, assisted by their staffs, develop a budget request. Because most responsibility centers will start the budget year with the same facilities, personnel, and other resources that they have currently, this budget is based on the existing levels, which are then modified in accordance with the guidelines. Initial Budget Proposal Changes from the current level of performance can be classified as (a) changes in external forces and (b) changes in internal policies and practices. Changes in External Forces Changes in the general level of economic activity as it affects the volume of sales Expected changes in the price of purchased materials and services. Expected changes in labor rates. Expected changes in the cost of discretionary activities e.g., marketing, R&D, and administration Changes in selling prices. Changes in Internal Policies and Practices Changes in production costs, reflecting new equipment and methods. Changes in discretionary costs, based on anticipated changes in workload. Changes in market share and product mix. Negotiation The budgetee discusses the proposed budget with his or her superior. This is the heart of the process. The superior attempts to judge the validity of each of the adjustments Slack Many budgetees tend to budget revenues somewhat lower, and expenses somewhat higher, than their best estimates of these amounts. Slack The resulting budget, therefore, is an easier target for them to achieve. The difference between the budget amount and the best estimate is called slack. Superiors attempt to discover and eliminate slack, but this is a difficult task Review and Approval The proposed budgets go up through successive levels in the organization. When they reach the top of a business unit, analysts put the pieces together and examine the total. In part, the analyst studies consistency for example, is the production budget consistent with planned sales volume? In part, the examination asks whether the budget will produce a satisfactory profit. If not, it is often sent back for reworking. Final approval is recommended by the budget committee to the chief executive officer. The CEO also submits the approved budget to the board of directors for ratification. This happens in December, just prior to the beginning of the budget year Contingency Budgets Some companies routinely prepare contingency budgets that identify management actions to be taken if there is a significant decrease in the sales volume from what was anticipated at the time of developing the budget e.g., actions to be taken based on a decrease of 20 percent from the best estimate of sales volume The contingency budget provides a way of quickly adjusting to changed conditions if the situation arises Budget Cycle process WHICH TOPICS HAVE WE DISCUSSED BEFORE?  RESPONSIBILITY CENTERS The responsibility center is an organization unit that is headed by a manager who is responsible for its activities. There are four types of responsibility centers: 1. Revenue center – output is measured in monetary terms, but no formal attempt is made to relate input (i.e. expense – cost) Tipically marketing/sales units. 2. Expense centers – are responsibility centers whose inputs are measured in monetary terms, but whose outputs are not 2/1. Engineered Expense Centers: a) input can be measured in monetray terms, b) output can be measured in physical terms and c) it can be determined the optimum money amount of input to produce one unit of output 2/2. Discretionary Expense Centers: includes administrative and support units (accounting, HR, PR) R&D and most marketing activities. The output of these centers can not be measured by monetary terms and the control is extremly difficult i.e. in R&D  3. Profit centers: an organization unit in which both revenues and expenses are measured in monetary terms. In setting up a profit center a company devolves decision-making power to those lower levels that posses relevant information for making expense/revenue trade offs. Profitabilty levels: Contribution margin, Direct profit, Controllable profit, Income before taxes, Net income 4. Investment centers: in that is measured the relationship between profit and investment AND NOW: TRANSFER PRICING CHAPTER 6 If two or more profit centers are jointly responsible for product development, manufacturing, and marketing, each should share in the revenue generated when the product is finally sold. The transfer price is the mechanism for distributing this revenue.  6.1. OBJECTIVES OF TRANSFER PRICING It should provide each business unit with the relevant information it needs to determine the optimum trade-off between company costs and revenues. It should induce goal congruent decisions that is, the system should be designed so that decisions that improve business unit profits will also improve company profits. It should help measure the economic performance of the individual business units. The system should be simple to understand and easy to administer 6.2. FUNDAMENTAL PRINCIPLE OF TRANSFER PRICE The fundamental principle is that the transfer price should be similar to the price that would be charged if the product were sold to outside customers or purchased from outside vendors.  6.2.1. DECISIONS When profit centers of a company buy products from, and sell to, one another, two decisions must be made periodically for each product: 1. Should the company produce the product inside the company or purchase it from an outside vendor? This is the sourcing decision. 2. If produced inside, at what price should the product be transferred between profit centers? This is the transfer price decision.  