Concept Notes On Enterprise Performance Management PDF

Enterprise Performance Management
Concept Notes
Contents
Concept Notes
Sl.No. 1. 2. 3. 4. 5. 6. 7. 8. 9. Title Pages
Enterprise Performance Management An Overview ..................... 1-18 Design of Organization Structure and Control Systems ................ 19-38 Strategic Performance Control ....................................................... 39-48 Budgeting Techniques .................................................................... 49-60 Business Performance: Targets, Reporting, and Analysis ............ 61-76 Auditing ........................................................................................... 77-94 Transfer Pricing ............................................................................ 95-106 Business Ethics and Enterprise Performance Management ...... 107-118 Performance Management of Production and Operations (A) ... 119-130
10. Performance Management of Production and Operations (B) ... 131-146 11. Performance Management of Service Organizations ................ 147-158 12. Project Control ............................................................................ 159-178 13. Implementation Issues in Enterprise Performance Management ......................................................... 179-194
Contents
Cases
Sl.No. 1. Title Pages
Jack Welch and Jeffrey Immelt: Continuity and Change in Strategy, Style, and Culture at GE............................................................. 197-220
2. 3. 4. 5. 6. 7. 8. 9.
GCMMFs Cooperative Structure ............................................... 221-237 Whole Foods Markets Unique Work Culture and Practices ...... 238-262 Balanced Scorecard Implementation at Philips.......................... 263-284 Tesco: The Customer Relationship Management Champion .... 285-302 Hollinger International: The Lord Black Saga ............................. 303-318 The Bribery Scandal at Siemens AG ......................................... 319-337 BP: Putting Profits Before Safety? ............................................. 338-362 P&Gs Brand Management System............................................ 363-377
10. Taiichi Ohno and Toyota Production System ............................. 378-396 11. Quality and Safety Practices at LEGO ....................................... 397-412 12. Consumer Driven Six Sigma at Ford .......................................... 413-426 13. The AXA Way: Improving Quality of Services ............................ 427-444 14. Pixars Incredible Culture .......................................................... 445-466 15. Millau Viaduct: Creating an Engineering Marvel. ....................... 467-490 16. CRM Implementation Failure at Cigna Corporation. .................. 491-505 17. Governance and Control at AXA ................................................ 506-525 18. The Fall of Barings Bank ............................................................ 526-537 19. Human Resource Management System Reforms at Matsushita .............................................................................. 538-553
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Concept Note - 1
Enterprise Performance Management An Overview

1. Introduction
In an organizational context, the words performance and control have traditionally been used interchangeably with financial performance and financial control. These words are very closely associated with terms such as budgets, variances, and financial audits; and in a broader sense, with rigidity, bureaucracy, imposed by management, and preserving the status quo. In this view, the emphasis is on controlling the numbers with a top-down orientation to management. However, organizations of today whether they are for-profit or not-for-profit can ill-afford to constrain themselves with these myopic worldviews . As Albert Einstein said, Not everything that can be counted counts, and no t everything that counts can be counted. On the one hand, it is important for organizations to comply with regulatory requirements and their own ethical code besides meeting the growing expectations of multiple stakeholders on economic, social, and environmental concerns. Also, disclosure requirements appear to be outpacing the ability of organizations to manage the data. On the other hand, effectiveness and efficiency are not merely about doing the right things and doing things right by planning and setting standards at the beginning of the planning period and conforming to the plan and standards during the execution phase. The business environment is dynamic; competition cuts across product categories and national boundaries, and consumers are well informed and willing to explore the choices at hand. At all levels and across all functions of the organization, excellence of execution requires double-loop learning the habit of anticipating changes and adapting to them in a proactive manner. Often, this adaptation is simultaneously required on multiple aspects such as strategy, structure, systems, and culture. And such adaptation is required both for guarding against possible declines in an organizations performance and for gaining competitive advantage. For example, JC Penney Company, Inc. (JCP) was unable to keep pace with the changes taking place in the retail environment in the US in the late 1990s. As part of a restructuring program that was introduced in 1999, it sold off the Eckerd drugstore chain that it owned, positioned itself as a trendy yet value-offering retailer, centralized its buying process to improve its working capital management and inventory turnover, and reformed its HR practices concerning recruitment, compensation, promotions, etc. As a result of these initiatives, the company turned around: for the year 2004, JCP was ranked 43 on the Fortune 500 list. In 2005, JCP initiated further steps to become a leader in performance and execution. Two important interventions in this regard were: changing the organizational climate and culture in order to attract and retain talent; and identifying high-potential employees and training them on retailing, strategy, and team development at JCPs Retail Academy. To study the concept and practice of enterprise performance management, we take a management control systems approach, that is, an integrated approach to performance and compliance. We look at organizations as open systems where people in different functional areas use resources to perform a variety of activities that result in outputs and outcomes that satisfy stakeholders and realize the organizations objectives, while
complying with the law and adhering to ethical principles. Therefore, to ensure that the organization achieves its objectives, management control has to address all its subsystems. Management control thus has four broad objectives effectiveness, efficiency, disclosure, and compliance. Technically, we can limit the scope of enterprise performance management to the first two issues of effectiveness (including learning and innovation) and efficiency. But in reality, these issues go hand in hand with the other two issues of disclosure and compliance for the management to meet the expectations of shareholders as well as other stakeholders. This note will help you understand the following fundamentals of management control: The various approaches to management control systems The different objectives of management control The schemes for classifying management controls The contextual factors influencing management control. The note Design of Organization Structure and Control Systems discusses how the management creates suitable structures in the organization and puts in place certain systems, processes, policies, and practices. The note Strategic Performance Control outlines the boundary-setting nature of vision and mission, and describes the use of a balanced performance measurement system for strategic control and strategic learning. The notes Budgeting Techniques, Business Performance: Targets, Reporting, and Analysis, Auditing, and Transfer Pricing discuss four important techniques that are used for managing the performance of an enterprise. The note Business Ethics and Enterprise Performance Management discusses the interplay between business ethics and enterprise performance management and explains the use of ethical control mechanisms to regulate the ethical behavior of employees. The operating core of organizations is usually concerned with production and operations, services, or projects. The notes Performance Management of Production and Operations (A), Performance Management of Production and Operations (B), Performance Management of Service Organizations, and Project Control discuss enterprise performance management in terms of these core functions. This is followed by a note on Implementation Issues in Enterprise Performance Management that discusses the challenges in operationalizing and maintaining a management control system over the life cycle of an organization. In addition to the above, enterprise performance management is dependent on the control of certain functions. These functions should not be confused with departments: for example, the financial control of the enterprise is not limited to the Finance department. Enterprise performance management tools and techniques with respect to finance, marketing, and information technology functions were discussed in the following concept notes: Financial Insights: Financial Control and Financial Reporting Strategic Marketing: Marketing Control IT for Competitive Advantage: Information Resource Management and IT Governance 2
2. Approaches to Management Control

Enterprise performance management is broadly concerned with attainment of goals and implementation of strategies. An organization has to make an effective and efficient use of its resources to achieve its objectives and succeed in its operations. It should maintain an edge over its competitors in terms of cost and/or quality. An organization can survive and continue operations in a complex business environment only if it meets its stakeholders (customers, suppliers, employees, investors, the government, and society) demands. In the management context, control refers to the activities of establishing performance standards, comparing actual performance with these standards, and implementing remedial actions to achieve organizational objectives. This approach assumes that the performance standards are set for operations which will take place in an established environment. However, this assumption may not hold for organizations operating in a complex and volatile business scenario. Organizations need such control systems which will help monitor and adapt to changes in the external environment, ensure best quality, cope with unforeseen change, and in creating faster cycles to market. Anthony Ferner defines management control as a process whereby management and other groups are able to initiate and regulate the conduct of activities so that their results accord with the goals and expectations held by those groups. According to Joseph A. Maciariello and Calvin J. Kirby, a management control system is a set of interrelated communication structures that facilitates the processing of information for the purpose of assisting managers in coordinating the parts and attaining the purpose of an organization on a continuous basis. A management control system may also be viewed as a collection of controls that are used to address one or all of the following situations: Managers and employees lack a clear idea of what is expected of them; They have a reasonable idea of what is expected but do not feel inspired, that is, organizational conditions (for example, reward system) fail to motivate; and In spite of knowing about the expectations and having sufficient motivation for performance, managers and/or employees are unable to perform.
2.1 The Cybernetic Approach to Management Control

Control systems in most organizations are based on the cybernetic approach - though they are customized to suit specific situations. When exercising the control function, a manager measures the performance of an individual, a plan, or a program against certain predetermined standards and takes corrective actions in case of deviations. Basic Control Process The basic control process involves the following steps Determining areas to control Establishing standards Measuring performance Comparing actual performance against standards Rewarding good performance and/or taking corrective action when necessary Adjusting standards and measures when necessary. 3
Step 1: Determining areas to control Before initiating the control process, the major areas that need to be controlled have to be determined. Such decision on control areas should be based on organizational goals and objectives defined during the planning process. Exercising control over critical areas helps a manager manage a large number of subordinates effectively, reduce costs, and improve communication. Step 2: Establishing standards Standards form the foundation for the cybernetic process. They are predetermined benchmarks against which employee performance and related behavior is assessed. Standards may be incorporated into goals or may need to be developed during the control process. Standards are usually expressed numerically and aim at achieving the desired quality and quantity within a specific cost and time boundary. In the context of employee behavior, establishing standards serve two purposes: It helps employees understand what is expected of them and how their work will be evaluated, thus helping them to perform effectively It also helps in identifying job difficulties related to the personal limitations of employees, which may include lack of experience, insufficient training, or any other task-related deficiency. The Management by Objectives (MBO) method encourages a participative approach to standard setting by involving employees in the setting of objectives. Step 3: Measuring performance After establishing standards, a manager needs to determine how to measure the actual performance. Evaluation of actual performance becomes easy if performance standards are clearly established and the means for exactly determining what subordinates are doing are available. There are certain activities which are difficult to measure, and for which it is difficult to establish standards. As a result, most organizations use a combination of quantitative and qualitative performance measures. After selecting the means of measurement, the frequency of measurement should be decided. Managers may need to control data on a periodic or continuous basis. Decision on the frequency of performance measurement depends on the importance of the goal, the nature of deviation from the standards, and the expenses that may be incurred on correcting the deviation. Step 4: Comparing actual performance against standards The performance measured in step 3 is compared with the standards established in step 2. Managers often make comparisons based on the information provided in reports. Computerized information systems give supervisors direct access to realtime, unaltered data and information. Online systems identify real-time problems and situations that require a management-by-exception approach. This approach suggests that managers should be informed about a difficult situation only when data shows a significant deviation from standards and when a situation is difficult to handle. 4
Step 5: Rewarding performance and/or taking corrective action when necessary When an employees performance meets or exceeds the standards, it should be acknowledged. Recognition of good performance helps sustain such performance and encourages further improvement. Specific actions should be taken to correct a negative discrepancy. The cause of deviation should be determined followed by the required action to eliminate or minimize it which may involve redrawing plans. Managers may reassign or clarify the subordinates duties and responsibilities. They may have to train existing employees; remove inefficient ones or recruit new employees. A manager should not only propose corrective action, he/she should also ensure that they are implemented correctly, for the successful rendition of the control process. Step 6: Adjusting standards and measures when necessary The established standards may at times become obsolete and inappropriate and may need to be modified. To ensure that standards and performance measures meet future needs, managers should conduct a periodic review of standards. This review may entail changing organizational objectives, technology, etc. If a manager feels that conforming to a particular standard may consume a lot of resources, it may be given low priority. The control process should ensure that it meets the current organizational needs. Management by Objectives (MBO) is a management control tool that can be viewed as a specific application of the cybernetic process.
2.2 Management by Objectives

Management by Objectives (MBO), proposed by Peter F. Drucker in 1954, aims at setting of goals/objectives jointly by the supervisor and the subordinate. This helps establish a system of mutual controls within the organization, which enables managers to control their subordinates as well as each other. The process also imposes selfcontrol upon managers. Objectives set should be SMART (Specific, Measurable, Achievable, Realistic, and Time-Specific). The MBO Process Figure 1 shows the steps in the MBO process. In the first step, managers must determine the mission and strategic goals of the organization. Next, goals must be set for all the key result areas of the organization, and then for various organizational levels. Each goal should contribute to the achievement of the overall goals set for the organization. As a third step, action plans must be developed which clarify what is to be done in order to achieve a goal and how, when, where, and by whom. They should focus on the methods or activities necessary for achieving particular goals. Next, the subordinates should be given considerable freedom to carry out their activities and implement their plans. MBO is expected to help subordinates get a clear idea of what they should achieve. It gives direction to the subordinates and allows them to evaluate their own progress. Periodic reviews, then, ensure proper implementation of plans and achievement of objectives. They allow managers to measure results, identify and remove obstacles, solve problems, modify the action plans that are not achieving the expected results, and determine whether the plans and goals are apt for the organization or need to be modified. In the sixth step, performance appraisal is carried out. Performance appraisal focuses on the extent to which goals have been achieved, extent of shortfall 5
in the achievement of goals, reasons for the shortfall, and preventive action required to avoid such difficulties in the future. It also recognizes the areas in which subordinates have performed effectively, and identifies areas in which individuals could improve by acquiring some specialized skills. The goals and plans for the next MBO cycle can also be discussed at this stage. Figure 1: The MBO Process
Adapted from Bartol, Kathryn M. and David C. Martin. Management. Third ed. USA: Irwin McGraw-Hill, 1998, p211.
MBO as a management control tool MBO facilitates the integration of individual, group, and organizational objectives. Its practice impacts various organizational processes and initiatives like performance appraisal, organization development, and long-range planning. As MBO forces the management to clearly state objectives, it leads to the development of effective controls. As it focuses on the result of activities, it helps in evaluation and control and in turn, in better management. A clear set of verifiable goals helps managers determine what should be measured and what action should be taken to correct deviations. MBO helps in identifying objectives for the key result areas; tries to link individual objectives with those of the organization; gives individual targets to all and thus, strengthens the employees commitment to the organizational goals; and facilitates impartial performance appraisal thereby ensuring better performance. Refer to Exhibit I for an overview of how MBO can be used in information technology (IT) projects.
Exhibit 1: MBO in Information Technology (IT) Projects

A group of Chief Information Officers (CIOs) felt that, in spite of having a good project team, state-of-the-art technologies, and well-framed project management methodologies, IT projects were not being delivered on time and within the budget laid out. The group decided to establish business-based objectives for the IT projects so that performance can be measured against those objectives. These objectives included achieving productivity, efficiency, reduction in wastage, and responding quickly to the changing market conditions.
Contd
Contd
To use MBO in an IT project and to see that business objectives are met, an IT project should be designed and developed to create the right deliverables at the right time, as without them, it is difficult to measure performance. To measure whether the IT project is meeting the business objectives, it is important to measure the performance of the user using the application. Through this, it has to be checked whether the transaction and the training times are reduced. The user interface should be carefully designed and prototyped as it determines various aspects like: The time taken by the user to perform a transaction The time taken by the user to learn the new user interface Whether wastage has reduced in the users activities Whether the user stopped double handling in his/her activities. Also, the performance of the user of the application should be measured immediately to take timely corrective action so that the project meets the business objectives.
Adapted from Craig Errey, Management by Objectives and IT Projects, November 01, 2006, <http://www.ptg-global.com/papers/strategy/management-by-objectives-and-it-projects.cfm>.
Limitations of MBO Some problems are inherent in the MBO process itself while others are due to shortcomings in the implementation of MBO concepts. Failure of the MBO process may occur due to: Failure among participants to understand the concepts of self-direction and selfcontrol on which the MBO philosophy is built on Inadequacy of guidelines provided to those who are expected to set goals Failure to set verifiable goals against which performance can be measured Failure to revise individual goals as and when the organizational goals change Inadequacy of time, effort, and paperwork and inability to meet the high costs of managerial training required Lack of top managements commitment which should be strong and sustained Misuse of objectives by overzealous managers - arising due to the over-emphasis on measurable objectives Frustration among managers arising out of dependence on one managers efforts to achieve goals on the achievement of goals of others.
3. Objectives of Management Control

By integrating the organizations diverse activities, the modern management control system addresses contextual issues that affect an organizations short-term success and long-term survival. It detects environmental variables that can significantly affect organizations, ensures effective resource utilization, sustains competitive advantage, translates corporate goals into business unit objectives, maintains transparency and clarity of financial reporting, and preserves conformity with the relevant regulatory framework. It is also concerned with operational efficiency issues. An adaptive MCS facilitates organizational learning and adoption of new strategies with a focus on the 7
external environment, and making innovations that improve business processes and responsiveness to the market conditions. The Committee of Sponsoring Organizations of the Treadway Commission (COSO) broadly classifies the objectives of management control under the following heads Effectiveness and efficiency of business operations Reliability of financial reporting Compliance with applicable regulatory and legal framework.
3.1 Effectiveness and Efficiency of Business Operations

An effective organization is one that is able to accomplish its purpose or mission, and is able to achieve the objectives and goals set within the scope of organizational purpose. Purpose reflects the intended position of the organization in society and the value that the organization aims to create for its target customers. An efficient organization will have achieved its purpose by making use of minimum resources while meeting stakeholders expectations. It should be noted that business operations include not only production-related operations, but also a wide range of organizational outcomes.
3.2 Reliability of Financial Reporting

Management control systems should ensure that financial statements are reliable and do not misrepresent facts or figures; should see that financial reporting has the qualitative characteristics of understandability, relevance, and materiality and also whether reporting has been done in conformity with applicable generally accepted accounting principles. Financial reporting refers to the preparation and publication of financial statements that may be done for interim periods or annually. These reports should provide a true and fair view of the transactions so that they may be referred to by both internal and external stakeholders evaluating the organization for their specific needs or ends.
3.3 Compliance with Applicable Regulatory and Legal Framework

The regulatory framework that includes legal and other compliance issues provides a boundary within which each organization has to function. Tax rates, pricing restrictions, workers safety and welfare, and rules regarding international business are some of the important aspects for which the regulatory framework lays down standards of what should be done or not done. Organizations must at least fulfill these standards and aim at setting higher ethical standards for themselves. MCS should build in regulatory issues within its compliance objectives. The objectives should be prioritized and a cost-benefit analysis should be carried out before implementing control measures to balance objectives and available resources. A control system should provide reasonable assurance that there will be no sudden, unpleasant developments that could/should have been prevented by managerial action. Controls may be used at specific stages of decision-making and execution activities through the organization structure, the organizational culture, and the organizations policies and code of ethics.
4. Schemes for Classifying Management Controls

Management controls are classified based on -The object of control The extent of formalization of control 8
The time of implementation of controls. Refer to Table 1 for the different classifications according to these three bases.
Table 1: Management Controls Classification Schemes

Classification Basis Object of control Classifications Action controls o Behavioral restrictions o Pre-action appraisals o Action accountability Results controls Personnel/Cultural controls Extent of formalization of control Formal control Informal control Time of implementation of controls Open loop control Closed loop o Feedforward control o Feedback control Compiled from various sources.
4.1 Based on the Object of Control

Based on the object of control, management controls can be classified into action controls, results controls, and personnel/cultural controls. Action Controls Action controls are aimed directly at the actions that take place at different levels of an organization. They try to ensure that all actions, being taken by the personnel in an organization, are aimed at achieving the organizations objectives. They also ensure that all activities that are either non-beneficial or counter-productive to the attainment of objectives are avoided. Action controls may be implemented in the form of behavioral restrictions, pre-action appraisal, and action accountability. These are described in Table 2.
Table 2: Forms of Action Controls

Action Control Behavioral restrictions Description These are limitations placed on the behavior of organizational personnel and are a form of negative discipline. An environment is created within an organization that deters one from doing things which are not in the organizations interests. The restrictions may be physical in nature (passwords on specific computers) or administrative (limited decisionmaking rights). 9
Action Control Pre-action appraisal
Description It involves a supervisor reviewing a subordinates plan of action. Control here takes place before an action is carried out so that wrong action may be prevented. This form of control entails making employees responsible for their actions and in essence is applicable after an action has been carried out. To be effective, it is required to set regulations for actions based on acceptability and unacceptability; make employees aware of this code; and have schemes in which commendable performance will be rewarded while non-conformance to regulations for action will lead to penalties.
Action accountability
Results Controls Results controls are focused on the consequences of actions taken rather than on the actions themselves. These controls do not place any restriction on actions, and empower employees to use their discretion in doing what they feel is best for the organization. The outcome or output of action is the focus of control based on which a reward system is put in place. Individual rewards often accompany these controls to motivate individuals to perform well. Results controls can be used at various levels of an organization, and are often used along with action controls. Personnel/Cultural Controls Personnel/cultural controls aim at encouraging employees to monitor themselves and others with whom they work. These controls co-exist with action and results controls or are used in organizations to control aspects in which actions and results controls are not effective or sufficient. These controls are established in a manner that certain culture, values, beliefs, and norms of behavior become intrinsic to the organization as a whole. It is to be ensured that the right people are placed in the right positions, and provided with the right resources. It is also to be ensured that the job is designed keeping in mind the person to whom it is being allotted. Training helps in orienting and familiarizing an employee with the organizations expectations. It also helps in new employees socializing with existing employees. Establishing a reward system which commends group achievement is suitable for personnel/cultural controls, rather than rewards based on individual performance. Group-reward systems enable the focus to shift to a group effort which motivates members of a group to monitor themselves and the others in the group.
4.2 Based on the Extent of Formalization of Control

Based on the extent of formalization, management controls can be classified into formal controls and informal controls. Formal Controls Formal controls or bureaucratic controls involve establishing standard rules and procedures for control of activities and their outcomes. These entail the delegation of tasks (authority and responsibility) in a structured manner within a well-defined framework; establishing a standard system for monitoring conformity with the rules 10
and regulations; and formulating explicit systems of rewards, penalties, and approvals to ensure compliance. Policies, standard operating procedures (SOPs), budgetary controls, financial reporting, audit, performance measurement systems, and incentive systems are examples of formal controls. Informal Controls Informal controls are not about any fixed rules and regulations. They are exerted by establishing a corporate culture and value system in which there is an interactive exchange of information which may not be strictly official at all times. For informal controls to develop and be effective, interpersonal relationships among employees at various levels are encouraged so that a feeling of trust pervades the organization and among external agencies dealing with the organization. Informal controls are found in organizations that rate high on innovation and creativity. In a controlled organization, both informal and formal controls co-exist, and the effect of one is not independent of the other. Informal controls complement formal controls and in ways, dilute certain drawbacks of formal controls by encouraging peer interaction, self-initiation, and creativity.
4.3 Based on the Time of Implementation of Controls

Based on the time of implementation of controls, management controls can be classified as open loop controls and closed loop controls. Open loop controls exist when an organization has a predetermined plan for attaining set objectives but there is no control mechanism to act if the actions deviate from the objectives. A closed loop control mechanism involves monitoring of (expected) outcomes at regular intervals and taking corrective action if a deviation is expected to occur, or has actually occurred. Closed loop control mechanisms are further classified into feedback control and feedforward control. Feedback control: In the feedback control process, deviation from the plan occurs first and corrective actions are taken after the deviation is measured. Once the deviations are corrected, the plans are updated accordingly. The most important aspect in the feedback control process is the diagnosis of the reasons for such deviations and the development of strategies to avoid them in future. Feedforward control: It entails continuously scrutinizing and monitoring the various processes in use along with the environment within which the organization is operating. Proactive modifications are made to either the processes or the environment or both, as and when the need arises. It has to function constantly from the start of the activity, and can stop only when the activity stops. The major difference between feedforward control and feedback control is that feedforward control is an anticipatory control, where information flows in the forward direction, whereas feedback control is a follow-up control where information flows in a loop in the reverse direction.
5. Contextual Factors Influencing Management Control

The design and use of control systems is dependent upon the particular context of the environmental and organizational setting in which the controls operate. The different factors (internal or external) which influence the effectiveness and operation of MCS include: the nature and purpose of the organization; organization structure and size; 11
national culture; corporate strategy and organizational diversification; competitive strategy; managerial styles; organizational slack; stakeholder expectations and controls; and organizational life cycle.
5.1 Nature and Purpose of the Organization

The nature and purpose of an organization (for profit or non-profit) chiefly determines the MCS design. A non-profit organization (NPO) is an organization in which owners do not earn any profit when revenues exceed expenses. It operates for the societys well-being and provides services, and does not participate in equity markets. It is funded by donor contributions and grants, and operating surpluses. The donors play a vital role in setting expectations for governance and management control, and the utilization of grants to achieve well-defined social objectives. Some ways in which NPOs differ from for-profit organizations are stated in Table 3. Controlling employees, systems, and processes is also different in an NPO from that of a profitbased organization.
Table 3: Non-Profit Organization vs. For-Profit Organization

Differentiating Factor Purpose Funding Non-Profit Organization For the well-being of society Funded by donor contributions and grants, and operating surpluses Amount of service that has helped in enhancing the quality of life in society through education, health, etc. For the benefit of society For-Profit Organization For pursuit of profits Equity, debentures, loans, and retained profits Financial profits
Basis for calculating profitability Use of profits
Passed on to the employees, the shareholders, and to the government as taxes from Is in the form of monetary benefits so, tangible in nature.
Type of rewards
Satisfaction derived serving others.
5.2 Organization Structure and Size

Organization structure defines the formal configuration of job roles and responsibilities that individual employees or groups have to take up to carry out the organizations activities effectively and efficiently. It determines the organizations hierarchical structure that in turn, defines the reporting relationships between hierarchies. While designing control systems, characteristics of organization structure like centralization/decentralization and span of control should be considered. A modern organizations structure should cope with a high degree of uncertainty, as new tasks are constantly included into the production or work process. An organic organization structure adapts itself easily to unstable conditions in rapidly changing environments. As a business grows, the managements work increases and the organization structure becomes more complicated, making MCS for such 12
organizations complex. Large organizations have more influence over the environment in which they operate. The use of mass production techniques in these organizations leads to mitigation of task uncertainty. In these organizations, the presence of many business units or functional departments leads to huge amount of information generation and processing. This helps in developing controls such as rules, documentation of the information, creation of specialized role functions, and a higher degree of decentralization.
5.3 National Culture

The MCS of any organization is influenced by the host countrys national culture along with the objectives of the business units. It influences the way in which an employee interprets the information received from the business environment. Multinationals should be able to assimilate the cultures of different countries and create a common understanding among the employees. Geert Hofstede defined culture as the collective programming of the mind that distinguishes the members of one category of people from those of another. He studied the values, beliefs, perceptions, and traditions of people in 50 countries and highlighted four dimensions on which culture varies across countries. These dimensions are described in Table 4. Each of these dimensions affects the various aspects of management controls differently.
Table 4: Hofstedes Dimensions of National Culture

Dimension Power distance Description Includes presence of hierarchical levels where there is inequality in the distribution of power. Organizations scoring high on power distance tend to follow strict budgetary control, a defined top-down approach of management, etc. Low score organizations follow a bottom-up approach of management and a more objective performance evaluation system. Uncertainty avoidance It refers to risk-taking ability and the extent of avoidance of ambiguity. Organizations scoring high have well-defined performance measurement systems explicitly connected to the incentive programs. Preference is given to a strict acceptance of rules. In low score organizations, culture is more open to flexible performance evaluation systems. Individualism/ collectivism It examines the tendency of people to either prefer working as individuals or as teams. In organizations high on individualism, people prefer to be appreciated for individual work, and prefer incentives based on individual performance rather than group performance. In organizations high on collectivism, people work as a team and believe in group rewards. 13
Dimension Masculinity/ femininity
Description High on masculinity a higher competitive spirit, independent thinking, assertiveness, etc. The higher the masculinity, the greater will be the tendency among employees to accept higher targets, and greater will be the tendency to expect incentives for individual achievements. In countries with low masculinity, the emphasis is more on better working conditions and team-based incentive programs. High on femininity higher interdependence, inclination toward service, etc.
5.4 Corporate Strategy and Organizational Diversification

Controls at the corporate strategy level provide a strategic direction to the organization and also impact the degree to which its objectives can be achieved. To achieve goal congruence between the organizational goals and individual strategic business units, it is necessary that the MCS has a good fit with the corporate strategy. A well-made corporate strategy may fail unless it concentrates on fostering each business units success, individually. Depending on the operating businesses, corporate entities can be classified into single business firms (deals with only one form of business) and diversified firms (deals with more than one business). Diversified firms are further classified into related and unrelated diversified firms. A related diversified firm has different businesses that are related in some way, share common core competencies. In these organizations, resources are shared between the different businesses, and there is open communication between the corporate managers and the individual business unit managers. When a firm has businesses operating in many different areas which are not linked, it is said to be unrelated diversification. These are however, financed and managed by a single parent firm. Management controls differ depending on the type of diversification. Designing and implementing MCS for a diversified firm is more difficult than designing control systems for a single business firm. The greater the extent of diversification, the more the managers need to update their expertise and knowledge about the firms operations. Strategic controls help in controlling the performance of individual businesses by evaluating all the operations in which the business is involved. Financial controls deal with setting certain standards for the level of financial returns expected and then comparing the achieved target with the standards.
5.5 Competitive Strategy

Michael Porter suggested three generic strategies which a business may pursue to gain competitive success overall cost leadership, differentiation, and focus. If a business adopts the overall cost leadership strategy, it will cut costs in every activity of its performance, and MCS will be designed to achieve this efficiency objective. If it differentiates itself from the competitors through its products and services, it will incur extra costs to build in this differentiation, and MCS will work toward building value into the product that is more than the cost of value added. If the focus strategy is adopted, a small set of customers is targeted with an exclusive set of product offerings at premium prices, and MCS ensures the right pricing policy for the product offerings. 14
5.6 Managerial Styles

Management style influences employees behavior in an organization. The level of autonomy that a manager can sanction a subordinate depends on variables like the level of involvement of the manager in the subordinates work activities and decisions, and the level of trust and confidence of the manager in the ability of the subordinates influence. Managers differ in their managerial styles -- autocratic and democratic being the two common styles. An autocratic manager generally takes decisions on his/her own, which the subordinates have to follow. A democratic manager allows the subordinates to participate in the decision-making process. Both autocratic and democratic managers can be permissive or directive. An autocratic permissive manager will take the decisions on his/her own, but allow the subordinates to choose their own working style. An autocratic directive manager will take the decisions and also decide on how the work should be carried out by the subordinates. A democratic permissive manager allows subordinate participation in decision making and gives them freedom to decide their work pattern. A democratic directive manager allows subordinate participation in decision making but closely monitors the way in which the work is done.
5.7 Organizational Slack

Organizational slack is that capacity in an organization which is in surplus of what is required for normal operations. It may exist due to Under-utilization of resources Setting targets lower than expected performance Giving a higher remuneration to employees than is necessary for retaining them Pricing products lower than is necessary for retaining customers. When created as a part of budgeting activity, such surplus capacity is called budgetary slack, which is the amount that is budgeted in excess of the actual requirement. Creation of slack may be voluntary or involuntary. The effect of slack on an organization may be considered good as it provides for creativity, improvement, and trials; helps retain people; accommodates any performance discrepancies; minimizes conflicts; and acts as backup in turbulent times and makes it easier for it to adapt to changes. Slack may also be considered bad as it promotes managerial and operational inefficiency, which in turn hinders the attainment of organizational objectives. Slack is an important consideration in designing MCS. In highly diversified firms, toplevel managers have little knowledge of the intricacies of operations of individual units, which may lead to existence of slack. MCS in such organizations will then be required to include tight budgetary controls. In certain situations, control systems may be so designed as to tolerate slack to prevent throttling of innovation and search for newer opportunities, and also to reduce information overload at the strategic management level.
5.8 Stakeholder Expectations

Stakeholders are individuals or groups of people who are impacted and who impact the organizations activities and operations. Shareholders, employees, and management are internal stakeholders while customers, suppliers, creditors, the community, government, and other authorities comprise the external stakeholders. 15
While designing its MCS, an organization has to consider stakeholders demands and the value it intends to deliver to them. This in turn leads to maintaining a mutually beneficial relationship that is profitable in the long run. Figure 2 shows the different factors to be considered and improved upon for increasing value for the specific stakeholders.
Figure 2: Responsibility of Organizations toward Stakeholders
Adapted from Business Ethics and Corporate Governance. ICMR Center for Management Research, 2004 and Walters, David. Performance Planning and Control in Virtual Business Structures. Production Planning & Control. Vol. 16 Issue 2, March 2005, p226-239.
Refer to Exhibit 2 for a description of a leading pharmaceutical companys initiatives to explicitly address stakeholder concerns and formally report its performance on financial, socio-economic, and environmental parameters by adopting a Triple Bottom Line approach.
Exhibit 2: Novo Nordisk and Stakeholder Relations

Novo Nordisk is a pharmaceutical company specializing in diabetes care, situated in Denmark. It was formed in 1989 through a merger between Novo and Nordisk. Novo Nordisk (Novo) considers stakeholders to be an integral part of their system. The organization believed that with the help of the stakeholders it is easier to find sustainable solutions to issues, and that it also helps in keeping track of the trends that may affect the business in the future. The aspects that were considered while deciding on the stakeholders are the level of influence that a stakeholder can exercise on the organization, the authenticity of the stakeholder-organization relationship, and how proactive the stakeholders are in responding to the organizations activities which affect their claims. These aspects along with the current and future business interests and the image of the organization were taken into consideration to decide the level of importance of each of the stakeholders and also in setting the organizations priorities toward them. Proper standards and regulations were adhered to in order to conform to stakeholder expectations regarding transparency of operations and ethical conduct.
Contd
16
Contd
The reporting activity in Novo had evolved over the years. It began with creating an environmental report which included information on aspects like resource utilization, effluents, and other harmful emissions, etc. Later it adopted the inclusive reporting approach, thus improving business performance and shareholder value. The reports presented to the stakeholders contain both financial and non-financial information. This approach involved aligning activities like setting of targets and devising the key performance indicators by involving both the internal and external stakeholders. Novo adopted the Triple Bottom Line approach of reporting by including socioeconomic information along with environmental and financial information in the report. This triple bottom line approach helped the organization build on its sustainability initiative and was integrated into the business objectives of the organization. Novo began publishing and distributing the sustainability report and the financial report at the same time. This helped the stakeholders gain a better understanding regarding the performance of the organization, and its strategic initiatives.
Adapted from <http://annualreport.novonordisk.com>.
6. Summary
In the management context, Control traditionally refers to the activities of establishing standards of performance, evaluating actual performance against these standards, and implementing corrective actions to accomplish organizational objectives. Management control is broadly concerned with the attainment of goals and implementation of strategies. In a dynamic environment, it helps fulfill the needs of effectiveness, efficiency, and adaptive learning. Management control is a process whereby management and other groups are able to initiate and regulate the conduct of activities so that their results accord with the goals and expectations held by those groups. A management control system is a set of interrelated communication structures that facilitates the processing of information for the purpose of assisting managers in coordinating the parts and attaining the purpose of an organization on a continuous basis. The basic control process based on the cybernetic approach comprises the following steps: determining areas to control, establishing standards, measuring performance, comparing performance against standards, rewarding good performance and/or taking corrective action when necessary, and adjusting standards and measures when necessary. MBO, a concept propounded by Peter F. Drucker, is a specific application of the cybernetic process of management control. In this, goals/objectives (which should be SMART) are set jointly by the supervisor and the subordinate. According to the COSO framework, objectives of management controls may be discussed under three heads effectiveness and efficiency of business operations; reliability of financial reporting; and compliance with the applicable regulatory and legal framework. 17
Management controls have been classified based on the object of control (action controls, results controls, and personnel/cultural controls); the extent of formalization of control (formal controls and informal controls); and the time of implementation of controls (open loop controls and closed loop controls). Closed loop control is further classified into feedforward control and feedback control. Contextual factors which influence the design and use of MCS include: the nature and purpose of the organization, organization structure and size, national culture, corporate strategy and organizational diversification, competitive strategy, managerial styles, organizational slack, stakeholder expectations and controls, and organizational life cycle. The nature and purpose of an organization, that is, whether it is a for-profit or a non-profit organization has a major impact on MCS. The organization structure establishes the formal pattern of job roles and responsibilities that individual employees and groups have to undertake, and the hierarchical structure and reporting relationships. An increase in size of organization necessitates development of controls such as rules, documentation of information, creation of specialized role functions, and a high degree of decentralization. The MCS of any organization is influenced by the national culture of the country in which it operates. Geert Hofstede identified four dimensions along which national cultures vary. The dimensions are: power distance; uncertainty avoidance; individualism/collectivism; and masculinity /femininity. To achieve goal congruence between the organizations goals and those of individual strategic business units, it is necessary that the MCS has a good fit with the corporate strategy. Management controls also differ depending on the type of diversification -related or unrelated. The choice of generic competitive strategy overall cost leadership, differentiation, or focus -- also influences the MCS. Managerial styles (autocratic or democratic, permissive or directive) play an important role in influencing the behavior of the employees in an organization, and thus, the design and implementation of control systems. Organizational slack refers to that capacity in an organization which is in surplus of what is required for normal operations. It may be created voluntarily or involuntarily, and may be considered good or bad for an organization. Stakeholders (investors, employees and managers, suppliers, customers, community, government, etc.) are defined as individuals or groups of people who are impacted by or who impact the activities and operations of the organization. It is necessary for organizations to consider what the stakeholders want while designing their MCS.
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Concept Note -2
Design of Organization Structure and Control Systems

1. Introduction
Management control is exercised when people exercise their power or perform their duties based on organization structure, abide by a code of conduct, or ensure adherence to policies and processes. To exercise control, the management creates suitable structures in the organization and puts in place certain systems, processes, policies, and practices. This note will help you understand: The structure of an organization The concept of responsibility structure within an organization The significance of designing an optimum management control system The management control of non-profit organizations The use of control systems for empowerment, innovation, and creativity.
2. Organization Structure
Organization structure refers to the role-responsibility relationships of individuals in an organization along with their pre-defined interaction patterns. It defines the formation of sub-groups within the organization, along with the formal techniques and methods of communication and coordination to be used. It facilitates both vertical (downward and upward communication between different hierarchical levels) and horizontal (between different people at the same hierarchical level) information flow in the organization. From a management control perspective, the organization design should promote communication, cooperation, teamwork, motivation, and performance. It should be best fitted to the organization and its external and internal environments.
2.1 Structural Dimensions of Organization Design

Communication, alliance, and cooperation should be encouraged in organization through management control of areas such as strategy, investments, marketing, internal processes, and human resources. Structural dimensions, which are the internal dimensions in the organization, are used as a basis for formally describing the organization structure. These dimensions are shaped based on the contextual dimensions that have a wider scope and include both internal and external factors like organization size, technology used, environment in which it operates, culture, and objectives. Richard L. Daft proposed six structural dimensions -- formalization, specialization, hierarchy of authority, centralization, professionalism, and personnel ratios. These dimensions are described in Table 1.
Table 1: Structural Dimensions of Organization Design

Dimensions Definition It refers to the extent to which written rules and records are maintained in the organization. Description It is maintained to document employees activities and related behavior. The number of pages of written records is one of the indicators of the degree of formalization. MCS in formalized setups require detailed reports to be prepared containing information about activities and outcomes; periodic comparisons to be made and detailed variances measured to assess progress; and formal reward systems to be put in place to motivate contributions toward achievement of objectives. In less formal organizations, the control mechanism is more implicit. The degree of formalization can be high in jobs of routine nature so that coordination is facilitated. Professionals performing complex non-routine jobs may be de-motivated if they are bound by too many formal rules and procedures. As organizations grow larger, one of the challenges as far as control system design is concerned is how not to become too formal or bureaucratic. Definition It refers to the extent of dividing the organizational activities into sub-groups, in which each employee performs only a small range of activities in which he/she is a specialist. Description The higher the number of sub-groups, the fewer the activities an employee performs and vice versa. Degree of Specialization Also called as division of labor or functional specialization in which a job is broken down into several parts. It is useful in overcoming restrictions of time and knowledge in performing complex jobs. In organizations with a high degree of specialization, the job performed by individual employees is of a routine nature. So, control systems usually consist of explicit rules and procedures which help establish certain standard actions and results. Definition and Description
Degree of Formalization
20
Dimensions Definition
Definition and Description
It refers to the reporting relationships prevalent in the organization and the span of control (number of subordinates who report to a supervisor). Description The hierarchy of authority is flatter In organizations with a wide span of control, (where a large number of people report to a particular manager) than in organizations with a narrow span of control. For effective control, the management needs to determine an optimal span of control for the organization depending on certain factors which include the complexity of the tasks performed by subordinates; the extent and nature of intervention required from the manager; whether tasks being performed by subordinates are identical or varied; and whether tasks being performed are inter-dependent or may be performed independently of each other. Tall structures provide closer supervision and tighter control by supervisors as there are only a few people reporting to a supervisor, while in flat organizations, supervision is less tight as a supervisor has a larger number of subordinates to supervise and the communication channel is simpler. Definition It refers to the level in the hierarchy which has the decisionmaking authority. Description When the decision-making authority lies with the top management, the organization is said to have a high degree of centralization, and when the decision-making authority is distributed among the lower levels of the hierarchy, the organization is said to be decentralized. Decentralization gives the individual business managers the right to take decisions for their respective business units. While a decentralized structure fosters innovation and entrepreneurship, and responsiveness to customer needs, centralization helps in strict adherence to plans. Coordination at the lower levels of the organization may be lower in a centralized organization, resulting in loss of effectiveness, bottlenecks, and lack of responsiveness to market demands. 21
Hierarchy of authority
Degree of Centralization
Dimensions Definition
Definition and Description
It refers to the level of formal education of the employees. Description The higher the number of years of formal education and training, the higher the professionalism. Degree of Professionalism In organizations with a high level of professionalism, MCS may be designed in such a way as to provide an environment which encourages accomplishment of objectives. While professional individuals may not require very close supervision of actions and results, they need to be placed in the right jobs to feel sufficiently motivated. Close supervision of actions and results is more useful where the level of professionalism is low. Definition It refers to the distribution of people into different functions and departments. Description Personnel ratios In a specific function, it is calculated as the ratio of the number of people in the function to the total number of people in the organization. They indicate the managements priorities judgments regarding the deployment of people. and
Examples of personnel ratios are administrative ratio, sales force ratio, etc.
2.2 Types of Organization Structures

