MANAGEMENT CONTROL SYSTEMS

AJANTA CHOUDHURY - 02ASHISH RATHI - 18NAOMI RODRICKS - 55PRITHA PUJARI - 60

Q.1. Under which condition management is better advised not to create profit centre. Explain the advantage of creating the profit centre.

DEFINITION

When a responsibility centre’s financial performance is measured in terms of profit. i.e. by the difference between the revenues and expenses, the centre is called a profit centre.

GENERAL CONSIDERATIONS

A functional organization is one in which each principal manufacturing or marketing function is performed by a separate organization unit.

When such an organization is converted to one in which each major unit is responsible for both the manufacture and the marketing, the process is termed divisionalization.

CONDITIONS FOR DELEGATING PROFIT RESPONSIBILITY Two conditions should exist:

1. The manager should have access to the relevant information needed for making such a decision.

2. There should be someway to measure the effectiveness of the trade-offs the manager has made.

ADVANTAGES OF PROFIT CENTRES

Establishing organization units as profit centers provides the following advantages:

The quality of decisions may improve.

The speed of operating decisions may be increased.

Headquarters management are relieved of day-to-day decision making.

Managers, subject to fewer corporate restraints, are freer to use their imagination & initiative.

ADVANTAGES OF PROFIT CENTRES

Profit centers provide an excellent training ground for general management.

Profit consciousness is enhanced.

Profit centers provide top management with ready-made information on the profitability of the company’s individual components.

Profit centers are particularly responsive to pressures to improve their competitive performance.

DIFFICULTIES WITH PROFIT CENTRES

However, the creation of profit centers may cause difficulties: Loss of control. Quality of decisions may be reduced. Friction may increase Competition Divisionalization may impose additional costs. Competent general managers may not exist in a

functional organization. Too much emphasis on short-run profitability Optimize the profits of the company as a whole.

2)Describe the Salient feature of cost based &

market price based transfer pricing method?

Transfer Pricing :-

If two or more profit center is jointly responsible for product development manufacturing and marketing each should share in the revenue that is generated when the product is finally sold.

The transfer price is not primarily an accounting tool; rather, it is a behavioural tool that motivates manager to make the right decisions

Objectives of Transfer Pricing:-

Provide each business unit with the relevant information

Induce goal congruent decisions.

Measure the economic performance of the individual business units.

The system should be simple to understand and easy to administer.

SALIENT FEATURE OF COST BASED TRANSFER PRICING METHOD

Cost-based transfer prices can easily lead to bad decisionsNo profit margin built into the transfer price, then the selling division has no incentive to cooperate in the transferSince inefficiencies are passed on, lacks incentive to control expenditures/assets

Does not reflect a division’s true profitability

Does not provide an incentive to control costs which are passed on to the next division.

SALIENT FEATURE OF MARKET BASED TRANSFER PRICING METHOD

May reduce possibility of generating benefits through cooperation

Market prices are not always known

Depends on existence of competitive markets

Market price may not provide you with the profit margin you want

Market-based pricing generally does not take into account non-traditional competitor

Market-based pricing requires that you track the market price

3)Explain the economic value

added? How is it a superior method over

the ROI method?

ECONOMIC VALUE ADDED(EVA)

Economic value added is a dollar amount rather than a ratio. It is found by subtracting a capital charge from the net operating profit. This capital charge is found by multiplying the amount of assets employed by a rate.

EVA= Net profit – Capital charge Where Capital charge= Capital employed (ROI – Cost of Capital)

EVA VERSUS ROI Same profit objective for comparable

investments.

Investments that produce a profit in excess of the

cost of capital will increase EVA and therefore be

economically attractive to the manager.

Different interest rates may be used for different

types of assets.

Stronger positive correlation with changes in

company market value.

4)What is Free Cash flow? Enumerate the

method of Calculation?

FREE CASH FLOW: Free cash flow is the cash flow actually

available for distribution to investor after the company has made all the investment in fixed assets and working capital necessary to sustain ongoing operation.

The value of operation depends on all the future expected free cash flows, defined as after- tax operating profit minus the amount of new investment in working capital and fixed assets necessary to sustain the business.

USES OF FCF:- Pay interest to debt holders, keeping in mind that the net cost to the company is the after tax interest expense.

Repay debt holders, that is pay off some of debt.

