Concept Notes On Enterprise Performance Management

Enterprise Performance Management
Concept Notes
Contents
Concept Notes
Sl.No. Title Pages
1. Enterprise Performance Management – An Overview ..................... 1-18
2. Design of Organization Structure and Control Systems ................ 19-38
3. Strategic Performance Control ....................................................... 39-48
4. Budgeting Techniques .................................................................... 49-60
5. Business Performance: Targets, Reporting, and Analysis ............ 61-76
6. Auditing ........................................................................................... 77-94
7. Transfer Pricing ............................................................................ 95-106
8. Business Ethics and Enterprise Performance Management ...... 107-118
9. 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. Title Pages
1. Jack Welch and Jeffrey Immelt: Continuity and Change in Strategy,

Style, and Culture at GE............................................................. 197-220
2. GCMMF’s Cooperative Structure ............................................... 221-237
3. Whole Foods Market’s Unique Work Culture and Practices ...... 238-262
4. Balanced Scorecard Implementation at Philips.......................... 263-284
5. Tesco: The Customer Relationship Management Champion .... 285-302
6. Hollinger International: The Lord Black Saga ............................. 303-318
7. The Bribery Scandal at Siemens AG ......................................... 319-337
8. BP: Putting Profits Before Safety? ............................................. 338-362
9. P&G’s 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. Pixar’s ‘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
[
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 not 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 organization‟s
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 JCP‟s „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 organization‟s 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 sub-
systems. 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
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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.
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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 real-
time, 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.
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Step 5: Rewarding performance and/or taking corrective action when necessary
When an employee‟s 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 self-
control 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
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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…
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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 user‟s 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 self-
control 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 management‟s 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 manager‟s efforts
to achieve goals on the achievement of goals of others.
3. Objectives of Management Control

By integrating the organization‟s diverse activities, the modern management control
system addresses contextual issues that affect an organization‟s 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
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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 organization‟s 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
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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 Classifications

Object of control 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 organization‟s 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 Description

Behavioral These are limitations placed on the behavior of organizational
restrictions 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 organization‟s
interests.
The restrictions may be physical in nature (passwords on
specific computers) or administrative (limited decision-
making rights).
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Action Control Description

Pre-action It involves a supervisor reviewing a subordinate‟s plan of
appraisal action.
Control here takes place before an action is carried out so that
wrong action may be prevented.
Action This form of control entails making employees responsible
accountability 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.
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 organization‟s 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
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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;
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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 society‟s
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 profit-
based organization.
Table 3: Non-Profit Organization vs. For-Profit Organization
Differentiating
Non-Profit Organization For-Profit Organization
Factor
Purpose For the well-being of society For pursuit of profits
Funding Funded by donor contributions Equity, debentures, loans,
and grants, and operating and retained profits
surpluses
Basis for Amount of service that has Financial profits
calculating helped in enhancing the
profitability quality of life in society
through education, health, etc.
Use of profits For the benefit of society Passed on to the employees,
the shareholders, and to the
government as taxes
Type of rewards Satisfaction derived from Is in the form of monetary
serving others. benefits – so, tangible in
nature.
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
organization‟s activities effectively and efficiently. It determines the organization‟s
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 organization‟s 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 management‟s work increases and the
organization structure becomes more complicated, making MCS for such
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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 country‟s 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: Hofstede’s Dimensions of National Culture
Dimension Description
Power distance 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 It refers to risk-taking ability and the extent of avoidance of
avoidance 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/ It examines the tendency of people to either prefer working as
collectivism 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
Masculinity/ High on masculinity – a higher competitive spirit,
femininity 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 unit‟s 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 firm‟s
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 subordinate‟s work activities and
decisions, and the level of trust and confidence of the manager in the ability of the
subordinate‟s 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, top-
level 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 organization‟s 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 company‟s 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 organization‟s 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 organization‟s 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 socio-
economic 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.
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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 organization‟s 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 and Description

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
Degree of variances measured to assess progress; and formal
Formalization 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 Also called as division of labor or functional
Specialization 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.
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Design of Organization Structure and Control Systems

Definition
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
Hierarchy of
organization depending on certain factors which include
authority
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 decision-
making 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.
Degree of
Centralization 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
Definition
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.
In organizations with a high level of professionalism,
Degree of MCS may be designed in such a way as to provide an
Professionalism 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
In a specific function, it is calculated as the ratio of the
Personnel ratios number of people in the function to the total number of
people in the organization.
They indicate the management’s priorities and
judgments regarding the deployment of people.
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
organization’s 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
Advantages and Limitations
Structure
Advantages
There is more emphasis on efficiency.
Functional
structure Employees are segregated based on their expertise and
are able to specialize in the jobs assigned to their
respective departments.
25
Organization
Structure
Limitations
They face difficulty in adapting easily to
environmental changes.
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).
Divisional
structure 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
Matrix structure
improving their own profitability.
Economical sharing of resources among the various
departments so as to achieve the organization’s goals
and objectives.
26
Organization
Structure
Presence of dual authority leading to greater
communication between managers.
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 skills in
individuals within the structure
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 employer’s contribution toward
organizational goals.
Horizontal
Limitations
structure
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
Hybrid structure 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.
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 organization’s control system should be able to measure the influence that the
activities of each manager have on the organization’s performance. In other words, it
should be able to pinpoint the contribution of each manager to the achievement of the
organization’s 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 employee’s
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 segment’s 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 organization’s 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.
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The responsibility center’s 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 manager’s 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.
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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
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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 organization’s 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, pre-
action 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.
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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 action’s 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
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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 management’s 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 Description

