REPUBLIC OF RWANDA

KIGALI INDEPENDENT UNIVERSITY ULK

P.O Box 2280, KIGALI
Website: http://www.ulk.ac.rw

E-mail: info@ulk.ac.rw

MODULE OF MANAGEMENT CONTROL

By:

Mr. UWAMUNGU K. Jean de Dieu

Tel. 0788618564

INGABIRE CHRISTINE

TEL.0783377999

Email: kagenza2@gmail.com

MAOMBI EMMANUEL
Tel. 0788739468

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1 Module Code: ......FIN404..........._ Faculty: ECONOMICS AND BUSINESS STUDIES

Module Title: MANAGEMENT CONTROL

3. Level: 2 Semester: 1 Credits: 12

4. First year of presentation: 2011 Administering Faculty: ECONOMICS AND BUSINESS

STUDIES

5. Pre-requisite or co-requisite modules, excluded combinations

Having successfully completed Third Year

6. Allocation of study and teaching hours

Total student hours ____________

Student Staff
hours hours

Lectures
30 40
Seminars/workshops
10 20
Practical classes/laboratory
20 30
Structured exercises
10 10
Set reading etc.
10 --------
Self-directed study
10 --------
Assignments – preparation and writing
10 10
Examination – revision and attendance
20 10
Other:
-------- ----------
TOTAL
120 120

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6.1 Brief description of aims and content

The module aims at:

-Making students aware of the Management control environments

-Making students aware of Historical evolution of Management control theory and
practices
-Making students understanding Management control as processes: Planning,
organizing, coordinating and controlling
-Making students understanding the various principles of each step or Management
control as processes
-understanding the principles of Management control
-Making students understanding the different roles of framework.
-Making students understanding decision making and leadership skills

6.2 Learning Outcomes

Knowledge and Understanding

Having successfully completed the module, students should be able to demonstrate
knowledge and understanding of:

 principles of each step or Management control function

 the Management control environment
 different roles of framework.

Cognitive/Intellectual skills/Application of Knowledge

Having successfully completed the module, students should be able to:

 apply principles of Management control in manufacturing or service industries

 apply Principles of Management control in any working environment
 apply Management control principles in any working environment

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 Communication/ICT/Numeracy/Analytic Techniques/Practical Skills
Having successfully completed the module, students should be able to:

 plan strategically, tactically and operationally, to organize, to supervise and to control

in any working environment
 teach or communicate to others all principles of Management control and of course
apply them in a working environment.
 explain different roles of framework.
 explain decision making and leadership skills

General transferable skills

Having successfully completed the module, students should be able to:
 demonstrate managerial skills in a working environment (being public or private sector)
 demonstrate conceptual, planning, organizing, coordinating and controlling skills in any
environment
 demonstrate teamwork skills in a working environment
 demonstrate decision making and leadership skills


1. Indicative Content

OBJECTIVE

This course is aimed at enabling the students to detect and correct the deviations
between planned and realized activities of a firm.

CONTENT

Introduction to Management control and management control systems –

characteristics of management control systems - management control vs. operational
control.

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 Designing the control process and managerial controls – key success variables and
performance measures. Style and culture of control systems components of control
systems: - organizing for adaptive control, autonomy, responsibility centres,
performance measures, reward systems, communication and integration, strategic
planning and programming, capital budgeting, operational planning, managerial
costing (traditional and activity based) and continuous improvement methods.

Control techniques with respect to the firms’ resources-humans, financial, marketing and
physical and maternal resources.

PEDAGOGY: Case study, experiential exercises, assignments.

2. PEDAGOGY

Case study/class room Discussion, Assignments.

 Learning and Teaching Strategy

.The learning and teaching strategy will be student centred.

 Assessment Strategy
 Assignment (Research and presentation)
 Examination
10 Assessment Pattern

Component Weighting (%)

In-course assessment:

Assignments 30

Partial Assessment Test 30

Final assessment:

Final Assessment Test 40

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11 Strategy for feedback and student support during module

 ; Each Presentation is marked, marks post on the course Web on the University Online
Campus Platform, with immediate feedback (direct contact with the student or contact
through the online courses platform);

 Specimen examination papers and solutions available

12 Indicative Resources

Core Text (include number in library or URL) (inc ISBN)

BOOKS : 1. Robert N. Anthony, John Dearden, Richard F.Vancil,

Management control systems, cases and Readings Richard D. Irwin, Inc.

2. Marvin E. Mundel, A Conceptual Framework for the Managements

Sciences, McGraw-Hill Book Company.

3. Subash Sarma, Management Control Systems, Prentice Hall of India.

Course Description
The central focus of this course is strategy implementation. In particular this course will
contribute to the student’s knowledge with insights and analytical and solid skills related to how
a corporation’s senior executives design and implement the ongoing management systems that
are used to plan and control the firm’s performance.

