management control systems jsb 606 part3

Management ControlSystems

Part 3

Debasis DasExemplar Consultancy

Tools of Management Control Systems

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Strategic Planning as a Tool

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Introduction

• Long term Process• Involves decisions of top

management• Effective only when suitable

infrastructure supports it• Strategic planning determines the

effectiveness of management

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Strategic Planning Characteristics

• Setting goals• Strategy formation• Needs long term perspective

– Complex process, requires evaluation of multiple variables– Not a regular exercise but as required– Uses internal as well as external data– Setting goals through communicating (process, policy,

objective) down the line– It is a creative process– End result oriented– At the top level it is conceptual, no measurement

standards

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How it’s Done• Ensures success comes from within the

organization• Key tool-capitalizing on the knowledge and

skills in the organization• Document do’s and don’ts• Carried out through team building,

personalized skills and effective organizational communication

• Top management does this, typically 2/3 top people

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Benefits• Create a vision statement• Develop organization mission• Identify critical success factors• Define goals• Identify barriers• Translate goals into business plans• Translate goals and barriers into action plan with

responsibility & accountability• Feedback & update process• Using team building, interpersonal and

communications skills for individual & org success

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Strategic Planning Significance

• Helps internalize strategic processes• No unpleasant surprises for managers

as goals and processes are scrutinized closely

• Environmental issues are factored in• Corporate culture gets considered• This being the overall plan, helps

coordinate the other planning/ budgeting processes

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Process of Strategic Planning

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Reviewing & Updating the Strategic plan

Decide on assumptions & guidelines

Create strategic plan

Analysis of plan

Final review &Approval

Nextiteration

Reviewing & UpdatingStrategic Plan

• Review existing plan (last year’s)

• Update with environmental and

internal changes

• Taken up any time it is required

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Deciding Assumptions & Guidelines

• Incorporate necessary strategic elements

• Data regarding current business situation

incorporated , keep revenue implications minimal

• Goals & objectives are aligned with business needs

• Short and long range business plans synchronized

• Decision to add or drop a line of business

• Labor, salary, wages guidelines account

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First Iteration of Strategic Plan

• Formulate business plan• Validity of data and assumptions

carried out by business unit members and then unit managers

• Top management to vet if in accordance with organizational needs

• Income statements, balance sheet items are scrutinized, justifications confirmed

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Analysis of Plans

• Meetings between business units and top management

• Analyses gaps in planning• Discuss means to cover the gaps,

acquisition if necessary• Strength and integration of current

business units considered• Internal strength is estimated

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Second Iteration of Strategic Plan

• Change in plans in view of recent

developments

• Generally short term changes

• New technologies and other changes

in the environment

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Final Review & Approval

• Approval of top management

including board of directors

• Approval before budgeting

• Budget is the key to implementing

the strategic plan

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Allocation of Resources

• Plan implementation can start only after resources are allocated

• Some uncertainty will remain in long-term plans• Line of involvement of managers & accountability

needs to be set up• Accountability to be set up• Approval and endorsement steps should be

minimal• Personnel should be trained & educated about

strategic business processes being enabled

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Investment decision Making-Bower’s Model

• Based on discrepancies between plan and actual process of implementation

• Based on discrepancies key variables are determined and moderated

• 3 level functioning of strategic planning– Lower level-basic data– Middle level-synchronizes it– Top level- design the action plan

• Rewards and line of authority is set up by top management

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Budget as a Tool

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Budgetary Control

• Use of short and long term organizational budget to control & guide business processes

• Compare with actual results, calculating variance and taking corrective action (if required)

• Appropriate authority, responsibility and accountability should rest with assigned manager

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Budgetary Control-Advantages

• Corporate intent in measurable monetary terms• Bridges the gap between plan and performance• Promotes specialization and focuses business

processes (budget is divided based on functions and cost allocation)

• Budget creation requires integration of functions. Promotes coordination and integration between business policies

• Brings objectivity to business by tagging monetary value

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Need for Budgetary Control

• Budget helps provide management control, strategy implementation

• Reduces uncertainty• Increases coordination between SBUs• Identifying weaknesses and focuses

on strengths• Keeps expenses under check• Identifying deviations

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Objectives of Budgetary Control