Routine control Clear objectives, quantifiable results, predictable
interfaces, and repetitive activities.
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, predictable

interfaces, and non-repetitive activities.
Experts are people who have in-depth knowledge about
the procedures and processes and hence are capable of
exercising control.
Trial and error Clear objectives, quantifiable results unpredictable

control 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.
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Type of Control Description

Judgmental When the objectives are clear but the results are not
control 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.
Political control 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.
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 Managerial Solution Lever of Control

Problem
Lack of focus or Communicate clear Diagnostic control
resources to accomplish targets; provide the systems
objectives necessary support and
feedback
Ambiguity of purpose Convey core values and Beliefs systems
mission
Pressure or temptation Indicate and enforce Boundary systems
to act illegally or rules
unethically
Suppressed creativity Open communication Interactive control
due to lack of prospects between functions to systems
or fear of risk. encourage
organizational learning
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 manager’s 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
organization’s 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: Pixar’s Organizational Culture

Pixar’s 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, Pixar’s 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.
Pixar’s 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. Pixar’s 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….
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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 other’s
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
person’s contribution alone. Though the star performers got higher 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 Pixar’s 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 Pixar’s unique culture. Some analysts felt that the
Disney’s bureaucratic style would threaten Pixar’s culture. However, the
management of both Disney and Pixar stressed that Pixar’s culture would be
protected.
Source: Purkayastha, Debapratim and Rajiv Fernando. “Case Study - Pixar‟s „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 organization’s 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
organization’s 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:
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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.
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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 management‟s 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 organization‟s 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 rendering resources for economic development.”1
The strategies that an organization adopts control its strategic positioning, which
translates into customer perception of the organization‟s 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 organization‟s

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 organization‟s or the business unit‟s 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 variable‟s performance that is being measured or the performance of collective
variables in a single indicator.
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The middle management may be interested in a PI that reflects a single variable‟s

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 organization‟s 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 indicator‟s 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 customer‟s (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 organization‟s 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.
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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 management‟s 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 organization‟s 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 organization‟s 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 Underlying Question

Customer perspective To achieve our vision, how should we appear to our
customers?
Financial perspective To succeed financially, how should we appear to
our shareholders?
43
Perspective Underlying Question

Internal business process To satisfy our customers and shareholders, at what
perspective business processes must we excel?
Innovation/learning and To achieve our vision, how will we sustain our
growth perspective 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 organization‟s 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 organization‟s 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 organization‟s 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 organization‟s 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 organization‟s 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 Strategy
formulation
Use of Balanced Scorecard Clarify and translate vision

for Strategy Execution and strategy
Communicate and
link strategic objectives
and measures
Strategic feedback
and learning
Corrective actions
Plan, set targets, and
for strategic
align strategic initiatives
performance control
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.
45
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 customer‟s 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 organization‟s 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 the continuous
monitoring/reporting of various performance measures.
Strategic information systems are information systems applications that serve the
top management‟s 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 organization‟s 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 organization‟s 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.
48
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…
50
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/cgi-
bin/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 organization’s 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 world’s 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>
52
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 organization’s 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
Characteristics Type of Cost Examples
Budget
Appropriatio A ceiling is set for Discretionary Training, advertising,
n Budget certain costs. sales promotion and
expenditures based R&D.
on the
management
decision.
Flexible A static amount is The static amount The static part:
Budget established for includes both salaries, depreciation,
fixed costs and a discretionary and property taxes, and
variable rate is committed costs planned maintenance.
determined per while the flexible The flexible part:
activity measure part includes direct material, direct
for variable costs. engineered costs labor, and variable
per X value. overhead. Also, some
costs related to sales
representatives such
as sales commissions
and travel.
Capital Decisions Committed costs. New plant and
Budget regarding potential equipment.
investments are
made using
discounted cash
flow techniques.
Master A comprehensive Discretionary, All revenues and
Budget plan is developed engineered and expenditures for any
for all revenues committed costs. organization.
and expenditures.
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 organization’s 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 short-
term 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 year’s 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.
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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
organization’s 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 year’s 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 organization’s
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 Hofstede’s 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.
59
• 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.
60
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.
• 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-to-
period.
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-to-
period 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 Features

Flat line target The performance parameter is expected to exhibit a linear pattern
throughout the period during which the performance is analyzed.
Step target 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 performance-
related changes.
Seasonal target In certain industries like retail and insurance, the management
generally sets targets that vary with the season (festivals, etc.).
Growth target The management sets targets based on the product life cycle
(PLC) stage in which the product is.
3. Factors Affecting Business Performance