Accordingly, this course aims to provide students not only with a mastery of key concepts related
to management control, techniques and tools but also with the understanding essential to their
application in business life and in resolving concrete situations in the fields of control and
performance.

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Learning outcomes
Students in the fourth year will soon complete their university studies (Bachelor’s level) and be
in positions where they are responsible for line or staff. They will either have to manage others
within a certain management control system; will become a key decision taker or even designer
of this kind of system or be the sufferer of management control systems that don’t report on
things they would like to know about. Either way, the materials covered in this course will be
highly relevant to your immediate job situations as they will contribute to your better
understanding of the role and impact of management control systems on the ways’how’
organizations manage and vice versa help you impact on the design of management control
systems and thus ‘what’ it is that your organisation manage.

The following issues will be discussed throughout the course.

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CHAP I: Introduction to Management control

CHAP II: Responsibility Centers (profit and Expense centers)

CHAP III: Strategic planning

CHAP IV: Budgeting

CHAPV: Decentralization, Responsibility, Accountability and Performance Evaluation

CHAP VI: Measuring and Controlling Assets Employed

CHAP VII: Balanced Scorecard

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CHAP 1: INTODUCTION TO MANAGEMENT CONTROL

Control is an important management function. Control ensures that standards are met, errors are
limited, quality is acceptable, products are safe and the company is performing at the highest
possible level.

When control is missing or inadequate, management cannot know if standards are being adhered
to or if outcomes are acceptable. Inadequate controls lead to poor or unsafe products, shoddy
service. One key management role is making sure that the process and outcomes of the
business meet expected standards. Without having data that provides this assurance,
management is hoping for the best but can’t know or promise customers what they will get in
terms of a product of service.

1.1 Origin and Definition of Management Control

a) Origin of Management Control
The origin of the management is well explained through three important approaches;
 Historical approach
With the historical approach, control takes source from accounting. Accounting is the ancestor of
the reflection on the management of companies. It is from the accounting that was appeared two
other related analysis which are respectively the cost accounting and the financial analysis.
Unfortunately, these two analysis systems have a common character which is of seeing and
explaining historical things in the same way. And from this perspective of knowing the past were
developed ways and techniques to plan and budget for the future of the company that is why
people tend to assimilate management control to budget control. The concept of management
control is recent (1966) but the concept of control date from the period of Fayol (1916).

 Systemic approach
Before the years 1950, the company was considered and looked in through the mirror of a closed
box. The systemic approach started few years after and this started to be perceived differently,
the company became an open space which is in interaction with the environment.

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Progressively the function of management control appeared to be an important service or unit in
the company with the specific mission and responsibility of conceiving and monitoring the
information and alert system in the company.
 Decentralized based approach
As a system in interaction with changing and uncertain environment, characterized by the needs
of the clients, motivation of human capital at work and the need to control the key factors to the
success of the company, a centralized system becomes a barrier/danger to the development of the
company.
To allow the company react as fast as possible to changing environment and be able to motivate
its employees, there was a necessity to decentralize through delegating some of the powers to
lower levels. The efficiency and effectiveness of this decentralization will depend on the efficient
information system which would help the delegator and recipient of powers to take quick and
rational good decisions .With this approach, the management was born in this willing of
delegating some of the powers by the companies which was reinforced by the presence of a good
information system.

b) Definition

Control is a process of comparing performance to standards and taking corrective action, if

needed. In other words, control involves measurement and regulation. It is the means by which
management assures that the desired objectives are effectively achieved. (Gomez-Mejia,
Balking, Cardy ; Management, people, performance, change,2008).

Control is closely associated with management function of planning. Some time people refer to
it as “planning and control” in one phrase as if the two were almost one function. Control
complements planning because it is the means by which management assesses whether or not
plans are being appropriately carried out and allows management to limit errors and imperfection
during the process of implementation.

An organisation must be controlled; that is, device must be in place to ensure that its strategic
intentions are achieved. But controlling an organisation or company is much more complicated
than controlling anything else.

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According to Herodotus,Greek Historian ( 5th Century BC), " Of all men’s miseries the
bitterest is this, to know so much and to have control over nothing".

It would be better indeed for a manager to have control over nothing. Not only would it be a
misery for the frustrated managers who would be little more than mere administrators or care
takers. It would also be a misery for the organizations which would need to constantly adjust
direction and objectives without a helmsman to guide the ship.

Management control system consist of “means of gathering and using information to aid and
coordinate the process of making planning and control decisions throughout the organisation and
to guide employee behavior”(Pearson Encyclopedia,2005).

The earliest definition of Management Control system was provided by Anthony (1965),
according to whom management control is “ the process by which managers ensure that
resources are obtained and used effectively and efficiently in the accomplishment of the
organization’s objectives”.