Organization structure decisions relate to division of labor and the formation of departments, divisions, or units; hierarchy, reporting relationships, and span of control of supervisors; and coordination mechanisms. The organization structure should encourage participation and innovation over and above maximization of performance levels and effectiveness of operations throughout the organization. The various types of organization structures include functional, divisional, matrix, horizontal, and hybrid structures. The advantages and disadvantages of these structures are given in Table 2. Figure 1 represents the various organization structures.
22
Figure 1: Organization Structures
Functional Structure The functional structure is characterized by people being grouped based on their expertise and skills (such as the R&D department looks after the research and development function). It is used when the requirement for expertise in a specific field is important. In this structure, the vertical hierarchy is stronger than the horizontal hierarchy. It calls for centralization as the decisions regarding resolution of issues are generally made by the top management. Divisional Structure The divisional structure is also called a product structure; the divisions may be referred to as strategic business units (SBUs). The divisions are formed based on an organizations product range, the specific markets which the organization caters to, or 23
the geographic locations in which it operates. This structure fosters higher adaptability to change due to the small size of each division and also better interaction between the various functions within a division. It is characterized by higher decentralization as the decision-making authority rests with business unit managers rather than the top management. When an organization is divided into small business units, the authority and responsibility of decision making for that unit is placed with unit-level managers. This delegation acts as an inherent motivator for them as they can clearly understand the impact of the choices made and actions taken on the performance of their unit. Matrix Structure The matrix structure tries to integrate the salient features of the functional structure (say, technical specialization) and those of the divisional structure (say, market responsiveness, product innovation, or project delivery). In this structure, an employee reports simultaneously to two different supervisors -- One supervisor representing a functional department and the other representing the division, product, market, geography, or project. This structure is commonly used in project-based organizations and for new product development. It is useful in organizations which have a limited product range and/or when a high degree of interaction is required between the functions. The matrix structure requires a high degree of cooperation and coordination among managers. Horizontal Structure Frank Ostroff proposed the horizontal structure as the structure that prevents the rigidity and departmentalization existing in a vertical system by grouping managers and employees into synergistic teams for problem-solving. Organizations move toward the horizontal structure through business process re-engineering. Here, process stands for an organized group of related tasks and activities that work together to transform inputs into outputs that create value for customers . The owner of a process is responsible for coordinating and controlling the process in its entirety. In a horizontal structure, the emphasis is on teams which direct themselves. Team members are provided with resources, motivation, and the authority to take core decisions. They are also cross-trained so that they can substitute for each other if required. Creativity, flexibility, trust, cooperation, employee empowerment, and a customer-centric approach characterize horizontal structures. In a horizontal structure, the people carrying out activities in a single process have better coordination with others in the same process. Hybrid Structure Hybrid structures are formed as a combination of the functional, divisional, or horizontal structures. They help organizations combine the strengths of different structures while eliminating the weaknesses of each. In an extremely volatile environment, it has become very important for organizations to quickly adapt to changes. This is an important characteristic seen in the hybrid structure, also called the flexible or adaptive organization. Two important characteristics of a hybrid organization are that there is scope for different ways of thinking and a participative style of management. For such organizations, organizational design is decided based on which structure is appropriate in a specific situation and at a particular point in time. Flexible organizations continuously assess and modify their structure so that the employees are best aligned to the strategic changes. 24
There are two types of hybrid structures. The first type combines the functional and divisional structures. When an organization with a functional-divisional matrix structure grows in size, it is generally divided into smaller divisions which have their own functional setup. Refer to Exhibit 1 for a description of the hybrid structure of the AXA Group, a France-based insurance and investment organization. The second type of hybrid structure combines the functional and horizontal structures.
Exhibit 1: The Winning Structure of AXA

The AXA Group (AXA) is a France-based company specializing in insurance and investment management solutions. AXA operates across Western Europe, North America, and the Asia-Pacific. AXA grew in size through acquisitions and continued to focus on insurance and investment markets, with a strategy of becoming the leader in financial protection. The Chairman of AXA, Henri de Castries, realized that it was necessary for the company to centralize some functions and decentralize the rest to leverage on the strengths of its subsidiaries in other countries. AXA operated through ten business units, each with its own specific targets. These units devised their own strategies depending on the set targets. To manage the operations better, the company decided to strike a balance between centralization and decentralization. The highly centralized functions included corporate strategy, brand management, approval of new products, and monitoring of the key performance indicators. To minimize cost of capital and improve financial strength, the capital allocation function was also centralized. In addition, procurement was centralized. This helped AXA reduce costs and obtain better prices from the suppliers. Technology was also centralized through the formation of AXA Tech. It helped reduce idle hardware, thus reducing costs. Decentralization in AXA was achieved by giving the subsidiaries the freedom to formulate their own local strategies. The new product development activity was decentralized with subsidiaries developing their own strategies. The products were launched keeping in mind the market demand and scope for market development. The subsidiaries also had their own distribution practices and risk management practices. By centralizing some functions and decentralizing the others, AXA was able to achieve a competitive advantage in all the markets through their best practices.
Adapted from Indu, P. and Vivek Gupta. Case Study - Governance and Control at AXA. The ICMR Center for Management Research, 2006. <www.icmrindia.org>; and <http://www.axa.com>.
Table 2: Advantages and Limitations of Various Organization Structures

Organization Structure Advantages Functional structure There is more emphasis on efficiency. Employees are segregated based on their expertise and are able to specialize in the jobs assigned to their respective departments. 25 Advantages and Limitations
Organization Structure Limitations
Advantages and Limitations
They face difficulty environmental changes.
in
adapting
easily
to
Most of the decision-making power is done at the top that leads to delay in the process. Lack of coordination between various departments and a myopic view prevailing among employees regarding organizational objectives lead to restrictions in innovation and creativity. Advantages It is easy to measure the performance of each small unit and to reward commendable performance with more accuracy. Increase in financial incentives and other rewards in the form of promotions, expressed praise, etc. can be directed at individuals and groups who actually deserve them. Increased speed of communication, understanding, analysis, processing and acclimatizing to new information (such as changes in customer preferences, supplier behavior, and change in risk profile due to the changed nature of competition). Such information is first available to the individual divisions/units (closer to the source of the information) rather than the top-level management which is more concerned with broader issues affecting the organization as a whole. Limitations Negative impact of some decisions (made by a business unit manager who is responsible for the performance of only his/her division/unit) on other divisions. A business unit manager may ignore the repercussion of, or may not have sufficient information required to assess the ripple effect of, a decision made for his/her unit, on other units. Advantages Retention of the functional aspect helps retain economies of scale and that of the divisional aspects helps in incorporating customers preferences, thus improving their own profitability. Economical sharing of resources among the various departments so as to achieve the organizations goals and objectives. 26
Divisional structure
Matrix structure
Organization Structure
Advantages and Limitations Presence of dual authority leading communication between managers. to greater
Capability of adapting to changes in the environment through better allocation of resources. Limitations Presence of dual authority leads to a higher chance of conflicts arising and so a lot of time is consumed in conflict resolution. Requirement of strong interpersonal individuals within the structure skills in
Meetings between participants take up a lot of time. Requirement of mutual respect among participants. Advantages Enables the organization to adapt easily to a changing environment, and it ensures that satisfaction and value addition for the customer are the main goals. Employee satisfaction due to shared responsibilities, enhanced authority for decision-making, and a clear understanding of an employers contribution toward organizational goals. Limitations More time taken to identify core processes; it becomes necessary to change the organizational culture, job structure and function, and performance measurement system; and there is the possibility that the employees specialization in specific functions may be hampered. Employees also require a great deal of training in varied areas in order to be effective in a horizontal structure. Advantages Scope for different ways of thinking and a participative style of management. Aids quick decision-making, quick adaptability to market changes, increased spending on R&D. Limitations Difficulty in identifying the environmental changes, deciding on the strategic modifications required for such changes, and the trickle down effect of such decisions.
Horizontal structure
Hybrid structure
3. Responsibility Structure
A responsibility structure is a collection of responsibility centers. Each responsibility center is a function, division, or unit of an organization under a specified authority with a specified responsibility. Performance evaluation of each of these responsibility 27
centers is done based on certain criteria (specific to each type of center) to assess its contribution to the organization as a whole using responsibility accounting. According to the Institute of Cost and Works Accountants of India (ICWAI), responsibility accounting is a system of management accounting under which accountability is determined according to the responsibility allotted to various levels of management. An organizations control system should be able to measure the influence that the activities of each manager have on the organizations performance. In other words, it should be able to pinpoint the contribution of each manager to the achievement of the organizations goals.
3.1 Controllability, Goal Congruence, and Transfer Pricing

Organizations should consider controllability and goal congruence while designing responsibility structures. Transfer pricing is used to measure the individual centers contribution to the overall organizational goals, and to ensure that fair performance measurement systems are designed. Controllability: According to this concept, each manager should be assessed and rewarded only for those factors that are under his/her control. For example, uncontrollable costs are those which the manager incurring the cost cannot influence over the relevant time period. Goal congruence: It is achieved when managers (and employees), while working toward their best self-interest, as perceived by themselves, take decisions that are successful in attaining the organization goals. Performance measurement systems should be designed so that the set organization objectives and the employees objectives are properly aligned. Transfer pricing: A transfer price is the internal price charged by a selling department, division, or subsidiary of an organization for a raw material, component, or finished good or service which is supplied to a buying department, division, or subsidiary of the same organization. It is the monetary value assigned in responsibility accounting for exchanges that take place between the responsibility centers of an organization. This value is treated as the revenue of the selling center and the cost of the buying center. Therefore, it is essential that transfer pricing is correctly done to provide a fair picture of the contribution of different responsibility centers.
3.2 Responsibility Centers

Responsibility center, according to the Chartered Institute of Management Accountants, UK, is a segment of the organization where an individual manager is held responsible for the segments performance. It is a department, function, or unit of an organization headed by a manager who is directly answerable for its performance. Responsibility centers facilitate management control and help in implementing the strategies chosen to achieve the organizations goals. For a responsibility center, the accounting system generates information on the basis of managerial responsibility, allowing that information to be used directly in motivating and controlling the action of the manager in charge of the responsibility center. Every responsibility center uses inputs (material, labor, etc.) and needs working capital, equipment, and other assets to function effectively. While the costs of inputs can be easily measured, outputs are not always easy to measure. 28
The responsibility centers performance can be judged using the effectiveness and efficiency criteria. Responsibilty centers can be classified into -- cost centers, revenue centers, profit centers, and investment centers -- according to the nature of monetary inputs and outputs. Cost Centers Cost centers are held responsible for the costs incurred. According to the cost center manager, either the costs or the level of outputs can be independently controlled, but not both. A cost center can operate in two ways -- either the cost budget is specified and the goal is to maximize the output, or the expected output is specified and the goal is to minimize the cost. In the first case, a certain fixed budget is allocated to the cost center, and it is expected to achieve the best possible result within the allocated budget. In the second case, the goal is to achieve the required level of output at minimum cost; the performance level depends on the cost incurred by that center. Responsibility center managers are expected to maximize the services offered while keeping within the budgeted limits. In the control of cost centers, managers make mistakes by evaluating performance with a view to only minimize costs and may ignore important non-financial indicators of performance such as output quality, safety issues, or ethical and environmental issues. The control system in a cost center should therefore be designed so that it recognizes the role of all factors that have an impact on organizational goals. Cost centers are of two types -- standard cost centers and discretionary expense centers. Standard cost centers are also known as an engineered expense centers; standard cost centers are usually found where a standard cost system is in place or in organizations that have a repetitive task to be performed. The managers aim is to prevent or reduce unfavorable variance between the actual and budgeted costs, while maintaining the quality and quantity of outputs at the desired levels. For a discretionary expense center, it is difficult to measure the outputs in monetary terms against a given level of inputs. Generally, a budget is decided upon for the chosen time period, say, a financial year. Revenue Centers Managers of revenue centers are held responsible for the revenues (outputs) but are not directly responsible for profits. Costs traceable to a revenue center are normally adjusted with the sales revenue to calculate the net revenue of the revenue center. In many organizations, revenue centers are the points of contact closest to existing and potential customers. The main objective of these centers is to maximize net revenues and assume no responsibility for production. Profit Centers Profit centers are responsible for profits. The profit center manager has control over both the input as well as the output, while he/she does not have control over the level of investment. A profit center aims to achieve profit targets by focusing on both cost reduction and revenue maximization. The manager cannot afford to reduce quality to reduce cost as that would lead to reduced sales revenue and profit, and may not optimally utilize the capital employed thereby not being able to maximize profit. 29
Traditional cost centers are now being converted into profit centers. For example, IT departments earlier provided services to other departments (internal customers) free of cost. But now, they are being charged a transfer price. In this scenario, the buying center and the selling center (earlier a cost center) have the option of contracting with an external firm that can provide similar services. Investment Centers Investment centers are responsible for the overall economic performance in terms of the cost incurred, the revenue generated, as well as the associated investment. Performance of investment centers is measured with respect to Return on Investment (ROI) or Return on Capital Employed (ROCE) (profit divided by the capital employed in making that profit), and Economic Value Added (EVA). These centers have a drawback - since the value of capital employed is taken from the balance sheet, the value of ROI or ROCE may depend on the accounting technique followed by the organization. Also, the investment center may postpone new investments like purchasing new equipment, as the ROCE will decrease in the short run, though the organization may benefit from these investments in the long run.
4. Designing Control Systems

Designing an optimal MCS is vital for the effectiveness and long-term sustainability of an organization. A very low degree of control can lead to confusion and chaos, while a high degree of control can lead to erosion of creativity and entrepreneurship. Effectiveness of a control system is evaluated by comparing the probability of achieving organizational objectives where a control system does not exist with the increased probability or assurance of achievement when the control system is implemented. This increased assurance, referred to as the degree of certainty, is the benefit derived from the control system. The degree of certainty is described in terms of its control tightness or control looseness. Tighter control aims for a higher degree of certainty and is usually accompanied by a higher cost of control. In designing an MCS, it must be seen that each of the controls used has a good fit with others and that it promote efficacy and learning. The MCS should also fit with the internal environment and the external environments. A well-designed MCS helps the organization prepare for the future to face environment changes. Designing an MCS involves an understanding of the expectations from the organizational units and employees in terms of either the key actions, or the key results, or both. It is also important to anticipate the likely actions and results in the absence of the control system. Problems may arise due to lack of knowledge of expectations of actions and/or results, lack of motivation to perform as expected, and lack of expertise to perform as expected. Depending on the degree of variance between the desired and the likely, and the resources available to meet the costs of control, the management has to make decisions regarding the control alternatives which will constitute a control system and the extent of tightness or looseness with which they are to be implemented.
4.1 Control Alternatives

Action control, results control, and personnel/cultural control are not mutually exclusive substitutes. Various combinations of these controls (and not a single type of control) are used depending on the purpose for which they are being used. Decision 30
about control alternatives to be used involves an analysis of the structural and contextual factors which influence control systems and also carrying out a cost-benefit analysis. Costs include the consumption of available resources, harmful behavioral side-effects like depletion of trust among managers and employees, and development of negative attitudes among employees on implementation of control. Benefits include the extent to which the variance between desired actions and likely actions is minimized. It is not feasible for a control system to eliminate this variance altogether at a reasonable cost. It should be possible for an organization to avoid sudden upheavals if this variance is minimized to the extent possible. While doing so, benefits derived should be higher than costs incurred on designing and implementing the MCS. After deciding the control alternatives, the organizations policies and practices should be framed and implemented to fit the control alternatives, which in turn will have major implications for the HRM function in the organization. For example, employee selection criteria, performance appraisal practices, and the design of reward systems may vary based on the selected set of control alternatives. Personnel/Cultural Controls Personnel/cultural controls are the primary control alternatives that try to ensure an environment where employees monitor themselves and their peers. It helps in restricting the variance between the desired and the likely outcomes and is able to address most problems that come in way of attaining organizational objectives. This type of control incurs lower monetary costs and usually does not lead to harmful side effects or negative attitudes. Before considering other types of control, an organization must first assess the extent to which these controls may be used. Tight personnel/cultural controls can be used easily in small, single business organizations as there is often a commonality between the desires of individual employees and that of the organization as a whole. Tight control is also possible in large organizations which have a very strong culture acting as a guide. Lack of formal accountability for actions and their results may make employees too sure of themselves and may also lead to a loss of direction and a decrease in effectiveness or efficiency. It is not easy to achieve tight controls only based on personnel/cultural controls as these controls are easily affected by environmental changes. To achieve tight controls, these should be accompanied by actions and/or results controls, depending on the given setting.
4.2 Action Controls

Action controls aim at matching activities with the objectives so that results need not be monitored. Tight action control is achieved when only activities that benefit the organization are allowed. Established policies and procedures provide employees with a point of reference to do what is right and guide them toward achieving what is expected of them. Action controls are sub-classified into behavioral restrictions, preaction appraisal, and action accountability -- which have different implications for control system design. The costs incurred on establishing tight physical restrictions are very high (like costs for using state-of-the-art computerized security systems that restrict access for unauthorized employees). Tight administrative behavioral restrictions can be implemented if the decision-making personnel can take the right decisions and personnel who are restricted from specific actions are not able to violate such restrictions. 31
The time spent by the managerial staff for pre-action appraisal increases their workload. Discretionary use of this control enables avoidance of operating holdups and reduction in the managerial staff size. It enables productive use of time by the existing staff for revenue-generating activities. Pre-action appraisal controls, to become tight, need to be thorough and should be carried out by competent personnel. Action accountability controls involve rewarding good actions and penalizing unacceptable ones. These controls result in a harmful side effect wherein employees lay more importance on the actions they perform rather than the results which are expected of them. Tight action accountability controls require defining the desired actions; communicating the actions definition to the performer of the action so that it is understood and agreed with; effectively tracking the action; and providing significant rewards or punishment for actions taken. Rewards and punishments, as an integral part of action accountability controls, should be significant to the person being rewarded or punished. Results Controls Results controls are directly focused on the output of actions and do not place limits on actions themselves. These controls are used if the outcome from actions can be assessed quantifiably and in situations where accepted norms for actions cannot be formed or are difficult to enforce. Employees are given the authority to use their discretion that leads to greater dedication among employees toward their role in the organization. The costs involved in results controls are less than those in actions control. The information that needs to be generated for such controls in most cases, already exists as it is also required for strategic planning and financial reporting. Results controls, to be tight, require setting of realistic targets against which performance may be measured. A well-designed reward-punishment (individual or group) system is required which rewards commendable performance and penalizes negative performance. These targets should be in alignment with organizational objectives and should be set in consultation with the concerned employees. Costs of results controls include pecuniary costs relating to performance bonuses. The results achieved are not always related to employees efforts; they may be affected by external factors and beyond the employees skill or motivation level. Targets and reward systems considered inappropriate by employees act as demotivators and lead to negative attitudes. For results controls, to be successfully implemented, it is necessary to ensure that there is correct understanding of the results. Employees tend to maximize only those aspects of their contribution which can be quantifiably measured and ignore the qualitative aspects. So, the result obtained will not be optimal if too much importance is laid on results control. It should be accompanied by actions control and personnel/cultural control to have an MCS which provides a reasonable assurance of achievement of organizational goals.
5. Management Control of Non-profit Organizations

NPOs face problems in obtaining funds to carry out their operations. Their leaders may consider the service as a good cause that will sell on its own than pay attention to deciding its features, selling strategies, mode of delivery, etc. Employees and volunteers may get the satisfaction to have worked for a good cause, due to which 32
they may not make any conscious effort to sell the service. Most NPOs believe that the service provider can decide the features of the service without taking inputs and feedback from the intended beneficiaries, unlike a product-based manufacturing business where the customer influences the product design. This belief leads to flaws in the design of service product. NPOs also face problems in service delivery due to lack of proper reward systems, poor communication and relationships between members, or lack of top managements support and encouragement. Due to the fundamental differences between them, it is not sufficient to merely extend controls used in the for-profit organizations to NPOs. Geert Hofstede proposed the criteria clarity of objectives, quantifiability of results, predictability of interfaces, and repetitiveness of activities -- which help in management control of public/NPOs and how different control systems are possible, depending on these criteria. Combinations of the four criteria give rise to different types of controls routine control, expert control, trial and error control, intuitive control, judgmental control, and political control. These controls are described in Table 3. These controls can be used in any type of organization, but, we have restricted their scope to public/non-profit organizations as discussed by Hofstede.
Table 3: Controls for Public/NPOs and their Descriptions

Type of Control Routine control Description Clear objectives, quantifiable results, interfaces, and repetitive activities. predictable
It is institutionalized in the form of standard operating procedures and rule books. Control activities can be performed manually or they can be automated. Expert control Clear objectives, quantifiable results, interfaces, and non-repetitive activities. predictable
Experts are people who have in-depth knowledge about the procedures and processes and hence are capable of exercising control. Trial and error control Clear objectives, quantifiable results unpredictable interfaces, and repetitive activities. Standard operating procedures cannot be devised as they come into play in activities like new product launch. Intuitive control Clear objectives, quantifiable results, unpredictable interfaces, and non-repetitive activities. Commonly seen in project-based non-profit organizations where each new project is unique and each project has to be approved by the top management. 33
Type of Control Judgmental control
Description When the objectives are clear but the results are not quantifiable, it is necessary to see whether other forms of control mechanisms can be put to use. If it is not possible, the control becomes judgmental and is dependent on the hierarchical structure and authority that the management has. If objectives are unclear, the control used is political control. It is dependent on the hierarchical structure, negotiation, availability of resources, and the differences of opinions regarding values and objectives. Generally works at the top level where the objectives get clarified. As the objectives cascade down the system, other forms of control can be incorporated at the lower levels.
Political control
6. Control Systems for Empowerment, Innovation, and Creativity

In a complex high-competition business environment, where talent is scarce and expensive, managers should strike the right balance between empowerment and control. Managers should encourage employees to be creative and initiate process improvements, but should retain enough control to ensure that they benefit the organization. To address this issue, Robert Simons proposed the concept of levers of control in 1995. He proposed four interlinked levers of control: diagnostic control systems, beliefs systems, boundary systems, and interactive control systems. Table 4 gives an overview of the four levers of control.
Table 4: Levers of Control

Organizational Problem Lack of focus or resources to accomplish objectives Ambiguity of purpose Pressure or temptation to act illegally or unethically Suppressed creativity due to lack of prospects or fear of risk. Managerial Solution Communicate clear targets; provide the necessary support and feedback Convey core values and mission Indicate and enforce rules Open communication between functions to encourage organizational learning Lever of Control Diagnostic control systems
Beliefs systems Boundary systems
Interactive control systems
Adapted from Simons, Robert. Control in the Age of Empowerment. Harvard Business Review. Vol. 73 Issue 2, Mar/Apr 1995, p83.
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6.1 Diagnostic Control Systems

Diagnostic control systems use quantitative data, statistical analyses, and variance analyses to scan for problems. These systems work well if the goals are reasonable and attainable. They relieve managers of the task of constantly monitoring employees and are very useful in detecting problems. Employees usually have a high degree of freedom to adopt creative means to achieve their targets. However, when goals are unrealistic, empowered employees may sometimes use their creativity to manipulate the factors under their control to live up to their managers expectations. Organizations should have the right number of measures to evaluate employees and also proper controls to check that no unethical means are used to achieve targets.
6.2 Beliefs Systems

Beliefs systems are used to communicate the doctrines of the corporate culture to all employees. These systems are generally broad and designed to appeal to different groups working in different departments, and to inspire and promote commitment to the organizations core values. For these systems to be effective, employees must be able to see key values and ethics in the same light as the managers and other people in high positions in the organization. The vision and mission statements of an organization are formal expressions of its beliefs systems. Organizations should make employees understand their beliefs systems so that they can contribute to its objectives. Refer to Exhibit 2 for a description of the unique organizational culture at Pixar that encouraged its employees to be innovative and contributed to its creative success.
Exhibit 2: Pixars Organizational Culture

Pixars organization structure had three parallel groups technology development, creative development, and production. These groups were expected to constantly talk to each other. As a result, there was open communication between them and the system worked very well. Further, Pixars unique organizational culture marked by a distinctive approach toward work and the workplace was seen as one of the factors contributing to its creative success. Pixars culture encouraged innovation, nurtured quality orientation, and facilitated teamwork. Innovation Employees at Pixar were encouraged to think in terms of steps. Each new movie was likened to a stepping stone where one could learn and try out new things to find out what worked and what did not. Intense self-scrutiny ensured that Pixar benefited from all the experiences. Pixar was also credited with bringing adult emotional appeal to a medium meant traditionally for children. This was possible due to its strong focus on the storyline. Quality Orientation Pixar believed in perfecting every detail in every production. Pixars employees were expected to have a good understanding of the world they were trying to animate. Before every movie, the crew spent quite some time trying to fully grasp the nature of the environment and the characters in the production.
Contd.
35
Contd.
Art as a Team Sport Pixar succeeded in making art a team sport, marked by collaborative action where everybody helped and even rescued the other. Directors looked over each others work and helped each other without imposing their own tone or style. Though there were various star performers in Pixar, the team was considered more important than any individual. The company recognized that movie-making was a collaborative process, and when a project succeeded, it was not due to any one persons contribution alone. Though the star performers got hig her salaries and received larger blocks of options when a film did well, everybody in the team was given a bonus. Analysts also noted that the hallmark of Pixars culture was that technology, creativity, and production were given equal importance and recognition. At Pixar, all the employees were encouraged to be a part of the filmmaking process. This unique atmosphere also helped Pixar retain talent. Preserving the Culture In 2006, the Walt Disney Company (Disney) acquired Pixar; this acquisition raised concerns regarding the future of Pixars unique culture. Some analysts felt that the Disneys bureaucratic style would threaten Pixars culture. However, the management of both Disney and Pixar stressed that Pixars culture would be protected.
Source: Purkayastha, Debapratim and Rajiv Fernando. Case Study - Pixars Incredible Culture. The ICMR Center for Management Research, 2006. <www.icmrindia.org>
6.3 Boundary Systems

Boundary systems have an approach to control that is in direct contrast to that of diagnostic control systems or beliefs systems, in the sense that boundaries are stated in negative terms whereas diagnostic and beliefs systems are positive and inspirational. Boundary systems are based on the principle that it is easier and more effective to set the rules regarding the inappropriate than the appropriate. It would allow employees to create and define new solutions and methods within defined constraints. Boundary systems work on the premise that empowered employees should not be given the freedom to do whatever they want. Employees should focus their efforts on areas that are in the organizations interests in terms of profitability, productivity, and efficiency. Boundary systems are thus minimum standards that the employees have to maintain. Organizations should be proactive in establishing boundaries. An organizations code of conduct acts as a boundary system.
6.4 Interactive Control Systems

Interactive control systems are futuristic and involve frequent communication between top managers. They help organizations in positioning themselves strategically in the rapidly changing market. Performance management, budgeting, and brand management are examples of such systems. The top management chooses which of them are to be focused on to bring about the necessary control in the organization. There are four characteristics of interactive control systems: 36
They focus on information like technologies, government policies, competitor activities, and customer preferences, which are ever changing This information is vital to all managers at all organizational levels The information and data generated by the interactive control systems has to be discussed at open meetings between all organizational levels Interactive control systems help in healthy discussions about the assumptions of the top management and action plans intended.
7. Summary
Organization structure refers to the role-responsibility relationships of different employees in an organization along with their pre-defined interaction patterns. The structural dimensions of organization design are -- formalization, specialization, hierarchy of authority, centralization, professionalism, and personnel ratios. The various types of organization structures include -- functional, divisional, matrix, horizontal, and hybrid structures. A responsibility structure is a collection of responsibility centers. A responsibility center is a function, division, or unit of an organization under a specified authority with a specified responsibility. In an organizational setting, it is necessary that the performance measurement systems are designed to be fair. Two major aspects to be considered are controllability and goal congruence. Transfer pricing is a tool used in responsibility accounting to assign monetary values to transactions taking place between two or more responsibility centers. According to the nature of monetary inputs and outputs, responsibility centers can be classified into four types -- cost centers (further divided into standard cost centers and discretionary expense centers), revenue centers, profit centers, and investment centers. Designing an optimal MCS involves determining the specific control measures to be used and the degree of tightness or looseness of control required to provide the desired level of certainty of achievement of objectives. An organization may choose any one or a combination of action control, results control, and personnel/cultural control. Decision about control alternatives to be used involves an analysis of the structural and contextual factors which influence control systems and also making a cost-benefit analysis. Management control of non-profit organizations is an area distinguishable from that in for-profit organizations because of the inherent difference with respect to source of funds, features of service, the strategies for selling the service, the mode of delivering the services, reward systems for employees, etc. According to Geert Hofstede, four criteria which determine the nature of management control of non-profit organizations are clarity of objectives, quantifiability of results, predictability of interfaces, and repetitiveness of activities. 37
NPOs can adopt different types of controls routine control, expert control, trial and error control, intuitive control, judgmental control, and political control. Managers must find ways to encourage employees to be creative and to initiate process improvements, but must still retain enough control to ensure that employee creativity benefits the organization. Robert Simons concept of levers of control aims at addressing this issue. The four levers of control are diagnostic control systems, beliefs systems, boundary systems, and interactive control systems.
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Concept Note - 3
Strategic Performance Control

1. Introduction
Vision, mission, and strategy provide a fundamental direction for the organization to grow and expand. They help in guiding the organization toward optimum resource utilization and in directing the managements efforts. Changing competitor moves, changing customer value-price perceptions, changing technology conditions, changing competitor profiles, and changing supplier equations are the various forms in which strategic change occurs. This note will help you understand: The relationship between strategy and control The importance of information technology and systems for strategic control The Balanced Scorecard framework.
2. Strategy and Control

It becomes difficult for an organization to survive in the marketplace if the business environment is characterized by significant changes. An organization that fails to quickly and appropriately respond to these changes would lose its competitive position. Organizations need to quickly learn from the changes and adapt to the changed variables. Strategic learning involves anticipating changes and monitoring the variables continuously, and countering them on a proactive basis. In a strategic learning context, management control aims at recognizing change and responding to it effectively. Vision is an important guiding factor for an organization as it clearly explains what the organization intends to become in the future and reflects its core ideology. It lays down the direction path and controls the efforts made by the employees in the process. The mission statement is made based on the vision statement and states the reason for the organizations existence. The vision and mission statements together give directions for the organization to grow. These statements define the scope of business activities that the organization may undertake, thus controlling resource allocation and utilization. For example, the Life Insurance Corporation of India (LIC) has a vision to become A trans-nationally competitive financial conglomerate of significance to societies and Pride of India. Its mission is to Explore and enhance the quality of life of people through financial security by providing products and services of aspired attributes with competitive returns, and by render ing resources for economic development.1 The strategies that an organization adopts control its strategic positioning, which translates into customer perception of the organizations products and services. The resources and strengths available with the organization and the strategic gaps existing in the marketplace play a key role in the choice of strategy that controls its
1
Source: <http://licindia.com/mission_vision.htm>.
performance. The degree to which strategies can control the organizations performance depends on the way it differentiates itself from its competitors and the ability of the competitors to respond to its strategies.
2.1 Critical Success Factors and Controls

According to John F. Rockart, critical success factors (CSFs) are the limited number of areas in which results, if they are satisfactory, will ensure successful competitive performance for the organization. They are the few key areas where things must go right for the business to flourish. These are the areas of activity that should receive constant and careful attention from management. CSFs, if ignored, will lead to eventual failure of the organization. The organization has to control its performance to address the needs placed on it by these factors. CSFs are monitored by the controls that are developed by the organization. Each industry, and in turn, each organization has a different set of CSFs. CSFs differ depending on the mission and strategic goals of an organization. Strategic controls ensure that the mission is properly aligned with the strategic goals. All the CSFs are interrelated to each other and should be attended to by the organization in order to have a competitive advantage in the marketplace. For example, for a grocery retail chain, the ability to source farm fresh vegetables at low prices and store location could be two of the critical success factors. And in the case of a consumer electronics manufacturer, sustainable customer relationships with distributors and cutting edge research and development could be critical success factors. CSFs, as a control function, indicate to the management the need to take timely action. Organizations should identify about five or six CSFs that would help them achieve their strategy, goals, and objectives. Once identified, the organization can depend on them to monitor business activities and be ready to face the changes in the business environment that could drastically affect the attainment of management goals. After deciding on the CSFs, the organization should track the activities that would help in achieving them and monitor their performance. Performance measures help in: finding out whether the approach taken to address the CSFs is appropriate or not; achieving a more stable performance; and defining the employees accountability.
2.2 Performance Measurement

Performance measures can be of three types performance indicators, key performance indicators, and key result indicators. Performance Indicators (PIs) PIs reveal the organizations or the business units performance. There might be a variety of PIs in different areas. For instance, production PIs could be plant efficiency rates and machine downtime rates; HR PIs could be the attrition rates; etc. PIs act as control tools by describing what is to be done, where to achieve the desired results or outcomes, and by identifying the specific areas that need control intervention to enhance organizational performance. PIs can be either lead indicators (performance drivers) or lag indicators (outcome indicators). PIs can be recognized by identifying the variable that is being measured and by understanding whether it is a single variables performance that is being measured or the performance of collective variables in a single indicator. 40
The middle management may be interested in a PI that reflects a single variables performance (e.g., machine downtime). However, the top management may be interested in a PI that indicates the collective performance of a number of variables in a single indicator (e.g., plant efficiency). Good PIs are SMART, that is, Specific, Measurable, Attainable (Achievable), Realistic, and have a Time perspective. The frequency of monitoring PIs has shifted from periodic intervals (weekly or monthly) to a continuous or daily basis with the emergence of concepts like TQM and continuous improvement, and improvements in information systems and technology. Key Performance Indicators (KPIs) KPIs deal with aspects which when enhanced would result in radical performance improvements and would lead to a cascading improvement in most of the other PIs. They have an impact on all the key result areas of the organization. Better results from KPIs would result in better organizational performance. The top management uses KPIs as yardsticks or measures to monitor and control the organizations performance. KPIs are identified from the PIs based on the strategic nature of the indicator considering the industry to which the organization belongs. Here, strategic nature refers to the indicators ability to include performance measurement of multiple factors, both internal and external to the organization. Thus, KPIs for organizations will vary from industry to industry. KPIs also vary from organization to organization within an industry depending on the strategic positioning of the organization in terms of customers (and other stakeholders) need fulfillment, that is, what is being satisfied, and how it is being satisfied. A KPI can be identified from a set of PIs based on how it reflects the performance parameters of several CSFs and based on how it reflects in totality the effect of other PIs. Characteristics of Key Performance Indicators KPIs are generally non-financial in nature. For example, in a dine-in restaurant, the occupancy level may be a KPI. These are usually measured at short intervals of time like 24/7, daily, or weekly. Top executives should devise KPIs in such a way that they are understood and effectively utilized by employees at all levels in the organization. Both teams and individuals are held responsible for the KPIs. KPIs have a major effect on most of the critical success factors and they have a positive impact on most of the PIs. Key Result Indicators (KRIs) KRIs emerge from the organizations activities. They indicate whether the approach toward achieving performance is appropriate but do not indicate a means or method to achieve better performance or outcomes. KRIs are indicators of the quality of the results achieved by the organization and are predominantly used for enforcing action accountability (after the action has been completed). These are measures that are useful for the governance aspect of the organization and are generally reported to the top management or the board, and are monitored on a monthly or quarterly basis. Return on capital employed and profitability are examples of key result indicators used by many organizations. 41
Figure 1 describes the relationship between critical success factors and the different performance measures performance indicators, key performance indicators, and key result indicators.
Figure 1: Critical Success Factors and Performance Measures
3. Information Technology and Systems for Strategic Control

Information technology and systems (IT&S) facilitate the continuous monitoring/reporting of various performance measures. Strategic information systems are information systems applications that serve the top managements needs for strategic performance control. In this section, we will discuss the areas where IT&S play a strategic role in management control. Deregulation and liberalization of economies has led to the emergence of the global organization. Present day organizations carry out manufacturing in various parts of the world to avail of cost-related and geographical advantages. They have also entered other countries to expand their market. This has called for fast and high quality of information flows, to effectively control the extensive and diverse activities of organizations. Investment in IT&S is seen as mandatory to achieve control of operations in many situations. The various contexts in which IT&S are of strategic significance are discussed in the next section.
3.1 Nature of Operations and Information Intensity

If the nature of operations is mechanistic and repetitive in nature (say, a printing press), IT&S are used to control the error rates and costs through Computer Numeric Control (CNC) machines and reduce reliance on human resources. In process industries (say, in dairy processing), IT&S enables automation and electronic links to schedule and control the workflow. In information-intensive industries (such as hotels and airlines), organizations use IT&S extensively to control their operations. For instance, in courier companies, IT&S controls the scheduling and routing of shipments. It also provides advanced tools to customers to track their shipment at any point of time. An organization that uses IT&S to control quality and costs related to a business process in a better way can gain a competitive advantage over the others. Strategic decision making involves a lot of uncertain and fuzzy variables. Techniques like the What-if Analysis and Decision Support Systems (DSS) help in controlling the inherent risks in decision making in such a scenario. For instance, entry into a new country to expand operations depends on political, economic, social, and cultural 42
variables that are diverse in nature and also uncertain. A DSS can be used to develop a range of outcome alternatives from very positive to very adverse for each country that is being considered for entry.
3.2 Extent of Geographical and Operations Spread

IT&S plays a crucial role in controlling the diverse operations of an organization if they are geographically widespread, and/or cut across multiple industries, or the nature of industry is such that it requires global sourcing to be successful. IT&S plays a crucial role in ensuring uniform global quality standards in industries which require global sourcing and in which, the goods are marketed globally.
3.3 Nature of Industry

IT&S plays a vital role in organizations that belong to industries such as automobiles and pharmaceuticals, which are significantly research-based, and those in which research activity is geographically widespread. It helps the organization to control both the overall research direction and the day-to-day research activities. IT&S also plays a crucial role in industries in which organizations work together with vendors to enhance the product design of the inputs or where Just-in-Time inventory control is used as a standard practice. In such cases, collaborations with the vendors in product design should be controlled to ensure that the modified inputs are in tune with the production process.
4. The Balanced Scorecard

Organizations should combine both financial as well as non-financial measures to gain a complete picture of their overall performance. The Balanced Scorecard (BSC) is a concept that has gained importance in the evaluation of the overall organizational performance through a combination of financial and non-financial metrics/measures. The BSC, proposed by Robert Kaplan and David Norton in 1992, helps organizations in strategic performance control by considering financial and non-financial measures; short-term and long-term goals; the organizations market performance and internal improvements; past outputs and ongoing requirements; etc. It also helps the organization in strategic learning. The BSC framework considers four perspectives customer, internal business, innovation/learning and growth, and financial which are observed and evaluated in a combined manner. For instance, apart from the net profit margin, factors like new products, quality of product and/or service, and quality of customer service provided, give a clear picture of the organizations performance. Refer to Table 1 for the underlying questions corresponding to each perspective of the BSC framework.
Table 1: BSC Perspectives and the Underlying Questions

Perspective Customer perspective Financial perspective Underlying Question To achieve our vision, how should we appear to our customers? To succeed financially, how should we appear to our shareholders? 43
Perspective Internal business process perspective Innovation/learning growth perspective and
Underlying Question To satisfy our customers and shareholders, at what business processes must we excel? To achieve our vision, how will we sustain our ability to change and improve?
Adapted from Kaplan, Robert S. and David P. Norton. The Balanced Scorecard Translating Strategy into Action. Boston: Harvard Business School Press, 1996, p9.
4.1 Customer Perspective

The customer perspective in BSC is concerned with attracting, satisfying, and retaining profitable customers/consumers in the chosen target segments. Attaining these objectives would enable the organization gain the targeted market share in terms of volume and/or value. Following four factors influence the customers perception of the value delivered by an organizations product or service. Quality: Enhanced quality would reduce the defects that the products have, which in turn, creates a better image of the organization in the minds of the customers. Time: Taking less time to respond to customers requirements consistently is considered critical in acquiring and retaining customers loyalty. Performance and service: This aspect helps in determining the value addition that a customer gets on using the product/service. Cost: This factor deals with reducing the costs of orders, delivery, etc.
4.2 Financial Perspective

The financial perspective looks at the financial health of the organization. It is concerned with increase in revenue, productivity, and profitability; reduction in costs; and better utilization of the organizations assets in monetary terms. Shareholders get the necessary information about the health of the organization when they look at the measures under the financial perspective. Sales turnover, earnings per share, and net profits are some of the financial indicators of the organizations performance. As financial results at a point of time are the outcomes of performance on the other perspectives at an earlier point of time, measures of financial performance are termed as lagging indicators.
4.3 Internal Business Process Perspective

The internal business process perspective deals with the processes, decisions, and actions that influence customer satisfaction, and are internal to the organization. Cycle time, quality, and employee skills are some of the internal factors, which are broken down to the individual employee level. Every employee is given a specified target in terms of quality, cost, time, and service, which when reached, leads to the achievement of the corporate objective. This helps in creating a greater sense of accountability among the employees. Besides, it ensures that the employee targets or goals are aligned with the broad corporate objectives of bringing out improved products, improving the internal and external processes and after-sales service for the customers. 44
4.4 Innovation/Learning and Growth Perspective

Organizations should regularly improve their existing products and processes and should also come out with new products. This strategy helps the organization to manage business in a changing environment. The ability to come out with new products, enhance and upgrade the existing processes, and enhance employee capabilities depends on the organizations value systems. The shareholder value increases only when the organization grows by capturing newer markets, developing new products, improving operations, and enhancing the customer value proposition.
4.5 Implementing the BSC

An organization that lays stress only on short-term or financial goals cannot successfully carry out its strategies and excel in business. BSC serves as a tool for strategic performance control. It clarifies the organizations vision and strategy, and expresses the expectations of the top management through clearly defined strategic objectives and related performance measures. These strategic objectives and measures are communicated throughout the organization in order to align the objectives of the organization with those of the individuals. They are also expressed in terms of more detailed, operational objectives at the department level, group level, or individual level. Once the individual and organizational objectives have been aligned, a business plan is devised. This plan helps the organization create a link between the short-term goals, long-term objectives, and the financials. The top management continuously monitors performance to assess whether the planned strategies are being successfully executed and to learn whether there should be a change in the strategy itself. In other words, BSC, as a tool, facilitates both strategic performance control and strategic learning. Figure 2 depicts the use of BSC as a tool for strategic performance control and strategic learning.
Figure 2: Implementing BSC for Strategic Performance Control and Strategic Learning
Vision and Mission
Strategy formulation
Strategy
Use of Balanced Scorecard for Strategy Execution
Clarify and translate vision and strategy
Communicate and link strategic objectives and measures Corrective actions for strategic performance control Strategic feedback and learning Plan, set targets, and align strategic initiatives
Measure / Monitor / Report
Adapted from Kaplan, Robert S. and David P. Norton. The Balanced Scorecard Translating Strategy into Action. Boston: Harvard Business School Press, 1996, p11.
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Exhibit 1 describes how Trent, the retail division of the Tata Group, implemented the Balanced Scorecard.
Exhibit 1: Trent and the Balanced Scorecard

In 2005, Trent, the parent company of Westside retail store chain, was included in the Balanced Scorecard Hall of Fame for successful implementation of the Balanced Scorecard for enhanced customer satisfaction. After having depended on financial measures for a long time to evaluate performance, Trent, in 2001 decided to base performance evaluation on the Balanced Scorecard by finding out what the customers felt about them and accordingly improve internal processes. Trent mapped the strategic objectives in each of the four dimensions of the Balanced Scorecard and linked them to the operational objectives through performance metrics. This helped to bring about a consensus among the management team on strategic issues. As part of the implementation, Trent conducted workshops for the heads of departments and select middle managers. Achieving profitable growth was decided as the objective under the financial perspective and action plans were devised around that concept. Key performance areas were fixed as also the time periods for achieving the objectives. Under the customer perspective, the strategy devised was surprisingly affordable style, quality, and a great shopping experience for the entire family. This gave an overall view of the other objectives of the organization. The retail industry was facing a high employee turnover at the store salesmen level and tackling this was the objective for the internal business perspective. This was addressed through the creation of an innovative training program, which was part of its learning and growth perspective. Under this program, the best employee was designated as the coach and given the task of training the other staff. The training was done at three levels customer service, information technology, and product knowledge. Apart from this, the store layout and display were changed to reflect the customers choice. New products were launched after studying the market for recent trends. This helped achieve the financial objective. According to K. V. S. Seshasai, head of information technology and corporate quality, the primary reasons for the successful implementation of the Balanced Scorecard at Trent were: the support and involvement of the top management, clear objectives and action plans, and the will to be consistent.
Adapted from Kasbekar, Chirag. Tilting the Balance. Trent Articles. November 30, 2005. <www.tata.com/trent/articles/20051129_tilting_balance.htm>
5. Summary
Strategic learning involves anticipating changes and monitoring the variables mentioned continuously and countering them on a proactive basis. In a strategic learning context, management control aims at recognizing change and responding to it effectively. 46
Vision clearly explains what the organization intends to become in the future and reflects its core ideology. The mission statement is based on the vision statement and states the reason for the organizations existence. The vision and mission statements together define the scope of business activities that the organization may undertake, thus controlling resource allocation and utilization. The strategies implemented by the organization directly control its strategic positioning and performance. Critical success factors (CSFs) are the limited number of areas in which satisfactory results will ensure successful competitive performance for the organization. CSFs should receive constant and careful attention from the management. Performance measures can be of three types: performance indicators (PIs), key performance indicators (KPIs), and key result indicators (KRIs). PIs act as control tools by describing what is to be done, by describing where to achieve the desired results or outcomes, and by identifying the specific areas that need control intervention to enhance organizational performance. KPIs deal with aspects which when enhanced would result in radical performance improvements and would lead to a cascading improvement in most of the other PIs. KRIs indicate whether the approach toward achieving performance is appropriate but do not indicate a means or method to achieve better performance or outcomes. Information technology and systems (IT&S) facilitate monitoring/reporting of various performance measures. the continuous
Strategic information systems are information systems applications that serve the top managements needs for strategic performance control. Nature of operations and information intensity, extent of geographical and operational spread, and nature of industry are some of the contexts in which IT&S are of strategic significance. Balanced Scorecard (BSC) helps the organization in strategic performance control and strategic learning. The BSC framework considers four perspectives customer, financial, internal business process, and innovation/learning and growth which are all observed and evaluated in a combined manner. The customer perspective is concerned with attracting, satisfying, and retaining profitable customers/consumers in the chosen target segments. The financial perspective is concerned with increase in revenue, productivity, and profitability; reduction in costs; and better utilization of the organizations assets in monetary terms. The internal business process perspective deals with the processes, decisions, and actions that are internal to the organization that influence customer satisfaction. The innovation/learning and growth perspective helps the organization to manage business in a changing environment by coming out with new products, enhancing and upgrading the existing processes, and enhancing employee capabilities depending on the value systems of the organization. 47
BSC clarifies the organizations vision and strategy, and expresses the expectations of the top management through clearly defined strategic objectives and related performance measures. These strategic objectives and measures are communicated throughout the organization in order to align the objectives of the organization with those of the individuals. The top management continuously monitors the performance to assess whether the planned strategies are being successfully executed and to learn whether there should be a change in the strategy itself.
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Concept Note - 4
Budgeting Techniques
1. Introduction
Budgets are business plans that are stated in quantitative terms and are usually based on estimations. A budget can be defined as a quantitative statement, for a defined period of time, which may include planned revenues, expenses, assets, liabilities, and cash flows. Budgeting refers to the process of designing, implementing, and operating budgets. It provides an action plan for an organization and serves as a control tool. This note will help you understand: The formulation and administration of budgets The human dimension in budgeting The different types of budgets The concept of zero-based budgeting.
2. Formulation and Administration of Budgets