An organization’s 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
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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 Descriptions
Rigid/efficient • Management follows a conservative approach; can
profile 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.
Flexible/inefficient • Prefer to make changes even if the change comes at a
profile 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 management’s
approach would help the organization in achieving
success.
Flexible/cost • Conservative (cost conscious) and innovation-oriented
conscious profile • Dual emphasis is on flexibility and efficiency
(Analyzing
• These managers accept new ideas less willingly than
organizations)
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.
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 organization’s 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 organization’s 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 ABC Limited XYZ Limited
2000 12,000 11,000
2001 15,000 12,000
2002 9,000 11,000
2003 9,500 10,500
2004 10,500 12,000
2005 11,000 13,000
2006 12,000 13,500
2007 12,500 14,000
2008 13,000 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
ABC Limited
XYZ Limited
8000
6000
4000
2000
0
2000 2001 2002 2003 2004 2005 2006 2007 2008
Years
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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 (Chairman’s report, the CEO’s report, the
Directors’ report, the Auditor’s 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 country’s 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 company’s 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 organization’s financial health.
Refer to Exhibit 1 for the contents of ITC Limited’s 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 ITC Infotech
o Technico
o Agarbattis
o 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 Analysis

Financial measures Variance analysis (comparison of actual financial
performance with a planned one) helps an
organization to take corrective measures in the future.
Customers Customer behavior and satisfaction analysis helps an
organization find out the organization’s 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
Performance Dimensions Analysis

Internal business Evaluating internal business processes helps in
processes ascertaining whether efficiency of the actual usage of
resources in business processes is at par with the
planned efficiency parameters or not.
Growth dimensions Evaluation of growth dimensions helps compare
actual training, technology adoption, and employee
productivity with industry standards and the
organization’s own plans. Corrective actions are
taken if there are any variances.
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 organization’s 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 )]
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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

organization’s 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 Alpha Beta Gamma Total
Planned number of units sold 3,000 5,500 3,500 12,000
Actual number of units sold 3,500 4,500 2,300 10,300
Estimated market size 6,500 7,500 5,500 19,500
Actual market size 6,000 8,000 5,000 19,000
Standard selling price per unit Rs. 12 Rs. 7 Rs. 10 Rs. 29
Actual selling price per unit Rs. 10 Rs. 8 Rs. 9 Rs. 27
Standard margin per unit Rs. 7 Rs. 3 Rs. 5 -
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.

(7 × 3,000 ) + (3 × 5,500 ) + (5 × 3,500 )
(3,000 + 5,500 + 3,500 )
⎛ 21,000 + 16,500 + 17,500 ⎞
= Rs. ⎜ ⎟ = Rs. 4.58
⎝ 12,000 ⎠
10,300
Actual Sales at Standard Sales Mix (Alpha) = 3,000 × = 2,575 units
12,000
10,300
Actual Sales at Standard Sales Mix (Beta) = 5,500 × = 4,721 units
12,000
10,300
Actual Sales at Standard Sales Mix (Gamma) = 3,500 × = 3,004 units
12,000
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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 Beta’s 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:
Sales Price Variance = Rs. 36,000 – Rs. 31,500 = Rs. 4,500.
Gamma:
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 Number of Units Sold
Total Actual Market Share % = ×100
Total Actual Market Size
10,300
= × 100 = 54.21%
19 ,000
Total Planned Number of Units Sold
Total Planned Market Share % = ×100
Total Estimated Market Size
12 ,000
= × 100 = 61.54%
19,500
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
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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 management’s
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
Budgeted Actual Variance Favorable/

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

Budgeted Cost per
Number of Units
Actual Cost per

Total Budgeted
Variable Cost
Variable Cost
Variance (Rs)
Total Actual
Unfavorable
Favorable/
Unit (Rs.)
Produced
Items
(Rs.)
(Rs.)
(Rs.)
Unit
Raw 3,000 50,000 150,000,000 45,000 135,000,000 15,000,000 Favorable

material
Labor 3,000 3,000 9,000,000 3,500 10,500,000 -1,500,000 Un-

favorable
Overhead 3,000 10,000 30,000,000 11,000 33,000,000 -3,000,000 Un-

favorable
Total 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.
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• 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 organization’s 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.
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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 enterprise’s 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 Brief Description
Financial statement audit • Gives an opinion on the accuracy of the

financial statement
• Ensures compliance with the relevant
accounting standards and reporting
frameworks
Internal audit • 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 auditing and forensic • Fraud audit: Deters, detects, investigates,

accounting and reports fraud
• Forensic accounting: Related to the legal
system, especially issues of ‘evidence’
Operational audit • Audits operational aspects of the enterprise

• Includes quality audit and R&D audit
Information systems audit • Audit of computer systems