Transfer price systems can range from very simple to extremely complex, depending on the nature of the business. Start with the ideal situation and then describe increasingly complex situations.  6.2.2. THE IDEAL SITUATION A market price-based transfer price will induce goal congruence if all of the following conditions exist. But rarely will all these conditions exist 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 (=philosophy)to see what changes should be made to improve the operation of the transfer price mechanism. 6.2.2. THE IDEAL SITUATION COMPETENT PEOPLE Ideally, managers should be interested in the long-run as well as the short-run performances of their responsibility centers. Staff people involved in negotiation and arbitration of transfer prices also must be competent. 6.2.2. THE IDEAL SITUATION GOOD ATMOSPHERE Managers must regard profitability, as measured in their income statements, as an important goal and a significant consideration in the judgment of their performance. They should perceive that the transfer prices are fair. 6.2.2. THE IDEAL SITUATION 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. 6.2.2. THE IDEAL SITUATION FREEDOM TO SOURCE Alternatives for sourcing should exist, and managers should be permitted to choose the alternative that is in their own best interests. The buying manager should be free to buy from the outside, and the selling manager should be free to sell outside. The market thus establishes the transfer price. 6.2.2. THE IDEAL SITUATION FULL INFORMATION Managers must know all the available alternatives and the relevant costs and revenues of each. 6.2.2. THE IDEAL SITUATION NEGOTIATION There must be a smoothly working mechanism for negotiating “contracts” between business units. 6.2.2. THE IDEAL SITUATION 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. 6.2.3. CONSTRAINTS ON SOURCING Ideally, the buying manager should be free to make sourcing decisions. Similarly, the selling manager should be free to sell products in the most advantageous market. In real life, however, freedom to source might not be feasible or, if it is feasible; might be constrained by corporate policy. 6.2.3. CONSTRAINTS ON SOURCING LIMITED MARKETS In many companies, markets of the buying or selling profit centers may be limited. There are several reasons for this: First, the existence of internal capacity might limit the development of external sales. If most of the large companies in an industry are highly integrated, as in the paper industry, there tends to be little independent production capacity for intermediate products. Thus, these producers can handle only a limited amount of demand from other producers. 6.2.3. CONSTRAINTS ON SOURCING LIMITED MARKETS Second, if a company is the one and only producer of a differentiated product, no outside source exists. Third, if a company has invested significantly in facilities, it is unlikely to use outside sources.  6.2.3. CONSTRAINTS ON SOURCING Even in the case of limited markets, the competitive price (=market price) is that transfer price type, that best satisfies the requirements of a profit center system.  6.2.3. Possibilities for determining the competitive price if the company does not buy or sell it on an external market 1. If published market prices are available, they can be used to establish transfer prices. 2. Market prices may be set by bids. 3. If the production profit center sells similar products in outside markets, it is often possible to replicate a competitive price on the basis of the outside price. 4. If the buying profit center purchases similar products from the outside market, it may be possible to replicate competitive prices for its proprietary products.  6.2.3. EXCESS OR SHORTAGE OF INDUSTRY CAPACITY Excess: Suppose the selling profit center cannot sell to the outside market all it can produce that is, it has excess capacity. The company may not optimize profits if the buying profit center purchased from outside vendors while capacity is available on the inside. Shortage: The buying profit center cannot obtain the product it requires from the outside while the selling profit center is selling to the outside. This situation occurs when there is a shortage of capacity in the industry. In this case, the output of the buying profit center is constrained and, again, company profits may not be optimum  6.2.3. CONSTRAINTS ON SOURCING To conclude, even if there are constraints on sourcing, the market price is the best transfer price. If the market price exists or can be approximated, USE IT!!! However, if there is no way of approximating valid competitive prices, the other option is to develop cost-based transfer prices. These are discussed in the next section…  6.2.4. COST-BASED TRANSFER PRICES If competitive prices are not available, transfer prices may be set on the basis of cost plus a profit, even though such transfer prices may be complex to calculate and 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 and (2) how to calculate the profit markup.  6.2.4.THE COST BASIS The usual basis is standard costs. Actual (fact) costs should not be used because production inefficiencies will be passed on to the buying profit center. If standard costs are used, an incentive is needed to set tight standards and improve standards.  