Budgets are based on estimates, hence, there is always an uncertainty factor attached to them. A budget can fail due to these uncertainties. Budgets are used to give an overview of the organization and its operations. Budgets are also used as forecast tools and make the organization better prepared to adapt to changes in the environment.
2.1 The Importance of Budgets

Budgets are useful in resource allocation whereby processes which are expected to give the highest returns are given priority. They act as a means to verify the progress of the various activities undertaken to achieve planned objectives. They help in the evaluation of performance of operations as well as the performance of employees against standards set in an organization. Budgets promote division of labor and specialization in an organization through delegation of authority and allocation of responsibility and accountability to more people.
2.2 Budget and Strategy

Budgets should be developed in such a way that they take into account the strategic requirements of each of the functions in an organization. Budgets, by involving managers in the budgeting process, help in integrating the tactical and operational strategies of individual departments with the corporate strategy of the organization.
2.3 Steps in Budget Formulation and Administration

The information that goes into making budgets is processed by the budget department. Information from all the other functions comes to the budget department where it is compiled and the overall organizational budget is formulated. The different steps in budgeting are:
Creating a budget department or appointing a budget controller Developing guidelines for budget preparation Developing budget proposals at the department/business unit level Developing the budget for the entire organization Determining the budget period and key budget factors Benchmarking the budget Reviewing and approving the budget Monitoring progress and revising the budget
Creating a Budget Department or Appointing a Budget Controller Large firms generally have a budget department, while small firms may have just an individual budget controller. The budget department/controller is responsible for issuing the guidelines for budget preparation and for ensuring that this information is properly communicated throughout the organization. It is the responsibility of the budget department/controller to analyze and suggest changes to projected budgets in proposals received from the departments/business units. Other responsibilities include co-coordination of budget related work with the departments/business units and periodical revision of budgets. Developing Guidelines for Budget Preparation The budget department/controller in consultation with the lower level managers, prepares the guidelines for budget preparation. These guidelines are then, approved by the top management. Once approved, the budget department or the controller sets a timeframe for the budget preparation process for the entire organization. Developing Budget Proposals at the Department/Business Unit Level The heads of different departments/business units propose their budgets taking into consideration the existing facilities, employees, objectives, etc. Refer to Exhibit 1 for some practical tips on budgeting.
Exhibit 1: Managers Guide to a Practical Budget

Budgets help employees know the extent of possible expenditure and the extent of savings needed. Some of the common ways by which managers can make the most out of the set budgets are given here. Be prepared to learn: Budgeting involves activities like controlling expenses, checking revenues, knowing about the cash reserves, etc. It takes some time and practice to gain proficiency in these activities. Hence it is better that managers spend time in learning the budgeting process to the smallest detail. This will help them create budgets which have a better utility. Learn from the errors: The budgets that are prepared are not real figures but estimates. A manager must be prepared to make the necessary changes to the budgets if the actuals overshoot or are below estimates.
Contd
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Contd
Establish a flexible budget: It is better that managers have provisions for changing the budgets mid-way if the need arises. That is, if revenues are higher than expected, the expenditure can be revised upward and the organization can go in for additional investments. If the revenues are lower, further control on expenses would be necessary. Keep track of the cash flow: If a manager wants to adhere to the budget expectations, it is necessary to ensure that the revenues more than offset the expenses. Keeping track of income helps ensure that there is sufficient cash flow. Budgets should be verified every month. This will help the manager keep track of the funds and cash flows. Be conservative: It is better for the manager to err on the high side in estimating expenses, and on the low side when estimating revenues. This is a conservative approach to budgeting for expenses and revenues, and provides a greater margin for dealing with the unpredictability of the revenues and costs. Provide a buffer: The manager must be prudent and set aside a part of the income to tide over lean times in the future. This can be used to cover unexpected expenses, and will stand the organization in good stead during difficult times. Use budgets as controls: The manager should ensure that the budgets are flexible enough to accommodate expenses that will benefit the business. The budgets should not be so rigid that they do not enable the manager to take last minute decisions to spend on something that could be a potential revenue earner.
Adapted from Wuorio, Jeff. 8 Ways to Make a Budget Work. <http://www.work911.com/cgibin/planning/jump.cgi?id=6659>.
Developing the Budget for the Entire Organization After the individual heads set the budgets for their respective departments/business units, these departmental budgets are combined to generate a budget for the entire organization. The combined budget should conform to the organizations strategic plan. The budget department or controller has to communicate the final approved budget and the performance measures that will be used for the current year to the respective departments/business units. Determining the Budget Period and Key Budget Factors The budget period is the time for which a budget is set. The period of the budget varies based on the type of industry, the production cycle of the organization, etc. Key budget factors like materials, working capital, labor, plant capacity, and the top management approach should be assessed in order to ensure that the budgets achieve their targets. Benchmarking the Budget A benchmarking exercise helps an organization be up-to-date with the standard budgeting practices followed by other companies in the industry. Benchmarking also helps an organization identify the weaknesses that need to be addressed or the strengths which can be enhanced in its budgeting approach. 51
Reviewing and Approving the Budget The budgets prepared by each department go through a series of reviews by different levels of management. If a budget is found inadequate at any of these levels, it is sent back for rework. Once a budget is found satisfactory at the budget committee level, it is forwarded to the CEO for approval. On being approved by the CEO, the budget is presented to the board of directors. Monitoring Progress and Revising the Budget The budget controller is responsible for checking the progress of the planned activities against the budgets. He/she should communicate the progress to employees and suggest ways to improve financial control. Internal factors (like changes in internal policies and practices regarding market share and/or product mix and production costs) and external factors (like changes in economic activity, labor rates, and raw material prices) can lead to changes in budgets. Budgets need to be revised only when there are discrepancies in them. It is necessary to keep revisions to the minimum as frequent revisions would mean that the budget is inconsistent with organizational objectives.
2.4 Rolling Budgets/Forecasts

Rolling budgets/forecasts are developed at regular intervals, say after every three months, and forecast performance for a specified time period, say the next twelve to eighteen months. As these forecasts are developed at regular intervals, they are frequently updated with the latest changes that occur in the environment. Rolling budgets help organizations to control inaccuracies regarding projections and to minimize the discrepancies between the standards and the actuals. Rolling forecasts consider key factors like orders, sales, costs, and capital expenditures, which can be collected and collated easily. Rolling forecasts help the top management in predicting the changes in performance and thus help them in influencing the expectations of the stakeholders. Refer to Exhibit 2 for an outline of how Cisco Systems, Inc. uses rolling budgets/forecasts.
Exhibit 2: Rolling Budgets/Forecasts at Cisco

Cisco Systems, Inc. (Cisco), established in 1984, is based in San Jose, California, USA. It is one of the worlds leading providers of products and solutions in the areas of routing, switching, and other computer networking equipment. In Cisco, a combination of traditional and rolling budgets and financial forecasts was used. At the beginning of the financial year, an annual budget was fixed under the supervision of the top management with information provided by the lower levels of management being used for the purpose. It was called the plan of record and was fixed for that particular year. Every quarter, the management reviewed the annual plan, analyzed the deviations, and revised the expectations for the rest of the year (if required). In addition to these annual budgets with quarterly reviews, the finance group of the company developed rolling financial forecasts on a monthly basis for the next twelve months. By factoring in the ever-changing environment, these forecasts helped the management to decide on capital expenditure projects, revise the manpower plan, update the inventory policy, etc. These forecasts also helped the company to provide guidance to investors on expected revenues and profit.
Adapted from Myers, Randy. Budgets on a Roll. Journal of Accountancy. The American Institute of Certified Public Accountants, December 2001. <http://www.aicpa.org/pubs/jofa/dec2001/ myers.htm> and <http://newsroom.cisco.com/dlls/corpinfo/corporate_overview.html>
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3. Budgeting the Human Dimension

Budgets are prepared by managers and employees, and hence, it is not possible to ignore the effects of budgets on employee behavior.
3.1 Participative Budgeting

Budgets can be devised by the top management (top down approach) or by the lower levels (bottom up approach) of management. Generally, the budgeting process is a combination of both the top-down and bottom-up approaches and is referred to as participative budgeting. Lower level of management sets the budget and presents it to the top management. The top management reviews it and suggests changes if necessary, before its implementation. Participative budgeting encourages communication between the top management and the employees. Involvement of the top management in participative budgeting helps control malpractices in the budgeting process and also helps in motivating the employees.
3.2 Degree of Budget Goal Difficulty

Difficult budget goals tend to influence the behavior of the employees. Easily attainable budget goals will not trigger enough effort from the employees and managers toward performance. High budget goals may prompt managers to resort to unethical means to achieve these goals. Ideally, budgets should be challenging but attainable. Budgetary Slack Budgetary slack is the amount that is budgeted in excess of the actual requirement. According to J. G. March, Resources and effort toward activities that cannot be justified easily in terms of their immediate contribution to organizational objectives are termed as slack. Slack, in a way, is considered beneficial as it improves creativity, helps solve goal conflicts, and also helps the management in retaining people. Slack, as it represents managerial inefficiency and self-interest, is also considered detrimental to an organizations well-being. The top management is responsible for identifying and minimizing budgetary slack. Tight budgetary controls and incentives that have a higher variable component help reduce budgetary slack.
3.3 Culture and Budgeting

The budgeting process is affected by the national culture(s) in the locations in which an organization operates. According to Geert Hofstede, the dimensions of national culture are -- power distance, uncertainty avoidance, masculinity/femininity, and individualism/collectivism. An organization which rates high on power distance does not employ participative budgeting. An organization which scores high on uncertainty avoidance, will have budgets decided by people who have enough expertise in the field. Such organizations will not employ participative budgeting as all the employees may not have the same level of expertise and the level of risks may be high. An organization with a flat structure and with a culture which allows freedom to employees to decide their own targets, employs participative budgeting. Budgeting is an internal process and hence, lack of cultural similarities poses a problem in the budget being communicated across subsidiaries of a multinational corporation. 53
3.4 Budgets and Compensation

The budgeting process, if linked to compensation in an organization, leads to unethical behavior on the part of employees. The incentives should be directly linked not only to the set targets but also to the means used to achieve the targets. In order to prevent employees from indulging in unethical means of achieving targets, compensation levels should have a lower and higher limit. Even if the set objectives are not achieved, the employees should be assured of receiving a certain sum. If the achievement is higher than the set targets, the rewards should not exceed a certain upper limit.
4. Types of Budgets
Table 1 outlines the different types of budgets.
Table 1: Types of Budgets

Type of Budget Appropriatio n Budget Characteristics A ceiling is set for certain expenditures based on the management decision. A static amount is established for fixed costs and a variable rate is determined per activity measure for variable costs. Type of Cost Discretionary costs. Examples Training, advertising, sales promotion and R&D.
Flexible Budget
The static amount includes both discretionary and committed costs while the flexible part includes engineered costs per X value.
The static part: salaries, depreciation, property taxes, and planned maintenance. The flexible part: direct material, direct labor, and variable overhead. Also, some costs related to sales representatives such as sales commissions and travel. New plant and equipment.
Capital Budget
Decisions regarding potential investments are made using discounted cash flow techniques. A comprehensive plan is developed for all revenues and expenditures.
Committed costs.
Master Budget
Discretionary, engineered and committed costs.
All revenues and expenditures for any organization.
Adapted from James R. Martin, Management Accounting: Concepts, Techniques & Controversial Issues, Chapter 9, The Master Budget or Financial Plan, <http://maaw.info/Chapter9.htm>.
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3.5 Master Budget

The master budget, also known as the financial plan, forms the basis of control systems in organizations. The master budget has two components: Operating budget: It includes the sales budget, cash collections from customers, purchases budget, disbursements for purchases, operating expense budgets, and disbursements for operating expenses. Financial budget: It includes capital budget, cash budget, and the budgeted balance sheet.
Figure 1: Components of the Master Budget
Adapted from <www.saskschools.ca/.../mod3masterbudget.html>.
Steps in the Preparation of a Master Budget The principal steps in the preparation of the master budget are preparation of the operating budget and preparation of the financial budget. The master budget should be subjected to a follow-up to ensure performance in terms of planned goals and objectives. The follow-up process is done by preparing performance analysis statements on a periodic basis, indicating the budgeted versus actual performance. Preparation of operating budget: The preparation of the operating budget entails preparation of: Sales Budget The sales budget starts with the sales planning exercise. This exercise is done to develop projections of the expected sales volume in physical and monetary terms. 55
Production budget Budgeted units of production = (Number of units sold) + (Desired ending finished goods inventory) (Beginning finished goods inventory).
Direct materials budget The direct materials budget constitutes calculation of five different heads: i. Quantity of material needed for production
ii. Quantity of material to be purchased iii. Budgeted cost of material purchases iv. Cost of material used v. Cash payments for direct material purchases
Direct labor budget The direct labor budget involves two calculations: i. Direct labor hours needed for production = Units to be produced x Direct labor hours budgeted per unit
ii. Budgeted direct labor cost = Direct labor hours needed for production x Budgeted rates per hour. Factory overhead budget Factory overhead =
BudgetedFixed Overhead + (BudgetedVariableOverheadRate Direct Labor Hours Neededfor Production)

Ending inventory budget Ending inventory is calculated as:
Ending Finished Goods = Desired Ending Finished Goods Budgeted Unit Cost
Cost of goods sold budget Cost of goods sold (COGS) involves two calculations: i. Budgeted total manufacturing cost = (Cost of direct material used) + (Cost of direct labor used) + (Total factory overhead costs) ii. Budgeted cost of goods sold = (Budgeted total manufacturing cost) + (Beginning finished goods) (Ending finished goods).
Selling & administrative budget Selling and administrative costs consist of variable and fixed components. The bottom line of the selling and administrative budget is the planned level of expenditures.
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Budgeted Income statement Preparing the budgeted income statement involves combining the relevant amounts from the sales, cost of goods sold, and selling & administrative expense budgets and then subtracting interest, bad debts, and income taxes to obtain budgeted net income.
Preparation of financial budget: The preparation of the financial budget involves preparation of: Capital budget The capital budget deals with the organizations long-term investments. Cash budget The cash budget is concerned with making estimates of cash inflows, outflows, and the expected surplus or deficit of cash. Cash budgets are developed for shortterm as well as long-term projections. Budgeted balance sheet The budgeted balance sheet projects each balance sheet item in accordance with the business plan. The balance sheet indicates the financial status as envisaged at the end of the budget year. It also projects the sources and uses of financial resources. Benefits of Master Budgets Some of the benefits of master budgets are: It guides performance: A master budget helps the employees track how each of their business unit objectives when achieved contribute to the objectives of the organization. It integrates and organizes: The master budget, a compilation of budgets from different departments, helps in better integration of all organizational functions. It is used as the base for acquiring and using the resources that are needed to achieve the objectives of the organization. It effects continuous improvement: The planning activity in the master budget helps organizations to look for alternative ways in which they can enhance value to customers and also minimize costs thus, helping in continuous improvement.
5. Zero-based Budgeting
Zero-based budgeting (ZBB) was put in to use formally by Peter Phyrr at Texas Instruments, a world leader in digital signal processing and analog technologies based in the US, in 1969. Unlike the traditional budgeting process which is a yearly process and uses the budget of the previous year as a starting point to devise the current years budget; in ZBB, the base is taken as zero and the budget is devised as for a new venture. In ZBB, the responsibility centers are called decision units. The processes and activities involved in each decision unit are called decision packages. 57
5.1 The ZBB Process

The ZBB process involves the following steps: Decision unit identification: Identification of the decision units (responsibility centers) is the first step in the ZBB process. Decision units are departments which contribute to the organizational goals. Decision package development: The activities in the decision unit are then, grouped into decision packages. A decision package describes the objectives of the activities and also gives details about the performance measures and the estimated costs of the activities. Evaluation and grading of decision packages: Next, the decision packages are ranked taking into consideration the contribution they make to the organizations well-being. Ranking is done on the basis of a cost benefit analysis, and helps in deciding the amount of resources to be allocated to each decision package. Resource allocation: Finally, the top management decides on the amount of resources to be allocated to each decision package. The decision package with the highest rank will receive the maximum resources.
5.2 Benefits of ZBB

Following are the benefits of ZBB. ZBB assumes the next years budget to be zero helping managers to carry out the cost benefit analysis of individual activities of their respective decision units. ZBB helps in devising a realistic budget compared to the traditional budgeting process as resources are allotted based on ranking of decision packages. It also helps in curbing redundant expenditure. It helps in integrating the planning and budgeting control processes. ZBB fosters better communication and participation between the different functions of the organization. It helps in managing activities and operations well, and aids in creating a flexible budget. It helps in performance evaluation of subordinates and aids the top management in advanced planning and goal setting for the budget period.
5.3 Issues in Implementing ZBB

Certain issues are involved while implementing ZBB such as: ZBB can result in the creation of budgetary slack by encouraging managers of all decision units to portray his/her unit as the best contributor to the organizations profitability. It involves evaluation and ranking of contributions of decision units, but these contributions are often intangible, hence, rendering ZBB ineffective. It involves a lot of documentation, making it a slow and expensive process.
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6. Summary
A budget can be defined as a quantitative statement, for a defined period of time, which may include planned revenues, expenses, assets, liabilities, and cash flows. Budgeting refers to the process of designing, implementing, and operating budgets. It provides an action plan for an organization and serves as a control tool. Budget formulation consists of a series of activities: creating a budget department or appointing a budget controller, developing guidelines for budget preparation, developing budget proposals at the department/ business unit level, developing the budget for the entire organization, determining the budget period and key budget factors, benchmarking the budget, reviewing and approving the budget, monitoring progress, and revising the budget. The budgeting process is referred to as participative budgeting when it is a combination of both top-down and bottom-up approaches. Rolling budgets/forecasts are developed at regular intervals, say after every three months, and forecast performance for a specified time period, say the next twelve to eighteen months. As these forecasts are developed at regular intervals, they are frequently updated with the latest changes that occur in the environment. The attainability of budget goals has a significant impact on the behavior of the employees. Budgetary slack may help in improving creativity, resolving goal conflicts, and retaining people but may also represent managerial inefficiency and self-interest. The relation between national culture and budgeting may be examined using Geert Hofstedes dimensions of culture: power distance, uncertainty avoidance, masculinity/femininity, and individualism/collectivism. Budgeting is an internal process and hence, lack of cultural similarities will pose a problem in the budget being communicated across subsidiaries of an organization. This problem becomes more pronounced in the case of multinational corporations. The budgeting process in an organization tends to lead to unethical behavior on the part of employees, if linked to compensation. The different types of budgets used by organizations are appropriation budget, flexible budget, capital budget, and the master budget. The master budget forms the basis of control systems in organizations. The principal steps in the preparation of the master budget are preparation of the operating budget and preparation of the financial budget. The operating budget consists of the following budgets: sales, production, direct materials, direct labor, factory overhead, ending inventory, cost of goods sold, selling & administrative, and income statement. The financial budget comprises the capital budget, the cash budget, and the budgeted balance sheet.
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In zero-based budgeting (ZBB), the base is taken as zero and the budget is devised as if it is for a new venture. The ZBB process involves the following steps: decision unit identification; decision package development; evaluation and grading of decision packages; and resource allocation. Some of the limitations of ZBB are that it provides for creation of budgetary slack; it involves a lot of documentation and hence is a slow process; and it is expensive to implement.
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Concept Note - 5
Business Performance: Targets, Reporting, and Analysis

1. Introduction
An organization plans for its performance, and devises targets to achieve the plans. Targets help employees understand what they need to achieve and when they need to achieve it. The management then evaluates the actual business performance compared to the planned or targeted performance. Reasons for variances (difference between actual and planned performance) are analyzed and corrective measures are taken. The actual performance is documented as business reports for easy comprehension and future reference. This note will help you understand: The need for targets and performance tracking The various factors affecting the performance of a business The format to be followed for preparation of internal performance reports and the corporate annual report The significance and means of performance analysis.
2. Targets and Performance Tracking An Overview

Both financial and non-financial targets can be framed by organizations to assess and enhance their business performance. Though targets are frequently used in sales, they are applicable to all organizational functions. Targets can be quality standards, service levels, benchmarks, service guarantees, numerical goals, budgets, and quotas.
2.1 Role of Targets

Targets may be applied to the organization as a whole, or at different levels like the business unit level, the branch level, the project level, the team level, or even the individual level. Usually, most organizations set targets and make an employee accountable for achieving that target. Targets help in performance monitoring and improving. The actual performances are tracked on a periodic basis weekly, monthly, quarterly, or yearly, and variances are identified. If the current targets are achieved, the organization may decide to raise the targets, and from then on, strive to achieve the new targets, thus leading to an improvement in the performance.
2.2 Tracking of Performance

Performance can be tracked and reported in two ways year-to-date or period-toperiod. Year-to-Date Reporting In year-to-date reporting, performance is tracked from the beginning of the financial year to the present date under review. This method is used when the weekly or monthly figures are not as important as the yearly figures as long as the yearly targets are met. To analyze year-to-date reporting against the established targets, summation of the monthly performance data for that year at a particular date of review is used.
Budgets and quotas are examples of year-to-date reporting, though they can also be used for period-to-period reporting. A budget refers to the amount of revenue or expense that should be realized over a specified period, say, yearly. This amount is broken down into monthly figures. Quotas relate to production volume or number of transactions for that period. Usually, the top management tries to ensure that the annual expenditure is within the budget than the monthly/weekly expenditure. Year-to-date reporting gives an idea of the activity level within a particular period. Monitoring the activity level will enable managers to track resource utilization and plan for future resource requirements. The actual activity undertaken can be compared with the targeted activity on a periodic basis. This can be represented in a graphical format. Year-to-date graphs alert the management to situations where past performance rates were too fast or too slow, so that it can adjust future activity so that the yearly targets are met. Period-to-Period Reporting In period-to-period reporting, performance is tracked and targets are set on a monthly or weekly or seasonal basis. There are four common types of targets in period-toperiod reporting depending on the behavior of the performance parameters. These are flat line, step, seasonal, and growth curve. Table 1 gives the various types of targets and their features.
Table 1: Types of Targets and their Features

Type of Targets Flat line target Step target Features The performance parameter is expected to exhibit a linear pattern throughout the period during which the performance is analyzed. Targets are set in a staggered fashion if the management expects changes in the business or the environment in the planning horizon, which in turn, might lead to performancerelated changes. In certain industries like retail and insurance, the management generally sets targets that vary with the season (festivals, etc.). The management sets targets based on the product life cycle (PLC) stage in which the product is.
Seasonal target Growth target
3. Factors Affecting Business Performance

An organizations success or failure depends on external or internal factors. External factors are those that are not under the direct control of the organization like government rules and regulations and natural calamities. Some factors like service orientation, product quality, purchasing, administration, partnership, employees, leadership, and strategy can be controlled by the organization. The importance of these factors is different among organizations and across industry sectors. Some of the internal factors are explained here.
3.1 Top Management and Organizational Culture

Organizational culture has been defined by Barney as a complex set of values, beliefs, assumptions, and symbols that define the way in which a firm carries out its business. The top management influences the organizational culture. The nature of interaction 62
between the top management and the organizational culture may be in the form of three different kinds of strategic business profiles rigid/efficient profile, flexible/inefficient profile, and flexible/cost conscious profile. Refer to Table 2 for a description of each of these profiles.
Table 2: Business Profiles and their Descriptions

Profiles Rigid/efficient profile Descriptions Management follows a conservative approach; can succeed in a stable industry Cost conscious; rigid culture; hesitant to execute changes Belief in maintaining a stable state than innovating and reacting to market changes Challenge is to maintain or enhance operational efficiencies that can be monitored by the top management due to its focus on cost efficiencies. Prefer to make changes even if the change comes at a cost Belief that businesses that innovate do not give importance to cost cutting Focus on achieving innovative breakthroughs rather than on day-to-day operations Performance dependent on external environment e.g.: a dynamic business environment will exert pressure on such organizations to emphasize innovation Flexible organizational culture and top managements approach would help the organization in achieving success. Conservative (cost conscious) and innovation-oriented Dual emphasis is on flexibility and efficiency These managers accept new ideas less willingly than managers who focus on innovation Business strategy for such organizations is to adopt successful innovation in the most cost-efficient way These organizations strike a balance between the other two extreme profiles. They perform well in a moderately volatile and a moderately stable environment.
Flexible/inefficient profile
Flexible/cost conscious profile (Analyzing organizations)
3.2 Product and Service Quality and Quality Management

Quality (features and performance) is the basic characteristic of any product/service that should meet/exceed customers expectations. Service quality differs from product quality as the services are characterized by intangibility, inseparability of production and consumption, heterogeneity, and perishability. A focus on quality will provide organizations with several benefits irrespective of whether it is a product-centric or service-centric organization. An organization that offers a higher quality product or 63
service than its competitors can charge a premium price, and thereby earn higher margins. Emphasis on quality helps enhance market share as customers today are more aware and give importance to quality. Quality management also helps in providing a competitive advantage and improve the organizations performance.
3.3 Market Orientation

Market orientation makes an organization cautious about market conditions. It helps it to respond quickly to the changes in the customer needs and wants in order to compete effectively in the dynamic business environment; helps it face threats and avail of market opportunities; helps in quickly identifying and minimizing risks, thereby minimizing losses; and also helps in influencing the financial and non-financial organizational performance. Market orientation requires investment in time and money, and cannot be imitated easily as it is intangible and complex in nature. Market-oriented organizations are also known as learning-oriented organizations as they have an intrinsic focus on learning about market changes and customer behavior. Influence of Market Orientation on Financial Performance Strong market orientation helps an organization take effective action in the first go rather than take action and then modify it in response to the market conditions. This leads to cost savings, and enhancements in the profit margins and financial performance. Influence of Market Orientation on Non-financial Performance Market orientation helps in enhancing employees organizational commitment and team spirit. Frontline employees are the contact point between the customers and the organization. They get direct information about the changing customer needs and requirements, market trends, etc. They feel more attached to the organization when they see their experience and contribution as being factored into the organizations strategies. Market orientation ensures a greater chance of new product success and customer satisfaction if goods and services are provided according to customer preferences.
4. performance Reports
The information required to evaluate the actual performance against the planned performance should be collected, collated, analyzed, and documented as a performance report which can be easily understood. Some reports are meant for internal use for decision making, for employees performance evaluation, etc., while some reports like the corporate annual report are meant for external users.
4.1 Report Format

Report format is the layout of the information (performance analysis) in the report. The way in which this information is presented is a function of three factors the information to be provided; the questions to be answered; and the form of presentation.
4.2 The Information to be Provided

This comprises the title and is described by the number and types of the variables. These variables can in turn be classified into three types categorical, ordinal, and quantitative. For example, if the report presents information on Market capitalization in Rs. of Tech Mahindra and Balrampur Chini, from the year 2000 to 2006, then market capitalization in Rs. is the quantitative variable, the year is the ordinal variable, and Tech Mahindra and Balrampur Chini are the categorical variables. 64
4.3 The Questions to be Answered

The information provided in the report should be relevant to the question to be answered or in other words, the decision making problem to which it caters. The extent of information required depends on the complexity of the problem at hand greater the complexity, more is the information required.
4.4 The form of Presentation

This refers to the visual representation of the information. Information should be presented in a way which will be easy for the user to interpret in the form of text, table, graph (bar chart, pie chart, line graph, etc.), or a combination of two or more forms. The form of presentation also depends on the number of different variables in the information and the information type. Refer to Illustration 1 for a representation of tabular data in graphical form.
Illustration 1: Form of Presentation

The data given below shows the turnover details of ABC Limited and XYZ Limited for the years 2000-2008. (All figures are in millions of Rs.)
Turnover
Year 2000 2001 2002 2003 2004 2005 2006 2007 2008 ABC Limited 12,000 15,000 9,000 9,500 10,500 11,000 12,000 12,500 13,000 XYZ Limited 11,000 12,000 11,000 10,500 12,000 13,000 13,500 14,000 16,000
The given data can be represented in the form of a column chart which will help in easy comprehension and interpretation.
Turnover of ABC Limited and XYZ Limited 18000 16000 14000 Turnover (Rs. in Million) 12000 10000 8000 6000 4000 2000 0 2000 2001 2002 2003 2004 Years 2005 2006 2007 2008
ABC Limited XYZ Limited
65
4.5 Internal Performance Reports

Internal performance reports are used within an organization to measure organizational performance on a periodic basis. These reports are used to correct variances in the performance. They are not statutory in nature, and are prepared and used based on the necessity and choice of the organization. Internal performance reports are used by all the levels of the management and in all the departments of the organization. These reports help in controlling the organizational performance on a constant basis. Performance appraisal reports of employees, progress reports of the projects, trend charts of the sales, variance reports, etc., are the common types of internal performance reports.
4.6 Corporate Annual Report (CAR)

A CAR is a key public document prepared by organizations mainly to fulfill the mandatory corporate reporting requirements. It is a formal communication document that is used to inform the public about its financial performance in a particular year. Format of Corporate Annual Report Annual reports comprise quantitative information (balance sheet, cash flow statement, and income statement), narratives (Chairmans report, the CEOs report, the Directors report, the Auditors report, management discussion and analysis, and mission statement), photographs, and graphs. The format of representation of these reports is specific for specific countries, depending on that countrys statutory requirement. Generally, the report is divided into two sections one section consists of non-statutory matters and is represented by the use of different types of colors and papers, while the other section consists of financial statements. The contents of the reports are partly voluntary and partly mandatory. The voluntary information provided in the report is generally related to the companys interaction with the environment, society, employees, etc. As the annual report is a communication statement to the public, organizations give special importance to the look and design of the report, to influence stakeholders. Information to be Disclosed in Corporate Annual Report Information regarding assets, revenue, expenses, profit; major elements of costs; capitalized interest; major contractual relationships; monetary and non-monetary risk disclosure; capital expenditure; etc., should be disclosed in the annual report in order to present a clear picture of an organizations financial health. Refer to Exhibit 1 for the contents of ITC Limiteds annual report for the financial year 2007-08.
Exhibit I: Contents of ITC Limited: Reports and Accounts, 2007-08

Board of Directors & Committees Report on Corporate Governance Shareholder Information Report of the Directors & Management Discussion and Analysis CEO & CFO Certification
Contd
66
Contd
Balance Sheet Profit and Loss Account Cash Flow Statement Schedules to the Accounts Report of the Auditors Balance Sheet Abstract Guide to Subsidiaries/ Joint Ventures/ Associates Consolidated Financial Statements Statement regarding Subsidiary Companies Ten Years at a Glance Financial Highlights Business Updates o o o o ITC Infotech Technico Agarbattis Safety Matches
Sustainability Updates Awards and Accolades Product Launches
Source: <http://www.itcportal.com/itc-annual-reports-2008/report&accounts.htm>
5. Performance
The performance of any business depends on both internal and external factors. In a competitive business environment, it is necessary to evaluate performance based on multiple performance dimensions that will reflect the changes in the business environment as well as the achievement of targets set by the organization. Refer to Table 3 for an analysis of the performance dimensions that may be used by organizations.
Table 3: Performance Dimensions and their Analysis

Performance Dimensions Financial measures Analysis Variance analysis (comparison of actual financial performance with a planned one) helps an organization to take corrective measures in the future. Customer behavior and satisfaction analysis helps an organization find out the organizations image in comparison with its competitors; whether its branding activity has been successful; whether the perceived image in the customers minds is in sync with the planned image; etc. 67
Customers
Performance Dimensions Internal processes business
Analysis Evaluating internal business processes helps in ascertaining whether efficiency of the actual usage of resources in business processes is at par with the planned efficiency parameters or not. Evaluation of growth dimensions helps compare actual training, technology adoption, and employee productivity with industry standards and the organizations own plans. Corrective actions are taken if there are any variances.
Growth dimensions
The difference between actual and planned financial performance could be due to revenue variance or expenditure variance or both. Revenue variance can be due to sales volume variance, sales mix variance, sales quantity variance, market share variance, and market size variance. Expenditure variance can be classified into fixed cost variance and variable cost variance. Refer to Figure 1 for the various types of financial performance variance. Figure 1: Types of Financial Performance Variance
5.1 Revenue Variance

Revenue variance is the difference between the actual and the planned revenue of an organization that can occur due to the difference between the actual and planned sales volume, due to the difference between the actual and planned selling price, or due to both. Thus, revenue variance has two components sales volume variance and sales price variance; sales volume variance has two components sales mix variance and sales quantity variance; and sales quantity variance is further subdivided into two components market share variance and market size variance. 68
Revenue variance can be calculated either through the value method or through the profit method. In the value method, the sales value is used for calculating the components of the revenue variance. In the profit method, they are calculated in terms of the margin. The profit method is recommended for the purpose of management control. We have used the following terms in our discussion on calculating the various components of revenue variance using the profit method: When we refer to the sales of one product, we will use the terms Planned sales and Actual sales. When we refer to the total sales of the set of products of an organization, we will use the terms Total planned sales and Total actual sales. When we refer to the market size with respect to one product, we will use the terms Estimated market size and Actual market size. When we refer to the total market size of the set of products of an organization, we will use the terms Total estimated market size and Total actual market size. When we refer to the organizations market share for its set of products, we will use the terms Planned market share and Actual market share. When we refer to the selling price per unit of a product, we will use the terms Standard selling price per unit and Actual selling price per unit. When we refer to the budgeted value of margin per unit of a product, we will use the term Standard margin per unit. When we refer to the budgeted value of average margin per unit for the set of products of an organization, we will use the term Standard average margin per unit.
Sales Volume Variance (Profit Method) Sales volume variance is the product of standard margin per unit and the difference between actual sales and planned sales. That is, Sales Volume Variance =
[( ) ( )] = Standard Margin Per Unit Actual Sales Planned Sales

Sales Mix Variance Sales mix variance is the product of the difference between the standard margin per unit (of the item) and the standard average margin per unit, and the difference between actual sales and actual sales at standard sales mix. That is, Sales Mix Variance =
(Standard Margin Per Unit Standard Average Margin Per Unit ) = (Actual Sales Actual Sales at Standard Sales Mix )
Sales Quantity Variance Sales quantity variance is the product of the standard average margin per unit and the difference between actual total sales and the planned total sales for a period. That is, Sales Quantity Variance = = [Standard Average Margin Per Unit (Actual Total Sales - Planned Total Sales )] 69
Sales Price Variance Sales price variance refers to the change in revenue caused by a difference between the actual selling price of the units sold during a period as compared to the standard selling price. It is defined as the difference between the product of the actual sales volume and the standard selling price per unit and the actual sales revenue. That is, Sales Price Variance = = [Actual Sales Revenue - (Actual Sales Volume Standard Selling Price Per Unit ) ] Market Share Variance Market share variance is a comparison of actual market share achieved to the organizations planned market share. It is the product of standard average margin per unit, total actual market size, and difference between total actual market share percentage and total planned market share percentage. That is, Market Share Variance =
(Standard Average Margin Per Unit ) (TotalActua l MarketSize ) = (Total Actual Market Share% - Total Planned Market Share% )
Market Size Variance Market size variance is a comparison between total actual market size and the total estimated market size. It is the product of standard average margin per unit, total planned market share percentage, and the difference between total actual market size and total estimated market size. That is, Market Size Variance =
(Standard Average Margin Per Unit ) (Total Planned Market Share% ) = (Total Actual Market Size Total Estimated Market Size )
Illustration 2: Calculation of Components of Revenue Variance

Given are the costing details of three products Alpha, Beta, and Gamma of Ankit Manufacturing Limited (AML) for the year 2007-08. AML uses the profit method for calculation of the various components of revenue variance. Details Planned number of units sold Actual number of units sold Estimated market size Actual market size Standard selling price per unit Actual selling price per unit Standard margin per unit Alpha 3,000 3,500 6,500 6,000 Rs. 12 Rs. 10 Rs. 7 Beta 5,500 4,500 7,500 8,000 Rs. 7 Rs. 8 Rs. 3 Gamma 3,500 2,300 5,500 5,000 Rs. 10 Rs. 9 Rs. 5 Total 12,000 10,300 19,500 19,000 Rs. 29 Rs. 27 Contd
70
Contd
Calculate the following: i. Total sales volume variance ii. Total sales mix variance iii. Sales quantity variance iv. Total sales price variance v. Market share variance vi. Market size variance Solution: i. Total Sales Volume Variance
SalesVolumeVariance= (StandardMarginPer Unit) (ActualSales PlannedSales)
Sales Volume Variance (Alpha) = Rs. 7 (3,500 3,000) = Rs. 3,500 Sales Volume Variance (Beta) = Rs. 3 (4,500 5,500) = Rs. 3,000 (-) Sales Volume Variance (Gamma) = Rs. 5 (2,300 3,500) = Rs. 6,000 (-) Total Sales Volume Variance = Rs. 3,500 Rs. 3,000 Rs. 6,000 = Rs. 5,500 (-). The negative total sales volume variance of Rs. 5,500 indicates the opportunity to earn a margin of Rs. 5,500 foregone by the organization. ii. Sales Mix Variance Sales Mix Variance =
(Standard Margin Per Unit Standard Average Margin Per Unit ) (Actual Sales Actual Sales at Standard Sales Mix )
Standard average margin per unit = Rs. = Rs.
(7 3,000 ) + (3 5,500 ) + (5 3,500 ) (3,000 + 5,500 + 3,500 )
21,000 + 16,500 + 17,500 = Rs. 4.58 12,000

10,300 12,000
Actual Sales at Standard Sales Mix (Alpha) = 3,000 Actual Sales at Standard Sales Mix (Beta) = 5,500
= 2,575 units
10,300 = 4,721 units 12,000

10,300 = 3,004 units 12,000
Actual Sales at Standard Sales Mix (Gamma) = 3,500
71
Therefore, Sales Mix Variance (Alpha) = Rs. (7 4.58) (3,500 2,575) = Rs. 2.42 925 = Rs. 2,238.5. Sales Mix Variance (Beta) = Rs. (3 4.58) (4,500 4,721) = Rs. 1.58(-) 221(-) = Rs. 349.18. Sales Mix Variance (Gamma) = Rs. (5 4.58) (2,300 3,004) = Re. 0.42 704 (-) = Rs. 295.68 (-). Total Sales Mix Variance = Rs. 2,238.5 + Rs. 349.18 Rs. 295.68 = Rs. 2,292. The positive total sales mix variance of Rs. 2,292 indicates that the organization had gained the potential to earn an additional margin of Rs. 2,292. Sales of Alpha were greater than planned while sales of Beta and Gamma were less than planned. Since, standard margin per unit of Alpha (7) was much higher than the standard average margin per unit (Rs. 4.58), AML benefited from the positive variance in its performance. Standard margin per unit of Gamma (5) was also higher than the standard average margin per unit (Rs. 4.58) but this did not benefit AML much as it also had a negative variance in sales. Since Betas standard margin per unit (Rs.3) was less than the standard average margin per unit (Rs. 4.58), lower actual sales of Sandal when compared to the planned sales benefited the organization. iii. Sales quantity variance Sales Quantity Variance =
[Standard Average Margin Per Unit (Actual Total Sales - Planned Total Sales)]
Sales quantity variance = Rs. 4.58 (10,300 12,000) = Rs. 7,786 (-) The negative sales quantity variance of Rs. 7,786 indicates that the opportunity to earn a margin of Rs. 7,786 was lost by the organization due to the fact that overall, fewer units of Alpha, Beta, and Gamma were actually sold when compared to the planned number of units to be sold. iv. Sales price variance Sales Price Variance =
[Actual Sales Revenue - (Actual SalesVolume Standard SellingPrice Per Unit) ]
Alpha:
Actual Selling Price of Actual Sales Volume = 3,500 Rs. 10 = Rs. 35,000 Standard Selling Price of Actual Sales Volume = 3,500 Rs. 12 = Rs. 42,000 Sales Price Variance = Rs. 35,000 Rs. 42,000 = Rs. 7,000 (-). 72
Beta:
Actual Selling Price of Actual Sales Volume = 4,500 Rs. 8 = Rs. 36,000 Standard Selling Price of Actual Sales Volume = 4,500 Rs. 7 = Rs. 31,500 Sales Price Variance = Rs. 36,000 Rs. 31,500 = Rs. 4,500.
Gamma:
Actual Selling Price of Actual Sales Volume = 2,300 Rs. 9 = Rs. 20,700 Standard Selling Price of Actual Sales Volume = 2,300 Rs. 10 = Rs. 23,000 Sales Price Variance = Rs. 20,700 Rs. 23,000 = Rs. 2,300 (-). Total Sales Price Variance = Rs. 7,000(-) + Rs. 4,500 + Rs. 2,300(-) = Rs. 4,800 (-). The negative sales price variance of Rs. 4,800 indicates that the organization has lost revenue of Rs. 4,800 due to a variance in the standard and the actual sales price. v.
Market share variance
Market Share Variance =

(Standard Average Margin Per Unit ) (TotalActua l MarketSize ) (Total Actual Market Share% - Total Planned Market Share% )
Total Actual Market Share % =

10,300 19 ,000 100 = 54.21%
Total Actual Number of Units Sold Total Actual Market Size
100
Total Planned Market Share % =

12 ,000 19,500 100 = 61.54%
Total Planned Number of Units Sold Total Estimated Market Size
100
Market Share Variance = Rs. 4.58 19,000 (54.21% 61.54%) = Rs. 6,378.57 (-). Negative market share variance of Rs. 6,378.57 represents the margin lost since the organization was unable to achieve its planned market share. vi. Market size variance Market Size Variance =
(Standard Average Margin Per Unit ) (Total Planned Market Share% ) (Total Actual Market Size Total Estimated Market Size ) = Rs. 4.58 61.54% (19,000 19,500) = Rs. 1,409.27 (-). The negative market size variance of Rs. 1,409.27 indicates the margin foregone by the organization due to reduction of the market size.
5.2 Expenditure Variance or Cost Variance