• Checks whether the computer system
safeguard assets, maintains data integrity,
and contributes to organizational
effectiveness and efficiency
Management audit • 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
Social audit • Audit of the enterprise’s reported

performance in meeting its declared social,
community, or environmental objectives
Environmental audit • Environmental compliance audit: A

checking mechanism
• Environmental management audit: An
evaluation mechanism
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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 view…of the entity’s 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 organization’s
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 organization’s 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
organization’s 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 auditor’s
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 auditor’s
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
organization’s 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 organization’s
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
organization’s 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
entity’s 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 organization’s 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 organization’s
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. PwC’s 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
organization’s 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 PwC’s 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.”
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Auditing
5. Management Audit
A management audit appraises an organization’s 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 organization’s activities and ascertain the
appropriateness of the management’s decisions for achieving the organization’s
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
organization’s 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
organization’s 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.
83
• 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
management’s decisions and actions on society and the general public.
5.3 Issues in Organizing the Management Audit Program

The management’s approval is essential for the establishment of a general program for
management audit. Audits are meant to highlight the strengths and weaknesses of the
organization’s 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
Auditing
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 company’s 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 organization’s operations on local
communities
• Report on the organization’s environmental performance
• Report on the organization’s 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 organization’s operations on society,” according to Blake,
Frederick, and Myers. Social audits assess adherence to the specified norms, which
may pertain to the government’s 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.
85
• 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 Scope
Social balance This kind of audit requires quantification of social costs and
sheet and income income. It is conducted to reduce social costs in terms of
statement money.
Social performance This audit is conducted to assess the performance of
audit 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.
Macro-micro social This type of audit is conducted to evaluate an organization’s
indicator audit 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.
Constituency group This kind of audit is conducted to ascertain how corporate
attitudes audit 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.
Government This type of audit is conducted by authorized government
mandated audits agencies to study an organization’s performance in areas of
social concern. Such audits could relate to environmental
protection, etc.
Social process or This audit is limited to specific processes and programs of
program audit an organization that may have social implications. It aims to
appraise a program which has already been initiated by the
organization.
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.
86
Auditing
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

organization’s 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 company’s 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.
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Auditing
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
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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 Description
Count Checking the accounting records of physical assets by physically
counting the assets
Compare 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.
Examine Scrutiny of documents or other records in order to detect errors or
irregularities
Inspecting Scrutiny of physical assets in order to detect errors or abnormalities
tangible
resources
Recompute Checking the mathematical calculations that have been performed
earlier
Reconcile Matching two independent sets of records and to show
mathematically, with supporting documentation, the differences (if
any) between the two records.
Confirm Obtaining information from an independent source so as to verify
the existing information.
Vouch 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.
Trace 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.
Adapted from “Audit Procedures Guidelines,”
<http://www.sanjoseca.gov/auditor/Procedures/5-06B.pdf>.
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Auditing
• 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 organization’s 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 team’s 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 auditor’s 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 Prioritize the concerns raised by the management and deal with the serious
ones immediately
o Summarize the concerns and convince the management that their concerns
will be taken care of
o 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.
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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 management’s 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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Auditing
• 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
organization’s 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 organization’s 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 organization’s 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 organization’s operations on society. Social audits assess
adherence to the specified norms, which may pertain to the government’s
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.
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• 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 management’s 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.
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
organization‟s profits as a whole because its effect on the selling division‟s revenue is
matched by its effect on the buying division‟s costs. Yet, when the profits of the
selling and buying divisions are taxed at different rates, there would be some impact
on the organization‟s 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 division‟s profits should not indulge in decision
making that fails to optimize the organization‟s 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 country‟s 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.
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Transfer Pricing
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
company‟s 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 arm‟s 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 TPO‟s 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 GSK‟s
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 IRS‟s 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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Contd…
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 team‟s 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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Transfer Pricing
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 intra-
company 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.
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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 company‟s 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 division‟s 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.
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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 item‟s 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
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organization‟s 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 Methods Remarks
1 Market-Based Organizations transfer goods and services
Pricing Method or between their profit centers at a price equal to the
Comparable prevailing open market price for those goods and
Uncontrolled Price services. This method provides the best evidence
(CUP) Method of an arm‟s length price.
2 Cost-Based Pricing Transfer prices are calculated on the basis of the
Method or Cost Plus cost of the goods or service. This method is
(CP) Method applicable when market price of the goods or
service is not available.
3 Negotiated Pricing The buying and selling divisions negotiate a
(NP) Method mutually acceptable transfer price.
4 Resale Price (RP) Transfer price is determined by calculating back
Method 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.
5 Two-Step Pricing There are two components of pricing – a variable
Method component and a fixed component. This method
is suitable for vertically integrated organizations.
6 Profit Sharing or The transfer price comprises a standard variable
Profit Split (PS) cost plus a share of actual profit on sales. This
Method 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.
7 Two Sets of Prices The selling unit is credited with the market sales
Method 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.
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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 OECD‟s (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 co-
founder 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.
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 individual‟s 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 individual‟s 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 High
Low Exceptionist Subjectivist
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.
2.2 Individual Factors

An individual‟s 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, post-
conventional 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:
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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 non-
monetary, 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.
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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 individual‟s 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.
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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
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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 company‟s 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.
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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 organization‟s 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. Reddy‟s Laborataries.
Exhibit II: Code of Ethics – Dr. Reddy’s Laboratories