• Establishes and ensures strategy is implemented

• Creates measurable standards and comparable standards

• Provides a common thread of coordination

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Organizational Set up

• Budget center• Budget manual• Personnel & operational set up– Controller of budget– Budget committees– Budget period– Determining key budget factors– Budget reports

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Formation of Budget

• Guidelines

• Budget Proposal

• Negotiations

• Review & approval

• Revision of budget

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Administration of Budget

• Determination of objectives• Establishing the objectives• Availability of accounting & verifiable records• Budget org chart and fixing responsibility• Establishing budget committees• Preparation of budget manual• Selecting budget period• Locating key budget factors• Determining cost allocations

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Types of Budget• Responsibility budget• Program budget• Operation budget

– Sales, production, production, selling, distribution costs

• Function budget– Sales, research, purchase, finance, etc.

• Financial budget– Source & utilization of cash, budgeted P&L and balance

sheet

• Capital budget– Capital expenditure and investments

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Budgeting Process

• Top-up budgeting

• Bottom down budgeting

• Budget report & variance analysis

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Capital Budgeting• Process of capital budgeting• Techniques of capital budgeting– Non discounted techniques– Discounted techniques

• Concepts of capital rationing– External factors– Internal factors– Risk factors

• Limitations of capital budgeting

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Capital BudgetingNon discounted techniques

• Payback period method– (Cash outlay of project) / (annual cash

inflow)

• Accounting rate of return method– ARR= (average income)/(average

investment)

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Capital BudgetingDiscounted techniques

• Net present value– PV= discounted inflow if it was available

now

• Internal rate of return– IRR= PV inflow/PV outflow

• Profitability index method– PI=(PV inflow)/(PV of outflow)

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Limitations of Capital Budgeting

• Alternatives may not be mutually exclusive

• Estimation of future inflow is hazardous always

• Goodwill, relationships and such factors cannot be accounted for

• Urgency of decision making could skew the estimates

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Valuation as a Tool

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Assets & Liabilities• Income=liability=distribute to owners• Expenses=basic functions of business

to create assets• Management control maximizes

efficiency such that value of business is increased and assets of the stakeholders

• Maintain a balance between increasing value, decreasing costs

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Measuring Liability Employed

• Valuation Based on Earnings– Based on book value, does not reflect

market value

• Capital charges– Profit carried over to capital & reserves– Deferred expenses difficult to value (as

they arise in current year but accrue in a later time)

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Measuring Asset Employed

• Is the decision regarding employment of asset correct?• Have the assets deployed been used correctly?

– Cash• Actual receipts-payments, handled centrally and allocated to units,

3 to 4 times annual sales

– Receivables• Influenced by sales & credit period, collection pattern

– Inventories• Similar to receivables, value would depend on inflow and outflow

– Overall working capital• Gross or net valuation, gross-only current assets, net-excess of

current assets over current liabilities

– Property, plant & equipment• Book vale less depreciation

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Book Value: Gross & Net

• Disposition of assets– Dispose of low value assets first before replacement

• Depreciation– Straight line or reducing balance method

• Leased assets– Type of debt, lower capital cost

• Idle assets– Affect ROI, lowers it

• Intangible assets– R&D expenses for example

• EVA vs. ROI– EVA=net profit-capital charges, ROI-cost of capital

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Evaluation of Economic Performance

• Economic analysis provides diagnostics

• Helps understanding business strategies

• Measures levels of success achieved

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Transfer Pricing as a Tool

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Objectives of Transfer Pricing

• Provide relevant information to the value chain to determine optimum trade off between cost & revenue

• Induce goal congruence by providing a competent atmosphere, freedom to source out & negotiate

• Measure economic performance of a profit center

• Single mechanism that’s easy to administer

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Fundamental Assumptions

• Dependent on assumptions of two managerial decisions– Sourcing decision: make or buy– Price at which item to be transferred if a

“make” decision is made• Transfer price approximately market price not

including costs that do not apply• When competitive price not available take cost +

profit• Cost based transfer could be made based on

standard cost + profit margin or a two step pricing

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Ideal Situation for Transfer Pricing