Expenditure (or cost) variance is the difference between planned expenditure (or standard cost) for a period and actual expenditure incurred over that period. The factors due to which it arises can be divided into two categories operational causes 73
and non-operational causes. Operational causes can be further divided into controllable causes and uncontrollable causes.
Operational causes: Operational causes occur due to operational activities like purchases. Uncontrollable operational causes are not directly under management control. For example, in operational activities involving human beings, a small degree of involuntary variations creep in from time to time, as human performance cannot be absolutely consistent over a period of time. Such variances are uncontrollable.
Controllable operational causes are those which are under the managements control. For example, implementing a new method of operation may lead to improved performance due to favorable efficiency and volume variances. In contrast, if there is a machine failure, it would lead to unfavorable efficiency and volume variances.
Non-operational causes: Non-operational causes relate to problems in the usage of the costing system. Variance could be misreported due to a system malfunction caused by wrong data entry, programming defects in the information system, etc. For example, when the cost of materials is recorded wrongly, it would lead to cost variance for materials. If its value is recorded as less than the correct or budgeted value, then it would lead to favorable variance, and if the value is recorded as higher than the actual value then the variance would be negative. In both cases, it would provide a wrong picture to the management.
Inappropriate estimates, budgets, or standards can lead to the reporting of variances (even if operational performance is satisfactory). For example, if project budgeting does not factor in any provisions for contingencies, then most probably the actual cost of the project would exceed the budgeted cost wrongly reflecting an unfavorable variance. Moreover, standards may become obsolete over a period of time if not reviewed and revised regularly, it will lead to wrong reporting of variance.
Types of Cost Variance
Cost variance can be of two types: fixed cost variance and variable cost variance.
Fixed cost variance: This is the difference between the planned or budgeted fixed cost for a period and the actual fixed cost. Expenses incurred on electricity, rent, administration, etc., can be categorized under fixed costs. These costs remain fixed for a particular time frame, and do not depend on quantity of production or sales. Variable cost variance: This is the difference between the actual variable cost and the planned or budgeted variable cost for a period. Variable costs are those which vary directly with quantity of production. Expenses for raw materials and labor are some of the variable costs. For calculation of variable cost variance, the budgeted variable cost should be adjusted with the actual quantity of production.
Refer to Illustration 3 to understand the calculation of cost variance.
Illustration 3: Calculation of Cost Variance

Table 4 and Table 5 show the fixed cost variance and variable cost variance calculations respectively, for the month of May 2009 for an automobile manufacturing facility. The plant produced 3000 units of the vehicle in that month (Note: The figures given here are fictitious). 74
Table 4: Fixed Cost Variance for the Month of May 2009

Items Budgeted Expense (Rs) Actual Expense (Rs) Variance (Rs) Favorable/ Unfavorable
Electricity Rent Administrative expense Fixed overhead Total
25,000 50,000 300,000 100,000 475,000
33,000 50,000 350,000 70,000 503,000
8,000 0 50,000 30,000 28,000
Unfavorable Not applicable Unfavorable Favorable Unfavorable
Table 5: Variable Cost Variance for the Month of May 2009

Budgeted Cost per Unit (Rs.) Number of Units Produced
Actual Cost per Unit (Rs.)
Total Budgeted Variable Cost (Rs.)
Total Actual Variable Cost (Rs.)
Variance (Rs)
Raw material Labor Overhead Total
Items
3,000 50,000 150,000,000 45,000 135,000,000 15,000,000 Favorable
3,000
3,000
9,000,000
3,500
10,500,000 33,000,000
-1,500,000 Unfavorable -3,000,000 Unfavorable
3,000 10,000
30,000,000 11,000
3,000 63,000 189,000,000 59,500 178,500,000 10,500,000 Favorable
From the tables given here, we can see that if the actual expense (fixed or variable) is less than the budgeted expense (fixed or variable), it leads to a favorable (positive) variance; if the actual expense (fixed or variable) is more than the budgeted expense (fixed or variable), it leads to unfavorable (negative) variance.
6. Summary
Based on certain plans regarding their business outcomes, organizations set targets for financial and non-financial performance. Actual performance can be tracked with respect to targets with the help of either year-to-date reporting or period-to-period reporting. For period-to-period reporting, targets can be divided into four types flat line target, step target, seasonal target, and growth curve target depending on the patterns they follow. Business performance depends on a number of external and internal factors. External factors are beyond the control of the organization whereas the internal factors can be controlled by the management. 75
Favorable/ Unfavorable
To evaluate and analyze actual performance with respect to planned performance, the actual performance should be recorded and documented properly in the form of performance reports. The corporate annual report is a mandatory reporting requirement for organizations. An organizations performance can be evaluated along various dimensions financial measures, customer satisfaction and behavior toward organization and competitors, internal business processes, and growth. The difference between actual and planned financial performance can take place due to cost or expenditure variance, revenue variance, or both. Revenue variance has two components sales price variance and sales volume variance. Sales volume variance can be divided into sales mix variance and sales quantity variance. Sales quantity variance can be further sub-divided into market share variance and market size variance. Expenditure variance can be classified into fixed cost variance and variable cost variance. Cost variance or expenditure variance can arise due to a number of factors, which can be divided into two categories operational causes and non-operational causes.
76
Concept Note - 6
Auditing
1. Introduction
Audit is the activity of examination and verification of records and other evidence by an individual or a body of persons so as to confirm whether these records and evidence present a true and fair picture of whatever they are supposed to reflect. Audits are most commonly used in the accounting and finance function. Audit ensures that an enterprises activities and their effect on different events and transactions are correctly accounted this is not only for achieving the control objective of reliability of financial reporting but also for the prudent and effective management of the enterprise. This note will help you understand: The different categories of audits The concept of financial statement audit The concepts of internal audit, fraud auditing, and forensic auditing The concept of management audit The concepts of social audit and environmental audit The process of auditing The benefits and limitations of auditing.
2. Categories of Audits
According to the Institute of Chartered Accountants of India, auditing is a systematic and independent examination of data, statements, records, operations, and performances (financial or otherwise) of an enterprise for a stated purpose. In any auditing situation, the auditor perceives and recognizes the propositions before him for examination, collects evidence, evaluates the same, and on this basis, formulates his judgment which is communicated through his audit report. Audits may be categorized based on their: Emphasis (on financial data and/or non-financial data) Primary audience (that is, for external reporting or for internal use) Primary purpose (compliance, certification, communication, and/or control) Scope (limited to the organization, or also concerned with the impact of/on the environment)
Table 1 summarizes the different categories of audits.
Table 1: Categories of Audits

Audit Category Financial statement audit Brief Description Gives an opinion on the accuracy of the financial statement Ensures compliance with the relevant accounting standards and reporting frameworks An independent appraisal function established within an organization to examine and evaluate its activities as a service to the organization Need not be limited to books of accounts and related records Fraud audit: Deters, detects, investigates, and reports fraud Forensic accounting: Related to the legal system, especially issues of evidence Audits operational aspects of the enterprise Includes quality audit and R&D audit Audit of computer systems Checks whether the computer system safeguard assets, maintains data integrity, and contributes to organizational effectiveness and efficiency Audit of the management, as a tool for evaluation and control of organizational performance Examines the conditions and provides a diagnosis of deficiencies with recommendations for correcting them Audit of the enterprises reported performance in meeting its declared social, community, or environmental objectives Environmental compliance checking mechanism Environmental management evaluation mechanism audit: audit: A An
Internal audit
Fraud auditing and forensic accounting Operational audit Information systems audit
Management audit
Social audit
Environmental audit
Compiled from various sources.
78
Auditing
3. Financial Statement Audit

A financial statement audit is defined as an exploratory critical review by an independent public accountant of the underlying controls and accounting records of a business enterprise that leads to an opinion of the propriety of the financial statements of the enterprise. As per the UK Auditing Practices Board, Financial statement audit is an exercise whose objective is to enable auditors to express an opinion whether the financial statements give a true and fair viewof the entitys affairs at the period end and of its profits or loss for the period then ended and have been properly prepared in accordance with the applicable reporting framework (e.g., relevant legislation and applicable accounting standards). Financial statement audits are conducted for the following reasons: To examine the correctness of financial statements To establish whether they present a true and fair picture of the organizations financial position at a given time To check compliance with regulations like the Generally Accepted Accounting Principles (GAAP) (such an audit is referred to as a statutory financial audit).
3.1 Concepts in Financial Statement Audit

Objective assessment of the financial statements requires significant inspection and evaluation of the organizations statements of accounts. This inspection and evaluation involves the application of certain key concepts. These key concepts are described below. Audit Materiality Critical or essential information that can influence the decisions of the stakeholders is considered as material information. Judgments regarding materiality constitute an evaluation of the quantity and quality of misstatements in the financial statements. When financial statements are doctored to present a robust picture of the organizations financial health to stakeholders, it is referred to as material misstatement of financial data. Audit Evidence Audit evidence is any kind of information that the auditor uses to determine whether the financial statements being audited are in accordance with the established rules and regulations. Audit evidence comprises the basic accounting data and all the supporting information like contracts, and inspection records available to the auditors. For the audit evidence to be useful enough to form a reasonable basis for the auditors professional opinion, it has to fulfill certain criteria, namely, sufficiency, which relates to the amount or quantum of audit evidence that is available; and appropriateness, which relates to the quality of the audit evidence. Audit Risk Audit risk is the risk of an auditor failing to detect actual or potential material losses or account misstatements at the conclusion of the audit. The auditor designs his/her audit strategy based on an acceptable level of the audit risk that he/she intends to undertake. Audit risk is the product of three components: 79
Inherent risk (I.R.): Inherent risk is the risk of a material misstatement assuming that there are no related internal control structure policies or procedures. Control risk (C.R.): As per Information Systems Audit and Control Association (ISACA), Control risk is the risk that a material misstatement could occur in an assertion for an account balance or class of transactions, and would not be prevented or detected on a timely basis by the internal control policies and procedures. Detection risk (D.R.): As per ISACA, Detection risk is the risk that the auditors substantive procedures will not detect an error which could be material, individually or in combination with other errors.
A.R = I .R C.R D.R
True and Fair Concept The concept of true and fair in the audit report deals with the opinion of the auditor as to whether the state of affairs and their results as confirmed by the auditor during the audit process are truly and fairly represented in the financial statements being audited. For a financial statement to be assessed as a true and fair representation of an organizations state of affairs, the auditors expect: Consistency in adhering to accounting principles Correct valuation of assets in accordance with the relevant accounting principles Separate disclosure of exceptional items that are material to the organizations financial health; etc.
3.2 Importance of Financial Statement Audits

The two important aspects of the accounting information of a firm from the point of decision-making are: the relevance and the reliability of the information. Financial statement audits by independent, certified professionals help in reducing the information risks associated with the following four factors: conflict of interest; consequence; complexity; and inaccessibility (remoteness) of information.
4. Internal Audit, Fraud Auditing, and Forensic Accounting

Internal audits are used to check whether the existing controls are effective and adequate, whether the financial reports and other records show the actual results of the organization, and whether the sub-units of the organization are following the policies and procedures laid down by the management. Fraud auditing and forensic accounting are undertaken by organizations to bring to light any frauds that have occurred in the organizations operations and/or record-keeping, and to pursue them within the framework of the legal system.
4.1 Internal Audit

Internal auditing is needed because of the growing size and complexity of organizations. The traditional role of internal audit was to check whether the existing controls were effective and adequate, whether the financial reports and other records showed the actual results of the organization, and whether its sub-units are following the policies and procedures laid down by the management. 80
Auditing
The modern role of internal audit may be explained by a definition by the Institute of Internal Auditors, which describes internal audit as, an independent appraisal function established within an organization to examine and evaluate its activities as a service to the organization. The objective of internal auditing is to assist members of the organization in the effective discharge of their responsibilities. To this end, internal audit furnishes them with analyses, appraisals, recommendations, counsel, and information concerning the activities reviewed. As per ICAI, Internal audit is an independent management function, which involves a continuous and critical appraisal of the functioning of an entity with a view to suggest improvements thereto and add value to and strengthen the overall governance mechanism of the entity, including the entitys strategic risk management and internal control system. Need for Internal Auditing The need for an internal audit is determined by the increasing size and complexity of organizational operations. In order to avoid discrepancies from creeping into their systems, processes, and operations, such organizations appoint teams of specialists called internal auditors to monitor, track, and report such discrepancies, or inefficiencies of personnel in the concerned departments. Usually an in-house internal audit team undertakes the internal audit. Organizations also hire the services of different external auditing and consulting firms for the internal audit process. There are many auditing organizations that provide internal auditing services to other organizations. For example, PricewaterhouseCoopers has a standard framework in place which it alters and modifies based on the internal audit requirements of its clients. Refer to Exhibit I for the framework that PricewaterhouseCoopers uses for providing internal audit services to its clients.
Exhibit I: Internal Auditing Services PricewaterhouseCoopers (PwC)

PricewaterhouseCoopers (PwC) is an accounting and consulting firm formed by the merger of Price Waterhouse and Coopers and Lybrand in July 1998. It provided both financial and non-financial services. PwC referred to its model of internal audit services as the hub and spoke model. Here the hub was a group of professionals whose primary concentration was on the operations and financial aspects of traditional internal auditing. They worked as a separate team or as a support to the client organizations internal audit team. The spokes were other professionals who provided global support with their industry related know-how. This model was then adapted to suit the client organizations requirements. PwC adopted a structured methodology ORCA, that is, objectives, risks, controls, and alignment. This methodology was used for handling problems in risk management for business units as well as for entire organizations. ORCA, if implemented strictly, helped the organizations in clearly identifying the problem areas and also in finding appropriate solutions for the problem. PwCs internal audit service assessed five different categories of risks operations risk, financial risk, compliance risk, strategic risk, and systems risk.
Contd
81
Contd
PwC customized its internal audit service in such a way that it took into consideration the organization and the industry in which it competed, the organizations priorities regarding risk management, etc. The internal audit was structured to include all these factors and their effect on the business. For example, one of the industry verticals targeted by PwCs internal audit services was the pharmaceutical and healthcare sector. For this sector, risks included clinical outsourcing, treasury management risk, regulatory compliance with the Food & Drug Administration (FDA), field sales operations, R&D grants, privacy and data protection, pricing compliance, sample management, ethics and business conduct, strategic alliances, e-business risk, intellectual asset management, managed-care reimbursement, and security and control risks. Adapted from <http://www.pwc.com/extweb/industry.nsf/docid/2A2A81CA456BAC6480257221005E 85FF/ $file/internal_audit.pdf> and <http://www.pwchk.com/home/eng/fs_im_manage_risk.html>.
4.2 Fraud Auditing and Forensic Accounting

Corporate crime or white collar crime can be defined as offences that are committed by those in professional occupations conducting dishonest activities, by themselves or through their agents, for financial gain. Corporate crimes include both financial and non-financial frauds, internal audit frauds and compliance breaches, corruption, and tax evasion. According to Albrecht, fraud is made up of three components i. Theft act which involves taking cash, inventory, information, or other assets manually, by computer, or by telephone
ii. Concealment which involves the steps taken by the perpetrators to hide the fraud from others iii. Conversion which involves selling or converting stolen assets into cash and then spending the cash. According to the Institute of Internal Auditors (US), the deterrence, detection, investigation, and reporting of fraud is the responsibility of the internal auditor. Frauds can be investigated or detected by Certified Fraud Examiners (CFEs) who are trained to detect, investigate, and deter fraud. CFEs are professionals who are knowledgeable in four major areas fraud investigation; legal standards regarding evidence of fraud; patterns of fraudulent financial transactions; and knowledge of the criminal behavior associated with fraudulent activities. The fraud auditor looks for potential loopholes in the system and does a deeper analysis of certain financial transactions by taking into consideration the underlying behavioral aspects. Bologna et al defined forensic accounting as the application of financial skills and an investigative mentality to unresolved issues, conducted within the context of rules of evidence. As a discipline, it encompasses financial expertise, fraud knowledge, and a strong knowledge and understanding of business reality and the working of the legal system. Its development has been primarily achieved through on-the-job training as well as experience with investigating officers and legal counsel. 82
Auditing
5. Management Audit
A management audit appraises an organizations position and helps it determine where it (the organization) is, where it is heading with its current plans and programs, whether it is meeting its objectives, and whether any revision of plans is required to enable it to achieve its predefined goals and objectives.
5.1 Objectives and Benefits of a Management Audit

The main aim of conducting a management audit is to critically analyze and evaluate management performance. Some of the benefits of conducting a management audit are: It helps detect and overcome existing managerial deficiencies and resulting operational problems. It helps evaluate the methods and processes used by the management to accomplish organizational objectives. It helps determine the effectiveness of the management in planning, organizing, directing, and controlling the organizations activities and ascertain the appropriateness of the managements decisions for achieving the organizations objectives. It can be used as a source of information in assisting the organization to accomplish the desired objectives. It provides an early-warning signal of managerial problems and related operational difficulties. It helps to objectively and impartially evaluate organizational plans, structure, and the directions that the management gives in the form of strategies and management processes.
5.2 Types of Management Audits

Management audits can be classified into complete management audit, compliance management audit, program management audit, functional management audit, efficiency audit, and propriety audit. Complete management audit: A complete management audit evaluates the organizations current activities and measures the gaps between its existing policies and objectives, and its actual activities. Compliance management audit: Auditors identify the gaps between the organizations existing policies and objectives, and its actual practices but do not make any recommendations for improvements. They simply present their observations to the top management. Program management audit: Program management audits are designed to appraise performance within a specified program; they do not disturb other operations of the organization. They measure how well a program is managed and how strong management commitment is.
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Functional management audit: A functional management audit measures the difference between the actual performance of an organization and its objectives, with emphasis on a particular function. Efficiency audit: The objectives of an efficiency audit are to establish how an organization is operating with regard to economy and efficiency, and whether it has a system in place to gather information on these aspects. These audits are conducted to ensure that resources are utilized in such a way that they generate the best returns. Propriety audit: Propriety audits are conducted to examine the effects of the managements decisions and actions on society and the general public.
5.3 Issues in Organizing the Management Audit Program

The managements approval is essential for the establishment of a general program for management audit. Audits are meant to highlight the strengths and weaknesses of the organizations operations. Some key issues in organizing the management audit program are devising the statement of policy; allocating personnel; drawing up training programs for staff; and deciding the audit time and frequency. Devising the Statement of Policy The statement of policy should lay down very clearly the scope of activities to be undertaken by the management auditor. The statement should clearly describe: The scope and status of the management/operational auditing within the organization Its authority to hold audits, issue reports, make recommendations, and evaluate corrective action.
Allocation of Personnel Personnel placed in the audit unit should have: Competence and required subject knowledge, experience, and professional ability A good understanding of audit processes and thorough knowledge of the fundamentals of organization and management Knowledge of the principles and effective methods of control and requirements for scientific appraisal A sound background in accounting and knowledge of other relevant disciplines. Ability to deal successfully with human relations issues Ability to objectively appraise others actions without generating undue suspicion.
Drawing up Training Programs for Staff A continuous training program is necessary to achieve quality in performing audit assignments. An effective training program enables the staff to assume additional responsibilities in the organization. It acts as an incentive for drawing capable people into the department and retaining them. 84
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Deciding the Audit Time and Frequency Management audits should be conducted often enough to provide protection against emerging problems. The time required to complete a management audit varies, depending on: The extent and nature of the assignment The number of auditors assigned to the work Whether more specialists in a particular field are required.
6. social audit and Environmental Audit

In addition to focusing on increasing profitability and improving financial stability, companies should also be concerned about the impact of their operations on society and the environment. This need has given rise to the concepts of social accounting, social auditing, and environmental audit.
6.1 Social Audit

Social accounting is defined as systematic accounting and reporting of those parts of a companys activities that have a social impact. It does not involve any accounting procedures. A social accounting report contains the following information: Details of financial performance against the stated objectives of the organization An assessment of the impact of the organizations operations on local communities Report on the organizations environmental performance Report on the organizations compliance with statutory and voluntary quality and procedural standards Views of stakeholders on the objectives and values of the organization.
A social audit is a systematic attempt to identify, analyze, measure, evaluate, and monitor the effect of an organizations operations on society, according to Blake, Frederick, and Myers. Social audits assess adherence to the specified norms, which may pertain to the governments standards of social performance, standards established by the organization, or norms set by outside agencies. The aim of conducting a social audit is to influence the policies, objectives, and actions of the concerned organization to improve its social performance. There are various approaches used to conduct a social audit, which are: Inventory approach: This approach involves a simple listing and short descriptions of programs which the organization has developed to deal with social problems. Program management approach: This approach is a more systematic effort to measure the costs, the benefits, and the achievements of the organization. Cost-benefit approach: This approach attempts to list all social costs and benefits incurred by an organization in terms of money.
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Social indicator approach: This approach pertains to utilizing social criteria (e.g., suitable housing, good health, job opportunities) to clarify community needs and then evaluating corporate activities in light of these community indicators.
Depending on the audit scope and coverage, Fredrick, Myers, and Blake have identified six types of social audits. These are described in Table 2. Table 2: Types of Social Audits Type Social balance sheet and income statement Social performance audit Scope This kind of audit requires quantification of social costs and income. It is conducted to reduce social costs in terms of money. This audit is conducted to assess the performance of companies with respect to some area of social or public concern. It can assume the form of a research-based appraisal that is conducted to find out the extent of pollution caused by cement and steel industries. This type of audit is conducted to evaluate an organizations social performance in terms of social indicators that signify public interest. It evaluates the contribution of the organization to the well-being of the local community. This kind of audit is conducted to ascertain how corporate actions affect employees or the general public in different ways. Depending on the findings of the audit, the policies or actions of the organization are modified. This type of audit is conducted by authorized government agencies to study an organizations performance in areas of social concern. Such audits could relate to environmental protection, etc. This audit is limited to specific processes and programs of an organization that may have social implications. It aims to appraise a program which has already been initiated by the organization.
Macro-micro social indicator audit
Constituency group attitudes audit
Government mandated audits
Social process or program audit
6.2 Environmental Audit

Environmental audits are used to evaluate the organization on various parameters, which include: conformance to the occupational health and safety requirements; conformance to the emission standards and license requirements of the local, state, and national governments; and generation, storage, and disposal of hazardous wastes. An environmental audit is an expensive procedure and generates a substantial amount of confidential information. It is necessary to get the top management involved in the audit.
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Organizations undertake environmental audits for many reasons. They are: To enhance safety For environment management To minimize costs For securing a financier or a buyer To improve the image of the organization
There are two types of environmental audits -- environmental compliance audit and environmental management audit. Environmental Compliance Audit An environmental compliance audit is generally conducted to gauge the position of the organization against these compliance parameters on the day of the audit. The issues that arise at the time of environmental compliance auditing should be prioritized in such a way that the issue that may cause the most harm to the environment is documented and addressed first. It is performed to check - Conformance with the occupational health and safety requirements Conformance with the emission standards and license requirements of the local, state, and national governments.
An environmental compliance audit usually involves two main activities: Obtaining some physical proof of non-conformity Checking records and documents.
Environmental Management Audit An environmental management audit is conducted to evaluate whether the organizations management has the resources to reach the level of compliance required and to maintain the level of compliance. The issues to be considered while conducting an environmental management audit are - Who is in charge of the environmental program? Who is responsible for the environmental issues? Who are the staff and how well are they trained? How well will a crisis be handled? How is the relationship of the organizational actors with the regulatory bodies? Refer to Exhibit II for the environmental audit initiatives at Kansai Nerolac Paints Ltd.
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Exhibit II: Environmental Audit Initiatives at Kansai Nerolac Paints Ltd.

Kansai Nerolac Paints Ltd. (Nerolac), erstwhile Goodlass Nerolac Paints Ltd., is a Mumbai, India-based company established in 1920. It is a manufacturer of paints, varnishes, and enamels. The companys mission is to ensure environment protection and to follow all statutory requirements. It has in place a corporate policy which deals with occupational health and safety for its employees. It has bagged the ISO 14001, OHSAS 18001, and British Safety Council Audit Certifications. At Nerolac, internal audits are carried out at the manufacturing plants to choose the activities where improvement is required and devising new measures of evaluation. Cross-functional teams are formed, which along with the members of the environment, health, and safety team conduct the audits based on a specified checklist. The feedback is taken and discussed in internal review meetings. In the year 2006, Nerolac undertook certain activities to minimize the amount of pollutants. Some of the activities were development of environment friendly products; reduction of environmental burden; safety and health; environmental conservation; and user and customer related environmental safety. For example, the objective of the development of environment friendly products activity was to minimize the utilization of hazardous material; at the end of the year, the company was successful in achieving a 10% reduction in the utilization of hazardous material.
Adapted from <http://www.nerolac.com/newsroom/EnvRep-07.pdf>.
7. The Auditing Process

An audit is the activity of examination and verification of records and other evidence by an individual or a body of persons so as to confirm whether the records and other evidences present a true and fair picture of whatever they are supposed to reflect. The auditing process consists of various stages which have been represented in Figure 1.
7.1 Staffing the Audit Team

The audit team usually consists of three to four people who report either to the CEO or some other senior executive. The audit team should consist of both newcomers and experienced people, who have knowledge in diverse areas. The team members should possess strong analytical and interpersonal skills and they should have an understanding of the organization's overall strategy and its goals and objectives. The audit team leader plays an important role in data gathering and is responsible for the overall success of the audit.
7.2 Creating an Audit Project Plan

An audit plan should provide a step-by-step approach to conducting the audit. This helps in proper allocation of resources, and in ensuring that audit tasks are begun and completed on schedule. It also ensures accountability and responsibility by clearly stating what is to be done, who is responsible for which task, and when the audit should be completed. 88
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Figure 1: The Auditing Process
Adapted from <http://audit.cnu.edu/process.html>.
7.3 Laying the Groundwork for the Audit

After preparing the audit plan, the next step is to gain the employees support for the audit. The audit team leader should check with the manager in charge of the process or site being audited on whether required arrangements have been made. The team leader should hold discussions with employees regarding the timing of the audit, the methods of data collection, the availability of required data, etc.
7.4 Conducting the Audit

The actual audit is conducted in a manner appropriate for the type and purpose of the audit. By studying the operations of the entire organization and its internal control systems, auditors have to assess the inherent and control risks before deciding on how 89
to conduct the audit. If the control risks are assessed to be high, the detection risk should be reduced by the extensive use of substantive procedures such as verification of documents, transactions, and account balances. The auditors perform tests of controls to check whether the internal controls are functioning appropriately and effectively. The broad categories of audit procedures are: Verification: It is aimed at ascertaining the accuracy, reliability, and validity of assets, records, statements, conformance to rules and regulations, etc. and assessing the effectiveness of internal controls. Table 3 shows the various procedures involved in verification.
Table 3: Verification Procedures

Procedure Count Compare Description Checking the accounting records of physical assets by physically counting the assets Identification of similarities or differences in the characteristics of information obtained from two or more sources. E.g. Comparison of actual operating procedures with prescribed policies and procedures. Scrutiny of documents or other records in order to detect errors or irregularities Scrutiny of physical assets in order to detect errors or abnormalities
Examine Inspecting tangible resources Recompute Reconcile
Checking the mathematical calculations that have been performed earlier Matching two independent sets of records and to show mathematically, with supporting documentation, the differences (if any) between the two records. Obtaining information from an independent source so as to verify the existing information. Verification of recorded transactions or amounts by examining supporting documents. The purpose is to verify correctness, that is, whether recorded transactions represent actual transactions. Here the direction of testing is from the recorded item to supporting documentation. Tracing procedures begin with the original documents and are followed through the processing cycles into summary accounting records. The purpose of tracing is to verify completeness, that is, whether all actual transactions have been recorded. Here the direction of testing is from supporting documentation to the recorded item.
Confirm Vouch
Trace
Adapted from Audit Procedures Guidelines, <http://www.sanjoseca.gov/auditor/Procedures/5-06B.pdf>.
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Observation: It deals with watching the behavior of people or the performance of a certain activity or process. This is a technique of collecting primary data. Inquiry: Oral or written inquiries can be performed using interviews or questionnaires. The auditor has to take care that the questions are appropriately framed keeping in mind the position and expertise of the person being interviewed, and the answers are documented and confirmed. Analysis: Auditors perform analysis of documented data to calculate financial ratios, discover trends, identify exceptions, compare the current actuals with historical data or benchmarks, etc. The intelligent use of computers increases the efficiency and effectiveness of the analytical procedures.
7.5 Analyzing Audit Results

When the audit is completed, the audit results are analyzed to check whether the available information is sufficient. If the information is found insufficient, additional information is sought. Analytical procedures (such as ratio analysis) are conducted to arrive at conclusions and recommendations. Analysis helps to identify the gaps between an organizations targets and its actual performance.
7.6 Sharing Audit Results

The audit results are presented at a feedback meeting before people who are affected by the audit or are interested in the results. The audit teams objective during the meeting is to present a clear and simple picture of the current situation, as revealed by the audit.
7.7 Writing Audit Reports

After the audit work is completed, a written report called the audit report is prepared. This report contains the auditors views and opinions regarding the financial statements of the organization. It includes the scope of the audit work that is undertaken and also the accountability that the auditor accepts in terms of conclusions. It should be written with reference to relevant standards, where applicable.
7.8 Dealing with Resistance to Audit Recommendations

Resistance to audit recommendations can take two forms direct resistance and indirect resistance. Direct resistance to audit recommendations is easy to identify and address. Some of the ways to deal with direct resistance are: o o o Prioritize the concerns raised by the management and deal with the serious ones immediately Summarize the concerns and convince the management that their concerns will be taken care of Deal with differences in opinion through free and fair dialogue in order to arrive at a resolution
Indirect resistance to audit recommendations is subtle and more difficult to identify. Indirect resistance can be resolved by making the people who are resisting write down their concerns and having open talks with them. 91
7.9 Building an Ongoing Audit Program

Ongoing audit programs help in monitoring improvements in performance over a period of time. They help in systematically monitoring the changes taking place in the organization's work environment and also assist managers in dealing with resistance to change.
8. Benefits and Limitations of Auditing

In order to maximize the benefits of auditing, organizations should make the most of audit results, identify improvement trigger points, lay down action plans, and attempt to achieve competitive advantage through systematic auditing.
8.1 Benefits
Auditing identifies opportunities for improvement of operational processes. It identifies outdated organizational strategies. Auditing increases the managements ability to address concerns. It enhances teamwork and commitment to change. It acts as a reality check.
8.2 Limitations
The quality of the audit will only be as good as the quality of the audit tool. A financial statement audit does not comment on the soundness of the management or on the safety of its practices. Nor does it assess the risk of losses if there is any change in the business environment. Though management auditing can highlight the changes that are important for the organization, it cannot be used for resource allocation or to decide which of the changes should be undertaken first. While an audit can bring out the weaknesses in the system and identify opportunities for improvement, it would not be beneficial unless there is a strong commitment to improve or strengthen the process being studied. In organizations which use audits to manage suppliers performance, audits may prompt the suppliers to resort to unethical means, especially in the matter of adherence to labor standards, if they fear that their contracts may be terminated.
9. Summary
Auditing is a systematic and independent examination of data, statements, records, operations, and performances (financial or otherwise) of an enterprise for a stated purpose. In any auditing situation, the auditor perceives and recognizes the propositions before him for examination, collects evidence, evaluates the same, and on this basis formulates his judgment which is communicated through his audit report. Audits may be categorized based on their emphasis; primary audience; primary purpose; and scope.
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The different categories of audits are: financial statement audit, internal audit, fraud auditing and forensic accounting, operational audit, information systems audit, management audit, social audit, and environmental audit. Financial statement audits are conducted: to examine the correctness of financial statements; to establish whether they present a true and fair picture of the organizations financial position at a given time; and to check compliance with regulations like the Generally Accepted Accounting Principles (GAAP). Objective assessment of the financial statements requires significant inspection and evaluation of the organizations statements of accounts which involves application of certain key concepts: audit materiality, audit evidence, audit risk, and the concept of true and fair. According to the modern approach, internal audit is an independent management function which furnishes organizations with analyses, appraisals, recommendations, counsel, and information concerning the activities reviewed. Frauds can be investigated or detected by Certified Fraud Examiners (CFEs) who are trained to detect, investigate, and deter fraud. Forensic accounting encompasses financial expertise, fraud knowledge, and a strong knowledge and understanding of business reality and the working of the legal system. It involves the application of financial skills and an investigative mentality to unresolved issues, conducted within the context of rules of evidence. A management audit appraises an organizations position and helps it determine where it (the organization) is, where it is heading with its current plans and programs, whether it is meeting its objectives, and whether any revision of plans is required to enable it to achieve its predefined goals and objectives. Management audits can be classified into complete management audit, compliance management audit, program management audit, functional management audit, efficiency audit, and propriety audit. A social audit is a systematic attempt to identify, analyze, measure, evaluate, and monitor the effect of an organizations operations on society. Social audits assess adherence to the specified norms, which may pertain to the governments standards of social performance, standards established by the organization, or norms set by outside agencies. There are various approaches used to conduct a social audit, which are: inventory approach; program management approach; cost-benefit approach; and social indicator approach. Depending on the audit scope and coverage, Fredrick, Myers, and Blake have identified six types of social audits. Environmental audits are used to evaluate the organization on various parameters which include: conformance to the occupational health and safety requirements; conformance to the emission standards and license requirements of the local, state, and national governments; and generation, storage, and disposal of hazardous wastes. There are two types of environmental audits -- environmental compliance audit environmental management audit. 93
The auditing process consists of the following steps: staffing the audit team, creating an audit project plan, laying the groundwork and conducting the audit, analyzing audit results, sharing audit results, writing audit reports, dealing with resistance to audit recommendations, and building an ongoing audit program. The benefits of auditing are that it identifies opportunities for improvement; acts as a reality check; identifies outdated strategies; measures performance improvements; strengthens managements ability to address concerns; enhances teamwork; and changes employee mindsets and increases acceptance to change. The quality of the audit will only be as good as the quality of the audit tool. While an audit can bring out the weaknesses in the system and identify opportunities for improvement, it would not be beneficial unless there is a strong commitment to improve or strengthen the process being studied.
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Concept Note - 7
Transfer Pricing
1. Introduction
Decentralization is one of the approaches large organizations use to attain operational effectiveness. The main challenges in decentralization lie in designing responsibility structures and framing suitable policies and methods to determine the responsibility centers performance. Transfer pricing helps in the smooth functioning of responsibility structures in such organizations. When there is a transfer of goods or services from one business unit to another, the concept of transfer pricing comes into play. Transfer price is a major determinant of the revenue and profits of a responsibility center that sells a product or service to an internal customer. For the responsibility center buying the product or service, transfer price is the major determinant of expenses incurred. So, the transfer price is an important factor for both the selling and the buying unit. This note will help you understand: The concept of transfer pricing The various factors influencing transfer pricing The different methods used for calculating the transfer prices The administration of transfer prices The Indian perspective of transfer pricing.
2. The Concept of Transfer Pricing

A transfer price is the internal price charged by a selling department, division, or subsidiary of an organization for a raw material, component, or finished good and/or service from the buying department, division, or subsidiary of the same organization. The concept of transfer price is fundamentally aimed at simulating the external market conditions within the organization so that the managers of individual business units are motivated to perform well. Transfer price does not have any direct impact on the organizations profits as a whole because its effect on the selling divisions revenue is matched by its effect on the buying divisions costs. Yet, when the profits of the selling and buying divisions are taxed at different rates, there would be some impact on the organizations profits as a whole.
2.1 Objectives of a Transfer Pricing Policy

Robert Anthony and Vijay Govindarajan stated that the fundamental principle of transfer pricing is that the transfer price should be similar to the price that would be charged if the product were to be sold to outside customers or purchased from outside vendors. The main objective of transfer pricing is the proper distribution of revenues and costs between responsibility centers. If two or more profit centers are jointly responsible for developing and marketing the product, then the resulting profit has to be shared between them. Broadly, there are three objectives that a transfer pricing policy should meet goal congruence, performance appraisal, and divisional autonomy.
Goal Congruence While designing the transfer pricing mechanism, the interests of individual profit centers should not supersede those of the organization as a whole. The divisional manager, in maximizing his/her divisions profits should not indulge in decision making that fails to optimize the organizations performance. Performance Appraisal Transfer pricing should aid in reliable and objective assessment of the profit centers activities. Transfer prices should provide relevant information to guide decision making, assess the divisional managers performance, and also assess the value added by profit centers toward the organization as a whole. Divisional Autonomy The transfer pricing policy should aim at providing optimum divisional autonomy, thereby allowing the benefits of decentralization to be retained. Each divisional manager should be free to satisfy the requirements of his/her profit center from internal or external sources. There should be no interference in the process by which the buying center manager rationally strives to minimize costs and the selling center manager strives to maximize revenues. Practically, it is a difficult task to simultaneously meet all these objectives. For multinationals, internal transfer pricing can determine where profits are to be declared and taxes paid. In case of transactions with sister concerns (legal entities) that supply intermediary products, it should considered that different countries have different tax and exchange rates. The transfer pricing policy should ideally enable multinational corporations to minimize tax liability.
2.2 Transfer Pricing Objectives in International Business

Apart from the objectives of the transfer pricing policy between responsibility centers in domestic operations, multinational corporations should consider several other factors for arriving at their transfer pricing policy applicable between legal entities (their subsidiaries) in different countries. These objectives are given below. Manage Exchange Rate Fluctuations Multinational corporations can reduce exchange rate risks through transfer pricing. If the value of a countrys currency falls, then the country has to pay more for its imports. Similarly, if the value of the currency appreciates, the revenues from exports will fall for companies based in that country. Organizations can depend on their subsidiaries for imports and exports, and avoid these fluctuations through transfer pricing. Handle Competitive Pressures The subsidiaries of a company operating in different countries can use transfer pricing to reduce prices to face local competition. Companies can do this by establishing subsidiaries in the countries where the inputs are available at a low price. This will also help cut the price of the final product. 96
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Reduce the Impact of Taxes and Tariffs Multinational corporations reduce their total tax liability by maximizing profits in countries where corporate taxes are low. This will result in reduction in the tax liability of the organization as a whole. Multinational corporations can also reduce the impact of tariffs on imports while purchasing products from the overseas business units of the organization. This will lead to low tariffs for the importing business unit, as most duties are levied on the value of the goods imported. Movement of Funds between Countries A multinational corporation may prefer to invest its funds in one country rather than another. Transfer pricing provides an indirect way of shifting funds into or out of a particular country. Refer to Exhibit I and Exhibit II for transfer pricing disputes in India and the US respectively.
Exhibit I: Transfer Pricing Judgment against Sony India

In 2006, in a case against Sony India, the Delhi High Court supported an instruction issued by the Central Board of Direct Taxes (CBDT) in May 2003. CBDT proposed that all international transactions above Rs. 50 million can be referred by the assessing officer to the transfer pricing officer (TPO). The ruling has given more clarity to the multinationals to follow a common approach for all their cross-border transactions. Sony India challenged this judgment as the TPO, using the arms length policy, had proposed adding Rs. 424 million to the companys income for 2001-02. The Delhi high court ruling also gave complete rights to the assessing officer to refer to the TPO transactions below Rs. 50 million if he/she feels necessary. According to the court, all multinationals would get an opportunity to defend their stand before the assessing officer against any revision suggested by the TPO. In deciding on the arms length price of a transaction, the assessing officer was required to make the assessment based on all materials available to him/her, over and above the TPOs order.
Adapted from Manju Menon, HC Ruling gives a Clear Picture to MNCs, November 10, 2006, <http://timesofindia.indiatimes.com/articleshow/386961.cms>.
Exhibit II: The GlaxoSmithKline Transfer Pricing Dispute

The US Internal Revenue Service (IRS) demanded back taxes from GlaxoSmithKline (GSK), a large UK-based drug manufacturer, for misusing transfer pricing to minimize its tax liabilities to the US government. The US affiliate of the company was charged with overpaying for product supplies during the period 1989 to 2000 and in subsequent years, while at the same time charging lower rates for the marketing services that it supplied, thus understating GSKs income subjected to US taxation during the period. The IRS wanted the pharmaceutical giant to pay taxes, penalties, and interest. The dispute was to go to trial in February 2007. According to experts, the IRSs decision to take GSK to court was a manifestation of the new thinking in transfer pricing regulation proposed by the IRS in September 2003.
Contd
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GSK decided to settle the issue to avoid future fund outflow toward legal proceedings. On September 11, 2006, GSK announced that it was settling the dispute by paying $3.1 billion to the IRS. According to Mark W. Everson, I.R.S. commissioner, The settlement of this case is an important development and sends a strong message of our resolve to continue to deal with this issue.
Adapted from <http://www.cfo.com/article.cfm/3012017?f=related>; and other sources.
3. Factors Influencing Transfer Pricing

There are some conditions necessary for the development of a proper mechanism of transfer pricing which are: Role definition: The role and scope of the team responsible for transfer pricing should be clearly defined. In some organizations, the transfer pricing department only draws up the transfer pricing policies, and the day-to-day operations are taken care by the finance and tax departments. In contrast, in some other organizations, it is also responsible for some or all of the facets of implementation and running transfer pricing matters on a day-to-day basis. Irrespective of which model the organization follows, there should be a clear demarcation of activities between the transfer pricing team, and the accounts and taxation teams. Also, a document setting out each teams responsibilities should be circulated to all those involved to ensure allocation of the necessary tasks. External advisers: The companies must be ready to appoint external advisers who can provide a bigger picture of the organization, whose knowledge and experience will be valuable to the transfer pricing team, and who can provide resources which are not available in-house. Competent managers: Organizations need managers who can balance long-term gains and short-term profits. As transfer pricing can be used for manipulating profits, organizations should have competent people skilled at negotiation and arbitration, who are capable of determining the appropriate transfer prices, so that long-term goals are not sacrificed for short-term gains. Equity: In order to achieve goal congruency, managers of profit centers should ensure that the transfer prices charged by the selling profit centers are fair. The managers of the selling profit centers should be given the freedom to sell their goods in the external market, while managers of the buying profit centers should have the option of buying their goods from the external market. This will create an atmosphere of trust between the sister concerns and make the market a major determinant of transfer prices. Information on prevailing market prices: The normal market price can be taken to fix the transfer price when the product is transferred from one profit centre to the other. The quality and quantity of the reference product should be identical to the product whose transfer price is to be fixed. Before they decide on whether to purchase goods from outside or in-house sources, managers should fully be aware of market conditions and should have all the necessary information regarding available options, and the cost and revenues of each option.
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Proper investment: The transfer pricing department should be well funded and should coordinate well with other departments in the same organization, the transfer pricing departments of other business units, as well as with the top management. Another important aspect is compliance with the transfer pricing jurisdiction and to maintain documentation of transfer pricing in order to deal satisfactorily with any legal issues that may arise. In reality, it is not possible to fulfill all these conditions due to the internal policies of the organization and certain external factors. These constraints, both external and internal, have been given below.
3.1 External Constraints

External constraints are those imposed by the external environment like government regulations, climatic conditions, and which cannot be controlled by the organization. Examples of such constraints are given below. Limited Markets The market for buying and selling the goods of the profit centers may be either very small or even nonexistent. Such a situation arises in case of highly integrated organizations where there is likely to be little independent production capacity for the intermediate products; in case of a sole producer of a unique or sharply differentiated product, for which outside capacity is non-existent; and in case of MNCs, if the intracompany trade takes place between divisions or subsidiaries in different countries and the interests of the company is in conflict with the interests of one or more of the host countries. Excess or Shortage of Industry Capacity The business units of an organization may not be able to consider all opportunities available to it when there is an excess or shortage of capacity in the industry in which it operates. If there is a shortage, the buying centre may not be able to buy from the open market due to high price, while the selling centre sells in the open market. In the first case, the buying center fails to maximize its output as it does not have sufficient inputs, and in the second, the selling center will be maintaining higher inventories. If there is excess capacity in the industry, the buying centre is allowed to buy from the open market if it is able to get a good deal in terms of quality, price, and service, while the selling center may be allowed to sell its products if it gets a higher profit by doing so. Whatever be the case, the management should aim at taking decisions that optimize organizational profits.
3.2 Internal Constraints