Dr. Reddy‟s 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 company‟s 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
company‟s 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 company‟s 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 organization‟s
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 organization‟s 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.
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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 management‟s 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 Everyone’s Business

The following section is a reproduction of the section „Compliance is Everyone‟s
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…
116
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 Company‟s policies, you
should promptly contact any of the following, in accordance with the company‟s
whistleblower policy:
Corporate Counsel;
Your Immediate Supervisor
You may also report your concerns anonymously by e-mailing the Company‟s e-
mail 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 Company‟s Board of Directors.
For more details, you should read the Company‟s 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 individual‟s
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.
118
Concept Note - 9
Performance Management of Production and

Operations (A)
1. Introduction
Production and operations are interrelated activities that influence an organization’s
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 organization’s
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.
• 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 organization’s
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/ m5s1-
03.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 pre-
determined 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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Performance Management of Production and Operations (A)
• 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 organization’s 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
Description
Measure
Labor • Labor is one of the major sources of production costs for
productivity 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
Description
Measure
Material • Material costs also affect productivity as they may add up to
productivity 30% to 40% of the overall costs, or even more.
• Material Productivity =
• =
Quantity of Material Used (Input)
Multifactor • Specific ratios are developed that gauge productivity in terms

productivity of change in combined inputs.
• These inputs can include raw materials and labor hours used
in the production of a particular output.
• Multifactor Productivity =
• =
Quantity of Raw Material Used + Labor Hours Used (Input)
Total • Many organizations measure productivity in terms of partial

productivity 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 =
• =
[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 Features
Production • Prepared to find out the efficiency of the shop-floor
efficiency report
• 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.
Production • Used to plan the production activity for a particular shift
planning report 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.
Daily production • Provides information to the production manager about
report the activities carried out on the shop-floor during a day
• Used to rectify any anomalies in the production process.
Downtime • The downtime analysis report is used to control the
analysis report 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.
Shift handover • Contains information about all the developments that
report 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
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 department’s
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 third-
party 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
product’s 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.
124
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 organization’s 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 organization’s 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 Transformation Order Management and

and Storage and Storage Consumer Satisfaction
Transportation Quality Assurance Transportation
Plants Distribution
Vendors Stores (Processing) Finished Warehouses channels/ Consumers
Materials Materials customers
goods
Purchases
Purchase Request
126
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
customer’s 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 Pfizer’s
supply chain activities.
Exhibit II: Pfizer’s 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 company’s manufacturing and logistics sites located
worldwide.
The company’s 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
Pfizer’s 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://outsourced-
logistics.com/ global_markets/outlog_story_6813/>.
127
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 Description
Inventory turns or • Refers to the number of times an organization’s

inventory turnover inventory turns over per year
• Calculated by dividing the annual cost of sales by
the average inventory level.
Projected inventory • Refers to the number of times an organization
turns 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
Cycle time • 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.
Customer order • Refers to the anticipated or agreed upon cycle time
promised cycle time of a purchase order
• Gap between the purchase order creation date and
the requested delivery date.
Customer order actual • Refers to the average time taken to actually fulfill a
cycle time customer’s 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.
Cash to cash cycle • Refers to the number of days between paying for the
time 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.
128
Supply Chain Metric Description
Supply chain cycle • Refers to the total time that would be taken to satisfy
time a customer order if all inventory levels were zero
• Calculated by adding up the longest lead times in
each stage of the cycle.
Defects Per Million • DPMO (total number of defects per one million
Opportunities opportunities) is a measure of process performance
(DPMO) used in Six Sigma calculations.
• DPMO =
Total number of defects
× 1,000,000
Number of units × Number of opportunit ies per unit
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).
129
• 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.
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Performance Management of Production and Operations (B)
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-à-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 activity’s
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
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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 product’s 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
product’s quality at each stage of the succeeding stage. Comparing the organization’s
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 industry’s
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 organization’s
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 product’s 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 product’s 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 organization’s activities in a holistic and
process-oriented manner rather than by merely automating existing processes.
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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 organization’s topmost priority.
The differences between TQM and traditional management are given in Table 1.
Table 1: TQM vs. Traditional Management
TQM Traditional Management

Customers are viewed as important Customer is considered separate from
resources that drive the processes of the the organization.
organization.
Assumes that profits follow quality. Assumes that quality follows profits.
Views quality as a composition of Does not hold this view.
multidimensional attributes.
Economy of time and scope are Only economy of scale is considered for
considered for achieving higher increasing efficiency.
efficiency.
Emphasis is on quality, flexibility, and Emphasis is on cost, technical
service. efficiency, and productivity.
It is the responsibility of both managers Workers should work and managers
and workers, to achieve the goals of the should manage.
organization.
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TQM Traditional Management