• Integration of business along value line

• Not diversified to unrelated businesses• Works best in horizontally integrated

business• There is common basis for calculating

fixed & variable costs• Multi-location business,

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Limitations

• Ideal when external market exists for components in the value chain (not often, it is not so)

• If captive capacity exists. Internal prices are far better than external market prices

• Investing in large facilities are often a strategic decision. Negotiating with external market would not make sense

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Methods of Transfer Pricing

• Full cost based– Full cost minus mark up

• Marginal cost based– Variable cost is used as reference cost

of transfer

• Negotiated– Negotiated between the units, based on

external market price

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Problems with Transfer Pricing

• Problem of integration of fixed costs in the upstream value chain– Profit centers higher in the value chain are not aware of

cost & profit coming up to them. They will be reluctant to negotiate own profits to optimize company’s profit

• Profit sharing– Product transferred to marketing at standard variable cost– Business units share the contribution realized from sale

• Two sets of transfer pricing– Each unit sold, a standard variable cost of production is

charged, a periodic charge fixed costs associated with facilities associated with facilities reserved by the buying unit

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Administering Transfer Prices

• Negotiations– Between heads of the two units involved

• Arbitration & conflict resolution– Top management intervenes as arbitrators,

formally or informally• Product classification– Some products that can be benchmarked

against market price will have transfer price fixed by top management, others by negotiation

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Theoretical Basis of Transfer Pricing

• Economic model– Fixed model of 1956 by Hirschleifier. Does not

provide for negotiations and applies in specific assumptions

• Linear programming model– Uses companywide optimum production patterns,

marginal costs and demand curves, not very practical

• Shapely value– Method of dividing profits between participants

based on contribution• Practical application of admin regulations & guidelines

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Management Control ofResponsibility Centers

throughAudit

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Audit of Responsibility Centers

• It is necessary because– Responsibility are the key functions of

business, auditing these tells you a lot about business health

– A management audit enables business to set up standards and propose compliance as the business requires

– Responsibility centers create value in the business. Functions of the end to end chain is also required

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Role of Audit

• A deep look into the business processes

• Look at opportunities to improve• Find if there are risks• Strategize for future• Check if desired path is being

followed• Create a required reward system

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Process of an Audit

• Establish an audit team– 3 or 4 persons conversant with the process– Internal or external

• Create an audit plan– Right timing, adequate resources are

essential

• Execute the audit– Team must clearly understand the purpose

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Scheduling an Audit

• Seasonal fluctuations of a business– Schedule audit at a time that is a

normally active period

• Time when most people are available– Peak work period is a bad time

• Choose the period that reflects overall performance– Should reflect the period when

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Audit Plan

• Proper utilization of manpower and resources

• Balance right number of people and resources w/o affecting normal business

• Clear and time bound picture to be made available

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Tools & Techniques• Surveys

– Types, advantages, disadvantages, using survey properly• Questionnaire

– Closed & open ended questionnaire, how to, structure, advantages, disadvantages

• Focus groups– Participants from a homogenous group with moderator, focused

response, participants and moderator need to be skilled• Interviews

– Structured, semi-structured, unstructured interviews, free information flow, could be expensive

• Direct observations– Freedom of expression, observer need to have expertise

• Which method to be used?– Normally a mix to be used, depends on time, resources and expertise

availability

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Continuous Improvement Through Audit

• Improvement in processes need continuous improvements

• Audits provide input as to what needs to change

• Audit is the starting point of problem solving & analysis

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Gaining Strategic Advantage

• Characteristics of continuous change– No improvement can be done in one step,

implementation should be on a continuous basis– Need for improvement change continuously– Change is not precise always– Priorities change– Feedback of performance needed to decide corrective

action

• Acquiring competitive advantage• Improvement through trigger point• Action planning

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Acquiring Competitive Advantage

• Audits should help understand strengths, weaknesses, threats & opportunities

• Identify capabilities that could be converted to strengths

• Findings should help discussions on changes planned

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Improvement through a Trigger Point