6.2.4.THE PROFIT MARKUP In calculating the profit markup, there also are two decisions: (1) what the profit markup is based on and (2) the level of profit allowed. The simplest and most widely used base is a percentage of costs. If this base is used, no account is taken of capital required. A conceptually better base is a percentage of investment  6.2.5. UPSTREAM FIXED COSTS AND PROFITS Transfer pricing can create a significant problem in integrated companies. The profit center that finally sells to the outside customer may not even be aware of the amount of upstream fixed costs and profit included in its internal purchase price. Even if the final profit center were aware of these costs and profit, it might be reluctant to reduce its own profit to optimize company profit. Methods that companies use to mitigate this problem are described following.  6.2.5. METHOD 1: AGREEMENT AMONG BUSINESS UNITS Some companies establish a formal mechanism whereby representatives from the buying and selling units meet periodically to decide on outside selling prices and the sharing of profits for products with significant upstream fixed costs and profit.  6.2.5. METHOD 2:TWO-STEP PRICING Another way to handle this problem is to establish a transfer price that includes two charges: First, for each unit sold, a charge is made that is equal to the standard variable cost of production. Second, a periodic (usually monthly) charge is made that is equal to the fixed costs associated with the facilities reserved for the buying unit. 6.2.5. METHOD 2:TWO-STEP PRICING - EXAMPLE 6.2.5. METHOD 2:TWO-STEP PRICING Two-step pricing corrects this problem by transferring variable cost on a per-unit basis and transferring fixed cost and profit on a lump sum basis. The transfer price for product A would be $5 for each unit that Unit Y purchases, plus $20,000 per month for fixed cost, plus $10,000 per month for profit: $1,200,000/ 12 x 0.10  6.2.5. METHOD 3: PROFIT SHARING If the two-step pricing system just described is not feasible, a profit sharing system might be used to ensure congruence between business unit and company interests. This system operates as follows: 1. The product is transferred to the marketing unit at standard variable cost. 2. After the product is sold, the business units share the contribution earned, which is the selling price minus the variable manufacturing and marketing costs.  6.2.5. METHOD 3: PROFIT SHARING This method of pricing may be appropriate if demand for the manufactured product is not steady enough to warrant the permanent assignment of facilities, In general, this method does make the marketing unit’s interest congruent with the company  6.2.5. METHOD 3: PROFIT SHARING PROBLEMS WITH PROFIT SHARING ❑there can be arguments over the way contribution is divided between the two profit centers, and senior management might have to intervene to settle these disputes ❑dividing up the profits between units does not give valid information on the profitability of each unit. ❑since the contribution is not allocated until after the sale has been made, ❑the manufacturing unit’s contribution depends on the marketing unit’s ability to sell as well as the actual selling price.  6.2.5. METHOD 4: TWO SETS OF PRICES In this method, the manufacturing unit’s revenue is credited at the outside sales price and the buying unit is charged the total standard costs. The difference is charged to a headquarters account and eliminated when the business unit statements are consolidated. This transfer pricing method is sometimes used when there are frequent conflicts between the buying and selling units that cannot be resolved by one of the other methods. Both the buying and selling units benefit under this method.  6.3. PRICING CORPORATE SERVICES In this section some of the problems associated with charging business units for services furnished by corporate staff units. There are described two types of transfers: 1. For central services that the receiving unit must accept but can at least partially control the amount used. 2. For central services that the business unit can decide whether or not to use.  1. CONTROL OVER AMOUNT OF SERVICE Business units may be required to use company staffs for services such as information technology and research and development. In these situations, the business unit manager cannot control the efficiency with which these activities are performed but can control the amount of the service received. There are three schools of thought about such services:  1. CONTROL OVER AMOUNT OF SERVICE THREE SCHOOLS ABOUT SUCH SERVICES One school holds that a business unit should pay the standard variable cost of the discretionary services. If it pays less than this, it will be motivated to use more of the service than is economically justified Second school of thought advocates a price equal to the standard variable cost plus a fair share of the standard fixed costs— that is, the full cost Third school advocates a price that is equivalent to the market price, or to standard full cost plus a profit margin. The market price would be used if available e.g, costs charged by a computer service bureau; if not, the price would be full cost plus a return on investment  2. OPTIONAL USE OF SERVICES In some cases, management may decide that business units can choose whether to use central service units. Business units may procure the service from outside, develop their own capability, or choose not to use the service at all. This type of arrangement is most often found for such activities as information technology, internal consulting groups, and maintenance work. These service centers are independent; they must stand on their own feet. In this situation, business unit managers control both the amount and the efficiency of the central services. Under these conditions, these central groups are profit centers.  6.4. ADMINISTRATION OF TRANSFER PRICES In this section, the selected policy should be implemented is discussed — specifically: 1. the degree of negotiation allowed in setting transfer prices, 2. methods of resolving transfer pricing conflicts, and 3. classification of products according to the appropriate method.  