Emphasis on a multi-skilled workforce Belief in division of labor and
that can be used for different kinds of separation of manual work from mental
jobs. work.
Process-oriented approach. Result-oriented approach.
Advocates a flat organization with Proposes a hierarchical and vertical
networking among the functions. organization structure.
3.5 Benchmarking
Benchmarking involves comparing the organization’s 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
organization’s competitors. This is done to exercise control over product performance
with regard to competitor’s products, and to enhance manufacturing capability and
eliminate wasteful processes. Generic benchmarking evaluates the organization’s
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 organization’s
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 world’s 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
Contd…
137
Contd…
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 Xerox’s 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 Xerox’s 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 organization’s 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.
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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 organization’s
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
team’s credibility.
Investment in employee training. Every employee should be allocated 40-50
hours of training per year.
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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 organization’s 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.
Contd…
140
Contd…
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 Description
D= Customers are identified and their service or product requirements are
Define 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.
M= Process-related metrics and defect data are collected in a planned
Measure manner from appropriate sources such as process measurements and
customer surveys.
A= The root causes of defects and process variations are determined. The
Analyze areas that need improvement are identified and prioritized based on
the organization’s needs.
I= To address the prioritized areas of improvement, solutions are developed
Improve 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.
C= Control mechanisms such as periodic monitoring, training programs,
Control 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.
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 operation’s 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.
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The audit report has to disclose the effect and status of the existing operation vis-à-vis
the overall objectives. Operational audit is a future-oriented, systematic, and
independent evaluation of the organization’s 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 Operational Audit

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

Financial audits concentrate on There are no generally accepted
assessment of the financial statements standards for operational audit.
based on generally accepted accounting
principles.
Financial audit results are often reported Operational audits are for internal use.
to external entities or stakeholders such
as shareholders, regulatory agencies,
and the general public.
The scope of financial audits is Operational audits may be directed
restricted to the financial aspects of the toward many non-financial areas such
organization. as personnel and engineering.
Financial audits are conducted by both Operational audits are conducted by
internal and external auditors. internal auditors or consultants.
Financial audits are conducted at the The timing of operational audit depends
end of every fiscal year by a certified on the discretion of the management.
external auditor. Apart from that, half-
yearly or interim audits can be
conducted by internal auditors.
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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 Description
Purpose definition The scope of the audit including the particular aspects of the
organization, function, or group of activities to be audited is
identified.
Knowledge A comprehensive knowledge of the objectives, organization
gathering structure, and operating characteristics of the unit to be
audited are obtained.
Preliminary survey A preliminary survey of the function or unit is done to get an
idea about the critical aspects of operation and potential
problem areas.
Development of A customized program is developed for the audit of a
program particular function.
Field work The program developed is actually executed.
Reporting 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.
Follow-up It includes determination of whether the recommendations of
the operational audit report are being effectively
implemented.
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 unit’s effectiveness and efficiency.
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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 organization’s 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 organization’s 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.
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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 organization’s 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.
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 India‟s 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 country‟s largest hotel
company, “The Indian hospitality sector is witnessing one of its rare sustained
growth trends.” But this growth was faced with a demand–supply 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 2005–2010, 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-bc84-
50f9e3e57a2e>.
149
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.
Contd…
150
Contd…
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 “India’s 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.
People’s actions: Includes punctuality, way of interaction, and problem resolving
capability.
Professional opinion: Includes integrity, knowledge, and experience of the
professional in the field.
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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 Description
Reliability Dependability – Consistency and accuracy
Responsiveness Promptness of service delivery service
Competence Employees have the required skills and knowledge
required for service delivery
Access Easy to contact – Convenience both in terms of timing
and location
Credibility Trustworthiness, believability, honesty
Courtesy Demeanor of the service provider – politeness, respect,
friendliness
Communication Demonstrated ability to explain the attributes of the
service (features and cost) effectively to the customer
and also to listen to the customer attentively
Security Freedom from danger, risk or doubt; includes physical
security, financial security, and data confidentiality
Understanding/ Understanding the needs of the customer, providing
Knowing the customer individualized attention, and also recognizing the regular
customer
Tangibles Physical facilities, tools, ambience, physical
representations of the service, appearance of the service
providing personnel
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.
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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
Contd…
154
Contd…
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 BoA‟s 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 achievement of better cross-functional teamwork
o improvement in job satisfaction and in the morale of employees due to
greater understanding of problem-solving methods.
On the operational front:
o improvement in the quality of decisions as the decisions are based on facts
rather than assumptions.
o fast service delivery due to minimization of steps which do not add value to
the process
o minimization of costs incurred due to late delivery, complaints, etc.
o enhanced consistency of results due to reduced process variability.
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>
2
Motorola is a multinational communications company based in Illinois, Chicago.
Source: <http://en.wikipedia.org/wiki/Motorola>
155
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
Equipment In equipment focus, the tool or machine used for delivering
focus/people focus the service is important; in people focus, the organization‟s
representatives who deliver the service are more important
than the tool or machine.
Product focus / Product focus deals with what the customer purchases;
process focus process focus deals with how the purchase is affected.
Level of This deals with the extent to which the service caters to
customization individual customer‟s need or whether the service is
standardized.
Back office focus/ The major part of value addition in the service may happen
front office focus either in the front office or in the back office.
Duration of This is the amount of time a customer spends in a service
customer contact system.
Level of discretion This empowers the service providing personnel to make
changes to the service (depending on the customer‟s
request) without having to consult with higher authorities.
** 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, people‟s
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.
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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 Project’s Success