• When organizations face significant changes–Mergers, acquisitions– New entrants– Technology change

• Can happen at any point– functional, entry, maturity or saturation

points

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Action Planning• Action must follow an audit• Action plans must include – person to prepare an action plan– Time of action plan– Content of action plan– Person in charge of the action plan– Actions to be taken and people who have

to carry them out– Role of auditor in the follow up action plan

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Management Control of Operational Processes

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Role of Information in Operational Management• Information is a natural outcome of

business processes• Business process is about

information interchange by people responsible for the process

• A business process supports the system of an operation, provides information that supports the business

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Type of information for Operation

• Formal & informal operation• Budget information• Task information• Audit information

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Approaches to Control of Operations

• Total quality control– Documentation of processes– Responsibility of quality– Product design– Dealing with suppliers

• Decision support systems– Streamlines task delivery– Second line of options– Helps understand processes & be proactive

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Continuous Process Improvements

• Process modification is the key to process improvement

• With continuous improvement process can be refined to deliver better quality and improve cost and delivery times

• Focus on limited areas at a time• People need training and education to

participate whole-heartedly

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Tools in Continuous Process Improvement

• Target costing– Planning phase, development phase,

production phase• Advantages of target costing– Fix the cost of design & product in great detail– Direct right products to right group of

consumers– Failure of products is reduced– Helps set realistic goals

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Benchmarking-1

• Continuously compare with standard and best practices• Choose the best practices

– Planning phase– Analysis phase– Bench trending

• Determine market by size, preference, competitors• Direction of industry, technology and geopolitics• Determine strengths of potential competitors• Performance data of competitors• Baseline business performance• Identify a set of activities that will improve strength

of business

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Benchmarking-2

• Bench trending is carried out– Requirements of the process understood– Flowchart of process is described– Specific objectives identified– Bench trending methods of competitors

identified– Best suited practices are chosen and

adopted

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Bechmarking-3

• Communication & integration– Information gathered from

benchmarking and bench trending must be integrated and implemented

• Implementation– Set realistic goals– Teams take care of implementation– Processes streamlined & linked

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Production Control

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Production Controls

• Nature of the production process

• Degree of mechanization involved

– Continuous process

– Discrete or assembly line process

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Production Issues in Discrete Processes

• Production of finished goods as per design• Finished components per time standards• Synchronization of production processes to avoid excess of

one type• Right balance of production capacity of different production

chains of various components• Ensuring work layout is appropriately designed• Specify maximum stacking of input/outputs• Number of persons that can be present on shop floor• Defining spoilage and wastage • Defining quality norms

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Measuring Production Performance

• Productivity, efficiency of converting input to output

• Productivity measurements– Labor productivity–Material productivity–Multi factor productivity– Total productivity

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Production Control Reports

• Production efficiency• Production planning• Daily production• Downtime analysis• Shift handover

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Marketing Control

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Types of Marketing Control

• Strategic control– Premise control, implementation control,

strategic surveillance, special alert control

• Annual plan control• Profitability control• Efficiency & effectiveness control–Marketing effectiveness

• Customer philosophy, marketing orientation, info about marketing, strategic orientation, operational efficiency

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Marketing Audit

• Tool for improving marketing effectiveness

• Roles it performs– Introduces or changes marketing

orientation & practices– Act as a framework for organizational

analysis & control

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External & Internal Audits

• External audit– Audit of external environment– Auditors must know the organization & the industry– Opportunities & threats will be identified– Help identify marketing resources, skills, assets

• Internal audit– Audit of internal environment– Strengths & weaknesses of the organization & its

products– Identifies & analyses positioning, pricing and target

strategies– Analysis of marketing activities and channels

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Characteristics of effective Marketing Audit• Systematic• Comprehensive• Independent• Periodic• Conducting an audit– Extensive analysis of present and past

marketing activities– Forecast of growth relative to market changes– Suggestions for improvement of quality of

plans & marketing performance

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Sales Control• Sales budgets

– Sales revenue, selling expense, departmental administrative budgets

– (rolling budgets followed often)• Methods of budgeting for selling expenses

– Affordability, percentage of sales, competitive parity, objective & task and return oriented methods