Pay dividends to shareholders.

Repurchase stock from shareholders.

Buy marketable securities or other non operating assets.

COMPUTATION OF FREE CASH FLOW

Suppose the company had a 2011 NOPAT of Rs 170.3million and depreciation is only the non cash charge which is Rs 100 million then its operating cash flow in 2011 would be NOPAT plus any non cash adjustment on the statement of cash flows.

Operating cash flow =NOPAT +depreciation (non cash adjustment)

= 17.03 + 100 = Rs 270.3 million

Company has Rs 1,455million operating assets, at the end of 2010, but Rs1,800 at the end of 2011.it made a net investment in operating assets of Net investment in operating assets = Rs 18, 00 – Rs 1,455 =Rs 345millionIf net fixed assets rise from Rs.870 million to Rs.1000 million however company reported Rs.100million of depreciation. So its gross investment in fixed assets would be

Gross investment = net investment + depreciation = Rs 130 + Rs 100

= Rs 230 million

Even though company had a positive NOPAT, its very high investment in operating assets resulted in a negative free cash flow.

Because free cash flow is what is available for distribution to investor, not only was there nothing for investors, but investor actually had to provide additional money to keep the business ongoing.

A negative current FCF not necessarily bad provided it is due to the high growth or to support the growth. There is nothing wrong with profitable growth; even it causes negative free cash flow in the short term.

NUCOR CORPORATION (B) This case examines Nucor's development from an

unprofitable conglomerate to a highly efficient enterprise. Nucor became the largest steel producer in the U.S. by

1999 which also marked the end of Ken Iverson‘s tenure Iverson is given the credit for

Getting Nucor off the ground. Establishing its culture. The company‘s early development.

Board wanted a fundamental shift in Nucor’s strategy and as a result Aycock brought about number of changes and fundamental shift’s in Nucor’s strategy. acquisitions, entering into global markets, building blast furnaces, diversifying into non steel areas, adding new organizational layers changing the composition of the board

1) Do you agree that Nucor must undergo a deep change to survive and

prosper in the twenty-first century? How do you

evaluate the specific shifts in strategy?

Strategy used by Iverson Decentralization structure at all division operated

autonomously. Management was obligated to manage the company in

such a way that employees will have the opportunity to earn according to their productivity. 

Nucor outsourced advertising, public and legal relations.

Aggressively pursue and implement cost-saving technologies

Employ incentive compensation that motivate above-average output

Create a low-cost culture More attention to own business than to competitors

was their strategy.   It kept maintaining low cost and efficiency, By keeping the employee force at the level it

empowered them, being totally honest, involving them in decision making process, and using effective incentive compensation system.

NUCOR’S COMPETITION Mittal Steel U.S. Steel Foreign competitors

China India Japan European imports

21ST CENTURY SHIFT IN STRATEGY

Exit certain product categories Make more acquisitions Acquire Mittal Steel

Dominate the domestic market Expand in China, Latin America Boost the quality of Nucor steel

Differentiation strategy Continue Foreign Joint venture Innovative backward integration

Reduce dependence on acquired scrap steel and iron ore

Should look for more suppliers for its raw materials because working through broker is not the safest and not the cheapest way.

2)Can Nucor preserve its unique culture and

control systems under its new strategic direction?

No it can’t preserve its unique

culture and control systems

because:-

Global expansion.

Increase in management layers

at different locations.

3) Would you like to work for Nucor under David

Aycock?

Nucor had to break from the past to meet the company’s aggressive growth goals.

Foreign and domestic rivals have been turning up the heat. Nucor needs innovate and explore new moves, in order to

survive/sustain which was accepted by Aycock. Iverson kept Nucor a domestic company whereas Aycock

believed in globalization. Aycock also believed that Nucor’s future growth hinged on its ability to enter South America and Asia using local partners.

Aycock on the other hand, was always open to change and kept exploring new alternatives

In contrast to Iverson’s mini-mill concept, Aycock wanted to build blast furnaces, the hallmark of integrated steel producers.

Iverson’s policy was to be a single industry player, concentrating on steel and steel-related products. Aycock insisted that Nucor should consider diversifying beyond steel.

Iverson believed in overseeing all the operations himself while, maintaining a lean corporate staff. Whereas, Aycock emphasized the need to add more management layers.