Project management must focus on the ways to manage the resources required for
successfully completing projects and fulfilling the project sponsor’s 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
project’s 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 project’s
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
company’s 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.
Contd…
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Project Control
Contd…
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/erp-
articles/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
project’s 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
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successful project completion; the anticipated risks and hindrances that may have a
significant impact on the project’s 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 manager’s 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 organization’s 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
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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 project’s
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 Features

Status review • 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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Project Control
Review Type Features

Design review • Conducted to check whether the design of the
product/service being produced is of the desired
performance quality.
Process review • 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).
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 project’s 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.
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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 project’s 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 project’s current status and the project’s adherence (or non-
adherence) to the planned schedule.
Manpower Utilization
As the project progresses, actual manpower utilization can be tracked against planned
utilization. If the project’s progress is slower than planned despite manpower
utilization as per plan, it has to be decided by the project management team whether
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Project Control
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 project’s 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 project’s or an activity’s 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 project’s financial control is taken up by
an accounting system as other costs (apart from project’s direct costs) are also
involved like subcontractor cost and overhead cost. Money is mostly used in non-
labor 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.
2. 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.
3. 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.
4. Monitoring and reporting each activity’s 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.
167
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).
6. 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
EV BCWP
• Schedule Performance Index (SPI) = =
BCWS BCWS
EV BCWP
• Cost Performance Index (CPI) = =
ACWP ACWP
Illustration 1:
Given below are the details pertaining to a project at KL Constructions.
Particulars Rs. Million
Budgeted Cost of Work Performed 14
Budgeted Cost of Work Scheduled 12
Actual Cost of Work Performed 15
Based on the given details, calculate the following metrics.
• 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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Project Control
Contd…
Schedule Performance Index (SPI)
EV BCWP Rs.14 million
= = = = 1.167
BCWS BCWS Rs.12 million
Cost Performance Index (CPI)
EV BCWP Rs.14 million
= = = = 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 pre-
defined 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 • Emphasis is on the problems that have occurred or are anticipated.
reports • 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.
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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.
Progress • They compare the actual schedule and costs with the planned
reports 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.
Financial • Accurate reports of project costs must be prepared in case of a

reports 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.
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.
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Project Control
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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Contd…
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.
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Project Control
• Examine the changes that are requested by the project stakeholders, and
determine the impact of these on the project’s 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 client’s agent and senior
management’s 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 auditor’s 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
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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 auditor’s
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 • Brief review of the project, carried out within a limited time
audit 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.
Detailed • Conducted as a follow-up to the general audit, and when an
audit 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.
Technical • Conducted when a detailed audit fails to evaluate the project’s
audit technical aspects satisfactorily because of the auditor’s 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.
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,
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Project Control
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 team’s 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 project’s 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 project’s 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 project’s direct costs. A cost data sheet should be
given as a supplementary table to highlight the project’s 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 evaluator’s conclusions, the project’s
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 project’s 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 report’s 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 report’s 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 organization’s 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 project’s 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
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Project Control
exercized through a series of analyses and audits. Project audits help in assessing the
project’s exact financial health, the project’s 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 project’s 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 manager’s 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 project’s
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 project’s course can deviate from the plan due to external or internal factors.
These changes should be kept in view to control the project’s 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 organization’s 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 organization’s
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.
• 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 organization’s
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
organization’s 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 Description

Top level reviews The top management’s review of organization’s
performance (against forecasts, benchmarks, etc.) and
the progress of strategic initiatives.
Control Activity Description

Direct functional/activity Functional/activity manager’s review of operational
management performance, reconciliation of records, etc.
Information processing Include control activities to ensure that information
regarding transactions is correct, complete, and
authorized.
Documentation Examples: Policy manuals, organograms, standard
operating procedures, evidence of ongoing use of
control systems.
Segregation of duties 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.
Physical controls Include physical security of assets and periodic
verification of the physical existence of assets as per
the records.
Analysis of performance Data analysis to identify trends, deviations, etc., so
indicators that corrective action may be taken, if required.
Meetings For coordination, problem solving, strategic planning
and performance review, innovation, etc.
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 Features

Daily check-in • 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.
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Implementation Issues in Enterprise Performance Management
Type of Meeting Features

Weekly tactical • 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
o Progress review: The team tries to compare the
progress of activities with the specific critical metrics
that have been decided by the organization.
o 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 • Duration: Monthly – 2 to 3 hours
and Ad hoc • Conducted regularly to discuss key strategic issues that
strategic 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 meeting’s agenda should be decided beforehand
through thorough research and preparation on the topics
to be discussed.
Quarterly off-site • Duration: Quarterly – 1 to 2 days; conducted in a location
review 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.
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