• Control through budgets– Establishes objectives & responsibilities,

coordination between different business segments

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Sales Quotas

• Can be set as sales volume or value, profit, expenses or activities

• For individuals or a team or a territory• Product categories or class of customers• Punishments or rewards follow on

achievement• Quotas should be fair, challenging• Can be from sales forecast, negotiations

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Importance of Sales Quotas

• Performance of targets– Must be communicated properly. Challenging targets

stretch performance, unrealistic target could be de-motivating

• Standards– Basis for judging performance

• Control– Helps judge variance and hence control is easier

• Change of direction– May be necessary for strategic/operational reasons

• Motivating the sales force– Specific targets help sales force perform better

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Sales & Cost Analysis

• Gathering, classifying and studying sales data

• Helps sales managers plan & direct sales efforts

• Helps identify strengths and weaknesses of the organization

• Cost analysis helps identify ways to increase efficiency of sales efforts

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Sales Variance Analysis

• Value method or profit method• Variances calculated at sales value &

profit value respectively• Sales volume variance is divided into

sales price variance and sales volume variance

• Sales volume variance is divide into sales quantity and sales mix variance

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Market Share Analysis

• Compare sales with total sales of

industry

• Regular analysis required

• Develop action plan

• Forecast demand

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Sales Expense-to-Sales Variance Analysis

• Fixed and variable expenses• Sales and marketing expense budgets

take these into account• Amount of sales and expenses are

compared with targets to find variability• Fixed budget basis, fixed expenses are

taken into account• With flexible budget take fixed and

variable components into account

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Sales Reporting

• Reports form sales force– Call reports, expense reports, sales work

plan, potential new business reports, lost sales report

• Report from sales management– Periodic sales forecasts & actual sales– Sales promotions, expected results,

actual results

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Credit Control

• Credit to customers & channel partners should be guided by a formulated policy

• Analyze accounts receivables & bad debts as also amount and type of receivables, credit rating of customers and channel partners

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Receivables Management

• Devising & implementing an appropriate portfolio strategy(collection strategies)

• Precise fulfillment strategy & invoicing

• Efficient conflict resolution procedure

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Credit Rating

• Amount of credit that can be given• Rate customers/channels partners

through no-risk to high-risk categories

• W/o the rating in place, it is either no credit or same credit to all customers, both are high risk

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Performance Evaluation

• Formal & planned system for evaluation of sales personnel

• Tool for motivation• Discovering areas that can be

improved• Bad performers can be counseled,

repeated bad performers should be taken out of the system

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Compensation & Incentives

• Usually salary & incentives• Incentives are linked to what can be

attributed to the efforts of an individual

• Salary component is higher when it takes team effort, organization is a leader in the market, uncertain and or risky environment

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Sales Force Management Audit

• Cross functional audit of selling function

• Involves environment, planning system, organizational evaluation and sales functions

• Identify problems, prevent recurrence of problems

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Distribution Control

• Channel integration– Vertical management systems

• Channel leader oversees functions of channel members

• Corporate VMS, Administered VMS, Contractual VMS– Horizontal management systems

• Cooperating organizations pool their resources• Channel management

– Recruit and select right channel members– Motivating channel members & increasing profitability– Periodically evaluate channel member performance

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Evaluation of Channel Performance

• Macro level performance– Channel efficiency, productivity, effectiveness and

equity• Micro level performance

– ROI, liquidity, financial leverage, growth pattern & potential of the individual member

• Managing channel conflicts– Structural, attitudinal, faulty channel design, goal

divergence or incompatibility• Conflict resolution strategies

– Negotiations & bargaining, problem-solving strategies, persuasion, political strategies and cooperation

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Marketing communication Control

• Advertising– Measuring ad effectiveness– Measuring effectiveness of Internet advertising

• Sales promotion– Measuring effectiveness of sales promotion

• Direct marketing– Evaluation of direct marketing campaigns

• Public relations– Measurement of PR output– Measurement of PR outtake– Measurement of PR outcome

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Marketing Control in Branding