The constraints imposed and controlled by the organization itself are called internal constraints. These constraints arise when due to excess capacity, the buying center is not allowed to purchase from outside sources, or when the company makes a major investment in the facilities during which it will not buy goods from outside even though outside capacity exists. To overcome these issues, the management is often forced to set a cost-based price as transfer price which is acceptable to both the buying and selling centers. 99
4. Methods of Calculating Transfer Prices

Transfer prices are calculated differently in different organizations. Before adopting a method, organizations should evaluate all methods for suitability. The most commonly used methods for calculating transfer prices are the market-based pricing method, the cost-based pricing method, the negotiated pricing method, and the resale price method. Vertically integrated organizations can use methods like the two-step pricing method, profit sharing or profit split method, and two sets of prices method for calculating transfer prices.
4.1 Market-based Pricing Method or Comparable Uncontrolled Price (CUP) Method

Under this method, transfer prices are based on the prevailing open market price for goods and services. The market-based pricing method has two main advantages the divisions can operate as independent profit centers with their managers being completely responsible for the business units performance, and the tax and customs authorities favor this method as it is more transparent and they can cross-check the price details provided by the company by comparing them with market prices on that date. In practice, however, it is difficult to use market price as a benchmark as there is no competitive market which can provide a comparable price due to the fact that there are price variations between markets because of differences in exchange rates, transportation costs, local taxes and tariffs, etc.
4.2 Cost-based Pricing Method or Cost Plus Method (CP)

The cost-based pricing method calculates transfer prices based on the product or service costs that are available from the companys accounting records. For applying this method, costs are divided into three categories direct costs like raw materials; indirect costs like repair and maintenance that can be allocated among several products; and operating expenses that include selling, administrative, and general expenses. Cost should be calculated carefully considering the acceptable accounting principles for the industry to which the company belongs to and the country where the goods are produced. The company should also consider aspects like costs and margin percentage. Costs In the cost-based pricing method, it is important to decide the type of costs to be used actual costs or standard costs. Standard costs are preferred as such costs are developed based on the standard cost structure of the division or on the basis of historical costs the transfer price is estimated by adding a profit margin to this cost. The standard price is modified when there is a major change in the prices of materials or in wage rates. Using these costs prevent the inefficiencies of the selling divisions from being passed on to the buying divisions. If actual costs are used, there will be no motivation for the selling division to reduce the actual cost because if it does so, transfer price will be reduced and there will not be any increase in the divisions margin. Profit Mark-up The selling division may either use a percentage of the investment applicable to the product or a percentage of cost. The disadvantage with using the former is that the selling division would tend to employ new assets irrespective of their requirements. 100
Transfer Pricing
This is because the cost of new equipment will be included in the margin, and would be able to reap higher profits. Organizations need to also decide on the treatment of fixed costs and research and development costs. The cost-based pricing method is generally accepted by the tax and customs authorities of a country as it provides some indication that the transfer price approximates an items real cost. This approach is, however, not as transparent as it may appear as it can be easily manipulated to alter the magnitude of the transfer price.
4.3 Negotiated Pricing (NP) Method

Under this method, the buying and selling divisions negotiate a mutually acceptable transfer price as each is responsible for its own performance. This would lead to cost minimization and encourage the divisions to agree on a transfer price that would give them good return. Tax authorities have their reservations about this system as companies can easily manipulate transfer prices to minimize their tax liability.
4.4 Resale Price Method (RP)

Under this method, the transfer price is determined by calculating back from the transaction taking place at the next level of the supply chain, by deducting a suitable mark-up from the price at which the internal buyer sells the item to an unrelated third party. This method is more suitable when the reseller does not add much value to the goods before selling. As the value added increases, there will be difficultly in estimating the margin or mark-up percentage.
4.5 Alternative Methods for Transfer Price Calculation

In vertically integrated organizations, if there is no proper transfer pricing mechanism in place, the division that sells the final product to outside customers may not be aware of the fixed costs involved in the internal purchase price. These companies adopt methods like two-step pricing, profit sharing, and two sets of prices to arrive at transfer prices. Two-step Pricing This method considers the two cost components fixed and variable for calculating transfer prices. Fixed cost is charged on a monthly basis, and includes the cost of facilities required for production such as electricity, capital equipments, and rent of shop floor. Variable cost is the cost incurred in producing each unit. A profit margin is then added to one or both these components. Profit Sharing or Profit Split (PS) Method This method is used when the transactions between units are too integrated to be evaluated separately and the existence of intangibles makes it impossible to establish comparability with market conditions. Under this method, the product is transferred to the marketing unit at the standard variable cost. After the product is sold, the business units share the profit earned based on the contribution made by each of them. The profit to be split is generally the operating profit, before the deduction of interest and taxes. Two Sets of Prices Under this method, revenue is credited to the manufacturing unit at the market sales price while the buying unit is charged for the total standard costs. The difference between the outside sales price and the standard cost is charged to the parent 101
Enterprise Performance Management organizations account. These charges are later eliminated while drawing up consolidated financial statements. This method is used when there are frequent conflicts between the buying and selling units, which cannot be resolved by any method. The disadvantages of this method are it is difficult to maintain a separate account each time a transfer of goods is made; and it motivates the managers to concentrate only on internal transfers (where they are assured of a good mark-up) at the expense of outside sales. Table 1 provides a summary of the different methods of transfer pricing.
Table 1: Methods for Calculating Transfer Price

S. No 1 Methods Market-Based Pricing Method or Comparable Uncontrolled Price (CUP) Method Cost-Based Pricing Method or Cost Plus (CP) Method Negotiated Pricing (NP) Method Resale Price (RP) Method Remarks Organizations transfer goods and services between their profit centers at a price equal to the prevailing open market price for those goods and services. This method provides the best evidence of an arms length price. Transfer prices are calculated on the basis of the cost of the goods or service. This method is applicable when market price of the goods or service is not available. The buying and selling divisions negotiate a mutually acceptable transfer price. Transfer price is determined by calculating back from the transaction taking place at the next level of the supply chain, by deducting a suitable mark-up from the price at which the internal buyer sells the item to an unrelated third party. This method is more appropriate where the reseller does not add much value to the goods before selling. There are two components of pricing a variable component and a fixed component. This method is suitable for vertically integrated organizations. The transfer price comprises a standard variable cost plus a share of actual profit on sales. This method is applied when the transactions between units are much too integrated to be evaluated separately and the existence of intangibles makes it impossible to establish comparability with market conditions. The selling unit is credited with the market sales price and the buying unit is charged for the total standard costs. This method is used when there are frequent conflicts between the buying and selling units and they cannot be resolved by any method.
3 4
Two-Step Pricing Method Profit Sharing or Profit Split (PS) Method
Two Sets of Prices Method
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Transfer Pricing
5. Administration of Transfer Prices

The administration of transfer pricing involves close monitoring of the implementation process as any errors in the process, intentional or unintentional, are viewed as grave offenses in the eyes of law and can be detrimental to the organization.
5.1 Implementing Transfer Pricing

Implementing a transfer pricing mechanism involves: Articulation and communication of the transfer pricing strategy Documentation of the process and inter-organization agreements Involvement of a multidisciplinary team Negotiations between the heads of various units Arbitration and conflict resolution in case conflicts arise. Articulation and Communication of the Transfer Pricing Strategy The first step involves identifying the inter-organization transactions and operational prices. Then, the regulatory transfer-pricing policies that will be enforceable for each transaction have to be determined. Decision has to be taken on whether the regulatory transfer pricing policies should be different from the operational pricing for the sake of taxation or other legal issues. All these policies should be communicated to the concerned managers to avoid confusion. Documentation of the Transfer Pricing Process and Inter-organization Agreements All transfer pricing policies and interdepartmental, inter-company agreements should be carefully documented to avoid the risk of being questioned by the tax authorities. Agreements should be flexible enough to operate even under conditions of market uncertainty, and should include clear definitions of the roles and responsibilities of all the parties involved. Involvement of Multi-disciplinary Team A multidisciplinary team in the transfer pricing team will help the company to efficiently practice transfer pricing as it requires proficiency in many areas like accounting, tax and legal expertise, knowledge of economics, and direct experience in operational functions such as R&D, manufacturing, marketing, and distribution. Negotiation and Conflict resolution The business units negotiate among themselves before taking decisions related to transfer prices. These decisions are left to the respective line managers and there is no involvement of the headquarters. At times, when the business units fail to arrive at a consensus on the transfer price, they follow a preset procedure for arbitrating such disputes. Arbitration is done by the headquarters by assigning a single executive to talk to the business unit managers and arrive at an agreed price, or by forming a committee that would settle transfer price disputes, review sourcing changes, and change the transfer price rules, whenever necessary.
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Organizations can form either a formal or informal system of arbitration to administer the transfer price mechanism and solve conflicts. In a formal system, both parties submit a written case to the arbitrator, who reviews it and decides on the price. In an informal system, most of the presentations are oral. Conflicts resolution techniques like forcing, smoothing, bargaining, and problem solving can be used by the management. Forcing and smoothing help in conflict avoidance, whereas bargaining and problem solving indicates conflict resolution.
5.2 Transfer Pricing Potential for Misuse

Organizations can misuse transfer pricing to minimize their tax liabilities, as well as to project a wrong image about their financial health, and thus mislead the stakeholders. With stringent government regulations, such instances are likely to become rare in future.
6. The Indian Perspective

Liberalization of the Indian economy has resulted in increased cross-border related party transactions between India and other nations. Many indigenous organizations have grown rapidly and become multinationals with subsidiaries and affiliates in foreign countries.
6.1 Transfer Pricing Guidelines

Transfer pricing regulations were introduced by the government with effect from April 1, 2001 to reduce tax avoidance by organizations operating in India. The regulations have chiefly been designed based on the OECDs (Organization for Economic Cooperation and Development) transfer pricing guidelines. According to these guidelines, companies can adopt any of the Comparable Uncontrolled Price method (CUP), the Resale Price Method (RP), the Cost Plus method (CP), and the Profit Split method (PS) transfer pricing methods, based on the situation. Detailed guidelines on the nature of the transaction, maintenance of documentation, adjustments and penalties, role of transfer pricing officers, and conflict resolution have also been provided to avoid confusion. Refer to Exhibit III for Indian regulations on the maintenance of documentation.
Exhibit III: Documentation Guidelines for Companies Operating in India

Section 92D of the Income Tax Act provides that every person who has undertaken international taxation has to maintain the information and documents specified by rules made by the Central Board of Direct taxes (CBDT). The documentation has been prescribed under Rule 10D. It includes: Background information on the commercial environment in which the transaction has been entered into Information regarding the international transaction entered into The analysis carried out to select the most appropriate method Identification of comparable transactions The actual working out of the arm's length price of the transaction
Contd
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Transfer Pricing
Contd
Under Section 92E, the documentation has to be available with the assessee by the specified date and has to be retained for a period of eight years. During the course of any proceedings under the Act, the Commissioner may require any person who has undertaken an international transaction to furnish the information and documents specified under the rule within a period of thirty days from the date of receipt of the notice issued in this regard, and this period may be extended by a further period not exceeding thirty days. Moreover, Section 92E provides that every person who has entered into an international transaction during a previous year shall obtain a report from an accountant and furnish this report on or before the specified date in the prescribed form and manner.
Adapted from <http://incometaxindia.gov.in/transferpricing.asp>.
7. Summary
Transfer price is the internal price charged when one business unit in the organization transfers goods or services to another business unit in the same organization. The main objective of transfer pricing is the proper distribution of revenue between responsibility centers. A transfer pricing policy should meet the three broad objectives of goal congruence, performance appraisal, and divisional autonomy. In international business, the additional objectives of transfer pricing are: managing exchange rate fluctuations, handling competitive pressures, reducing the impact of taxes and tariffs, and providing ease of movement of funds between countries. The conditions necessary for the development of a proper transfer pricing mechanism are: role definition, external advisers, competent managers, equity, information on prevailing market prices, and proper investment. Constraints to the implementation of a transfer pricing mechanism may be classified as external (limited markets; surplus or shortage of industry capacity) and internal constraints. The different methods for calculating transfer prices are: market-based pricing method (comparable uncontrolled price method), cost-based pricing method (cost plus method), negotiated pricing method, and resale pricing method. Vertically integrated organizations can use some alternative methods for transfer price calculation: two-step pricing method, profit sharing or profit split method, and two sets of prices method. The administration of transfer pricing involves close monitoring of the implementation process, because any errors in the process, whether intentional or unintentional, are viewed as grave offenses in the eyes of law and can be detrimental to the organization.
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Implementing a transfer pricing mechanism involves: articulation and communication of the transfer pricing strategy; documentation of the process and of inter-company agreements; involvement of a multidisciplinary team; negotiations between heads of various units; and arbitration and conflict resolution in case conflicts arise. Organizations can misuse transfer pricing to minimize their tax liabilities, as well as to project a wrong image about their financial health, and thus mislead the stakeholders. The Government of India has introduced full-fledged transfer-pricing regulations with effect from April 1, 2001 to reduce tax avoidance by organizations operating in India.
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Concept Note - 8
Business Ethics and Enterprise Performance Management

1. Introduction
The term ethics is derived from the Latin word ethicus meaning manners or character. It deals with morality and rules regarding behavior and conduct. In an organizational setup, ethics can be defined as the rules or standards governing the conduct of individuals and organizations. Ensuring ethical behavior among employees is a very complex problem that requires an in-depth understanding of the many factors which contribute to their decisions to behave ethically or otherwise. Organizations attempt to ensure that their employees behave ethically, using control systems. Infosys Technologies Ltd. is an example of an organization that has built a solid reputation for management that is driven by values. According to N R Narayana Murthy a cofounder of the company and its first Chief Mentor, pursuing business legally and ethically is one of the prerequisites for an organization to become a great one. This note will help you understand: The concept of ethical behavior in organizations The management controls used and the ethical issues arising in the different organizational functions The different ways of regulating ethical conduct.
2. Ethical Behavior in Organizations

The ethical approach to handle a specific issue in the organization would benefit the organization but may not benefit the individual, while the unethical approach may benefit the individual but would harm the organization. It is the responsibility of supervisors to ensure that their subordinates act in an ethical manner. The ethical behavior of an employee depends on factors such as the individuals ethical philosophy and ethical decision ideology; other individual factors; organizational factors; and external environmental factors.
2.1 Ethical Philosophy and Ethical Decision Ideology

The ethical system of an individual consists of his/her ethical philosophy and ethical decision ideology. Ethical Philosophy An individuals ethical philosophy represents the collection of ethical principles that he/she holds. Under different situations in an organizational setup, individuals may follow three different ethical philosophies utilitarianism, individual rights, and justice. Utilitarianism recommends that a course of action that achieves the greatest good for the greatest number of people is ethical. The individual rights philosophy deals with safeguarding the rights of individuals, such as the right to be informed, right to free speech, right to free consent, the right to privacy, and the right to due process. Justice requires that the rules of the organization should be enforced with fairness and impartiality, and suggests that individuals should be accountable only for factors which are under their control and not otherwise.
Ethical Decision Ideology Ethical decision ideology is concerned with how different individuals apply their ethical philosophies for decision making when faced with ethical dilemmas. Ethical decision ideologies can be classified based on two dimensions: idealism and relativism. Idealism refers to the belief that behaving ethically ensures positive results. Relativism refers to the belief that moral values depend on circumstances. There are four classifications of ethical decision ideologies based on these two dimensions: Absolutist: It refers to a person who scores high on idealism and low on relativism. Exceptionist: It refers to a person with a low score on both idealism and relativism. Situationist: It refers to a person who scores high both on idealism and relativism. Subjectivist: It refers to a person who scores low on idealism and high on relativism. Figure 1 depicts the matrix of ethical decision ideologies. Figure 1: Ethical Decision Ideologies Matrix Relativism Low Low Idealism High Absolutist Situationist
Adapted from Stead, Edward W.; Dan L. Worrell and Jean Garner Stead An Integrative Model for Understanding and Managing Ethical Behavior in Business Organizations. Journal of Business Ethics. Vol. 9 Issue 3, Mar1990, p233-242.
High Subjectivist
Exceptionist
2.2 Individual Factors

An individuals value system is an important factor that determines whether he or she will behave ethically, or not, when faced with an ethical dilemma. Other individual factors which influence ethical behavior include: Age of the person Ego strength High, low His/her locus of control Internal, external Level of moral development Pre-conventional level, conventional level, postconventional level. The decisions taken by the individuals in the past form the decision history and influence his/her present and future decision-making. The ethical philosophy of the individual and the ethical decision ideology impact his/her decision history.
2.3 Organizational Factors

Several organizational factors directly impact the behavior of employees and the ethical decision-making process. These include: 108
Culture and Structure The culture of an organization includes the prevailing values, belief systems, and norms. The hierarchy of authority decides the level of autonomy or freedom (both the number and types of decisions taken and the extent of empowerment that the employees have) that the employee enjoys. This is an important factor that contributes to ethical behavior. Ethical decision making can be encouraged by allowing the employees, whose activities ethically affect the organization, to choose activities which are ethical. Unethical behavior can be curbed by delegating decision-making rights to employees who are skilled enough and aware of the characteristics and outcomes of the decisions that are made. Performance Measurement Systems Performance measurement systems are used to assess the performance of employees against predetermined standards or targets. Systems which are too stringent may trigger unethical behavior. A performance measurement system should be designed to identify unethical behavior and to communicate to the employees that the management would not approve of unethical behavior. Employees empowered to make ethical decisions should be well informed about the consequences of unethical behavior. Performance measurement systems should be so designed that they do not require employees to resort to unethical means to achieve expected performance levels. Also, it should reward ethical behavior. Reward Systems The reward systems in an organization, which may be both monetary and nonmonetary, should incorporate clauses which enforce ethical behavior. Reward systems should be integrated with the performance measurement systems, and should reflect the extent of decision-making authority given to employees. Position-Related Factors Position-related factors that influence ethical behavior include peer pressure, expectations of the top management regarding achievement of objectives, presence or absence of a code of conduct, superior-subordinate relationships, and the extent of resource availability. Positions that have a central role would entail employees to face more situations where ethical dilemmas arise. Organizational factors also affect the decision history through the reward systems. Employees will tend to behave ethically if that behavior is rewarded. Employee will refrain from unethical behavior if he/she gets punished for that behavior.
2.4 External Environmental Factors

Environmental factors, here, refer to external environmental factors like greater competition in business, fluctuations in the economy, and the availability of resources, which influence the ethical behavior of employees.
Political and Economic factors

Political and economic factors include government policies, tax structures, and the tariffs and duties levied on imports. To stay ahead of competition, many organizations resort to bribing government officials to get contracts or licenses for businesses or to get the duties and tariffs reduced. 109
Social Factors
Giving the right information to customers regarding the products being sold or new product being launched is one of the major ethical considerations that companies must keep in mind. Being ethical serves as a competitive advantage for organizations, as it builds a good reputation and image.
2.5 Integrated Framework for Ethical Behavior

Edward Stead, Dan L. Worrell, and Jean Garner Stead developed a conceptual framework to explain why employees behave ethically or unethically, and provided pointers as to how this behavior can be controlled by managers. It suggests that individual factors and organizational/position-related factors influence each other and also influence the way in which the individuals ethical philosophy and ethical decision ideology are formed. The organizational factors are in turn influenced by external environmental factors. Ethical behavior of the employee results from the decisions that the employees take depending on their ethical philosophy and ethical decision ideology. The manifestation of ethical decisions as ethical behavior is also directly influenced by the organizational/position-related factors. When the ethical behavior of the individual is rewarded or punished, these decisions become a part of the decision history which further influences the decisions and behavior of the employees. Figure 2 depicts this integrated framework of ethical decision-making and behavior of employees in an organization.
Figure 2: Ethical Decision-Making and Behavior of Employees
Adapted from Stead, Edward; Dan L. Worrell and Jean Garner Stead An Integrative Model for Understanding and Managing Ethical Behavior in Business Organizations. Journal of Business Ethics. Vol. 9 Issue 3, Mar 1990, p233-242.
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2.6 Controlling Ethical Behavior

Organizations should have mechanisms like a code of ethics, ethics committee, and ethics training in place so as to ensure that ethical behavior is ingrained in the employees. Ethical behavior can also be managed in an organization by selecting the right people through proper selection tests and by creating positions in the organization which deal specifically with ethical issues.
3. Management Control and Ethical Issues in Different Functions

In the context of management control systems design and their implementation, there are several ethical issues that may arise in different functions.
3.1 Budgetary Slack

Budgetary slack is a deliberate understatement of revenues and/or overstatement of expenses in the budget. It is caused by managerial intention rather than by an unforeseen error in the estimation process. The primary aim of creating budgetary slack is that managers seek to achieve both their individual/personal goals and the organizational goals. Whether the manager feels that creating slack is ethical or unethical depends on: his/her personality traits (related to honesty and fairness) and the extent of open communications possible between the manager and his/her supervisors regarding the ability and the support necessary to achieve the desired objectives. In organizations using output-based control systems, there are higher chances that managers will resort to creation of slack for personal benefit. In organizations using behavior-based control systems, the chances are that the managers will try to integrate the objectives of the organization with their personal objectives without creating slack.
3.2 Managing Earnings

Earnings management aims at reporting financial performance differently than the actual performance usually, more robust performance is reported. It is defined as those actions undertaken by the management that have an impact on the reported income of an organization, even though it is not beneficial for the organization. Incidence of earnings management is higher in organizations that have poorly designed control systems due to which there is a lack of clear authority and proper auditing. The objective behind managing earnings is an important factor to be considered, that is, whether it is used to gain rewards for oneself or to help the organization in maintaining its creditworthiness. To prevent managers from resorting to such actions, especially for personal benefits, an organization should have audits and other control mechanisms in place to identify any occurrence of enhanced earnings and take remedial action before the financial statements are made public.
3.3 Ethical Issues in Sales

Most organizations try to instill a sense of responsibility and the need to sell ethically, in their salespersons as a salesperson is the representative of the organization, and the person who deals directly with customers. Ethical issues are faced in the sales function in terms of the daily work carried out, that is, in getting business for the organizations. 111
An example of ethical dilemma in the sales function may be given pertaining to the pharmaceutical organization where every salesperson has a monthly sales target. Generally, for target achievement, salespersons meet wholesalers and the retailers, take orders, and supply them with the necessary products. At the end of the month, if targets have not been met, some salespersons resort to promising additional discounts or special gifts for orders from distributors and chemists, so as to achieve their targets.
3.4 Ethical Issues in Operations

Productivity is defined as the efficient use of resources to produce the desired output. The quality (which encapsulates many dimensions like performance, features, reliability, conformance, durability, serviceability, and aesthetics) of the output is the level to which the product or service satisfies the customer. Productivity and quality have to be simultaneously considered in the strategic planning process. Ethical issues may be faced by the operations manager on the quality front in trying to maximize productivity. For instance, he/she may try to minimize the costs incurred in aspects where quality issues cannot be detected by consumers in the short-term. Another ethical issue to be considered in operations is that of the safety of employees. Safety may be compromised in trying to gain maximum profit at minimum costs, thereby making working conditions dangerous and/or unhealthy. Further, ethical issues may arise in the form of loss of important and confidential information and theft by employees. Proper security and surveillance techniques should be put in place to curb such unethical activities.
3.5 Ethical Issues in Human Resource Management

Issues that have become important in terms of their ethical implications for the practice of human resource management include: Lack of job Security and Increased Risk of Unemployment Outsourcing of business activities and downsizing of organizations, which are common phenomena in the business world today, have led to increased risk of unemployment. Organizations recruit employees on contract, paying low wages, and setting stringent performance standards, thereby increasing the sense of job insecurity among employees. Excessive Scrutiny and Control Organizations nowadays adopt various forms of scrutiny and control over employees, right from the selection stage to their performance on the job. There is a growing feeling that the extent of freedom an employee is given for decision-making is gradually being curtailed. Discrimination Ethical problems related to discrimination may arise due to: Sexual discrimination; discrimination based on religion, caste, nationality, and education Absence of proper performance appraisal policies 112
Qualitative measures used for performance appraisal leading to biased evaluations wherein undeserving candidates are rewarded instead of deserving candidates Misuse of authority by management. Refer to Exhibit I for some ethical scandals at a multinational corporation.
Exhibit I: Ethical Scandals at Siemens AG

Siemens AG (Siemens), a Germany-based conglomerate established in 1847, had businesses ranging from power and transportation to automation and control. On May 14, 2007, a German court convicted two former managers of Siemens AG (Siemens) for diverting the companys money to bribe employees of Enel SpA (Enel), an Italian energy company. Both the former managers admitted that they had bribed employees at Enel who had demanded money in return for contracts. They also said that they had not done anything wrong as they did it for the benefit of the company and not for any personal gain. Moreover, there was no other way to win contracts in several countries abroad where bribing for contracts was a common practice, they said. Earlier, in late 2006, another scandal had surfaced in the telecommunications division of Siemens involving slush funds created to bribe foreign officials to secure contracts abroad. In still another case, Siemens was accused by IG Metall, a dominant labor union in Germany, of having tried to bribe a small union called AUB to gain support for its policies. Siemens was also being probed in several other countries like Italy, Switzerland, Greece, and the US for possible ethical misconduct. Analysts said that the bribery scandals at Siemens reflected the ethical costs of intense competition in global markets. Companies were resorting to underhand payments to win contracts. In several developing countries it was common practice to take money from companies in return for contracts, it was said. The companies themselves considered it as a business cost. In the light of the number of scandals that rocked Siemens in a short span of time, questions were raised as to how the top management had failed to notice such a deep network of embezzlement involving huge amounts of money. The crisis ultimately led to the exit of the chairman of Siemens supervisory board, Heinrich von Pierer and its CEO, Klaus Kleinfeld. Though they were not directly implicated in the scandals, the leadership change was effected to give the company a clean break from the past.
Adapted from Bharath Krishna and Rajiv Fernando, Case Study: The Bribery Scandal at Siemens AG, The ICMR Center for Management Research, (www.icmrindia.org), 2007.
3.6 Regulating Ethical Conduct

The management control systems in any organization have three interconnected parts, all of which need to be effective. These parts are: Indicating and communicating the objectives of the organization to all the levels in the organization: To give the employees the direction to perform. Measuring performance through a set performance measurement system: To give the employees the necessary feedback. 113
Integrating the reward systems of the organization with the accomplishment of objectives and in turn encouraging the employees to perform: To help the employees integrate their personal goals with organizational goals. The different mechanisms used by organizations to regulate ethical behavior are: Code of Ethics, Ethics Committee, ethics training for employees, corporate governance focused on ethics, system of whistleblowing, and reward systems based on ethics.
3.7 Code of Ethics

An organizations Code of Ethics is a document which gives details about the expected behaviors from each level of management. It covers the relationship of the top management with the employees, the relationships of employees among themselves, bribery, disclosure of confidential information, customer relationships, accounting, and legal and political actions. The Code should include clauses on behavior of employees with each other and have rules in place which curb behaviors like unhealthy rivalry between individuals or departments. An organization must update its Code of Ethics as often as necessary, so as to ensure that it remains capable of dealing with new types of unethical practices that may arise over time in the business environment. Refer to Exhibit II for the Code of Ethics adopted by Dr. Reddys Laborataries.
Exhibit II: Code of Ethics Dr. Reddys Laboratories

Dr. Reddys Laboratories, a pharmaceutical company headquartered at Hyderabad, India, has a code of business conduct and ethics for all its employees and the board of directors. The various aspects spelt out in the Code of Ethics are: Values: Values guide and facilitate the companys path toward its objective and represent an unwavering commitment to all stakeholders. The commitment includes: quality to customers; respect for the individual; an environment promoting innovation and continuous learning; creation of value through teamwork; and social awareness and responsibility. Responsibilities of the employees: The employees need to imbibe all the values of the company well and strictly adhere to all the policies and rules, and ensure ethical behavior. They have to strictly adhere to the regulations and this is checked by the companys compliance system headed by the Chief Compliance Officer. Business partners: With regard to partners in business, no preferential treatment of any particular party is accepted and employees are restrained from accepting material gifts from business partners. Work Culture: Employees are expected to keep the work atmosphere open, that is, a culture which ensures non-discrimination, and trust and respect among employees. The company aims at providing a safe work environment to its employees. Confidentiality: Employees are required to protect all confidential information and utilize it only for the companys benefit. Confidential information should be protected and if appropriate, additional protection should be arranged through the acquisition of intellectual property rights. In addition, the Code also contains rules regarding insider trading, accounting principles, safety of the environment and society as a whole, etc.
Source: <http://www.drreddys.com/coverview/pdf/DRL_Code_of_Business_Ethics.pdf>.
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3.8 Ethics Committee

Ethics Committee should ideally be a high-powered committee at the board level, or should be directly reporting to the board. It has to strike a balance between the ethical issues cropping up due to the strategic decisions taken at top management level, and the ethical problems that the employees face at various functional levels. Some of the responsibilities of the Ethics Committee are: Ascertaining that all employees are appropriately trained in the organizations Code of Ethics Communicating the importance of ethical values and ethical business practices Establishing proper systems for monitoring the ethical implications of activities and performance, and penalizing unethical activities, if any Creating avenues for employees to openly discuss ethical issues that they face, for example, creating and maintaining an ethics hotline Reviewing the Code of Ethics periodically, and revising it as and when required.
3.9 Ethics Training for Employees

Ethics training for employees is the basic process by which the ethical conduct and decision making power of employees can be improved. It should help employees decide the ethical implications of their decisions and actions. An ethics training program should: Strengthen the organizations stand on ethics Give the employees the guidelines regarding bringing to light wrong behavior Make the employees aware of the likely penalties for wrongdoing. The ethics training program should provide modules for all levels of employees. Organizations should devise the training program, which clearly communicates the core values of the organization.
3.10 Corporate Governance and Ethics

According to Sir Adrian Cadbury, Corporate governance is concerned with holding the balance between economic and social goals and between individual and communal goals. The corporate governance framework is there to encourage the efficient use of resources and equally to require accountability for the stewardship of those resources. The aim is to align as nearly as possible the interests of individuals, corporations and society. It is necessary that corporate governance is integrated with the ethical code of the organization. For successful integration of corporate governance with the code of ethics, the top management of an organization must: Recognize the value and belief systems of the organization and evaluate them for appropriateness Assess their own thoughts and attitudes toward the ethical concerns of the organization Assess the existing strategies and processes of the organization to check whether they promote ethical behavior and display the ethical values. 115
For the proper conformity between ethics and corporate governance, it is necessary that the behavior of the top management and all employees is monitored to check for compliance with the ethical code at all levels as well as with the mission statement and functional strategies of the organization.
3.11 Whistleblowing
Whistleblowing is the act whereby an employee of an organization informs the higher authorities or public about the unethical practices taking place in the organization. Whistleblowers have helped organizations in tracking and curbing unethical practices, which would otherwise have damaged the reputation of the organization and also caused harm to the well-being of other employees. Albeit the benefits, whistleblowing as a control mechanism, is not an easily accepted approach in many organizations. In some organizations, whistleblowers reports may be overlooked by the concerned people, and the unethical practices in the organization may continue. Often, whistleblowers are perceived as a threat to the top managements authority and this may lead to the whistleblower being reprimanded for his/her act. Refer to Exhibit III to understand the ethical responsibilities of the employees of Infosys Technologies Limited, as laid down by its Code of Business Conduct and Ethics.
Exhibit III: Compliance is Everyones Business

The following section is a reproduction of the section Compliance is Everyones Business from the Code of Business Conduct and Ethics of Infosys Technologies Limited. Ethical business conduct is critical to our business. As an employee, your responsibility is to respect and adhere to these practices. Many of these practices reflect legal or regulatory requirements. Violations of these laws and regulations can create significant liability for you, the Company, its directors, officers, and other employees. Part of your job and ethical responsibility is to help enforce this Code of Business Conduct and Ethics. You should be alert to possible violations and report possible violations to the Human Resources Department or the Legal Department. You must cooperate in any internal or external investigations of possible violations. Reprisal, threats, retribution or retaliation against any person who has in good faith reported a violation or a suspected violation of law, this Code of Business Conduct or other Company policies, or against any person who is assisting in any investigation or process with respect to such a violation, is prohibited. Violations of law, this Code of Business Conduct and Ethics, or other Company policies or procedures should be reported to the Human Resources Department or the Legal Department. If you find or have concerns related to questionable accounting, accounting controls, auditing matters, OR reporting of fraudulent financial information to our shareholders, government or the financial markets, OR of Grave Misconduct, that is, conduct which results in a violation of law by the Company or in a substantial mismanagement of company resources and if proven constitutes a criminal offence
Contd
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Contd
or reasonable grounds for dismissal of the person engaging in such conduct, OR conduct which is otherwise in violation of any law or the Companys policies, you should promptly contact any of the following, in accordance with the companys whistleblower policy: Corporate Counsel; Your Immediate Supervisor You may also report your concerns anonymously by e-mailing the Companys email id for this purpose at whistleblower@infosys.com or by sending an anonymous letter to the Corporate Counsel. If you have reason to believe that both of those individuals are involved in these matters, you should report those facts to the Audit Committee of the Companys Board of Directors. For more details, you should read the Companys whistleblower policy. Violations of law, this Code of Business Conduct and Ethics or other Company policies or procedures by Company employees can lead to disciplinary action up to and including termination. In all cases, if you are unsure about the appropriateness of an event or action, please seek assistance in interpreting the requirements of these practices by contacting the Human Resource Department or Legal Department.
Source: Code of Business Conduct and Ethics. Infosys Technologies Limited. <http://www.infosys.com/ investor/corp_gov/CodeofConduct.pdf>.
3.12 Reward Systems and Ethics

It is necessary for organizations to incorporate reward systems which promote ethical means of achieving the specified objectives. Integrating ethics into the reward systems will increase the commitment of the employees toward the ethical program of the organization. The system should ensure rewards for employees who show good judgmental capabilities or take proactive decisions that benefit the organization.
4. Summary
Ensuring ethical behavior among employees requires an in-depth understanding of the many factors which contribute to their decisions to behave ethically or otherwise. Organizations attempt to ensure that their employees behave ethically, using control systems. The ethical behavior of an employee depends on factors such as the individuals ethical philosophy, that is, utilitarianism, individual rights, or justice; ethical decision ideology, that is, absolutist, exceptionist, situationist, or subjectivist; other individual factors, organizational/position-related factors, and external environmental factors. In the context of management control, ethical issues can arise in any department or function of an organization. On the financial front, the ethical issues may arise due to creation of budgetary slack and managing earnings. 117
Ethical issues in the sales function arise when the salespeople are under pressure from the higher authorities to achieve targets in order to earn incentives or recognition. In the operations function, ethical issues may arise in terms of productivity and quality or on the safety front. In human resource management, lack of job security and increased risk of unemployment, excessive scrutiny and control over employees, and discrimination are some issues that are important in terms of their ethical implications. To regulate ethical conduct, organizations have in place different mechanisms like Code of Ethics, Ethics Committee, ethics training for employees, corporate governance focused on ethics, system of whistleblowing, and reward systems based on ethics.
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Concept Note - 9
Performance Management of Production and Operations (A)

1. Introduction
Production and operations are interrelated activities that influence an organizations performance. In a manufacturing organization, production activity involves conversion of inputs to outputs, while operations involves processes like procuring the inputs and ensuring optimal supply of finished goods to customers or consumers. Production and operations are interrelated activities that influence an organizations performance. Production operations include the various activities executed during the production process. Operations management and control covers both production and non-production operations. Production and operations, when combined and synchronized, would be classified as supply chain management (SCM). SCM ensures that the organization produces products that are demanded by the market in right quantities. It covers activities like procuring inputs, which in turn, includes activities like inbound logistics, improving production activities to match market demand, and outbound logistics. This note will help you understand: The significance of control of production and operations The concepts of production and operations controls The concept and importance of supply chain management The use of information systems in production and operations management.
2. Control of Production and Operations An Overview

Production and operations should be controlled to ensure optimal utilization of the production capacities, minimization of wastages, and reduction in the machine downtime. Production management controls the production activities by achieving quick conversion cycles, optimal scheduling of operations on the plant floor, efficient movement of material on the plant floor, and avoiding spillages and accidents. It will also identify the various work points and measure the work point efficiencies to ensure high productivity levels. In production operations, quality control checks or quality assurance is conducted on the materials used to ensure high product quality, Control of production methods, laying down quality standards for materials, and laying down standard operating procedures for activities taking place on the shop floor are important aspects of controlling production operations. Operations management assumes great importance in service organizations as the core product is an intangible service whose quality is difficult to assess. The finished product is the result of operations and its quality depends on how the operations are executed. The production process is also intangible and it is difficult to identify the control parameters. Successful service organizations are those which come up with controls that develop clearly measurable yardsticks for controlling the organizations operations. Refer to Exhibit I to understand the key differences between service operations and manufacturing operations.
Exhibit I: Manufacturing Operations vs. Service Operations

Following are some of the points that clearly differentiate service operations from manufacturing operations. Unlike manufacturing operations where consumption is followed by production, both production and consumption take place simultaneously in service operations. E.g.: In a restaurant, once the order is placed, the production begins and the consumption takes place immediately as soon as the production gets completed. A product in a manufacturing operation has a shape, size, and can be seen and touched. This is not possible in case of services as they are intangible. E.g.: The service provided by an air hostess on an airline or by a teacher in a college cannot be defined. Manufacturing operations comprise inventories of stock. There is no inventory in case of service operations. E.g.: The empty seats on an airline cannot be reserved or saved for a later period of time. Once the flight takes off, the seats will be gone. Consistency can be maintained in case of manufacturing operations as the production process is carried out based on a predefined process that involves complete specifications and strict quality control. This is not possible in case of services as they are intangible. There will be variations in service delivery from time-to-time. E.g.: A waiter may not serve you in the same way as he/she has served you a few days back. Service operations comprise both substantive and peripheral components. E.g.: In a hotel, food will be the substantive component, while ambience would be the peripheral component.
Adapted from <http://www.unb.ca/jhsc/resourcectr/TME_courses/tme3113/production/ m5s103.htm>.
3. Production Controls
Production controls in manufacturing organizations are dependent on two broad variables the nature of the production process (process production or discrete production) and the degree of mechanization (high or low) involved in the production process. In process (continuous) production (e.g., petroleum refining and petrochemicals industry, pharmaceutical industry, the food and beverages industry), the plant supervisor controls the settings of various machines in accordance with the production plan of the day. Control is exercised to a large extent through visual inspection and less through manual intervention. In discrete (assembly line) production (e.g., car manufacturing, television manufacturing, and computer manufacturing) a variety of components are combined to make the final product. Production controls in such organizations focus on the following issues: Producing the finished components as per design specifications and the predetermined time standards laid down Synchronizing the production processes of all the components and ensuring the right balance of production capacity of different production chains of the various components
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Ensuring the right production capacity within a component production process Ensuring that the work layout is appropriately designed and there is a smooth flow of materials on the shop floor. Specifying the quantum of materials to be stacked on the production floor of both the inputs and the outputs Specifying the number of persons who can be present on the shop floor, the uniform or dress which the employees have to wear, and the safety precautions which have to be followed Defining the wastage and spoilage norms, and benchmarking the actual wastage and spoilage against these norms Defining the quality norms which are to be met at each stage of production process and strictly adhered to, to consistently deliver a high quality product.
In a manual production process, say a printing press, each activity has to be closely controlled to ensure uniform quality of the finished product, and to minimize wastage and spoilage. If the production process is highly mechanized and uses advanced techniques like robotics and Computer Numeric Control (CNC) machines where there is a high degree of precision and low scope of error commitment, the control element is built into the production activity itself to a large extent.
3.1 Measuring Production Performance

Productivity is a controlling tool used to measure the production performance of the organization and ensure that all the resources are judiciously and efficiently utilized. It measures the organizations efficiency in terms of ratio of outputs to inputs; higher the ratio, greater will be the efficiency. Productivity helps to track progress in terms of efficient resource utilization in the production process and identify inefficient activities in the process in terms of effort spent, material consumed, etc. Productivity Measurement Productivity can be measured in relation to a single factor (single factor productivity), a combination of factors (multifactor productivity), or all the factors taken together (total productivity). Single factor productivity and multifactor productivity are also called partial productivity as all the factors of production are not considered in these measures. A few productivity measures are discussed in Table 1.
Table 1: Productivity Measures and their Descriptions

Productivity Measure Labor productivity Description Labor is one of the major sources of production costs for organizations, therefore, most productivity ratios are calculated considering labor as the specific input. This partial productivity ratio is referred to as the labor productivity index or output per work-hour ratio. Labor Productivity =
= Goods and/or Services Produced (Output) Labor Hours/Manhours Spent (Input)
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Productivity Measure Material productivity Multifactor productivity Total productivity
Description Material costs also affect productivity as they may add up to 30% to 40% of the overall costs, or even more. Material Productivity =
= Goods and/or Services Produced (Output) Quantity of Material Used (Input)
Specific ratios are developed that gauge productivity in terms of change in combined inputs. These inputs can include raw materials and labor hours used in the production of a particular output. Multifactor Productivity =
= Goods and/or Services Produced (Output) Quantity of Raw Material Used + Labor Hours Used (Input)
Many organizations measure productivity in terms of partial productivity (single factor or multifactor) as it is difficult to measure total productivity due to the difficulty in identifying/understanding the particular input variable(s) (among many variables) that has led to lower productivity. The problem with total productivity is that all the variables (inputs and outputs) must be expressed in the same units. Total Productivity =
= Goods and/or Services Produced (Output)
[Labor + Capital + Energy + Technology + Materials](Input )
3.2 Production Control Reports

Decision making in production control depends on the proper use of quantitative inputs in a timely manner. The queuing theory model can be used to find out the probability of machines breaking down on a given day using various inputs like the number of machines, their average breakdown rate, and the replacement time required. Some of the input parameters used in this model are: number of machines that can be used for backup, number of workers who can repair the machines, the mean time between failures (MTBF), the mean repair time, cost of the workers who can repair the machines, and cost in terms of production that has been lost due to the breakdown. Management requires regular reports on various production-related parameters and activities for effective production control. These are described in Table 2.
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Table 2: Reports and their Features

Reports Production efficiency report Features Prepared to find out the efficiency of the shop-floor Certain standards are set for the production departments based on machine capacity, required cycle time, manpower required to produce the yield, etc., based on budgetary control and standard costing Gives details of the standard production within a given timeframe as against actual production, or the comparison of the standard time required to produce the given target as against the actual time utilized for the given target Useful in taking corrective actions in case of any irregularity. Used to plan the production activity for a particular shift or day Production planning takes care of crucial resources like manpower, machines, and materials of the organization Lack of proper production planning will lead to wastage of the resources used in the production process The important points considered in the production planning reports are targeted production, cumulative production, capacity per shift, etc. Provides information to the production manager about the activities carried out on the shop-floor during a day Used to rectify any anomalies in the production process. The downtime analysis report is used to control the downtime. Provides the production manager with the reasons for and the length of the downtime To ensure effective management of the shopfloor, the production manager has to increase the efficiency of the production department by cutting down the downtime of the machines. Contains information about all the developments that have taken place during a particular shift As the production process is carried out in two or three shifts, it is the responsibility of the person-in-charge of a particular shift to give a report on the happenings in his/her shift to the person-in-charge of the next shift. Contains details about the production achieved, the materials used, the utilities used, the problems that occurred during the shift, the actions taken to resolve or reduce the problems, etc. 123
Production planning report
Daily production report
Downtime analysis report
Shift handover report
4. Operations Controls
In the business context, an operation is a set of activities carried out to achieve a specific purpose. For instance, purchase operations comprise activities like identification of vendors, comparing vendors, placing orders with vendors, and scheduling and monitoring deliveries from the vendors. Purchase operations ensure timely supply of various materials (raw material or packaging material) required to carry out business, and aims at procuring the materials at optimal costs and quality. Operations of a manufacturing organization can be classified as internal and external operations. Internal operations are executed within the organizational boundaries and have limited or no external linkages. The control elements to such operations are largely defined by the organization and thus can be easily controlled. Internal operations include production operations taking place in the organization, inventory and warehouse operations, and the quality assurance mechanism implemented with respect to the production process and the finished product. However, there may be significant dependencies on external entities. For example, the sales departments inputs on the product mix desired for a future period is an important consideration for production planning, inventory planning, and purchase planning. The marketing and sales, and purchase operations have an external focus as they deal with customers and vendors, respectively, who are external to the organization. They also deal with thirdparty service providers (transporters) to achieve the goals. Quality controls and inventory controls are two important control areas in internal operations, while purchasing controls and warehousing controls are two important control areas in external operations.
4.1 Quality Controls