management’s behavior with its formal communications (oral/written) is an important
component of internal communication to employees. Employee orientation and
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socialization helps in spreading the organization’s 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…
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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 system’s effectiveness. The former helps in providing feedback on whether the
control components are effective or ineffective, while the latter, helps in
understanding the control system’s 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.
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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 Providing managers with the right means of pursuing
performance objectives
o Deciding on the values and standard operating
procedures which are integral to MCS
o Assessing how well the managers implement the
control systems in their respective departments.
Chief financial officer and Controller
o Devising budgets and other plans for the entire
Management organization
o 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
o Monitoring the effectiveness of controls in their
specific departments and for specific activities
o Devising the departmental and functional controls.
o Finding discrepancies and other issues
o Communicating problems to the higher levels of
management that will significantly affect the
achievement of organizational objectives.
• The board members should have proper knowledge about
the organization’s operations and activities.
• Board members form different committees, which help
them in the proper discharge of duties.
Board of • They should be able to spend the time and effort needed to
Directors fulfill their responsibilities toward the organization.
o Governance, and supervising and directing the
management of the organization
o Selecting the key members of the top management
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Internal Entity Functions

o Guiding the organization in making certain critical
decisions regarding objectives and strategies
o Implementing appropriate controls by providing
proper supervision
o Regularly communicating with all the important
internal and external entities involved in the control
process.
• 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.
o Evaluating the controls and suggesting improvements
in them
Internal
Auditors 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
Employees
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.
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 nitty-
gritty, 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.
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3.2 External Entities

External entities that play a vital role in an organization’s 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
Functions
Entity
• 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 organization’s
External internal control systems so as to conduct an effective audit.
Auditors • 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
Legislators
internal control systems that comply with the law of the land.
and
Regulators • 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
Customers compliance objectives.
and Suppliers • 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 organization’s
effectiveness – current performance as well as potential for
Financial future performance – is good enough from the perspectives
Analysts 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.
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External
Functions
Entity
• 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 management’s 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 organization’s 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 principal’s 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 agent’s 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 organization’s 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 organization’s 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 organization’s functioning,
the control systems, and procedures, as well as the way in which it will react and
adapt to the external environment. The organization’s survival and success depends on
its ability to handle these transition issues effectively.
Table 5: Phases of Development and Growth

Phase Features
Creativity • Begins at the inception of the organization
phase • 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.
Direction • The organization appoints a leader who directs the
phase organization’s 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.
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 more levels are
introduced in the hierarchy.
• 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.
Decentralizat • A decentralized structure is implemented, wherein the lower
ion phase 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.
Coordination • It involves an extensive use of formal monitoring and control
phase 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
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.
Collaboratio • Increased levels of collaboration between the line and staff
n phase 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.
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 organization’s
resource base occurs over a period of time.” Organizational decline can occur due to
reasons such as the organization’s 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 management’s 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 organization’s 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 system’s 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 organization’s
activities. These will influence the organization’s 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

Concept Notes On Enterprise Performance Management

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Enterprise Performance Management

Sl.No. Title Pages

1. Enterprise Performance Management – An Overview ..................... 1-18

2. Design of Organization Structure and Control Systems ................ 19-38

3. Strategic Performance Control ....................................................... 39-48

4. Budgeting Techniques .................................................................... 49-60

5. Business Performance: Targets, Reporting, and Analysis ............ 61-76

6. Auditing ........................................................................................... 77-94

7. Transfer Pricing ............................................................................ 95-106

8. Business Ethics and Enterprise Performance Management ...... 107-118

9. 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

Sl.No. Title Pages

1. Jack Welch and Jeffrey Immelt: Continuity and Change in Strategy,

2. GCMMF’s Cooperative Structure ............................................... 221-237

4. Balanced Scorecard Implementation at Philips.......................... 263-284

5. Tesco: The Customer Relationship Management Champion .... 285-302

6. Hollinger International: The Lord Black Saga ............................. 303-318

7. The Bribery Scandal at Siemens AG ......................................... 319-337

8. BP: Putting Profits Before Safety? ............................................. 338-362

9. P&G’s 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. Pixar’s ‘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

Enterprise Performance Management – An Overview

Financial Insights: Financial Control and Financial Reporting

2. Approaches to Management Control

The basic control process involves the following steps –

Step 1: Determining areas to control

After establishing standards, a manager needs to determine how to measure the

The performance measured in step 3 is compared with the standards established in

Step 5: Rewarding performance and/or taking corrective action when necessary

When an employee‟s performance meets or exceeds the standards, it should be

Figure 1 shows the steps in the MBO process.

Figure 1: The MBO Process

MBO as a management control tool

Exhibit 1: MBO in Information Technology (IT) Projects

3. Objectives of Management Control

3.1 Effectiveness and Efficiency of Business Operations

4. Schemes for Classifying Management Controls

The time of implementation of controls.

Classification Basis Classifications

Action Control Description

Action Control Description

5. Contextual Factors Influencing Management Control

national culture; corporate strategy and organizational diversification; competitive

5.2 Organization Structure and Size

organizations complex. Large organizations have more influence over the

5.4 Corporate Strategy and Organizational Diversification

5.6 Managerial Styles

Figure 2: Responsibility of Organizations toward Stakeholders

Refer to Exhibit 2 for a description of a leading pharmaceutical company‟s initiatives

Exhibit 2: Novo Nordisk and Stakeholder Relations