• Brand equity– Value of a brand to consumers and the organization,

helps attract new customers, retain old customers, higher equity less promotional expenses

– Brand assets, brand strength and brand value• Brand measurement

– Perception, performance and financial measurements• Brand portfolio management

– Less than 20% of brands contribute to profit– Brand Audit

• Review brand to find market share, percentage contribution, positioning

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Information Systems for Marketing Control

• Marketing DSS– Helps marketing data analysis and

decision making– Benefits• Increases effectiveness, breakdown of

complex problems, analysis capabilities, identifying deviations early

• Marketing intelligence– Correlation between marketing activities and

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Sales Force Automation as Control Tool

• Surveillance & control– Close supervising and monitoring

behavior of the sales force– Standardization in conduct of business

• Accountability– Increased interaction between manager

& the sales force– Voice questions easily and get answers

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Mobile CRM

• Mobile, remote access or wireless component application extension of the corporate CRM

• Mobile sales force automation (SFA)• Mobile field service management

(FSM)

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Enterprise-wide Applications

• Improves overall control over business operations– Customer relationship management– Enterprise resource planning– Sales force automation

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Performance Reports & Reward System

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Analysis of Variance-1• Financial aspects: Expenses &

Income(Revenue)• Variance: variances in revenue and

income• Volume variance and price variance• Expenses: manufacturing & non

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Analysis of Variance-2

• Costs: determine extent & dimension to which revenues are affected by business operations

• Costs are measured against standard costs set up by management

• Variance analysis helps by– Identifying key factor that may affect operational profit– Focus on key variables, if variance is negative– Segregate the causal factor– Identify sequence of impact on the variables and impact

on operational profit

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Analysis of Variance-3

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Total variance

MFG costs RevenueNon Mfg Cost

Variable costs

Semi variable

costsa. Adminb. Sellingc. R&Dd. Mktg

VolumeSellingprice

a. Materialb. Direct

laborc. Variable

overheads

Fixed costs

Market shareSelling volume

Standards in Standard Costing

• Current standards– Prevailing short time standards

• Ideal standards– Standards under ideal conditions

• Expected/attainable standards– Realistic attainable standards

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Setting Standards• Set up committee of key people from key

functions and all management levels• Identify costs for which standards are needed– Labor costs where standard quantity and

standard price is determined– Direct labor costs involving standard time

& rate– Overhead costs where standard variables

overhead and standard overhead are considered

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Analysis of Variance

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Material Cost Variance

• Material cost variances• Material price variances• Material usage variance• Material mix variance• Material yield variance

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Labor Variance

• Labor cost Variance

• Labor rate(pay) variance

• Total labor efficiency variance

• Labor efficiency variance

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Overhead Variance

• Variable overhead variance

• Fixed overhead variance

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Other Variances

• Selling price variance

• Market penetration and industry

volume variance

• Expense variance

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Variance in Practice

• Time period comparison• Focus on margin• Evaluation standards– Predetermined standards– Historical standards– External standards

• Full cost system

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Limitations of Variance Analysis

• Why the variance cannot be determined

• Is a variance significant?• When aggregating plus or minus

variances can balance out• Variances can happen due to

extraneous factors such as inflation

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Tight vs. Loose Control

• Variance analysis helps in tight control, it directly measures performance

• In tight control, employees are given specific goals and are monitored to perform as expected

• Loose control chooses the right people and it is expected they would do their best. Variance analysis acts as just an indicator

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Reward for good Performance

• Rewards induce good performance

• Good variance indicates good

performance

• Reward system integrated with

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Purpose of Reward System

• Recognition of good work• Creates sense of belonging• Good communication line • Aspirations of employees need to be

reflected in the appraisal system• Acts as a morale booster

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Reward through Compensation

• Salary– Fixed

• Benefits– Fixed

• Incentives– Variable

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Performance Variables

• Controllable• Non-controllable• Financial• Non-financial• Feedback

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Designing a Reward System

• Understanding what is a reward for the management and the managers

• Linking reward to the control system provides autonomy to the manager

• Values & culture of an organization influence the reward system

• Targets should be attainable• Both formal and informal rewards

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