Quality controls involve setting quality norms for the product or service to be produced and for the various operations of the organization. The quality norms of product will relate to product characteristics or attributes. The products have to adhere to these quality norms before they are dispatched and delivered to the customers. If not, then the production department may have to rework on the product till the norms are adhered to, or the product may be sent for recycling or disposal. The finished products quality is an outcome of both the quality of inputs being used and the quality of the operations which are executed on the inputs. Quality norms are laid down for the incoming material and if it fails to meet these standards, it is rejected and sent back to the vendors. They are also laid down for various processes or operations executed in the production process which are to be adhered to. Quality inspection points in the production process are predefined and inspection may be carried out regularly or periodically on a random basis. A number of tools and techniques like random sampling, destructive quality control, and control charts, are adopted as per the need of the process or product. In control charts, different measurement criteria are plotted on the chart with a central line representing the mean value and two control limits above and below that central value. A process is said to be under control if the noted variable and attribute values fall between these control limits. It is said to be out of control if the values fall outside these control limits, and remedial actions are taken to rectify these discrepancies. Control charts are easy to develop, analyze, and understand.
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Quality control is also exercised over activities that are outside the production domain. It ensures that products satisfy the customer expectations and that the services offered by the organization are able to resolve problems quickly and properly. Total Quality Management, a management philosophy, aims to build and inculcate the quality element in the work ethic of the business itself, and does not view quality as a separate organizational function.
4.2 Inventory Controls

Inventory controls aim at maintaining stocks of materials in desired quantities at various production stages to ensure uninterrupted production, at the same time, keeping the production costs to the minimum. It helps in identifying and tracking the stock available with a department at a particular time. It is carried out for all items used in the production process and ensures that materials are appropriately stocked; correct safety procedures are followed; and storage standards are complied with based on the nature of the material. Inventory policy and procedures include clear rules for stock taking and stock verification to identify and control pilferages and thefts. Efficient inventory control leads to holding right amount of stock in the right place and at the right time, and ensures that the capital does not unnecessarily get tied up in inventory.
4.3 Purchasing Controls

An organizations purchase policy lays down purchasing controls and procedures for executing the purchase process. These controls will track the costs of the materials being procured, the vendors effectiveness in terms of the quality and timeliness of supplies, and the rejection rates. Purchase operations will also involve vendors evaluation based on their reliability, capability, and capacity. An organizations purchase function can be either centralized or decentralized. A centralized system exercises a large degree of control on procurements. It allows pooling of all requirements so that the benefits of bulk purchasing can be realized. It also leads to consistency in buying policies and uniformity in maintenance of purchase records. In a decentralized purchasing system, the procurement managers of different departments purchase the required materials based on their requirements. This gives flexibility to each department to alter its purchasing policy based on its requirements. To provide for the right balance between control and flexibility, most organizations use a combination of both the systems. Each department identifies its specific purchasing requirements while a central authority, such as a purchase manager, manages the actual purchasing activities. The purchase activity is segregated to ensure control over the procurement process and eliminate the possibility of bribery and other malpractices.
4.4 Warehousing Controls

The objective of warehousing controls is to ensure prompt order fulfillment by ensuring that the finished goods are properly stocked, and that the packing and picking lists are prepared. They also ensure that correct safety standards are being complied with in stocking and that correct packaging norms are being followed.
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5. Supply Chain Management

The traditional approach toward operations control related to purchases, inventory, production, and warehouse being viewed as separate and distinct operations, on which control was to be exercised independently. Now, the management of operations starting from inputs procurement to finished goods distribution is collectively referred to as Supply Chain Management (SCM). The chain dealing with the post-production activities is referred to as the downstream chain and involves controlling the outbound logistics. The chain dealing with purchases and inventory leading up to production is referred to as the upstream chain and involves controlling inbound logistics. The supply chain can be classified into three broad sets of processes procurement and storage, transformation and storage, and order management and customer satisfaction. Figure 1 represents the supply chain processes. An organization can enhance its performance by influencing any of these processes. The procurement and storage process is to do with inbound logistics which deal with ensuring timely receipt of material and involves consideration of the transportation element. The transformation and storage process deals with the actual production and storage in the warehouse. Supply chain controls ensure that products produced are in line with the material availability and as per the market demand. The inbound supply chain component provides alerts to the production department on the likelihood of shortages in the near future, and the purchase and stores department work jointly to provide for such shortages. The order management and consumer fulfillment process directs attention to the movement of finished goods from the warehouse to the customer locations and finally to the consumer. The customer orders are fulfilled by packing the products on the basis of packing lists (what should be packed) and picking lists (from where should the goods be picked). Outbound logistics deal with the scheduling of the dispatches, the routes to be taken by the dispatch trucks and the various stopover points, the combination of one or more dispatches in a single shipment, and which mode of shipment to be used till what stage in the dispatch route. If the customer is different from the end consumer, the organization should ensure that the product reaches the end consumer on time and that he/she is happy with the product.
Figure 1: Supply Chain Processes

Procurement and Storage Transformation and Storage Order Management and Consumer Satisfaction
Transportation
Quality Assurance
Transportation
Vendors
Materials
Stores
Materials
Plants (Processing) Finished Warehouses goods
Distribution channels/ customers
Consumers
Purchases
Purchase Request
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Transportation plays a key role in logistics control and management. Through transportation, goods are moved from one place to the other in the supply chain. The various issues involved are timing, routing, promptness, and scheduling of the tasks involved. Timing is important as any delay or errors in delivery would lead to financial losses to the organization, and erosion of the brand image or corporate reputation. Routing and scheduling are concerned with the way to be taken and the plan to be followed, respectively, in the transportation of the goods. These should be framed such that the goods are delivered at the required places in the planned sequence. SCM aims at complete synchronization of every supply chain cycle with the customers final demands. It also aims at controlling and monitoring the vendors supply chains. The current global business environment is characterized by increased distances and longer lead times between the placing of orders and receipt of goods; more complicated transportation routes and distribution patterns; large number of participants in the supply chain; increase in the number of trading partners; difficulty in responding to the consumer demand in a timely fashion; increase in impact of weather or natural disasters on the plans; increase in communication problems; more demanding customers; decreasing product life cycles and time for research and development; increase in the variety of products demanded; and the need for effective coordination among supply chain partners. By focusing on the supply chain element, an organization can control its response to all these challenges, and directly control and influence its speed to market, reduce costs, and fulfill customer needs more effectively than its competitors. Refer to Exhibit II for a brief overview of Pfizers supply chain activities.
Exhibit II: Pfizers Supply Chain

Pfizer Inc.s (Pfizer) supply chain activities were supported by three functional areas -- the distribution/logistics team, the planning team, and the procurement team. The distribution/logistics team at Pfizer coordinates the product movement between the various sites of the company worldwide. The planning team converts the customer requirements into production. They also work along with the marketing and sales team at Pfizer. The procurement team procures raw materials and other inputs for the companys manufacturing and logistics sites located worldwide. The companys order entry system and material resource planning (MRP) system is linked to a fulfillment management system. This helps in providing inventory to the production and distribution sites of the company located worldwide; curtailing Pfizers dependence on supply-to-order; creating a supply chain replenishment model for enhancing service levels and inventory turnover; and increasing visibility into the supply chain. Pfizer also launched a new packaging security measure for the products it sells in Europe to fight out supply chain related risks like fake and inappropriate re-packaging.
Adapted from 10 Best Supply Chains of 2004, December 08, 2004, <http://outsourcedlogistics.com/ global_markets/outlog_story_6813/>.
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5.1 Performance Assessment of the Supply Chain

Supply chain performance can be evaluated by using metrics like inventory turns and cycle time. These metrics help in giving ideas about the ways to optimize the supply chain performance. They also allow the management identify problem areas and compare similar organizations using tools like industry benchmarking. There should always be people or departments responsible for achieving a target on the metric. Some of the supply chain metrics are explained in Table 3.
Table 3: Supply Chain Metrics and their Descriptions

Supply Chain Metric Inventory turns or inventory turnover Projected inventory turns Description Refers to the number of times an organizations inventory turns over per year Calculated by dividing the annual cost of sales by the average inventory level. Refers to the number of times an organization projects or estimates its inventory to turn over per year Calculated based on estimates and not on actual values Calculated by dividing the total cost of a 12-month sales plan by the total cost of goal inventory Refers to the total time that elapses in moving a unit of work from the beginning to the end of a physical process Includes process time during which the unit is acted upon to bring it closer to an output, and delay time, during which the unit of work is spent waiting to take the next action. Refers to the anticipated or agreed upon cycle time of a purchase order Gap between the purchase order creation date and the requested delivery date. Refers to the average time taken to actually fulfill a customers purchase order The length of time between the date on which the order is sent/received/entered and the date of delivery to the customer. Refers to the number of days between paying for the raw materials and receiving payment for the finished product Calculated by inventory days of supply plus days of sales outstanding minus average payment period for material.
Cycle time
Customer order promised cycle time
Customer order actual cycle time
Cash to cash cycle time
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Supply Chain Metric Supply chain cycle time Defects Per Million Opportunities (DPMO)
Description Refers to the total time that would be taken to satisfy a customer order if all inventory levels were zero Calculated by adding up the longest lead times in each stage of the cycle. DPMO (total number of defects per one million opportunities) is a measure of process performance used in Six Sigma calculations. DPMO =
Total number of defects Number of units Number of opportunit ies per unit
1,000,000
6. Information Systems in Production and Operations Management

Traditionally, information systems were used in production and operations management to build separate systems for the functional areas of purchase, inventory, production, and warehouse. The purchase system was used to compare vendor quotations and raise purchase orders. The inventory management system was used to enter receipts from vendors, enter issues to plants and departments, calculate the stock of materials, and indicate their storage location. The production system was used to calculate material consumption, to calculate wastages, to record machine downtimes, to develop the production plan and production schedules, and to keep track of employees on the shop floor. The warehouse system was used to record the receipts and dispatches of finished goods, and the location of the various types of finished goods. Today, the role of information systems in production and operations management has evolved from the piecemeal, standalone approach to a tightly knit integrated approach (integrated information system). Progress in telecommunication technologies and networks has enabled development and implementation of integrated production and operations information systems. Information systems integrate the entire supply chain. Operations information systems are designed to automatically initiate, plan, and execute the logistics of stock movement from the warehouse to the branches or the customer locations. Third party transportation companies also facilitate the tracking of the exact location of the shipment at any given point of time, en route to the destination.
7. Summary
For a manufacturing organization, the conversion of inputs to outputs is viewed as the production activity; and operations cover the processes involved in procuring the inputs and ensuring the optimal supply of finished goods to the customers or consumers in order to satisfy their needs. Production operations include the various activities executed during the production process. Operations management and control covers both production and non-production operations. Production and operations, when combined and synchronized, would be classified as supply chain management (SCM).
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The production controls which are established in a manufacturing organization are dependent on the nature of the production process (process (continuous) production or discrete (assembly line) production) and the degree of mechanization (high or low) involved in the production process. Productivity is used as a control tool to ensure that all the resources are utilized judiciously and efficiently. Productivity can be measured in relation to a single factor such as labor or material (single factor productivity), a combination of some factors (multifactor productivity), or all the factors taken together (total productivity). A variety of reports are made use of to ensure effective production control like production efficiency report, production planning report, daily production report, downtime analysis report, and shift handover report. In the context of a business, an operation is a set of activities carried out to achieve a specific purpose. The various operations of a manufacturing organization can be classified as internal and external operations. Quality controls and inventory controls are two important control areas in internal operations. Purchasing controls and warehousing controls are two important control areas in external operations. Operations starting from procurement of inputs to distribution of finished goods are grouped together and are collectively referred to as SCM. The chain dealing with the post-production activities is referred to as the downstream chain and involves controlling the outbound logistics. The chain dealing with purchases and inventory upto production is referred to as the upstream chain and involves controlling the inbound logistics. The performance of the supply chain can be evaluated with the help of metrics like inventory turns or inventory turnover, projected inventory turns, cycle time, customer order promised cycle time, customer order actual cycle time, cash to cash cycle time, supply chain cycle time, and defects per million opportunities (DPMO). Information systems play a crucial role in production and operations management. Information systems of the present day integrate the entire supply chain. The present day automated operations information systems plan, execute, and reliably track the logistics of stock movement from the warehouse to the branches or the customer locations.
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Concept Note - 10
Performance Management of Production and Operations (B)

1. Introduction
In the concept note Performance Management of Production and Operations (A), we discussed production controls, operations controls, control of the entire supply chain, and the role of information systems in production and operations management from a control perspective. In this note, we focus on controlling cost of operations and a few techniques for enhancing organizational performance. We also discuss the areas of operational audit and safety audit.
2. Controlling Cost of Operations

Conventional cost control systems focus on maintaining current level of costs rather than on working toward reducing them. Strategic cost management involves identifying areas that have the potential to reduce costs and working to improve process efficiency and effectiveness in these areas. The important strategic cost management techniques address areas which include: Costs associated with making versus buying a component (make-or-buy analysis) Life cycle costing Cost management based on the ability and willingness of the customer to pay a certain price (target costing) Activity-specific costs incurred on production and operations (activity-based costing) Costs associated with each step of value creation (cost management across the value chain) Environmental cost management
2.1 Make-or-Buy Analysis

Make-or-buy analysis helps managers determine whether it is more economical to produce an item in-house or to purchase it from external vendors. A typical make-or-buy decision is based on break-even analysis. Refer to Figure 1 for a diagrammatic representation.
Figure 1: Make-or-Buy Analysis
In the case of buying an item from external sources, there are no fixed costs associated. The total cost of buying is the product of price per unit (P) and the number of units demanded (Q), i.e., Total Cost buy = P Q On the contrary, if the item is made in-house, some fixed cost (F) on equipment and facilities installation is incurred. Also, variable production cost which is equal to variable cost per unit (V) times the number of units demanded (Q) is incurred. The total cost of making will be: Total Cost make = (VQ) + F At the break-even point, the total cost of buying is equal to the total cost incurred on making the item in-house. Let us assume that the break-even point is reached at Q1 units. P Q1 = (VQ1) + F Q1 = F/ (P-V) If the annual demand for the product is less than Q1, the total cost of purchasing the product from an external vendor will be less than the total cost of making it in-house. If demand is greater than Q1, the total cost of making the product in-house will be less than the cost of purchasing it from an external vendor. Apart from the cost of the product, organizations consider many other factors before making a make-or-buy decision -- availability of raw materials in the long run and the ability to monitor and control quality are some such factors. Many organizations maintain both make and buy capabilities to ensure prompt delivery of materials. Organizations may opt for in-house production to have control over all the value chain activities, to put excess plant capacity to productive use, or to ensure that confidentiality of product design is maintained. Organizations may opt for outsourcing of a material to take advantage of the expertise of suppliers, to avoid infrastructure expenditure when the volume of material required cannot justify in-house production, or to maintain a multiple source policy.
2.2 Life Cycle Costing

The three stages of a typical product life cycle are: the planning and design stage, the production stage, and the service and abandonment stage. Life cycle costing analyzes the costs incurred on a product throughout its life cycle, i.e., both during the pre- and post-manufacturing phases of the product. Thereby, it helps to correctly determine the profitability of the product. Life cycle costing helps the management identify the areas where cost reduction techniques are to be implemented. It also helps to find out new products that can be introduced. In life cycle costing, certain costs known as committed or locked-in costs, are involved. These are costs that have not yet been incurred but will be incurred in future due to decisions that have already been taken. A major portion of such costs is committed to during the planning and design stage of the product life cycle, although a significant amount of costs is actually incurred at the manufacturing stage. 132
2.3 Target Costing

Target costing concentrates on managing costs during the planning and design stage of a product. It involves four stages: i. Identifying the price that customers are ready to pay for the product
ii. Deducting the target profit margin from the target price to determine the target cost. iii. Estimating the actual cost of the product iv. Finding ways to reduce the actual cost to meet the target cost -- in case of estimated cost exceeding the target cost. Target costing is primarily a customer-focused method. Through market research, an organization tries to estimate the value which customers may attach to the product (based on features and attributes) vis--vis competing products. The planned return on investment determines the target profit margin from the product. The target cost is calculated by deducting the target profit margin from the target price of the product. It is then compared with the predicted actual cost of production. If the predicted actual cost is more than the target cost, then efforts are made to reduce costs wherever possible to match the two costs. A team is constituted with personnel from design, marketing, finance, production, and purchasing departments to arrive at a target cost of production, at a predetermined level of functionality and quality. It is ensured that preferences and recommendations of all functional areas are represented equitably in this process. The target cost is arrived at by adding only those product features that will be valued by customers. The product cost should be monitored during the development stage to ensure that the product is developed within the target cost. The advantage of target costing is that it is done during the planning and design stage of the product life cycle and as a result can have a significant impact in determining the committed costs. The target cost process is iterative where several design alternatives are analyzed. Such products or product designs should not be taken to production if the cost of designing the product exceeds the target cost. Products should be designed in such a way that the costs of producing them are equal to or less than the target costs, no compromises having been made on their functionality.
2.4 Activity-Based Costing

Activity-based costing is based on the premise that if activities can be managed, then the costs associated with them can also be managed. It involves allocating costs to each and every activity of the organization and determining the cost driver for each major activity. The aim of activity-based costing is to satisfy the needs of customers by utilizing minimal organizational resources. It provides information about the output derived from each activity that may cross departmental boundaries -- the activitys cost is spread across all the departments in which costs have been incurred. Else, the entire cost of the activity will be assigned to one department, although costs related to the activity have been incurred in other departments. This method helps the management in developing strategies to perform activities more efficiently. For reducing costs incurred on activities that are performed, activities are classified as value adding and non-value adding. Value adding activities are those that 133
customers perceive as adding to the usefulness of the product or service purchased by them. A non-value added activity provides scope for cost reduction, without reducing the products value as perceived by the customer. Although it is difficult to clearly distinguish between value adding and non-value adding activities, organizations should try to ensure that customers do not pay for non-value adding activities. They should identify ways and means of reducing costs incurred on such activities either by totally eliminating them or by improving their performance efficiency. Kaplan and Cooper have suggested that organizations classify their activities based on a five-point scale to overcome the limitations of the value adding and non-value adding classification. According to them, an activity can be highly efficient with very low (below 5%) scope for improvement; moderately efficient with little (5-15%) scope for improvement; efficient on an average scale with potential (15-25%) scope for improvement; inefficient with a significant (25-50%) scope for improvement; and highly inefficient with (50-100%) considerable scope for improvement.
2.5 Cost Management across the Value Chain

Value chain analysis involves evaluating the various activities in the value chain, improving their efficiency, and identifying the areas for cost reduction. Higher the efficiency of the value chain, the greater the competitive advantage an organization can achieve in the market. The value chain activities are interlinked and so, the performance of one activity influences that of another each link should be perceived as a customer by its previous link. This process ensures satisfaction to the final customer in the value chain, and also helps in obtaining valuable feedback about the products quality at each stage of the succeeding stage. Comparing the organizations value chain with that of competitors or the industry provides ideas that can be used to further enhance the activities in the value chain. In such a comparison, the industrys value chain is identified, and then the activities that incur unnecessary costs in the value chain are identified. Finally, the organization works toward achieving lower costs than its competitors. Such an analysis helps the organization assess its strategic position in the industry in relation to its competitors. Long-term relations with suppliers and distributors helps an organization reduce costs and provide value to its customers by providing better quality products.
2.6 Environmental Cost Management

Environmental cost management is gaining importance since governments across the world are imposing stringent regulations for organizations to comply with in order to protect the environment. Considering the huge size of investments being made by organizations, especially those engaged in oil and gas sectors, managing environmental costs has become very important. Environmental costs are generally hidden and are allocated arbitrarily, and therefore cannot be traced back to the products they are related to. In some organizations, environmental costs are equally attributed to all the products even though only one product is actually responsible for them, which leads to incorrect costing of products. Organizations should prepare an environmental cost report that states the costs incurred by it on account of its environment development and sustainability initiatives. It presents an overall picture to the top management of the environmental costs incurred by the organization which can be used to identify areas that have scope for cost reduction. Four cost categories environmental protection costs (costs 134
incurred in preventing waste production that may harm the environment), environmental appraisal costs (costs incurred to ensure that the organizations activities confirm to the environmental regulatory laws imposed by the government), environmental internal failure costs (costs incurred on waste elimination which has not been released into the environment), and environmental external failure costs (costs incurred on waste elimination that has been discharged into the external environment) are reported.
3. Enhancing Organizational Performance

Due to the dynamic and complex business environment, organizations, irrespective of the markets being served, should consider business practices of both local and global competitors. Consumers are becoming more aware of product offerings, quality, and price-value associations, and are setting clear price-performance parameters in their minds. To survive and grow in such an environment, an organization requires distinct techniques value engineering, business process reengineering, Kaizen, total quality management, benchmarking, benchtrending, just-in-time, lean manufacturing, and Six Sigma that guide and control organizational performance.
3.1 Value Engineering

Value engineering is the process of analyzing the factors that influence the product cost so that the necessary quality standards and functionalities can be obtained to arrive at the target cost. It is used as a target costing tool and aims at obtaining the preset target cost by examining improved product designs that can reduce the costs without compromising on the products functionality. Value engineering helps in eliminating from the product design all those functions that are not valued by customers and also those that tend to increase the manufacturing cost. Through functional analysis, product features are analyzed individually, based on the amount the customer is ready to pay for each of them. After collecting this information through surveys, it is analyzed to arrive at the products selling price by estimating the total of all the values of each product function. The target cost of production is arrived at after deleting the target profit from the estimated selling price. The cost incurred on each product function is compared with the customers perceptions of the value from such function. This technique helps organizations to remove those functions from a product where the costs exceed the value as perceived by customers.
3.2 Business Process Reengineering

A business process is a set of logically related tasks carried out to accomplish a defined business outcome. Business process reengineering (BPR) is a management technique used to improve operational effectiveness, efficiency, and profitability through a fundamental and radical redesign of business processes. Michael Hammer and James Champy defined reengineering as the fundamental rethinking and radical redesign of business processes to achieve dramatic improvements in critical, contemporary measures of performance such as cost, quality, service, and speed. BPR involves significantly altering the existing systems and simplifying the processes to improve productivity, reduce costs, and adopt better business practices. It may also result in redesigning the corporate structure around the business processes. Transformation is done by rethinking the organizations activities in a holistic and process-oriented manner rather than by merely automating existing processes. 135
Progressive and proactive organizations create new industry benchmarks by reengineering their business processes and so, gain a competitive edge through superior performance.
3.3 Kaizen
Kaizen is a term used for making improvements in processes through small increments rather than through large-scale innovations. Japanese organizations follow Kaizen to improve productivity, and to reduce/control costs. Kaizen costing is applied during the production stage, and aims at reducing costs by focusing on improving the manufacturing process. Employees are given the power to improve processes, and are encouraged to identify ways to reduce costs, as they are closely associated with the production process and the customers.
3.4 Total Quality Management

Total quality management (TQM) helps improve the effectiveness and flexibility of the business as a whole by organizing and involving every department, activity, and person across all hierarchical levels. It is an integrated effort to gain competitive advantage by continuously improving every aspect of the organization. The underlying principle of TQM is continuous improvement which is possible through incremental steps or a breakthrough improvement. TQM includes external customers and suppliers in the work processes. It emphasizes doing things right for the first time and every time, and attempts to make every organizational aspect customer-oriented. It is a management philosophy to guide a process of change and starts at the top. The top management establishes a quality management system by determining and communicating the quality policies to all employees. It also has to demonstrate its commitment to quality by establishing it as the organizations topmost priority. The differences between TQM and traditional management are given in Table 1.
Table 1: TQM vs. Traditional Management

TQM Customers are viewed as important resources that drive the processes of the organization. Assumes that profits follow quality. Views quality as a composition of multidimensional attributes. Economy of time and scope are considered for achieving higher efficiency. Emphasis is on quality, flexibility, and service. It is the responsibility of both managers and workers, to achieve the goals of the organization. 136 Traditional Management Customer is considered separate from the organization. Assumes that quality follows profits. Does not hold this view. Only economy of scale is considered for increasing efficiency. Emphasis is on cost, efficiency, and productivity. technical
Workers should work and managers should manage.
TQM Emphasis on a multi-skilled workforce that can be used for different kinds of jobs. Process-oriented approach. Advocates a flat organization with networking among the functions.
Traditional Management Belief in division of labor and separation of manual work from mental work. Result-oriented approach. Proposes a hierarchical and vertical organization structure.
3.5 Benchmarking
Benchmarking involves comparing the organizations practices with the best international practices. It helps to find the best way to perform operations that would lead to superior organizational performance. By comparing its own operations with that of industry leaders, the organization can control the limitations and eliminate weaknesses in its operations. Benchmarking can be classified as competitive and generic. Competitive benchmarking focuses on the products and manufacturing processes of the organizations competitors. This is done to exercise control over product performance with regard to competitors products, and to enhance manufacturing capability and eliminate wasteful processes. Generic benchmarking evaluates the organizations processes with those of other organizations, which are considered to be the best in those processes, irrespective of the nature of the industry. Industries which share some characteristics can also be identified and selected best practices can be adopted from those industries. Steps Involved in Benchmarking The steps involved in benchmarking are: Determining the functions to be benchmarked. The functions that need to be benchmarked are those which have a significant impact on business performance. Identifying the critical success factors of the functions to be benchmarked. Typical critical success factors are quality and delivery. Identifying the best-in-class organizations. Measuring their performance and comparing them with the organizations performance that is to implement benchmarking. Taking suitable actions to meet or exceed the performance of the best-in-class organization. Refer to Exhibit I for the pioneering benchmarking initiatives at Xerox Corporation.
Exhibit I: Benchmarking Initiatives at Xerox Corporation

Xerox Corporation (Xerox), one of the worlds leading copier companies, started its benchmarking initiative in the 1980s as part of its Leadership by Quality program. Initially, the company went in for competitive benchmarking. It defined benchmarking as the process of measuring its products, services, and practices against its toughest competitors, identifying the gaps and establishing goals. Our
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goal is always to achieve superiority in quality, product reliability, and cost. However, it found this type of benchmarking inadequate as competing copier companies were not adopting the very best practices in many business processes. The company then adopted generic benchmarking, which involved a study of the best practices followed by a variety of companies regardless of the industry they belonged to. Xerox benchmarked its warehousing and inventory management system against that of L.L. Bean (Bean), a mail-order supplier of sporting goods and outdoor clothing. Bean had developed a computer program that made order filling very efficient. The program arranged orders in a specific sequence that allowed stock pickers to travel the shortest possible distance to collect goods at the warehouse. This considerably reduced the inconvenience of filling an individual order that involved gathering relatively fewer goods from the warehouse. The increased speed and accuracy of order filling achieved by Bean attracted Xerox. The company was convinced it could achieve similar benefits by developing and implementing such a program. Similarly, Xerox zeroed in on various other best practice companies to benchmark its other processes. These included American Express (for billing and collection), Cummins Engines and Ford (for factory floor layout), Florida Power and Light (for quality improvement), Honda (for supplier development), Toyota (for quality management), Hewlett-Packard (for research and product development), Saturn (a division of General Motors) and Fuji Xerox (for manufacturing operations), and DuPont (for manufacturing safety). The first major payoff of Xeroxs focus on benchmarking and customer satisfaction was the increase in the number of satisfied customers. Highly satisfied customers for its copier/duplicator and printing systems increased by 38 percent and 39 percent respectively. Customer satisfaction with Xeroxs sales processes improved by 40 percent, service processes by 18 percent, and administrative processes by 21 percent. The financial performance of the company also improved considerably through the mid- and late 1980s. Overall, customer satisfaction was rated at more than 90 percent in 1991. During the 1990s, Xerox, along with companies such as Ford, AT&T, Motorola, and IBM, created the International Benchmarking Clearinghouse (IBC) to promote benchmarking and to guide companies across the world in benchmarking efforts.
Source: Radhika, Neela A. and A. Mukund. Case Study Xerox: The Benchmarking Story. The ICMR Center for Management Research, 2002. <www.icmrindia.org>.
3.6 Benchtrending
Benchtrending helps in controlling and directing an organizations response to the volatility of market forces and the industry dynamics in which it operates. It involves reviewing the existing situation and anticipating changes in the market, and consumer preference variables and evaluating their impact, to control the degree of performance gap that might emerge due to better responsiveness of competitors to the market forces. Benchtrending can be broadly classified into strategic benchtrending and process benchtrending. 138
Strategic benchtrending controls the growth direction of the business unit and sets long-term goals and objectives. It involves defining the market by size, customer preference, competition, etc., and assessing future industry trends and technological shifts. Current and potential competitors are identified and then the organizations current and projected performance is compared with that of competitors. Necessary actions are then taken to bridge the performance gap with the best-in-class organizations. Process benchtrending is used to control the performance of a specific function or process of the organization. It involves understanding the requirements of the process to be benchtrended and the process flow. Processes adopted by present and potential competitors have to be studied and compared, and necessary action taken to eliminate the process gap.
3.7 Just-in-Time (JIT)

Material cost has two cost components -- the procurement cost (also called ordering cost) and the holding cost in stores. Both these costs are inversely related to each other. Both these costs can be controlled using the JIT technique. To reduce procurement costs, JIT uses stable relationships and electronic links between the organization and its vendor(s). Whenever the material nears reorder levels, the vendor automatically ships the material so that it reaches the organization exactly when it is required. Thereby, the average inventory level is maintained at very low levels, reducing the inventory holding costs.
3.8 Lean Manufacturing

Lean manufacturing, a business strategy introduced by Toyota, focuses on the elimination of process waste. It is estimated that only 5 percent of manufacturing activities actually add value to the product implying that the remaining 95 percent are a waste as the organization does not get paid for them. Lean manufacturing identifies 7 kinds of wastes overproduction, waiting time, transportation, excessive inventory, over processing, unnecessary motion, and quality problems and concentrates on reducing these wastes. According to the Lean philosophy, elimination of wastes leads to enhanced productivity and quality, thereby leading to cost reduction. The financial performance improvements begin to surface in a short period, typically within 12-36 months from the time lean manufacturing is implemented. Improvements include gross margin, cash flow, inventory turns, floor space reduction, sales/employee improvement, and customer satisfaction. These improvements motivate employees to improve process flow and eliminate items that do not add value. There is also focus on improving formal and informal communication, which helps solve problems more effectively. The five critical elements necessary for successful implementation of lean thinking are leadership, vision and planning, execution, present-day focus, and follow-up, of which leadership is the most important factor. The success factors required within the leadership component for the successful implementation of lean thinking are: Identification of and taking apt steps against employees not supportive of the management decisions and who disrupt the process and harm the management teams credibility. Investment in employee training. Every employee should be allocated 40-50 hours of training per year. 139
Interaction of managers with employees to motivate them and to get a better understanding of the processes, and to look for ways to make the employees jobs easier. Establishment of accountability and discipline so that employees know what is expected of them, and the consequence of not doing what is expected. Taking care of and personally thanking employees for their efforts and contribution. This will strengthen the bonding between employees and the organization. Proper communication with employees about business performance, changes in the business, and the direction the organization is taking to ensure smoother transition to the lean mode. Provision of an environment in which employees are allowed to express their ideas and then work to implement them. Creation of a set of goals (with respect to the organizations financial performance and customer satisfaction), which should be easy to understand and achievable and to which everyone can relate. Hiring of a leader with experience, as transition to lean is fundamentally different and complex compared to the traditional management processes.
3.9 Six Sigma

Six Sigma is a technique used to meticulously manage process variations that cause defects and to work systematically to manage those variations and eliminate the defects. It is a powerful tool specially designed to solve complex quality problems. Six Sigma was first introduced in early 1980s by Motorola, and was later popularized by organizations like GE. Six Sigma controls defect occurrence, thereby, resulting in world-class performance, reliability, and value for customers. Refer to Exhibit II for the impact of the Six Sigma implementation program at GE.
Exhibit II: Six Sigma Implementation at GE

Jack Welch (Welch), CEO at GE between 1981 and 2001, pioneered the implementation of Six Sigma at the company. Although skeptical at first, he initiated a huge program for its implementation -- to the extent that its scope was considered unprecedented in any other company. The target of improving the quality at GE was 10,000 times greater than that of its competitors. Welch made the official launch announcement of the quality initiative in January 1996 setting year 2000 as the target year for becoming a Six Sigma quality company. Welch expected the following qualities in his employees for implementation of Six Sigma: enormous energy and passion for the job; ability to excite, energize, and mobilize the organization around Six Sigma benefits; understand that Six Sigma is all about customers winning in their marketplace and the GE bottom line; should have the technical grasp of Six Sigma which is bettered by a strong financial background and capability; and has real edge to deliver bottom-line results -- not just technical solutions.
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The results of the implementation of Six Sigma at GE were phenomenal. GE achieved 11 percent increase in revenues, 13 percent increase in earnings, 9.2 percent increase in working capital turns, and 17 percent increase in the operating margin during the first two years of implementation.
Adapted from Six Sigma and Quality Revolution at GE, <http://www.1000ventures.com/business_ guide/cs_quality_six-sigma_ge.html>.
Refer to Table 2 for a description of DMAIC which is an important methodology for Six Sigma implementation, especially for enhancing the quality of the existing processes of an organization.
Table 2: The DMAIC Methodology

Stage D= Define Description Customers are identified and their service or product requirements are understood. Critical to Quality (CTQ) issues are defined from their perspective. The overall scope of the improvement project is defined. The process flow is mapped and the processes that need improvement are specified. Process-related metrics and defect data are collected in a planned manner from appropriate sources such as process measurements and customer surveys. The root causes of defects and process variations are determined. The areas that need improvement are identified and prioritized based on the organizations needs. To address the prioritized areas of improvement, solutions are developed from two perspectives: corrective action for existing problems and preventive action for new problems that may occur. On testing and implementing the solutions, the actual improvement is measured. Control mechanisms such as periodic monitoring, training programs, and changes in reward systems are put in place in order to institutionalize the improvements, and to prevent the recurrence of defects and process variations that had occurred earlier.
M= Measure A= Analyze I= Improve
C= Control
Adapted from <http://www.isixsigma.com/dictionary/DMAIC-57.htm> and other sources.
4. Operational Audit
Operational auditing is a technique for appraising the effectiveness of a unit or function on a regular and systematic basis against corporate and industry standards. It is done to identify areas for improvement and to assure the management that its aims are being carried out. Operational audit plays a vital role in appraising the management about an operations efficiency, effectiveness, and profitability. Such an audit is performed on a continuous basis by internal auditors or consultants specializing in various areas such as engineering, survey, designing, and accounting. 141
The audit report has to disclose the effect and status of the existing operation vis--vis the overall objectives. Operational audit is a future-oriented, systematic, and independent evaluation of the organizations activities. The primary sources of evidence for this audit are the operational policies and achievements related to organizational activities, though financial data may be used. The differences between management audit and operational audit are given in Table 3, and those between financial audit and operational audit in Table 4.
Table 3: Differences between Management Audit and Operational Audit

Management Audit Management audit is an audit of the management. Management audit is concerned with the quality of management. It critically analyzes and evaluates management performance. Management audit tests the effectiveness of the top management, its formulation of objectives, plans, and policies, and its decision-making. Operational Audit Operational audit is an audit for the management. Operational audit is concerned with the quality of operations.
Operational audit verifies the operations of control and procedures, and fulfillment of plans in conformity with the prescribed policies.
Table 4: Differences between Financial Audit and Operational Audit

Financial Audit Financial audits concentrate on assessment of the financial statements based on generally accepted accounting principles. Financial audit results are often reported to external entities or stakeholders such as shareholders, regulatory agencies, and the general public. The scope of financial audits is restricted to the financial aspects of the organization. Financial audits are conducted by both internal and external auditors. Financial audits are conducted at the end of every fiscal year by a certified external auditor. Apart from that, halfyearly or interim audits can be conducted by internal auditors. 142 Operational Audit There are no generally accepted standards for operational audit.
Operational audits are for internal use.
Operational audits may be directed toward many non-financial areas such as personnel and engineering. Operational audits are conducted by internal auditors or consultants. The timing of operational audit depends on the discretion of the management.
4.1 Usefulness of Operational Audits

As an important tool for management control, operational audits ensure proper performance in each functional or organizational area for achieving the organizational objectives. An operational audit is an effective tool for performance appraisal and is concerned with the availability of acceptable standards, and with accumulating evidence to measure the effectiveness and efficiency with which the operations are being carried out. It is also useful in the appraisal of objectives, plans, and organization structure.
4.2 Steps in Operational Audit

The various steps in operational audit are purpose definition, knowledge gathering, preliminary survey, development of program, field work, reporting, and follow-up. These steps are described in Table 5.
Table 5: Steps in Operational Audit

Steps Purpose definition Description The scope of the audit including the particular aspects of the organization, function, or group of activities to be audited is identified. A comprehensive knowledge of the objectives, organization structure, and operating characteristics of the unit to be audited are obtained. A preliminary survey of the function or unit is done to get an idea about the critical aspects of operation and potential problem areas. A customized program is developed for the audit of a particular function. The program developed is actually executed. A report is developed based on the findings of the fieldwork; it includes suggested improvements in the operational policies and procedures of the unit or function, and instances of non-compliance with existing policies and procedures. It includes determination of whether the recommendations of the operational audit report are being effectively implemented.
Knowledge gathering Preliminary survey
Development program Field work Reporting
of
Follow-up
4.3 Classification of Operational Audit

Operational audit can be broadly classified into three categories functional, organizational, and special assignment. A functional audit addresses a particular set of activities, like marketing or purchasing. An organizational audit deals with organizational units like departments or manufacturing plants and not with individual activities or processes. It studies the organizational units effectiveness and efficiency. 143
A special assignment operational audit deals with process, quality, safety, risk, environment control techniques, etc. While these audits are generally initiated at the request of the management for varied purposes, they can also be undertaken on a regular basis.
5. Safety Audit
To manage risks effectively, safety should be treated as any other business area. Authority and resources should be given to people who will manage risks and be liable if anything untoward happens. Safety performances should be evaluated against set targets to find out the scope for improvements in future. Safety audit is the study of an organizations operations and assets. It discovers existing and potential hazards, and the actions needed to render these hazards harmless. Organizations should do periodic safety audits to improve their safety programs. The areas to be assessed in a safety program are: Accident, disease, illness, or injuries of employees arising due to occupation Safety issues of organization-owned automobiles Safety issues related to the physical plant of the organization -- includes fire prevention and machinery condition, and condition of the plant building Safety issues related to business functions occurring away from the organization premises Safety issues related to the product, if the organization is a manufacturer. The focus of safety audits varies widely from organization to organization, depending on the nature of their operations, nature of the products, management focus, etc. There is no standard safety audit procedure; it needs to be customized for various organization types. Certain points to be kept in mind when conducting safety audits are: Whether safety is among the top priorities for the top management Whether the line managers and supervisors make safety a priority Whether managers have the authority to make safety a priority Whether the organization measures the safety performances and publicizes the results Whether the work-site and work practices are reviewed Whether the investigation process, as to finding answers to questions like who is charged with fact-finding after accidents and whether the organization takes lessons from the investigations to avoid future mishaps, is effective.
6. Summary
Strategic cost management ensures cost reduction in addition to enhancement of the various processes of the organization.
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Make-or-buy analysis, life cycle costing, target costing, activity-based costing, cost management across the value chain, and environmental cost management are some techniques used to manage and/or reduce costs of production and operations. The make-or-buy analysis helps managers to determine whether it is more economical to produce the item in-house or purchase it from external vendors. Life cycle costing analyzes the costs incurred on a product throughout its life cycle. Target costing concentrates on managing costs during the planning and design stage of a product. Activity-based costing is a method of allocating costs to each and every activity of the organization and determining the cost driver for every major activity. Value chain analysis involves evaluating the various activities in the value chain, improving their efficiency, and identifying the scope for cost reduction. An environmental cost report generated through environment cost management states the costs incurred by the organization with regard to its environmental development and sustainability initiatives. Value Engineering, Business Process Reengineering, Kaizen, Total Quality Management, Benchmarking, Benchtrending, Just-in-Time, Lean Manufacturing, and Six Sigma are some techniques that can be used to enhance organizational performance. Value engineering is the process of analyzing the factors that influence the cost of the product so that the necessary quality standards and functionalities can be obtained in order to arrive at the target cost. Business process reengineering (BPR) is a management technique through which an organization can improve its operational effectiveness, efficiency, and profitability through a fundamental and radical redesign of business processes. Kaizen is an approach to productivity improvement that is applied during the production stage. It aims at cost reduction by keeping its focus on improving the manufacturing process. TQM is an integrated effort to gain a competitive advantage by continuously improving every aspect of the organization. Benchmarking involves comparing the practices of the organization with best management practices from across the globe. Benchmarking can be broadly classified into two types competitive and generic. Benchtrending helps in controlling and directing the organizations response to the volatility of the market forces and the dynamics of the industry in which it operates. Benchtrending can be broadly classified into strategic and process benchtrending. Just-in-Time or JIT is a technique which helps in controlling the inventory costs on both the fronts of procurement costs as well as holding costs. Lean manufacturing is a business strategy focused on the elimination of process waste. Six Sigma is a rigorous technique used to manage process variations that cause defects and to work systematically to manage those variations in order to eliminate the defects. 145
Operational auditing is a technique for appraising the effectiveness of a unit or function on a regular and systematic basis against corporate and industry standards. Operational audits can be broadly classified into three categories functional audits, organizational audits, and special assignment audits. A safety audit is the study of an organizations operations and assets that aims at identifying existing and potential hazards, and the actions needed to render these hazards harmless. It is important for organizations to periodically assess the soundness of their safety systems.
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Concept Note - 11
Performance Management of Service Organizations

1. Introduction
In recent times, the number, scale, and scope of service organizations have been on the rise. In many countries, the services sector has overtaken the agriculture and manufacturing sectors in terms of contribution to the gross domestic product. The growing importance of services for the growth of the economy has in turn increased the need for proper management and control of service organizations. This note will help you understand: The characteristics of services The different generic techniques used in controlling services The different ways in which service organizations are classified The control mechanisms used in controlling different categories of service organizations.
2. Characteristics of Services
Service organizations differ from manufacturing organizations with regard to certain attributes, which are:
2.1 Intangibility
Unlike products, services cannot be counted, measured, or felt. It is difficult to explain to the customer what a specific feature in the service will give to the customer. As services are intangible, the perceptions of customers regarding the service may differ at any given point in time. Each customer will have a different experience from the same service. Due to this intangibility factor, evaluating the quality of service poses a major problem for service organizations.
2.2 Heterogeneity
Heterogeneity of services means different people rate the characteristics of services differently. It is easy to assess the quality of a product as it is tangible and also because there are specific characteristics associated with each product. But in the case of services, there are different characteristics and different people may rate these characteristics differently. The services provided involve human interactions (between the service personnel and customer), it is not possible to ensure that all customers receive or perceive the same level of quality every time. Heterogeneity has an effect on three areas service encounter, productivity, and service quality. Management control of service organizations has to grapple with all these implications of heterogeneity of services.
2.3 Inseparability
Irrespective of whether a service is provided by a person or by a machine, the production and consumption of the service cannot be separated from the source that provides it. Services involve the customer in the production process and they generally first get sold, then produced, and then consumed. Thus, inseparability is an integral attribute of services and it has a major bearing on service delivery. The production of the service requires the customer to communicate with the producer to get the desired output.
2.4 Perishability
Services cannot be stored. They are consumed as soon as they are produced. This describes the perishability characteristic of services. In the hotel industry, the metric associated with the perishability characteristic is the occupancy rate the percentage of rooms that are occupied at a given point of time.
3. Generic Techniques for Control of Services