6.4.1. NEGOTIATION In most companies, business units negotiate transfer prices with each other; that is, transfer prices are not set by a central staff group. If headquarters controls pricing, line management's ability to affect profitability is reduced. Also, many transfer prices require a degree of subjective judgment. Consequently, a negotiated transfer price often is the result of compromises made by both buyer and seller 6.4.2. ARBITRATION AND CONFLICT RESOLUTION No matter how specific the pricing rules are, there may be situations in which business units will not be able to agree on a price. For this reason, a procedure should be in place for arbitrating transfer price disputes. There can be widely different degrees of formality in transfer price arbitration  6.4.2. ARBITRATION AND CONFLICT RESOLUTION At one extreme, the responsibility for arbitrating disputes is assigned to a single executive the financial vice president or executive vice president, for example who talks to business unit managers involved and then orally announces the price. The other extreme is to set up a committee. Usually such a committee will have three responsibilities; (1) settling transfer price disputes, (2) reviewing sourcing changes, and (3) changing the transfer price rules when appropriate.  6.4.3. PRODUCT CLASSIFICATION The validity and formality of the sourcing and transfer pricing rules depend to a large extent on the number of intracompany transfers and the availability of markets and market prices. Some companies divide products into two main classes: Class I Class II  CLASS I Class I includes all products for which senior management wishes to control sourcing. These would normally be large-volume products; products for which no outside source exists; and products over whose manufacturing, for quality or secrecy reasons, senior management wishes to maintain control.  CLASS II Class II is all other products. In general, these are products that can be produced outside the company without any significant disruption to present operations, and products of relatively small volume, produced with general- purpose equipment. Class II products are transferred at market prices.  The sourcing of Class I products can be changed only by permission of central management. The sourcing of Class II products is determined by the business units involved. Both the buying and the selling units are free to deal either inside or outside the company. THANK YOU FOR YOUR ATTENTION! Chapter 4-1  Activity-Based Costing 5. Seminar Chapter 4-2  Study Objectives 1. Recognize the difference between traditional costing and activity based costing. 2. Identify the steps in the development of an activity-based costing system. 3. Know how companies identify the activity cost pools used in activity-based costing. 4. Know how companies identify and use cost drivers in activity-based costing. Chapter 4-3  Study Objectives 5. Understand the benefits and limitations of activity-based costing. 6. Differentiate between value-added and non-value-added activities. 7. Understand the value of using activity levels in activity-based costing. 8. Apply activity-based costing to service industries. Chapter 4-4  Traditional Costing To allocate as fairly as possible the true costs of the products. When management has more accurate costs, better decisions can be made. Direct Materials and Direct Labor costs are easiest to trace through: Material requisitions. Payroll time sheets. Chapter SO 1: Recognize the differences between traditional costing and 4-5 activity-based costing.  Hard Part of Determining Product Costs is? Determining the proper amount of overhead to assign to each product, service or job. Chapter 4-6  Traditional Costing and ABC Chapter 4-7  Traditional Costing Allocates overhead using a single predetermined rate. Job order costing: Direct labor cost is assumed to be the relevant activity base. Assumption was satisfactory when direct labor was a major portion of total manufacturing costs. There should be of a high correlation between direct labor costs and overhead costs. Chapter SO 1: Recognize the differences between traditional costing and 4-8 activity-based costing.  Traditional Costing Allocates overhead using a single predetermined rate. Process Costing: Machine hours is assumed to be the relevant activity base. Assumption was satisfactory when machine hours was a major portion of total manufacturing costs. There should be of a high correlation between machine hours and overhead costs. SO 1: Recognize the differences between traditional costing and Chapter activity-based costing. 4-9  Why Do Companies Need a New Approach? Tremendous change in manufacturing and service industries. Decrease in amount of direct labor usage. Significant increase in total overhead costs. May be inappropriate to use plant-wide predetermined overhead rates based on direct labor or machine hours when a lack of correlation exists. Complex manufacturing processes may require multiple allocation bases; this approach is called Activity-Based Costing (ABC). Chapter SO 1: Recognize the differences between traditional costing and 4-10 activity-based costing.  Activity-Based Costing ⚫ Is another approach (other than traditional costing) to allocate manufacturing overhead. ⚫ An overhead cost allocation system that allocates overhead to multiple activity cost pools, and ⚫ Assigns the activity cost pools to products or services by means of cost drivers that represent the activities used. ABC SO 1: Recognize the differences between traditional costing and Chapter 4-11