Service organizations differ from manufacturing organizations in many respects. Due to these differences, the planning and control processes used in service organizations are also quite distinct from those used in manufacturing organizations. Service organizations use some generic techniques to manage and control their operations.
3.1 Service Blueprinting

A service blueprint is a map or a diagrammatic representation of the service delivery process, the associated tangible evidence, and the employees involved in the service delivery process. Service blueprinting is the process of designing the service blueprint. Service blueprinting involves the following steps: Identification of all activities in the service to be blueprinted Identification of activities which may create problems in the delivery process Estimation of time for service delivery taking into consideration the profitability, quality of service, and reputation of the organization The benefits of blueprinting are: It reduces the likelihood of a service being provided in an adhoc fashion. It encourages a controlled service delivery process so that variations in the quality of a service are reduced. It provides a precise picture of the process to be followed leaving minimal chances of misinterpretation. It helps the marketing department in identifying the need for redesigning existing services and also developing new services. The blueprint helps the human resource department in identifying needs for recruitment, training, and development and the need to redefine performance standards. In mapping the time that may be spent on each activity, it helps employees in better time management. In mapping service features, it is able to highlight those features which are considered important by the customer and eliminate those perceived to be unnecessary.
3.2 Capacity Management

Capacity management deals with managing the demand and supply of services to the customers. It is an important aspect in managing service organizations as it helps in maintaining the quality of service given to the customer, tackling the level of demand uncertainty, and adapting the capacity to the fast changing demands of the market. Refer to Exhibit I for some facts about the demand-supply gap felt in Indias hotel industry. 148
Exhibit I: The Indian Hotel Industry Trends in Demand-Supply Gap

In the early 2000s, India became a hot spot for tourists and foreign business travelers alike. This increase in travelers opened up newer opportunities for the hotel industry in India. According to Ajoy Misra, Senior Vice-President, Sales & Marketing, Indian Hotels, owners of the Taj group, the countrys largest hotel company, The Indian hospitality sector is witnessing one of its rare sustained growth trends. But this growth was faced with a demandsupply mismatch which resulted in an increase in the occupancy rates and average room rates. Industry analysts predicted an eight percent growth in the number of five star rooms and a 10 percent increase in demand over the period 20052010, in Mumbai. In cities like Delhi, Chennai, and Bangalore, the corresponding growth in availability of rooms and demand would be 4 and 7 percent; 16 and 14 percent; and 21 and 19 percent respectively. The occupancy rates for the industry were expected to increase and reach approximately 77 percent in the year 2007-2008 and 83 percent in the year 2008-2009. The Federation of Indian Chambers of Commerce and Industry (FICCI) and Evalueserve (a knowledge process outsourcing company) survey reported that the revenue per available room showed an increase of approximately 30 percent from 2005 to 2006 going up from Rs. 2,966 to Rs. 3,765; the average room rates increased from Rs. 4,876 to Rs. 6,206 in that period. The primary reason for this boom was the massive growth in the IT and ITeS sectors. The number of foreign institutional investors, equity and venture capitalists, and other foreign business travelers increased due to the growth in business opportunities. One major factor which helped the hotel industry was the introduction of low cost airlines and the open skies policy that led to an increase in the commercial flights both domestic and international. There was a 17 per cent increase in the number of tourists coming to India in the beginning of 2005. It is estimated that a majority of the tourists are business travelers, said S S Mukherji, Vice-Chairman and Managing Director, East India Hotels, which owned the reputed Oberoi brand. Business travelers guaranteed business for the whole year in contrast to leisure travelers who visited only during certain times of the year. The hotels also benefited from the importance that companies place on exhibitions, meetings, etc. The difference between the demand and supply in the hotel industry varied across cities. For instance, Bangalore had one of the highest room rates and occupancy rates at US$ 266 and 80 percent respectively as against a room rate and occupancy of US$ 111 and 70 percent respectively in Mumbai. In the past, the Indian hotel industry had been concentrated more in the four metro cities (Delhi, Mumbai, Kolkata, and Chennai) and some tourist locations like Agra and Jaipur. But the upsurge in the economy increased the demand for hotels in small towns like Kochi, Pune, and Ludhiana. Kamal Sharma, Secretary General of the Federation of Hotel and Restaurant Associations of India (FHRAI), said, There are as many as six five-star hotels coming up in different places in Kerala. Most five stars are coming up in places that are in tourists destinations or have big commercial enterprises like SEZs coming up.
Adapted from Joshi, Abhijit. For the Good Times. India Brand Equity Foundation. <http://www.ibef.org/download/for_goodtimes.pdf>; and Menon, Shailesh. Onset of Tourism Spurs Hotel Stocks. The Hindu Business Line. November 9, 2006. <http://www.thehindubusinessline.com/2006/11/09/stories/2006110901951400.htm>; and <http://www.hindustantimes.com/StoryPage/StoryPage.aspx?id=03d52c9e-3f45-4690-bc8450f9e3e57a2e>.
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Capacity management and service quality determine how effective the service will be. The interaction between capacity management, service quality, and productivity is the basis on which service operations are planned and controlled. Capacity Management Strategies Organizations use different strategies for capacity management. They are: Customer development: Service organizations try to gain the loyalty of the customers through loyalty programs or by allowing customers to try out the services before purchasing them. Bundling: Two or more services are marketed together and the customer is given a discount. Differentiation: In this technique, some of the capacity is kept idle at normal times in order to be able to handle exceptional situations. Queueing theory is a mathematical model widely used in capacity management. This enables mathematical analysis of several related processes, including arriving at the (back of the) queue, waiting in the queue (essentially a storage process), and being served by the server(s) at the front of the queue.
3.3 Yield Management

Sheryl E. Kimes (Kimes) defines yield management as a method which can help a firm sell the right inventory unit to the right type of customer, at the right time, and for the right price. Yield management is also known as revenue management. Certain situations in which yield management is used are: When the capacity that the organization has cannot be modified When the demand can be classified into groups When the service cannot be stored When the products are sold and delivered at different times When there is a high amount of uncertainty in demand When the costs involved in modifying the capacity are higher than production or sales costs, etc. Organizations in industries (such as the airline industry) where the service is highly perishable have to work toward maximizing the use of their capacity. In the case of the airline industry, an unsold seat has a cost to the organization. The opportunity cost of a seat going empty is the marginal revenue that is obtained by selling that unsold seat. The unfilled seats can even be sold for a lower price in order to increase the total revenue. Refer to Exhibit II for a discussion of how yield management systems can be used by airlines to increase profitability.
Exhibit II: Pricing and Yield Management in Airlines

In the Indian aviation market, pricing strategies were influenced by rising fuel costs, higher investment in increasing capacity, growing competition, and the need to reduce the fares to fill up the seats. Prices are generally based on the demand and supply of the product or service in the market. Yield management or revenue management is a technique used by airlines to decide on the fares and control the inventory of the available seats.
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Yield management considers three factors to decide the prices: the route of travel, that is, from the origin to the destination; the attributes whether the flight is a non-stop flight, whether the money is refundable, whether the ticket is booked in advance, etc.; and deciding on a pricing slab for the number of seats for each fare class. Yield management helps in increasing profits by applying the peak load pricing policy, categorizing customers based on their price consciousness, and by applying seat inventory control to handle the fluctuations in demand. Yield management systems are used by airlines to predict the demand for each fare class for a specific flight. This can be achieved by collecting data on the booking and cancellation trends on similar flights for a period of 12 to 18 months. This trend analysis together with the fares for different classes helps in effectively segregating the available seats into different fare classes for a similar flight on a later date. Implementing yield management systems helps the airlines increase their revenue by three to eight percent. One airline that has benefited from the implementation of the yield management system is Air India, which has been able to price its tickets very effectively. Issues in yield management: The major issues that airlines face are the differences in demand, overbooking, elasticities of demand, and information systems. Differences in demand arise on the basis of the available fares. Airlines have to find out what rates are preferred by most of the customers. This helps them in gauging how many seats could be sold at a higher rate so as to increase profitability, rather than selling them at a lower price. Overbooking is a concept where the airlines book more number of passengers than the number of seats; this is done as a buffer against cancellation of tickets by customers. The next issue is elasticity of demand, that is, the effect of increasing prices on the customers buying decision and also on the competitors has to be checked. Another issue is that of proper information systems in that the data collected should be accurate.
Adapted from Indias Airlines find that Fast Growth has its Ups and Downs. Knowledge@Wharton. January 25, 2007, <http://knowledge.wharton.upenn.edu/india/article.cfm?articleid=4151>; and A Strategy for Intelligence. <http://www.networkmagazineindia.com/200307/cover2.shtml>.
Control through Yield Management Some models used in yield management, according to Kimes are: Mathematical programming models Economics based models Threshold curve Expert systems The more commonly used models are economics based models and threshold curve. Taking the example of the airline industry, economics based model and threshold curve can be described as follows: 151
Economics based models: A typical scenario in the airline industry is selling the flight tickets at premium or at concession rates. Generally, the demand for concession rate tickets comes much before the demand for premium rate tickets. This trend makes it necessary for organizations to decide on a ceiling on the number of seats that can be sold at a concession rate. Setting a high ceiling may result in the loss of premium customers and a low ceiling may result in idle inventory. To resolve this issue, airline industry players make use of a marginal revenue model, which is based on economics. Threshold curve: The threshold curve is constructed using past data available on seat bookings. A trend of bookings made in the past is collected and threshold curves are constructed keeping in mind the historical aggregate demand patterns. Once these curves have been constructed, the present booking trends are plotted against the forecast. Figure 1 shows the threshold curves plotted for estimating the demand for airline seats.
Figure 1: Threshold Curve for Airline Seats Demand
Adapted from Kimes, Sheryl E. Yield Management: A Tool for Capacity-Constrained Service Firms. Journal of Operations Management, Volume 8, Issue 4, October 1989, Pages 348-363.
3.4 Service Quality Management

Unlike manufacturing organizations where quality is defined by the product having a certain set of standard specifications, quality in service organizations primarily depends upon how a customer perceives what he/she gets and whether it meets his/her expectations. The three main components of service quality also known as the three Ps of service quality are: Physical facilities and processes: Includes place of operation, the ambience, types of services offered, and the process. Peoples actions: Includes punctuality, way of interaction, and problem resolving capability. Professional opinion: Includes integrity, knowledge, and experience of the professional in the field. 152
Determinants of Service Quality A. Parasuraman, Valarie A. Zeithaml, and Leonard L. Berry have given a classification of certain factors that customers rely on to judge service quality. Table 1 summarizes these service quality determinants.
Table 1: Service Quality Determinants

Determinant Reliability Responsiveness Competence Access Credibility Courtesy Communication Description Dependability Consistency and accuracy Promptness of service delivery service Employees have the required skills and knowledge required for service delivery Easy to contact Convenience both in terms of timing and location Trustworthiness, believability, honesty Demeanor of the service provider politeness, respect, friendliness Demonstrated ability to explain the attributes of the service (features and cost) effectively to the customer and also to listen to the customer attentively Freedom from danger, risk or doubt; includes physical security, financial security, and data confidentiality Understanding the needs of the customer, providing individualized attention, and also recognizing the regular customer Physical facilities, tools, ambience, physical representations of the service, appearance of the service providing personnel
Security Understanding/ Knowing the customer Tangibles
Adapted from Parasuraman A.; Valarie A. Zeithaml; and Leonard l. Berry. A Conceptual Model of Service Quality and its Implications for Further Research. Journal of Marketing. Vol. 49, Fall 1985, p41-50.
The major factors on which service quality depends are the service delivery process and the people who deliver the service. To control and improve service quality, it is necessary that the top management of service organizations designs the service quality standards keeping in mind the expectations of customers from that service. Once the service standards are set, it is the responsibility of the management to train the employees and equip them with the necessary knowledge, skills, and behavioral traits. The management of the organization should ensure that the employees understand what is expected of them, and are aware of the objectives, strategies, values, vision, and quality standards of the organization. The service organization should ensure that there is adequate publicity about the service and that the right message and information is communicated to customers. 153
The organization should ensure that it delivers whatever it has promised. It is very important for the organization to keep track of whether the customers feel that the service that they receive is as per their expectations. This is achieved by asking the customers to give suggestions and/or feedback regarding the service. Evaluating Service Quality Two important ways in which service quality can be evaluated are: By conducting a service quality audit: J.M. Juran defines service quality audit as an independent evaluation of service quality to determine its fitness for use and conformance to specification. By collecting customer feedback: A customer feedback system is used to gather information regarding customer satisfaction levels. These systems help the organization understand whether the customers are satisfied or dissatisfied in their transactions with the organization and also the satisfaction levels regarding each service that they have experienced. Six Sigma for Service Quality Six Sigma helps in increasing the effectiveness and efficiency of services by minimizing the defects, errors, and flaws in their processes. The Six Sigma strategy helps organizations to attain the desired levels of service performance (on an average) and to reduce the variability in the process. In the services setting, Six Sigma aims at understanding how defects arise and at developing improvements in the processes to minimize these defects. This ultimately results in increased customer satisfaction. P.D. Hinduja Hospital in the healthcare industry and Bank of America in the banking industry are some examples of service organizations that have implemented Six Sigma. Refer to Exhibit III for a discussion on the Six Sigma initiative of Bank of America.
Exhibit III: Six Sigma in Bank of America

Bank of America (BoA) was formed in 1998 out of the merger agreement between NationsBank of Charlotte, North Carolina, and BankAmerica of California. This inorganic growth strategy helped the company to enlarge its customer base but it failed to generate customer satisfaction and retention. In the year 2001, the Six Sigma quality initiative was adopted under the then Chairman and CEO Kenneth D. Lewis, to provide high-quality service to the customers and enhance their satisfaction and retention. Six Sigma in BoA was applied in three ways: As a core process performance metric As a business approach As a leadership philosophy As a core process performance metric, Six Sigma was used to arrive at standards or targets for each branch and for each banker. BoA used Six Sigma to develop a metric for the sale of products made on each day by each banker. Customer feedback was gathered regarding the areas where the company needed to make improvements. This helped the company to understand customers needs and their
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expectations from its services. Six Sigma was applied to enhance the usage of the computerized and electronic channels such as ATMs, telephone banking, and online banking by the customers. The basic idea was to reach the customers in a variety of ways. As a business approach, Six Sigma was applied to every aspect of BoAs operations and to the entire value chain of the company. Importance was given to the way the business was being done. An integrated business planning process was implemented that proved very effective for the company. Six Sigma helped BoA in analyzing business processes, identifying problems within them, increasing efficiency, and reducing the errors arising during the course of providing the services. Six Sigma was also used as a leadership philosophy to lead the entire organization toward the predetermined goals. BoA recruited senior Six Sigma professionals from General Electric, Honeywell1, and Motorola2 to help it to adapt to a culture of quality. Quality training was imparted by these professionals to the employees. Process engineering teams were set up to select the top business priorities that define customer delight/experience.
Adapted from Pushpanjali Mikkilineni and Sanjib Dutta. Case Study Six Sigma: A Tool to Increase Customer Satisfaction at Bank of America. The ICMR Center for Management Research, 2005. <www.icmrindia.org>.
Through Six Sigma, an organization can benefit both on the human resource and the operational fronts: On the human resource front: o o achievement of better cross-functional teamwork improvement in job satisfaction and in the morale of employees due to greater understanding of problem-solving methods. improvement in the quality of decisions as the decisions are based on facts rather than assumptions. fast service delivery due to minimization of steps which do not add value to the process minimization of costs incurred due to late delivery, complaints, etc. enhanced consistency of results due to reduced process variability.
On the operational front: o o o o
3.5 Service Recovery

A mismatch between the customers perception of the service they receive and their expectations leads to service failure. Service recovery refers to actions taken by a service provider to rectify a situation of service failure. Some issues and challenges that service organizations face during service delivery are:
1
Honeywell is a multinational conglomerate that produces a variety of consumer products, engineering services, and aerospace systems. It caters to private consumers and corporations. Source: <http://en.wikipedia.org/wiki/Honeywell> Motorola is a multinational communications company based in Illinois, Chicago. Source: <http://en.wikipedia.org/wiki/Motorola>
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Absence of a service person when a machine needs to be repaired Delay in the service delivery Faulty administration of service The service recovery process is one of the most significant processes in a service industry as it is during this process that customers are more focused on the way the organization treats them. The person who handles the service recovery process plays an important role in improving customer satisfaction. Service Failure and Customer Switching Customer switching (defection) occurs when an existing customer defects and becomes the customer of a competitor. Customer switching results in market share erosion and reduced profits. The absence of effective and timely service recovery is one of the important reasons for customer switching. As the cost of acquiring new customers is much higher than the cost of retaining existing customers, service organizations search for various alternatives to reduce the rate of customer switching. Keaveney identified eight different reasons relating to service failure on the part of service organizations that cause customers to switch to other service providers. Five of these reasons can be addressed by service recovery. They are: Core service failures Service encounter failures Price failures Inconvenience Employee response to service failures. The other three reasons are: attraction by competitors, ethical problems, and involuntary switching; these reasons cannot be addressed by service recovery.
4. Classification of Service Organizations

Some earlier classifications of service organizations were based on dimensions that are generally used in a manufacturing organization. Some other classifications did not consider the systems involved in service organizations nor did they consider the fact that customers are an integral part of service operations.
4.1 Dimensions of Classifying Service Organizations

Studies on the classification of service organizations brought out six specific dimensions along which such classifications could be based. Table 2 lists the dimensions that can be used to differentiate between the various types of service organizations.
5. Control of Different Categories of Service Organizations

The dimension degree of variation has its implications for managing service quality. On the other hand, the throughput time dimension is associated with the productivity aspect of the services. In service organizations, operational control generally deals with the productivity and service quality aspects of the service being offered. To simultaneously increase both productivity and service quality, managers may try to reduce both the relative throughput time and the degree of variation. 156
Table 2: Six Dimensions for Classification of Service Organizations

Dimension Equipment focus/people focus Description In equipment focus, the tool or machine used for delivering the service is important; in people focus, the organizations representatives who deliver the service are more important than the tool or machine. Product focus deals with what the customer purchases; process focus deals with how the purchase is affected. This deals with the extent to which the service caters to individual customers need or whether the service is standardized. The major part of value addition in the service may happen either in the front office or in the back office. This is the amount of time a customer spends in a service system. This empowers the service providing personnel to make changes to the service (depending on the customers request) without having to consult with higher authorities.
Product focus / process focus Level of customization Back office focus/ front office focus Duration of customer contact Level of discretion
**
Relative throughput time Throughput time measured for a service transaction as compared to others in the industry.
Adapted from Schmenner, Roger W. Service Businesses and Productivity. Decision Sciences. Summer2004, Vol. 35 Issue 3, p333-347 and Olorunniwo, Festus and Maxwell K. Hsu. A Typology Analysis of Service Quality, Customer Satisfaction and Behavioral Intentions in Mass Services. Managing Service Quality. Volume: 16 Issue: 2; 2006.
5.1 Professional Service Organizations

Professional services are characterized by high degree of variations and high relative throughput time, where employees are usually highly skilled or educated, and are empowered to take decisions independently. In professional services, the service provider interacts with the customer to decide on the specifications of the service that has to be provided. The high dependency of professional service organizations on the service providing personnel makes it important for them to focus on human resource management. It becomes necessary for the organization to be careful and choosy about the people they hire; that is, there is a greater emphasis on personnel control than on behavioral control. Professional service organizations need to give their employees the authority to use their discretion in handling customers.
5.2 Mass Services and Service Shops

Mass services are characterized by a low degree of variation and high relative throughput time. The focus of the mass services should mainly be on achieving lower throughput time and in turn achieving higher productivity. Throughput time can be reduced by identifying and eliminating the sources of waste such as lack of accurate data, inconvenient locations of the facilities delivering the services, waiting, unnecessary steps in the process, and defects in the product/service. Such an elimination of wastes can also result in higher service quality in terms of reliability, accessibility, responsiveness, etc. According to Schmenner, tangibles, responsiveness, competence, access, and reliability are the service quality determinants which are important in the case of mass services. In managing mass services, a difficulty faced is that of customers perceiving 157
lower responsiveness due to lower degree of variations. This issue can be handled by training the workforce in the required skills. Proper monitoring of customer feedback should be carried out to increase customer retention and customer loyalty. Service shops are characterized by a high degree of variation and lower relative throughput time. The issue in controlling the service shops generally focuses on reducing the variations through standardizing the services and trying to spread the overhead costs over a greater number of service units without compromising on the throughput time.
5.3 Service Factories

Service factories are characterized by a low degree of variation and low relative throughput time. Managing services which have low interactions and low customization, that is, a low degree of variation, will call for development of standard operating procedures with very little improvisation from the employees in handling the customers. It is therefore necessary for the service factory to have employees who are well-versed (competent) in the standard operating procedures. In a service factory, the service quality determinants that are usually to be considered are tangibles, responsiveness, recovery, and competence.
6. Summary
Service organizations differ from manufacturing organizations with regard to: intangibility, heterogeneity, inseparability, and perishability. A service blueprint is a map or a diagrammatic representation of the service delivery process, the associated tangible evidence, and the employees involved in the service delivery process. Service blueprinting is the process of designing the service blueprint. Capacity management deals with managing the demand and supply of services to the customers. It is an important aspect in managing service organizations as other factors like service quality and productivity are closely associated with it. Yield management, also known as revenue management, is a method which can help an organization sell the right inventory unit to the right type of customer, at the right time, and for the right price. Quality in service organizations primarily depends upon how a customer perceives what he/she gets and whether it meets his/her expectations. The three main components of service quality are physical facilities and processes, peoples actions, and professional opinion, which form the three Ps of service quality. Service recovery is a set of activities that an organization undertakes to rectify issues faced during delivery of the service. There are six dimensions that can be used to understand the differences between various types of service organizations -- equipment focus / people focus; product focus / process focus; level of customization; back office focus / front office focus; duration of customer contact; and level of discretion. Services are broadly classified into four categories -- service factory, service shop, mass services, and professional services -- based on the degree of variation and the relative throughput time. The dimension degree of variation has its implications for managing service quality; while the throughput time dimension is associated with the productivity aspect of the services. To simultaneously increase both productivity and service quality, managers may try to reduce both the relative throughput time and the degree of variation. 158
Concept Note - 12
Project Control
1. Introduction
A project can defined as a temporary endeavor undertaken, to create a unique product or service or a unique set of coordinated activities, with definite starting and finishing points, undertaken by an individual or organization to meet specific objectives within defined schedule, cost, and performance parameters. Project planning and execution are the basic business activities for project-based organizations. Manufacturing or service organizations take up projects to fulfill specific needs. Project-based organizations and other organizations can succeed in their businesses if they have the ability to identify viable projects and execute them successfully. This note will help you understand: The significance of project control in the successful execution of projects The use of project overview statement as the basis for control How to use project plan as the primary control mechanism The importance of organizing for project control How to control the execution of a project The concepts associated with overall change control The process of project auditing How to conserve and utilize resources in projects.
2. Factors Influencing a Projects Success

Project management must focus on the ways to manage the resources required for successfully completing projects and fulfilling the project sponsors objectives. Resources requirement can vary from project to project. Managing resources involve managing people, money, time, quality, etc. Following factors have an impact on a projects success. Clear definition of project goals A priori agreement on success factors by the project stakeholders, before the project commences Support and involvement of the top management/ project sponsor to ensure project success Comprehensive project planning Ongoing collaboration between the project sponsor and the project manager, including involvement of the project sponsor in key discussions and decisions during the planning and execution of the project
Technical/managerial competence, troubleshooting capabilities, and flexibility of the project personnel Project control systems, including (but not limited to) progress review, information systems, communication, and coordination mechanisms.
Refer to Exhibit I for details of the commercial failure of the Concorde project and Exhibit II for details of the implementation failure of a software project.
Exhibit I: The Concorde Project

In September 1965, the governments of UK and France took up a project to create a plane that would break down the barriers of distance by traveling at speeds greater than that of sound. The aircraft construction project was given to four companies The British Aircraft Corporation, Sud Aviation, Bristol Siddeley, and SNECMA. The construction began in September 1965 and by 1967, the first prototype of the jet was rolled out. The aircraft was considered as a technical and engineering triumph, especially as it involved international collaboration. However, it was a commercial failure as it was designed with the premise that speed determines the success or failure of an airliner. The project was taken up without considering the basic rules of project management. For instance, there was no owner and person-in-charge with whom the project can be clearly identified with. It also suffered design and technology related problems. The project ran into huge costs and schedule overruns, which also resulted in a huge public criticism. Other reasons that lead to the projects commercial failure were huge fuel costs, high travel prices, and opposition from the environmentalists to fly the plane over land.
Adapted from Balaji, K and S. V. Rama Krishna. Case Study The Concorde Project A Technical and Engineering Triumph but a Commercial Disaster. The ICMR Center for Management Research, 2003. <www.icmrindia.org>.
Exhibit II: ERP Implementation Failure at Hershey

The technical team at Hershey, a US-based chocolates, confectionaries, and beverages manufacturing company, worked continuously for more than three years to implement SAP ERP. Its implementation, and the business process which it followed, however, proved to be failure for the company. The company incurred heavy losses. The important reasons for this failure are explained here. Bad timing The company implemented ERP during the peak business season. Companies, during this period, usually do not change their business conduct or go for any form of restructuring. They focus on profit-making activities, fighting competition, and generating income. ERP implementation at Hershey at this time interrupted the companys normal business and created confusion in the company. Hershey suffered on both ends they were not able to do justice to the ERP implementation, which was interrupted during the last moment, and they were not able to solve the problems that arose in the regular business. Hershey could have avoided this by taking up the ERP implementation project in the lean period of the year.
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Too many things at the same time Apart from implementing ERP at the wrong time, Hershey made another mistake. It went for a simultaneous implementation of other enterprise applications like CRM. While the company was busy solving problems in its businesses, ERP and other applications were not fully implemented. When the regular business problems were solved and changes made in the business processes to go with the applications, the applications failed to function properly as the implementation was incomplete and as there was gap in the implementation process.
Adapted from Analyzing ERP Failures in Hershey, <http://www.erpwire.com/erparticles/failure-story-in-erp-process.htm>.
Project managers exercise control over the project team and others who are involved in various project functions. The purposes of project control are to plan and organize the project in order to achieve the effectiveness and efficiency objectives; to execute the project so that its performance is close to the plan; to suitably revise the project plan (when required); and to conserve and ensure proper utilization of resources (physical assets, finances, or human resources). Project control systems are required to have a check on the progress of the project in terms of time, cost, and quality of output. The cybernetic process in project control involves planning of control, assessing performance, and taking corrective actions; and plays a vital role in the overall project life cycle. Planning of control involves deciding on how, when, and what to monitor and control. Assessment involves evaluation of actual performance and comparison with planned performance. The task of taking corrective actions focuses on analyzing the reasons for the difference between actual and planned performance and applying corrective measures. Successful completion of a project depends on the ways in which problems are identified and immediately controlled or corrected. The control activity is required to keep a check on time, cost, and quality of output. It should not be viewed as a coercive tool, but should be thought of more as an activity that guides the project team toward goal-directed behavior.
3. Project Overview Statement as the Basis for Control

Effective project control requires an accurate description of what is expected from the projects execution. The output requirements are recorded as the product scope that includes details about the features and quality standards required in the product or service that is to be delivered. The project overview statement (also known as the project scope statement, statement of work, initial project definition, or document of understanding) is a precise description of what the project goal is and how it will be achieved. The project scope has to be decided based on the requirements of the project sponsor, the users, and the relevant stakeholders. It should provide details about the activities to be carried out and the resources required for project completion. The scope should be clearly laid out for each phase if a project has multiple phases. Project overview statements comprise the problem or opportunity (the reason for taking up the project); the broad project goal, the specific objectives, and criteria for assessing 161
successful project completion; the anticipated risks and hindrances that may have a significant impact on the projects progress and completion; and the assumptions involved. Project control requires that the concerned project stakeholders should agree on the project scope. After the agreement, the project overview statement provides the basis for effective project control during the later stages of project execution, and guides the project managers decision-making during project execution. However, it may not provide the level of detail required by the project team members. The project team can develop a detailed project definition statement that can be used as a standard reference by all the project team members. This statement will be aligned to the project overview statement so that it guides the project team members in the right direction during the project execution.
4. Project Plan as the Primary Control Mechanism

The project plan preparation starts with the project scope definition. For a given scope, the activities to be carried out are identified along with their interdependencies in terms of sequence, the effort required to finish each activity is estimated, and the project schedule is developed. The schedule guides the project manager to focus attention on the critical path along which any delay in activity completion will result in a delay in project completion. After the schedule is finalized, the project plan development involves resource planning, cost estimation of each resource, and cost budgeting of activities. At this stage, the project manager can evaluate options of reducing the total project duration by incurring higher costs. This trade-off between effectiveness and efficiency would depend on the organizations priorities and the needs of the project stakeholders. Preparation of the overall project plan also involves establishing the quality standards and identifying ways of ensuring quality assurance; planning for staff acquisition; identifying roles, responsibilities, and reporting relationships among the project team members; determining communication needs of different stakeholders and ways of addressing them; risk identification and evaluation; etc. The project plan has to be approved (signed) by the project sponsor, after which it becomes the main reference for control in the project execution. Project milestones, defined in the project plan, mark the end of major phases. They serve as go or no go control points for executive decision making. At each milestone, the intermediate project outcome is communicated to the project sponsor, based on which it is decided whether or not to continue the project. Periodic review and assessment of progress is conducted. Frequency of review varies within and between various project phases, depending on parameters like distribution of total effort among the various phases and risks associated with each phase.
5. Organizing for Project Control

The matrix organization combines the advantages of the pure functional and product organization structures, and is usually adopted by project-driven organizations. The project teams are formed within the traditional line and staff organization, and the project uses various resources grouped together temporarily to achieve a particular objective. Different project teams may work under one department, or one project team may work under different departments. Whatever may be the case, the project 162
Project Control
members are answerable to the project manager and the departmental managers. This may lead to conflict between the project and functional managers as they have to share the same set of workers for their individual responsibilities. Each manager should try to prioritize his/her jobs and responsibilities to minimize such conflicts. Figure 1 depicts the typical reporting relationships in an organization dealing with construction projects. Figure 1: Typical Matrix Organization Structure
Adapted from Milosevic, Dragan Z. Organizing Project Control Systems. International Journal of Project Management. Vol. 5 Issue 2, May 1987, p76-79.
5.1 Roles of Members in Project Control

Each project member should achieve the project objectives by adhering to the project plan. The control-related roles and the responsibilities of each project member should be clearly differentiated with the help of a Linear Responsibility Chart (LRC). The LRC for project control can be structured in three steps. i. The units are stated in the upper right hand side of the chart and so arranged that the project units are separate from the non-project (functional) units. This arrangement does not depict any line relationship within the project.
ii. Control tasks of the project control process are depicted on the left hand side of the chart. They are grouped according to the project stages to enhance clarity. iii. Symbols are used to show the relationship between units and control tasks. This can be done through relationship: category-task (RCT).
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Five types of RCTs are used to define roles in project control. Perform Task/RCT (PT/RCT) means the unit performs the control task. Approves Task Performance/RCT (ATP/RCT) means the unit is supervising the unit performing the control task and has to approve that particular task. General Supervision/RCT (GS/RCT) means the unit is supervising a unit performing ATP/RCT. Its role is to formulate the policy framework for the functioning of ATP/RCT and PT/RCT. The last two types of RCTs are Has to Be Consulted/RCT (HBC/RCT), where the HBC/RCT unit must be consulted by another unit which is performing some control task for inputs, and Has to Be Informed/RCT (HBI/RCT), where the HBI/RCT unit must be informed about certain things by another unit performing some control task.
6. Control of Project Execution

In the project execution stage, the project managers should review the projects progress in a timely and phased manner, and take corrective action, if required. Various factors are involved in the monitoring and controlling of projects. These factors can be tracked using some tools and methods like project review, cost monitoring and control, schedule control, earned value analysis, progress measurement, productivity measurement, and progress reporting.
6.1 Project Review

Project reviews conducted at various stages of project implementation enables the project manager to solve problems before they get out of control, or to enhance the way in which the project is being handled. Reviews are conducted to find out if the project can achieve the business goals; whether the organizational rules are understood properly and implemented; and whether the project is being managed effectively and the team members are sure of completing it by following the guidelines. Types of Project reviews A project manager has to conduct various reviews throughout the project life to ensure that it is progressing toward achieving the planned objectives. The manner in which these reviews are conducted decides the success of current and future projects. In general, a project manager conducts three types of reviews status reviews, design reviews, and process reviews, which are described in Table 1.
Table 1: Types of Reviews and their Features

Review Type Status review Features Usually conducted at two levels cursory review and comprehensive review. A weekly cursory and a monthly comprehensive review are usually conducted for projects of one year duration. The project manager should ensure that team members give status reports that are substantiated by meaningful details about cost, performance, time, and scope. A reporting system should be designed that can detect deviations that are greater than the permissible variance limits.
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Review Type Design review
Features Conducted to check whether the design of the product/service being produced is of the desired performance quality. Conducted to determine whether the processes are going on as planned and whether any improvements are possible. Objectives to preserve the project processes performances that are going on well, and to improve the processes that are below standard. Used for suggesting improvements (even if there is nothing wrong).
Process review
5.2 Project status review meetings

Meetings help in effectively and essentially conducting project reviews in an organization. These are aimed at reviewing the project status and have a specific agenda. Meetings are useful for making decisions; for discussing aspects of the project; for planning and scheduling work; for discussing project scope changes and their impact on various project stakeholders; for deciding the suitable decisions to be taken; for resolving conflicts among the stakeholders, and as coordination mechanisms for solving project-related problems.
5.3 Cost Monitoring and Control Tools

Regardless of the project type, cost control is a critical issue - the project team should take maximum care to ensure accuracy of the planned budget to avoid execution problems. The team is answerable to the top management or the client if the actual cost goes beyond budgeted cost. Cost Monitoring Activities should be monitored regularly so that problems can be addressed at an early stage. A cost summary table should be maintained to keep records of the costs incurred. The table integrates all project-related costs like engineering and construction costs and can be used as a ready reference for financial status of a project. Details of the original budget, current budget, expenditures incurred till date, and forecasts of expenditures for various cost categories are entered in the table. The labor rates and usage of production equipment and bulk materials should also be tracked. In certain projects, it becomes very essential to track the equipment costs as it forms an important part of the projects budget. A table of equipments should be maintained with the original estimates, current forecasts, and final purchase order costs to analyze the trends of cost of equipment and to make provisions for future purchases, if any. Tracking reports help in buying materials for future activities when the costs are relatively low. The procurement activities should be thoroughly tracked and the information obtained should be revised regularly in the cost summary table. 165
Cost Control Budgeting plays a vital role in project control. The budget should be planned as accurately as possible keeping in mind unforeseen events that may occur due to external factors. Contingency plans (as part of the budgeting process) along with cash flow management help in cost control. Contingency planning: Some amount is set aside in the budget to cover unplanned events. Contingency, however, is not meant to cover activities that involve project scope changes. Preparing a contingency rundown chart (plotting balance in the contingency fund against project period) may ensure that the contingency usage pattern does not deviate significantly from the plan. If the actual contingency rundown curve is above the planned contingency rundown curve, it is a good sign for the project as it means that the actual balance in the contingency fund is more than the planned balance. If the actual contingency usage curve is going below the planned contingency usage curve, the project is using contingencies at a faster rate than planned and may exhaust all contingencies before the project is completed. Therefore, the curve alerts the management to discrepancies in project execution. Cash flow management: The cash flow should be managed during the project. The project team should try to complete the project considering budget constraints. It should always have information about the amount of cash that has been used up and the balance left out for the particular period or particular activity. A cash flow tracking chart helps compare the actual expenditure with the original planned cash flow (Y axis) over the project duration (X axis), and also shows forecasted cash flow, thus estimating the projects final cost. Corrective actions can be taken if there is a considerable difference between actual and planned cash flow.
5.4 Schedule Control Tools

The project completion time should be estimated in the project planning phase using the Critical Path Method (CPM). A comprehensive project schedule should be developed that contains the details of all the resources (like equipments, bulk materials, and manpower) required for each of the activities. In case of outsourced projects, the client and the contractor should agree on a baseline schedule before project approval. After this, the project schedule should be continuously monitored by tracking critical activities, milestones, and manpower utilization. Critical Path and Milestone Tracking After commencing the project execution phase, the efforts toward the critical path activities should be tracked. Care should be taken that the objectives of the project and the critical activities are achieved. A milestone tracking chart helps in tracking milestones, i.e., activity completion. It uses a graphical format for showing the actual milestone dates or dates of completion of activities (Y axis) and the planned dates (X axis). It shows the projects current status and the projects adherence (or nonadherence) to the planned schedule. Manpower Utilization As the project progresses, actual manpower utilization can be tracked against planned utilization. If the projects progress is slower than planned despite manpower utilization as per plan, it has to be decided by the project management team whether 166
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the project duration will be extended or the project will be completed within the stipulated time by using more manpower.
5.5 Earned Value Analysis

Earned value (EV) analysis method is used for both cost and schedule control, and for evaluating the projects progress and financials. Earned value represents the value earned from a project as and when the activities are completed. EV is a common and consistent unit to measure the projects or an activitys progress and cost performance. Time and money are the common units associated with EV. Time is mostly used in labor-intensive industries. In such cases, the projects financial control is taken up by an accounting system as other costs (apart from projects direct costs) are also involved like subcontractor cost and overhead cost. Money is mostly used in nonlabor intensive projects as it is useful where one needs to consider variables like salary rates, hikes, and overhead adjustments. Usefulness of EV EV forms a consistent basis for schedule and cost analysis by using a uniform unit of measurement (time or money), thereby simplifying the analysis of complex situations. The uniform unit used by EV also helps to compare the progress and performance of different activities in a project. EV helps in enhancing cost performance analysis by measuring the amount of work done in a unit that is comparable to cost, that is, the unit of measuring physical progress of the project is the same as the unit for measuring cost. Implementation of EV The steps in the implementation of EV are: 1. Establishing a Work Breakdown Structure (WBS) to divide the project into manageable components. It should be established at multiple levels in a hierarchical order. One component at a particular level can be broken down into smaller components, which in turn, form the next lower level. All the components must cumulatively add up to the total project. Each component should be monitored and controlled by an individual employee. Identifying and allocating costs of each project activity based on direct cost and time consumed by that activity. The activities have to be then scheduled, i.e., the resources allocation has to be planned over the time period. This resource allocation is in the form of an S curve, also called as the budgeted cost of work scheduled (BCWS) curve. Preparing a project schedule to confirm that the plan is acceptable so that the total resource allocation does not exceed the total available resources. Developing the schedule also helps study the cash flow of the project and to check if the budget of the project supports the schedule. Monitoring and reporting each activitys progress. The activities are to be reported as started, completed, or part completed. In the case of unfinished activities, the percentage of completion should also be reported. The actual costs of the activities should also be identified and updated in the schedule.
2.
3.
4.
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5.
Calculating EV by multiplying the percentage completion of an activity with the budgeted cost. In other words, EV is the budgeted cost of work performed (BCWP). Calculating the performance metrics as follows: Schedule Variance (SV) = EV BCWS = BCWP BCWS Cost Variance (CV) = EV Actual Cost of Work Performed (ACWP) = BCWP ACWP Schedule Performance Index (SPI) =
6.
BCWP EV = BCWS BCWS
Cost Performance Index (CPI) =
BCWP EV = ACWP ACWP
Illustration 1:
Given below are the details pertaining to a project at KL Constructions.
Particulars Rs. Million
Budgeted Cost of Work Performed Budgeted Cost of Work Scheduled Actual Cost of Work Performed Based on the given details, calculate the following metrics.

14 12 15
Schedule variance Cost variance Schedule performance index Cost performance index
Solution
Given that, Budgeted Cost of Work Performed (BCWP) = Rs. 14 million Budgeted Cost of Work Scheduled (BCWS) = Rs. 12 million Actual Cost of Work Performed (ACWP) = Rs. 15 million Schedule Variance (SV) = EV BCWS = BCWP BCWS = Rs. 14 million Rs. 12 million = Rs. 2 million Cost Variance (CV) = EV ACWP = BCWP ACWP = Rs. 14 million Rs. 15 million = Rs. 1 million (-)
Contd
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Contd
Schedule Performance Index (SPI) =

Rs.14 million BCWP EV = = = 1.167 BCWS BCWS Rs.12 million
Cost Performance Index (CPI) =

Rs.14 million BCWP EV = = = 0.93 ACWP ACWP Rs.15 million
5.6 Progress Measurement

Progress measurement calculates the percentage of project completed. The basis on which progress measurement is done can be finalized once the detailed schedule of the project is developed. The measurement criteria for assessing this percentage must be clearly defined. Progress measurement, which should be done on a regular basis, should always reflect tangible work and not time expended. The validity of the progress report can be cross-checked with the help of quantity surveying and quantity sampling. Progress measurement can be represented through a graph that plots the actual cumulative percent complete with the planned cumulative percent complete (Y axis) against time (X axis). This curve can also be developed by allocation of work hours to activities against time.
5.7 Productivity Measurement

Productivity is the ratio of outputs produced to resources consumed, that need not remain constant throughout the project duration. Planned productivity for various project phases can be determined based on the planned work and planned resource utilization. During project execution, actual productivity is measured based on the actual progress and actual resource utilization. A comparative trend analysis of actual productivity versus planned productivity helps the project manager to take corrective actions, when required. Productivity measurement provides inputs for revising cost estimates and schedules.
5.8 Progress Reporting

Periodic reporting is an important function of project control. Vital issues should be reported to the top management at the earliest without waiting for the end of the predefined period. The reports help the top management in better decision making if they are easily comprehensible and are prepared timely and accurately. Different tools lead to the generation of three different types of reports trouble reports, progress reports, and financial reports. Refer to Table 2 for their descriptions.
Table 2: Types of Reports

Reports Description
Trouble reports
Emphasis is on the problems that have occurred or are anticipated. Critical problems are identified and highlighted. These reports should essentially be sent to the appropriate manager in time so that corrective actions can be taken at the earliest. 169
Reports
Description
Information is usually transmitted face-to-face or through the telephone. If the report contains important information, the oral communication is followed by a written document to provide a record. Immediate action is taken based on the seriousness of the problem. They compare the actual schedule and costs with the planned schedule and costs for the work done. These reports also contain similar comparisons for overhead activities that are not directly related to the work. Variances associated with costs, schedule delays, and similar factors are identified and measured quantitatively. Emphasis is on the amount of work already done and the amount of work to be carried out. Accurate reports of project costs must be prepared in case of a cost-reimbursement contract since it is the basis for later payments. These reports are not necessary if the project is a fixed-price contract. Maintenance of these reports provides a clear picture of the ways in which financial resources are utilized.
Progress reports
Financial reports
The reports are based on actual time compared to the scheduled time or actual cost compared to the budgeted cost. While interpreting the former, the top management raises the question whether more than estimated time was spent. But the analysis of the latter is somewhat different. If the proposed quality is maintained, the actual costs are compared with the budgeted cost. If the actual costs are less than the budgeted costs, quality might have suffered. So, the top management has to study all the reports individually.
5.9 Information Technology for Project Control

Technological progress has made project control easier. The Project Management Information System (PMIS) is used to collect, analyze, and share project-related information. It is a useful tool for sequencing, scheduling, and tracking activities, especially in complex projects. The analysis output from the PMIS aids progress review and facilitates decision making. PMIS can be used to update the project plan on a regular basis with minimal effort and to communicate the revised plans to various stakeholders. Software tools like Microsoft Project not only save time and money spent on control but also help in improving connectivity among various project locations, leading to better collaboration, coordination, and communication. 170
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7. Overall Change Control

Many a time, the course of action in a project changes from that originally planned due to various reasons like external factors or if there is a change in the instructions from the top management. Keeping track of all these changes is essential to control the project cost. A formal process must be in place to identify, quantify, and verify changes to the work that has to be performed. Change control systems, configuration management, and scope creep are three key concepts associated with overall change control. The change control system includes tracking systems and approval procedures necessary to authorize the changes. It is desirable for a project to have an independent Change Control Board (CCB) that approves or rejects change requests. Configuration management is a documenting procedure that is used to ensure that the project output (product or service) description is accurate and complete. It documents all physical and functional project characteristics of the outputs and records any change in these characteristics. While implementing the project, many changes can occur in the project scope due to many different reasons related to the external environment, user requirements, etc. This is referred to as scope creep. It is caused by absence of a detailed scope definition and repeated attempts by the project team and the client to improve the product/service. It is important to design an effective control mechanism to handle scope creep.
7.1 Scope Change Control

Scope change control aims at controlling the changes in the project scope that occur at various project life cycle stages by identifying the scope changes and managing the factors that cause scope changes to see that the changes are advantageous to the project. Project managers use information collected from documents such as work breakdown structure, performance reports, and change requests. Work Breakdown Structure (WBS) is a deliverable-oriented grouping of project elements that organizes and defines the total project scope. Performance reports organize and summarize the information gathered and provide information on scope performances. Change requests may be external (like government regulations) or internal (like errors in defining the scope) to the project, oral or written, legally mandated or optional. Refer to Exhibit III for a sample scope change request form.
Exhibit III: Sample Scope Change Request Form

Scope Change Number - An arbitrary numbering scheme, usually 1, 2, 3.... Also, some coding scheme for categorizing the scope change request. Requested By: Who requested the scope change? Date Reported: When was the change requested? Status: Usually Pending, On Hold, In Progress, Complete, Not Approved Assigned To: Who is assigned to investigate the scope change? Date Resolved: When was the request resolved?
Contd
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Scope Change Description: Describe the change in sufficient detail so that others can understand the scope change request. Business Benefit: Why is the request being made? What is the benefit from a business perspective? Implications of Not Making the Change: Describe the consequences if the change is not made. Impact Analysis to the Project: Describe how the change would be incorporated into the project, as well as the impact on the project in terms of cost, effort, and duration. Alternatives: If there are any alternatives, note them here, along with their impact on cost, effort, and duration. Final Resolution: Briefly describe how the scope change was resolved. Approval from Sponsor for Final Resolution: Signifies that the Project Sponsor agrees to the resolution, including any budget, effort, and/or duration implications.
Adapted from <http://www.tenstep.com>.
A scope change control system defines the procedures by which the project scope can be changed such as paper work, tracking systems, and levels of approval necessary for authorizing the changes. Performance techniques like variance analysis, trend analysis, and earned value analysis help in assessing the magnitude of the variations that occur. The scope changes made to the already approved plans (technical plans, financial plans, etc.) are updated, and then all project stakeholders are informed of the changes. The causes of variances and the corrective actions taken are documented for future reference.
7.2 Schedule Change Control

The project manager has to consider the project schedule, performance reports, and change requests while controlling the schedule. The schedule change control system describes the procedures by which project schedules can be modified using methods like redrawing the project network diagrams and understanding the proposed changes. Performance measurement systems assess the effective project activity completion in the normal duration, and calculate the magnitude of variation that may occur for each project activity.
7.3 Cost Change Control

Cost change control describes the procedures that bring about changes in the cost baseline, and includes the paper work, the tracking systems, and the approval levels necessary for authorizing changes.
7.4 Change Control System

A formal change control system that can minimize the risk associated with a change is usually a part of the configuration management system that integrates and coordinates changes across the project development life cycle. Following are the tasks of the system. 172
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Examine the changes that are requested by the project stakeholders, and determine the impact of these on the projects cost, schedule, and performance Explore alternate changes that could yield the same or a better output Accept or reject the proposed changes, communicate the changes to the parties involved, and incorporate the changes properly as per the plan Develop monthly reports detailing all the changes and their impact on the project.
Following guidelines are useful in designing an effective change control system. All project agreements should include a detailed report on how requests for a change in the plan, budget, schedule, or output of a project should be introduced and processed. A change order should be prepared which should include a description of the changes that are agreed upon, along with corresponding changes in the plan, budget, schedule, and output. An approval letter must be obtained, both from the clients agent and senior managements representative, on the changes to be implemented. The project manager should be consulted before finalizing the change order. But, his/her approval is not mandatory. Once the change order is approved, a master plan of the project should be made reflecting the changes and the change order becomes a part of the master plan.
An effective change management process contains two documents a requisition for change in a project and a project impact statement.
Requisition for change in a project: Every change requested by the client should be documented in the form of a simple memo or in the format prescribed by the project team. This will help the team evaluate the impact of the change on the project and to determine whether the change can be incorporated. Project impact statement: This is prepared after a requisition for change is made. It identifies various alternative actions along with the pros and cons of each. The client then chooses the best alternative. Following are the possible responses to a requisition for a change accommodating the change within the allocated resources and time schedule of the project; accommodating the change with an extension in the delivery schedule of the project; accommodating the change with additional resources and/or extension in delivery schedule; or implementing the change in a phased manner by way of prioritizing the output needed.
8. Project Auditing
Project auditing can be defined as the process of detailed inspection by the management of a project, its methodology, techniques, procedures, documents, properties, budgets, expenses, and level of completion. A project audit is a key step in the process of closing a project. It can be carried over for the whole project or for a part of it. The project auditors basic responsibility is to convey facts and while doing so must acknowledge the presence of the various kinds of biases of the people in the project. He/she should be aware of the limitations and should seek external help when certain audit aspects of the project are beyond his/her area of expertise. The gathered 173
information should be kept confidential till the official release of the audit report. He/she should not allow any political or technical pressures to influence the audit report.
8.1 Depth of the Project Audit

Time and money are two practical constraints that limit the scope of an auditors project evaluation. They limit the depth of the investigation and also affect the amount of detail presented in the audit report. Costs (professional and clerical costs) are incurred as part of the audit process; for gathering, storing, and preserving the data to be audited; due to the distraction caused by the auditing process to the people working on the project; and due to the drop in morale of the individuals working on the project. An audit report, though presented in a constructive and positive style, can demoralize team members and negatively affect the project. The depth of the audit varies with the situation and the project needs. A project audit generally may be carried out at the following three levels general audit, detailed audit, and technical audit. Refer to Table 3 for the various levels and their respective descriptions.
Table 3: Project Audit Levels

Levels Description
General audit
Brief review of the project, carried out within a limited time period and with only a few resources. Usually touches on all the six dimensions of the auditing report, that is, the present status of the project, the future status, the status of the crucial tasks, assessing the risk, information relating to other projects, and the project limitations. Conducted as a follow-up to the general audit, and when an unacceptable level of risk has been discovered by the general audit. Depth depends on the seriousness of the issues and their impact on the project objectives. More serious the issue, greater will be the audit depth. Conducted when a detailed audit fails to evaluate the projects technical aspects satisfactorily because of the auditors lack of technical knowledge. The project auditor then employs a technically qualified individual to conduct the audit based on certain guidelines. If such individuals are not employees of the organization, they should be asked to sign a non-disclosure document to ensure confidentiality. It is generally conducted in a detailed manner.
Detailed audit
Technical audit
8.2 Timing of the Project Audit

The timing of an audit is project specific. The first audit is conducted early in the project life cycle, as early problem detection would ease the rectification process. Early audits focus on solving key technical problems. As the project progresses, 174
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adherence to schedule and budget is given more importance. Auditing at the end of the project life cycle is a value addition to the organization than to the project. During this stage, management concerns like disposing of equipment and reallocating personnel become key issues. Post project evaluation could be necessary for the following reasons: it is specified by the client in the agreement and is required legally; it constitutes a major part of the project report and is also the key information source for giving feedback to the parent organization; and it accounts for all the project assets and expenses as a part of project closure.
8.3 Project Audit Report

The top management and the project teams seriousness in considering the audit report vary depending on the credibility of the information given in the report. Data should be checked and calculated carefully to ensure its accuracy. The auditor should explore ways in which he/she can enhance the effectiveness, efficiency, and value of the auditing process. The audit report format depends on the nature of the project under evaluation and the purpose of evaluation. Though some project managers prefer complex and custom made audit report formats, the structure of the audit report should always be simple and straightforward as it makes it easy for the project manager and the top management to understand and comprehend. The management should prepare a distribution list if the audit report is to be distributed within the organization. Restricted distribution may attract every individual, thinking it as a confidential report, which might in turn lead to interpersonal and intergroup conflicts. Focus of the report should be on deviations of actuals from the plans, along with explanations and comments. Such a structure would aid the management to identify project-related problems easily. The audit report should not include negative comments about the people involved in the project. The content in the report should be limited to the project-related information and issues. The report should be written in a professional style without any scope for emotional overtones. Following are the various information items to be included in a typical audit report.
Introduction: This section should present the projects framework. It should include a clear representation of the project objectives. An appendix should be added to the report providing additional information on the project objectives in case of highly complex objectives. Present project status: The projects current status has to be reported when auditing the project. This section should include the following performance measures. Cost: The actual costs are compared with the planned costs in this section. The report should mention the timeframe during which the comparison is made. It concentrates on computing the projects direct costs. A cost data sheet should be given as a supplementary table to highlight the projects total costs along with the overheads. Schedule: This section reports project performance in terms of the milestones accomplished. The auditor must clearly report the completed tasks, pending tasks, and the percentage of work completed. Progress: This section compares the completed tasks with the resources utilized. The report should have adequate information to help the project manager to zero in on the activities that are the sources of the problem, and estimate the time and expenditure required to complete the remaining project.
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Quality: The significance of quality as an evaluation factor depends on the nature of the project. Quality refers to all the features and characteristics of a product or service which bear on its ability to satisfy a stated or implied need. These needs, in terms of projects, are pre-specified characteristics. If detailed quality specifications are attached to a project, this part of the project status report should contain a detailed review of the quality control procedures, along with the latest results of the quality tests conducted. Future project status: This includes the project evaluators conclusions, the projects progress, and makes suggestions about the pending tasks. Audit report does not rewrite the existing project proposals, but provides guidance to future projects. Critical management issues: This section should address all the important issues that should be continuously monitored by the top management; should explain the link between the critical issues and the project objectives; and should briefly describe the time, cost, and performance trade-off. This helps the management to make decisions in future projects. Risk analysis: This section describes all the major risks involved in the project; discusses the impact of these risks on the projects time, cost, and performance. The report can recommend an alternative course of action for minimizing risks. Limitations and assumptions: This section can be included in the introduction or can be placed toward the end of the report. While the audit reports accuracy and timeliness depends on the project auditor, the top management is responsible for the interpretation and actions taken based on the information given in the report. Therefore, it is important to state the limitations of the audit reports validity.
9. Conservation and Utilization of Resources

Control aims at regulating the results through alteration of activities and the proper utilization of organizational assets. The project manager should simultaneously act as a conservationist and should guide the organizations physical assets, its financial resources, and its human resources. The process of conserving these three different kinds of assets is different and so must be done carefully.
9.1 Conservation of Physical Assets

Physical asset control deals with asset maintenance, asset replacement, and quality of maintenance. Asset maintenance can be either preventive or corrective. If the project uses considerable amounts of physical equipment, the project manager may have a problem setting up maintenance schedules to keep the equipment in operating condition. Physical inventory (equipment or material) must be received, inspected (or certified), or possibly stored carefully before use. All the records of incoming shipments should be validated carefully so that payment to suppliers can be authorized.
9.2 Conservation of Financial Resources

It is difficult to track the expenses incurred on larger and more complex projects, and also difficult for the project sponsor to work out the projects correct financial health before it becomes too late to fix problems economically. Financial control tools like current asset controls, project budgets, project accounting, and capital investment controls are used to conserve and regulate financial resources. These controls are 176
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exercized through a series of analyses and audits. Project audits help in assessing the projects exact financial health, the projects output, the suitability of the technical approach, the accurateness of the project plan, and the practices being followed in the project.
9.3 Conservation and Development of Human Resources

The manpower requirement of a project depends on the projects nature. Proper planning should be done regarding manpower requirements for each stage of the project at the inception of any project. Human resource control requires controlling and developing members. Projects provide an effective platform for gathering people, and they have to be utilized carefully. Measures like employee appraisals; personnel performance indices; and screening methods for appointment, promotion, and retention are taken up to ensure proper quality of manpower for a project.
10. Summary
The main purposes of project control are -- to plan and organize the project in order to achieve the objectives of effectiveness and efficiency; to execute the project so that its performance is as close as possible to the planned schedule, budget, and specifications; and to suitably revise the project plan, when required. The project overview statement describes what the goal of the project is and how it will be achieved. The approved project overview statement provides the basis for effective project control, and guides the project managers decision-making for planning, organizing, and executing the project. Project plan development includes schedule development, resource planning, cost estimation of each resource, and cost budgeting of activities. Preparation of the overall project plan also involves: establishing the quality standards and identifying the ways of ensuring quality assurance; planning for staff acquisition; identifying the roles, responsibilities, and reporting relationships among the project team members; determining the communication needs of different stakeholders and ways of addressing them; risk identification and evaluation; etc. Project-driven organizations usually adopt the matrix organization structure that combines the advantages of the pure functional organization structure and the product organization structure. In the project execution stage, the project manager should review the projects progress in a timely and phased manner in order to take corrective actions, if required. Project execution can be controlled using methods and tools like project review, cost monitoring and control, schedule control, Earned Value analysis, progress measurement, productivity measurement, and progress reporting. The projects course can deviate from the plan due to external or internal factors. These changes should be kept in view to control the projects cost. Change control systems, configuration management, and scope creep are three key concepts associated with overall change control.
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Overall change control also includes scope change control, schedule change control, and cost change control. A formal change control system can minimize the risks associated with change. Project audit involves detailed inspection of the management of a project, its methodology, techniques, procedures, documents, properties, budgets, expenses, and level of completion. Some of the important considerations in project auditing are the depth of the project audit, timing of the project audit, and the content and format of the project audit report. The project manager should at the same time, become a conservationist; and should conserve and properly utilize the organizations physical assets, its financial resources, and its human resources.
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Concept Note - 13
Implementation Issues in Enterprise Performance Management

1. Introduction
Management controls will be effective if they are integrated into the organizations activities. Organizations should have realistic expectations from management control systems (MCS). MCS may not always be effective (in design or implementation), and may not guarantee that the organization will achieve its objectives of effectiveness, efficiency, accuracy of financial reporting, and compliance. These systems merely enhance the probability of achieving these objectives. This note will help you understand: The operationalization of a management control system The various organizational roles and responsibilities involved in implementation of control systems The challenges involved in implementing these controls The impact of the organizational life cycle on the evolution of an organizations control requirements.
2. Operationalizing a Management Control System

According to the Internal Control Integrated Framework proposed by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), there are five components of management control control environment (comprising people attributes, management attributes, and the direction and guidance provided by the Board of Directors); risk assessment (identification of risk that may derail the organizations progress in the pursuit of its objectives, analysis of each risk to estimate the probability of its occurrence and impact, and the suitable action that has to be taken to manage the risk); control activities; information and communication; and monitoring the control system.
2.1 Control Activities

Control activities refer to the policies and procedures that are used in an organization to provide a reasonable assurance that the directions and instructions given by the management are followed appropriately. Control activities differ depending on the business environment, organizational objectives, complexity in business operations, people involved in implementation of these activities, and organizational structure and culture. Table 1 lists some such control activities.
Table 1: Control Activities in Management Controls

Control Activity Top level reviews Description The top managements review of organizations performance (against forecasts, benchmarks, etc.) and the progress of strategic initiatives.
Control Activity Direct functional/activity management Information processing
Description Functional/activity managers review of operational performance, reconciliation of records, etc. Include control activities to ensure that information regarding transactions is correct, complete, and authorized. Examples: Policy manuals, organograms, standard operating procedures, evidence of ongoing use of control systems. Dividing the duties (such as making a demand draft and checking/authorizing it in a bank) in the organization among employees to minimize errors intentional or unintentional. Include physical security of assets and periodic verification of the physical existence of assets as per the records. Data analysis to identify trends, deviations, etc., so that corrective action may be taken, if required. For coordination, problem solving, strategic planning and performance review, innovation, etc.
Documentation
Segregation of duties
Physical controls
Analysis of performance indicators Meetings
Adapted from Internal Control Integrated Framework. Committee of Sponsoring Organizations of the Treadway Commission (COSO). 1994, <http://www.coso.org/publications/executive_summary_integrated_ framework.htm>; and Rittenberg, Larry E.; Frank Martens; and Charles E. Landes. Internal Control Guidance. Journal of Accountancy. Vol. 203 Issue 3, March 2007, p46-50.
Meetings Patrick Lencioni identified four types of meetings that will serve different purposes -the daily check-in, the weekly tactical, the monthly strategic, and the quarterly off-site review. According to him, conducting these meetings will help enhance decision making and reduce the time taken in the decision-making process. Table 2 gives the various types of meetings and their features. Table 2: Types of Meetings and their Features Type of Meeting Daily check-in Features Duration: 5-10 minutes Employees stand and discuss the tasks and activities they will handle that day. Clarifies the priorities to be set and how they have to be tackled. Reduces the time spent on scheduling daily activities. Held at a fixed place and time; should not be cancelled due to low attendance. Discussion should be restricted to the daily priorities of the activities.
180
Type of Meeting Weekly tactical
Features Duration: 45-90 minutes Conducted to discuss problems that need to be handled immediately; should avoid discussion of long-term decisions. Comprises three parts o Lightning round: Deals with everyone trying to bring out 2-3 of their most important priorities for the week Progress review: The team tries to compare the progress of activities with the specific critical metrics that have been decided by the organization. Real time agenda: The agenda of the tactical meeting is decided depending on the outcomes of the lightning round and the progress review.
Monthly strategic and Ad hoc strategic
Duration: Monthly 2 to 3 hours Conducted regularly to discuss key strategic issues that arise during the weekly tactical meetings. Key aspects (only 2 to 3) that may affect the business are discussed. Ad hoc strategic meetings should be called for to sort out exceptional strategic issues that require to be addressed urgently. The meetings agenda should be decided beforehand through thorough research and preparation on the topics to be discussed. Duration: Quarterly 1 to 2 days; conducted in a location away from office. Focus of this discussion is about the issues regarding long-term strategies, employees, teams, the industry, and the competitors. Less number of presentations and outside speakers. Avoid tourism spots as they may lead to distractions.
Quarterly off-site review
2.2 Communication
Information systems will not be effective without proper communication between the various management levels. Communication helps in passing on the information, work coordination, assigning of responsibilities, etc. Two types of communications take place in any organization internal communication and external communication. Internal Communication Meetings act as mechanisms of internal communication. Consistency/inconsistency of managements behavior with its formal communications (oral/written) is an important component of internal communication to employees. Employee orientation and
181
socialization helps in spreading the organizations culture, and shared values to new and existing employees. Internal communication includes Informing the employees about the importance and functioning of the control systems, and the role each employee has to play within the control system Making the employees aware of problems that may arise and the ways to handle them Letting employees know how their activities affect the jobs of other employees Having both regular and exception reporting systems in place which will help employees report important business related information to the higher levels in the hierarchy Collecting and processing employee feedback and ideas related to business functions, products, continuous process improvement, etc. Ensuring proper, two-way communication between the management and the board of directors.
External Communication External communication includes communication with the suppliers, customers, external auditors, regulators, etc. Through such communication, customers can provide feedback about the quality of products and services, and external auditors and regulators can provide information about the effectiveness of the internal controls of the organization. Most business processes, these days, are being outsourced, to organizations located worldwide. Managers, who cannot be present at all the outsourced locations, face problems in controlling aspects like time and costs of the business. These issues can be solved by using various software and communication technologies. Refer to Exhibit I to understand the role of communications in an outsourcing relationship.
Exhibit I: Communicating for Control in Outsourcing Relationships

Medical Product Outsourcing surveyed original equipment manufacturers, contract service providers, and industry consultants to identify the ten most common problems faced in outsourcing relationships and the solutions for addressing these problems. One of the most important problems faced in outsourcing/offshoring relationships is insufficient communication or absence of communication. To solve this issue, experts advice that it is always better to put down the terms and conditions clearly on a paper. This would help in enhancing understanding and would also help in clarifying any queries related to the specifications. Experts also suggest that the whole project team should communicate. Some companies are facilitating multilayer communication in which employees belonging to similar domains at each end communicate with each other. The project managers, on the other hand, should have complete and clear knowledge about all crucial aspects of the project. Companies are also sending employees to the clients locations to work there along with them and have a clear understanding of the project.
Contd
182
Contd
Communication is carried out on a daily and regular basis through phone, e-mail, etc. Companies also conduct monthly or quarterly face-to-face meetings that deal with issues, problems, and progress of the project.
Adapted from Stacey L. Bell, Your Top 10 Outsourcing Problems Solved, October, 2006, <http://www.mpo-mag.com/articles/2006/10/your-top-10-outsourcing-problemssolved>.
2.3 Monitoring the Control System

Organizations should develop controls so that they become flexible to adapt to changes, and incorporate any changes in plans when required. As the business environment is volatile, the control systems should be reviewed and monitored regularly to assess their relevance and suitability for the organization at a given point of time. This monitoring involves evaluating the design and functioning of the controls at proper intervals of time and fixing them in case of any discrepancies. Continuous monitoring of control systems includes: regular management and supervisory activities, periodic audits both internal and external, and inputs from external stakeholders such as customers and regulators. Separate assessment of controls can also be performed through self-assessment by the management or by audits commissioned specifically for this purpose. Continuous monitoring and separate assessment of controls helps in improving the control systems effectiveness. The former helps in providing feedback on whether the control components are effective or ineffective, while the latter, helps in understanding the control systems effectiveness as a whole and, in turn, of the continuous monitoring processes. Decision regarding separate assessment of activities depends on factors like level and type of changes taking place and the risks that these changes pose for the organization; the proficiency of the people involved in implementing the controls; and on the outcomes of the continuous monitoring effort. While implementing control systems, it is important that the organizations should have proper systems in place to identify, communicate, follow up, and correct discrepancies (if any) in the set plans and objectives. The control functions should be closely integrated with the management functions of planning, organizing, staffing, and directing.
3. Organizational Roles Involved in Implementation

The MCS of an organization comprise different procedures to help in the proper monitoring and control of its various operations. Management control is implemented by a number of people who may be either internal entities or external entities. Each entity plays a different role and has a different responsibility toward the effective implementation of an MCS.
3.1 Internal Entities

The internal entities who contribute to the effectiveness of the control systems include the management, board of directors, internal auditors, and most of the employees. Table 3 lists the important internal entities and their functions. 183
Table 3: Internal Entities and their Functions

Internal Entity Functions Chief Executive Officer (CEO) CEO is the highest authority responsible for the MCS Functioning of the MCS depends on his/her attitude and integrity Responsible for: o o o Providing managers with the right means of pursuing performance objectives Deciding on the values and standard operating procedures which are integral to MCS Assessing how well the managers implement the control systems in their respective departments.
Chief financial officer and Controller Management o Responsible for: o Devising budgets and other plans for the entire organization Monitoring performance on all fronts operational, financial, and compliance.
Departmental managers and managers for specific activities Number of hierarchical levels determine the degree of responsibility that each departmental or lower level manager has in implementing control policies and procedures Responsible for: o o o o Monitoring the effectiveness of controls in their specific departments and for specific activities Devising the departmental and functional controls. Finding discrepancies and other issues Communicating problems to the higher levels of management that will significantly affect the achievement of organizational objectives.
Board of Directors
The board members should have proper knowledge about the organizations operations and activities. Board members form different committees, which help them in the proper discharge of duties. They should be able to spend the time and effort needed to fulfill their responsibilities toward the organization. Responsible for: o o Governance, and supervising and directing the management of the organization Selecting the key members of the top management
184
Internal Entity o o o
Functions Guiding the organization in making certain critical decisions regarding objectives and strategies Implementing appropriate controls by providing proper supervision Regularly communicating with all the important internal and external entities involved in the control process.
Internal Auditors
They should be in a position to contact the board whenever necessary, and also have the power and authority to suggest improvements when required. They should be appointed in such a way that there is no conflict of interest or bias involved regarding any of the functions or operations that they are auditing. Responsible for: o Evaluating the controls and suggesting improvements in them o Assessing whether the financial and operating information is reliable and the methods used for obtaining information are appropriate o Assessing whether the control systems conform to the set standards and regulations o Protecting the assets and ensuring proper utilization of resources o Assessing the operations to check whether the outcomes of the operations are matching with the set objectives of the organization. Each employee, within his/her role and responsibility, contributes to the control process. They need to accept accountability for reporting discrepancies, operational issues, non-conformance to the code of ethics, etc., to their supervisors or designated authorities. They should avoid resorting to unethical activities due to any coercion from their supervisors and should also be given the assurance that they will not be punished if they report such coercion.
Employees
In an interview, N R Narayana Murthy, the non executive chairman and chief mentor of Infosys Technologies Ltd., said, A great leader is one who is not only good in creating a vision, creating the big picture, but also ensuring that he goes into the nittygritty, into the details of making sure that the vision is actually translated into reality through excellence of execution. In other words, great leaders have great vision, great imagination, great ideas, but they also implement those ideas through hard work, commitment and flawless execution. In doing so, they motivate thousands of people.1
1
Source: The Renaissance Man, The Times of India, October 14, 2009. 185
3.2 External Entities

External entities that play a vital role in an organizations control systems include external auditors, legislators and regulators, customers and suppliers, and financial analysts. Refer to Table 4 for the list of important external entities and their functions.
Table 4: External Entities and their Functions

External Entity Functions External auditors play an important role in the financial statement audit of any organization. They offer an objective view and help the organization in accomplishing its financial and other objectives. They help in doubly ensuring that the financial statements are fairly presented, and in assisting the management in discharging their duties regarding controls properly. They need to have right knowledge of the organizations internal control systems so as to conduct an effective audit. If the internal control systems are deficient, the auditor may have to undertake thorough checks of the financial statements and the supporting evidence to arrive at a conclusion. Through audit findings, external auditors convey to the organization systematic information and suggestions regarding actions to be taken to accomplish set goals. They also identify deficiencies in the internal control system; provide suggestions for improvement; and are also used for quality audit, safety audit, environmental audit, etc. Legislators and regulators develop rules that organizations have to abide by while developing and implementing internal control systems that comply with the law of the land. Important laws and regulations generally relate to financial statements; in certain cases, they also relate to the compliance aspects of operational and environmental issues. Customers and suppliers help organizations in improving their activities to meet the operations, financial, as well as compliance objectives. The organization should take care that proper processes are in place to take feedback into consideration and rectify issues on a timely basis. Financial analysts assess whether the organizations effectiveness current performance as well as potential for future performance is good enough from the perspectives of investors and/or lenders. This is done by examining the objectives of the organization, the financial statements, adaptability to changes in the environment, etc.
External Auditors
Legislators and Regulators
Customers and Suppliers
Financial Analysts
186
External Entity
Functions They provide information that helps organizations know how their performance is rated; the environmental risks that they may be subject to; and newer strategies that they may adopt to improve performance. This in turn helps it in improving the internal control process.
4. Challenges in Implementation
Control systems can be effective if they are designed and implemented appropriately. For technical control subsystems, a good control system design can reduce implementation problems to a great extent. For control components concerned with behavioral aspects, implementation problems often occur even if the design of the control system is good. Consistency of execution is important for the successful administration of MCS. The issues faced in implementation can be of two types: hindrances to the management control process, and dysfunctional consequences of implementing the management control system.
4.1 Hindrances to the Management Control Process

The management of any organization should focus and continuously monitor the implementation and administration of MCS. It may also have to interfere and take suitable action when the control system is not able to handle a specific situation. Following are some of the issues that hinder the management control process. Problems in the control environment due to organizational values, management style, and managements priorities. Lack of a proper organization structure and clear hierarchy. Lack of proper personnel, especially for the key organizational roles that are involved in management control The employees preferences and needs, and the reward systems used should correspond with each other. The employees should also appreciate the rewards given to them. Deficiencies in the employees training and development Managers and employees may fail to discharge their control-related responsibilities due to poor judgment, incomplete information, errors, or intentional mistakes. Lack of proper communication between the supervisors and subordinates (or line and staff). The controlled person may not accept the control process or may fail to understand what is expected of him/her. The controlled person (say, line manager) and the controlling person (say, internal auditor) may team up to cover up financial frauds or violate the control procedures. Employees may not be committed to the set performance targets due to their perception. Employees may not perform well if they feel that the performance targets are too high or too low. 187
Delays in providing reasonably correct data required for management control Differences in the planning horizons of different functions can affect the control systems performance as it involves the combined efforts of the managers from various departments. Difficulty in assessing the total costs incurred in implementing the control system. Management override, that is, the illegitimate use of management authority to show that the organizations performance is better than it actually is or to bypass procedures and policies for personal gain. The issues of conflict of interest between the manager and the organization and the difficulty of monitoring can be explained in terms of the agency theory. Refer to Exhibit II for a description of agency theory.
Exhibit II: Agency Theory and Control System Implementation

The agency theory is defined as the analysis of principal-agent relationships, in which one person, an agent, acts on behalf of another person, a principal; that is, the principal assigns work and delegates decision-making to the agent. In the management control system context, the principal-agent relationship can be of two types. One, the relationship between the shareholders (principal) and the CEO or the top management (agent) and two, the relationship between the CEO or the top management (principal) and the managers (agent) at the lower levels in the hierarchy. Some studies on the agency theory also cover the supervisor-subordinate and employer-employee relationships under this principal-agent framework. The agency theory is based on the assumptions that agents are self-interested, not ready to take risks, and do not prefer to work hard. Principals and agents are expected to have conflicting interests. The theory also assumes that agents are opportunistic in nature. Conflict of interest Financial compensation along with leisure time, a good work culture, etc., motivates agents to work hard. The harder the agent works, the higher is the value he/she generates for the principal. If the agent prefers leisure time over hard work, he/she is said to be work averse. If he/she demonstrates work aversion by purposefully avoiding work, it is termed as shirking. The principals basic objective will be to maximize the returns on investments made. The control dimensions of compensation and incentive programs attempt to bring about goal congruence between the agent and the principal. Though the principal uses management control systems to minimize the opportunistic behavior of agents, the implementation can never be expected to result in perfect alignment of the goals of all agents with that of the principal. Another area of conflict of interest is risk preference, that is, the risk that the principals and the agents are ready to take. The agency theory states that agents do not like to take high risks, that is, they are risk averse. It emphasizes the importance of taking into account uncertainty and risk considerations while designing management control systems, especially compensation and incentive systems. However, as all agents under the purview of the same control system need not have the same risk preference; there will be problems in the implementation of control systems.
Contd
188
Contd
Difficulty in monitoring When the principal is not able to monitor the activities of the agent properly, he/she may not be in a position to compensate the agent appropriately. A condition called information asymmetry results when the principal does not have complete information about the agents contribution to the organizational outcomes. When there is a lack of monitoring, information on whether the activities are beneficial to the principal is available only to the agent. That is, the agent has more information regarding the activities than the principal and this information is called private information. This conflict of interest and private information leads to a moral hazard, that is, the agent attempts to misrepresent information to the principal.
4.2 Dysfunctional Consequences of Management Control Systems

MCS should ideally help organizations achieve their objectives of effectiveness, efficiency, and compliance -- this is possible through shared understanding of the importance of the control system, commitment to the organizations objectives, and mutual trust between the management and the employees. However, in reality, MCS implementation may lead to consequences that are counterproductive to the achievement of organizational objectives. The control system should be closely monitored to check whether it is actually motivating managers and employees to act in the organizations interests so that necessary corrective actions may be taken in the design and/or implementation. Following are some of the possible dysfunctional consequences of control systems. In a control system/environment that emphasizes negative reinforcement, managers and employees may focus on diverting the blame than trying to find ways to solve problems or discrepancies. Rigid controls can lead to negative emotions like fear and resentment, negative attitudes, and counterproductive behavior like active or passive resistance to the control system implementation. Overemphasis on quantification and on measuring all possible parameters may simply increase the cost of control without corresponding benefits. Standard operating procedures and rules may not allow the employees to think innovatively and creatively. They also restrict the employees from the dynamics of the environment and hence, hamper adaptability. Goals and standards setting may lead to inversion of means and ends, mainly if the performance parameters are decided based on ease of quantification and measurement. In performing multiple activities, an employee or manager may choose to focus more on the activity that gives him/her more returns than giving enough attention to each of his/her responsibilities. A manager or employee may manipulate the control systems at the cost of organizational objectives to portray a better picture of performance than what the reality is.
189
Lagging indicators of performance such as accounting profits or return on investment (ROI) may mislead the management in the short term, and may not be very useful for proactive management control. When different functions or divisions in the business are interdependent, optimization of performance of an individual function or division may not result in an optimal performance of the entire organization. If the control system holds managers responsible for achieving targets which are not in their control but are subject to significant influence of the environment, it reduces the credibility of the top management and the control system. Compared to good performance, bad performance of an employee or a team gets reported to the higher authority, usually faster. This kind of a feedback mechanism is biased against employees and may risk his/her future career prospects.
5. Impact of Organizational Life Cycle on Control Systems

Every organization has a life cycle and the control requirements change depending on the stage of the life cycle in which the organization is in. According to Larry E. Greiner, organizations usually go through five different phases of development and growth the creativity phase, the direction phase, the decentralization phase, the coordination phase, and the collaboration phase. Refer to Table 5 for the various phases and their features. The growth phases have been referred to as evolution and the transition between these phases as revolution. A shift from one stage to another is a difficult process that involves change in the rules for organizations functioning, the control systems, and procedures, as well as the way in which it will react and adapt to the external environment. The organizations survival and success depends on its ability to handle these transition issues effectively.
Table 5: Phases of Development and Growth

Phase Creativity phase Features Begins at the inception of the organization High focus on developing products/services to compete with the existing players in the market, and on getting orders from customers Focus is on technical and operational aspects than on the management aspects High level of informal communication within the organization Market conditions and the external environment influence the business decisions and are usually taken by the owners As the organization grows, the focus shifts to innovation, creativity, achievement of economies of scale, putting higher investments, and financial controls. The organization appoints a leader who directs the organizations performance and takes it on a path of controlled growth. It adopts a functional organization structure and employees tend to specialize in a specific function such as marketing or production.
Direction phase
190
Phase
Features It puts in place control systems for accounting, budgets, inventory management, etc. Departments are typically viewed as revenue centers or cost centers. Standard operating procedures and formal reward systems are devised and implemented. Communication becomes formal as introduced in the hierarchy. more levels are
Decision-making authority lies with the senior management team. As the organization grows, it becomes difficult to manage and control it due to the presence of many hierarchical levels and functional departments. This leads to dissatisfaction and frustration among the lower level managers and employees as they are not allowed to apply their expertise and take business decisions on their own. A decentralized structure is implemented, wherein the lower level managers are given the authority to take decisions and the responsibility for business growth. Direct communication between the top-management and the lower levels decreases and takes place via occasional site visits, circulars, etc. The top management also restricts its decision-making responsibility to strategically important decisions. The organization tries to increase motivation levels by introducing the concept of profit centers and by giving incentives. Greater autonomy and higher incentives motivate managers to perform well. Internal control and reporting systems help monitor the activities of lower level managers. Issues arise when the managers fail to comply with the plans and budgets of the organization, and choose to use their own discretion in decision making. The top management perceives a loss of control and tries to restore the centralized structure, which is actually difficult to do. Rather, the management needs to implement suitable coordination mechanisms to align the behavior of line managers toward organizational objectives. It involves an extensive use of formal monitoring and control systems, which are created and implemented by the top management. The functional or geographical organization structure is changed to form a divisional or product based structure. 191
Decentralizat ion phase
Coordination phase
Phase
Features Planning processes become more formalized and are thoroughly evaluated. The staff functions are strengthened to closely monitor the activities and outcomes of line managers. Decisions regarding investments are thoroughly evaluated by headquarters. Divisions are considered to be investment centers and resource allocation is done considering the return that each center generates on the investment made. Strategically important activities and decisions are centralized while day-to-day operating decisions are decentralized. Incentive systems are revamped to emphasize organizational performance rather than mere individual performance. Coordination mechanisms help in improving resource allocation between the different units. Managers are expected to take decisions that comply with the rules and processes of the organization, which could lead to the problem of goal displacement. Managers and employees tend to resent the increased number of rules and regulations that have to be followed. Conflicts often occur between the members of line and staff functions. Presence of a large number of standard procedures to be followed hampers the innovativeness of employees. Competitive position of the organization may be weakened due to rigid internal processes. Increased levels of collaboration between the line and staff functions Emphasis on social controls and self-discipline rather than formal control mechanisms Organizations may further change their structure from a divisional structure to a matrix structure. Focus on creating interdisciplinary teams that comprise members from both line and staff functions Employees are trained to work in cross-functional teams and manage conflicts constructively. Integrated information systems are put in place to enhance day-to-day decision making. Incentive systems are modified to reward team efforts rather than individual accomplishments. The overall atmosphere of collaboration fosters innovation.
Collaboratio n phase 192
5.1 Control Systems and Organizational Decline or Change

Kim S. Cameron, Myung Kim, and David A. Whetten have defined organizational decline as, a condition in which a substantial, absolute decrease in an organizations resource base occurs over a period of time. Organizational decline can occur due to reasons such as the organizations age (old), excessive bureaucracy, inability to adapt to the changing environment, and lack of availability of resources for the functioning of the organization. Organizational decline may be accompanied by more conflicts, greater resistance toward change, decrease in the top managements credibility, downsizing, lack of motivation among employees, and exit of key employees. These situations can be handled if the organization can enhance its efforts toward making employees understand the strategies through better and more frequent communication. Some of the ways in which organizations can handle organizational decline are by centralizing key decisions, changing job profiles, and devising better ways of downsizing. Apart from organizational growth, decline, or turnaround, change takes place when the control system is modified or when a new one is implemented. Following are some of the issues that have to be considered while implementing new control systems or modifying an existing one. All employees may not agree to a change. Therefore, implementation of change should be initiated with people who accept change so that they will convince others who resist the change. Change in the control system requires change in the organization structure and processes. Organizations should know the amount of change required and how much of it will actually help in meeting the organizations objectives. Proper training should be provided to managers and employees. If it is a project control system, the new control system has to be tested using pilot projects to certify the systems advantages to the stakeholders. This will help in understanding the new system and the technical problems that may arise.
6. Summary
Management control systems may not always be effective, either in terms of design or in terms of implementation. Management control systems merely increase the probability of achievement of organizational objectives of effectiveness, efficiency, accuracy of financial reporting, and compliance. Management controls should be integrated or in-built into the organizations activities. These will influence the organizations capability to achieve its objectives and also help in improving the quality of its business operations. According to the COSO framework, management control has five components -control environment, risk assessment, control activities, information and communication, and monitoring the control system. Control activities refer to the policies and procedures used in an organization to provide a reasonable assurance that the directions and instructions given by the management are followed appropriately. These activities differ depending on the 193
business environment, organizational objectives, complexity in business operations, the people involved in the implementation of these activities, and organizational structure and culture. Conducting meetings helps in improving decision making and in reducing the time taken for the decision-making process. The daily check-in, the weekly tactical, the monthly strategic, and the quarterly off-site review are the four different types of meetings. Communication is not only required to pass on the information but is also necessary for coordination of work, assigning responsibilities, etc. Internal communication and external communication takes place in any organization. Management controls are designed in such a way that the control activities involved are monitored on a continuous basis or separately. This helps the organization by offering feedback on whether the control components are effective or ineffective. The most important factor while implementing control systems is that the organizations should have proper processes in place to identify, communicate, follow up, and rectify discrepancies (if any) in the set plans and objectives. Management control is implemented by a number of people both internal and external to the organization. The entities internal to the organization are the management, the board of directors, the internal auditors, and most of the employees; the entities external to the organization include external auditors, regulatory bodies, customers, suppliers, and financial analysts. The issues faced in implementation can be those which hinder the management control process or dysfunctional consequences of implementing the MCS. Some issues that hinder the management control process are: lack of proper organizational structure, management style, well-defined hierarchy, etc.; lack of proper person-job and person-reward fit; deficiencies in training and developing employees; collusion between the controlled person and the controlling person; illegitimate use of management authority; and lack of proper communication. The implementation and administration of MCS can lead to consequences that are counterproductive to the achievement of organizational objectives. Some dysfunctional consequences of management control systems are excessive quantification and attempt to measure all possible measures, presence of standard operating procedures curbing innovation, and data manipulation. Organizations usually go through five phases of development and growth the creativity phase, the direction phase, the decentralization phase, the coordination phase, and the collaboration phase in their life cycle. The control requirements change depending on which stage of its life cycle the organization is in. In addition to organizational growth, decline, or turnaround, change can also take place when an existing control system used by an organization is modified or a new control system is implemented.
194

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Enterprise Performance Management

Enterprise Performance Management An Overview

Enterprise Performance Management

Enterprise Performance Management An Overview

2. Approaches to Management Control

2.1 The Cybernetic Approach to Management Control

Enterprise Performance Management

Enterprise Performance Management An Overview

2.2 Management by Objectives

Enterprise Performance Management

Exhibit 1: MBO in Information Technology (IT) Projects

Enterprise Performance Management An Overview

3. Objectives of Management Control

Enterprise Performance Management

3.1 Effectiveness and Efficiency of Business Operations

3.2 Reliability of Financial Reporting

3.3 Compliance with Applicable Regulatory and Legal Framework

4. Schemes for Classifying Management Controls

Enterprise Performance Management An Overview

Table 1: Management Controls Classification Schemes

4.1 Based on the Object of Control

Table 2: Forms of Action Controls

Enterprise Performance Management

Action Control Pre-action appraisal

4.2 Based on the Extent of Formalization of Control

Enterprise Performance Management An Overview

4.3 Based on the Time of Implementation of Controls

5. Contextual Factors Influencing Management Control

Enterprise Performance Management

5.1 Nature and Purpose of the Organization

Table 3: Non-Profit Organization vs. For-Profit Organization

Basis for calculating profitability Use of profits

Satisfaction derived serving others.

5.2 Organization Structure and Size

Enterprise Performance Management An Overview

5.3 National Culture

Table 4: Hofstedes Dimensions of National Culture

Enterprise Performance Management

Dimension Masculinity/ femininity

5.4 Corporate Strategy and Organizational Diversification

5.5 Competitive Strategy

Enterprise Performance Management An Overview

5.6 Managerial Styles

5.7 Organizational Slack

5.8 Stakeholder Expectations

Enterprise Performance Management

Figure 2: Responsibility of Organizations toward Stakeholders

Exhibit 2: Novo Nordisk and Stakeholder Relations

Enterprise Performance Management An Overview

Enterprise Performance Management

Design of Organization Structure and Control Systems

2.1 Structural Dimensions of Organization Design

Enterprise Performance Management

Table 1: Structural Dimensions of Organization Design

Design of Organization Structure and Control Systems

Definition and Description

Enterprise Performance Management

Definition and Description

2.2 Types of Organization Structures

Design of Organization Structure and Control Systems

Figure 1: Organization Structures

Enterprise Performance Management

Design of Organization Structure and Control Systems