The Management control process is the process by which managers at all levels ensure that the
people they supervise implement their intended strategies (Nathan).

A System is a prescribed and usually repetitious way of carrying out an activity or a set of
activities.

It is also an assembly of components or elements connected together in an organized way to

produce outputs (Dictionary of business management )

Financial Control: At the heart of financial management is the concept of financial control.
This is a situation where the financial resources of a company/organisation are being correctly
and effectively used. Financial control occurs when systems and procedures are established to
make sure that the financial resources are properly handled. With poor financial and management
control in a company;

 Assets will be put at risk of theft, fraud or abuse,

 Funds may not be spent in accordance with the company’s objectives,
 The competence of managers may even be called into question

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1.2 What is Internal Control
i) Definition: Internal control is a process designed to provide reasonable assurance regarding
the achievement of objectives in the following categories:
 Effectiveness and efficiency of operations
 Reliability of financial reporting
 Compliance with applicable laws and regulations
They are several key points that are linked to the above definition:
a) People at every level of an organization affect internal control. Internal control is, to
some degree, everyone's responsibility. Within the each organisation, administrative
employees at the department-level are primarily responsible for internal control in their
departments.

b) Effective internal control helps an organization achieve its operations, financial

reporting, and compliance to the objectives. Effective internal control is a built-in part of
the management process (i.e., plan, organize, direct, and control).

Internal control keeps an organization on course toward its objectives and the achievement of its
mission, and minimizes surprises along the way. Internal control promotes effectiveness and
efficiency of operations, reduces the risk of asset loss, and helps to ensure compliance with laws
and regulations. Internal control also ensures the reliability of financial reporting (i.e., all
transactions are recorded and that all recorded transactions are real, properly valued, recorded on
a timely basis, properly classified, and correctly summarized and posted).

c) Internal control can provide only reasonable assurance - not absolute assurance -
regarding the achievement of an organization's objectives. Effective internal control helps
an organization achieve its objectives; it does not ensure success.

There are several reasons why internal control cannot provide absolute assurance that objective
will be achieved: cost/benefit realities, collusion among employees, and external events
beyond an organization's control.

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ii) Internal Control Process
Internal control consists of five interrelated components as follows:
► Control (or Operating) environment
► Risk assessment
► Control activities
► Information and communication
► Monitoring
All five internal control components must be done to assure that internal control is effective.
The following section captures the internal control environment as one component of internal
control process.

1.3 Control Environment

The control environment is defined as the control consciousness of an organization; it is the
atmosphere in which people conduct their activities and carry out their control responsibilities.
An effective control environment is an environment where competent people understand their
responsibilities, the limits to their authority, and are knowledgeable, mindful, and committed to
doing what is right and doing it the right way. They are committed to following an organization's
policies and procedures and its ethical and behavioral standards.

The control environment encompasses technical competence and ethical commitment; it is an

intangible factor that is essential to effective internal control. A governing board and
management enhance an organization's control environment when they establish and effectively
communicate written policies and procedures, a code of ethics, and standards of conduct.
Moreover, a governing board and management enhance the control environment when they
behave in an ethical manner-creating a positive "tone at the top"—and when they require that
same standard of conduct from everyone in the organization.

Who is Responsible?
Management is responsible for "setting the tone" for their organization. Management should
foster a control environment that encourages:
O the highest levels of integrity, personal and professional standards

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 O a leadership philosophy and operating style which promote internal control throughout
the organization
O Assignment of authority and responsibility.

1.4 Control Environment Tips

Effective human resource policies and procedures enhance an organization's control
environment. These policies and procedures should address hiring, orientation, training,
evaluations, counseling, promotions, compensation, and disciplinary actions. In the event that an
employee does not comply with an organization's policies and procedures or behavioral
standards, an organization must take appropriate disciplinary action to maintain an effective
control environment. The control environment is greatly influenced by the extent to which
individuals recognize that they will be held accountable.

Listed below are some tips to enhance a department's control environment. This list is not all
inclusive, nor will every item apply to every department; it can, however, serve as a starting
point. Make sure that the following policies and procedures are available in your department:
1. Administrative Procedures
2. Business and Finance Bulletins
3. Employee Handbook
4. Purchasing Manual(Procurement manual)
5. Personnel Memorandum
6. Make sure that the department has well-written departmental policies and procedures
manual which addresses its significant activities and unique issues. Employee
responsibilities, limits to authority, performance standards, control procedures, and
reporting relationships should be clear.
7. Make sure that employees are well acquainted with the organization’s policies and
procedures that pertain to their job responsibilities.
8. Discuss ethical issues with employees. If employees need additional guidance, issue
departmental standards of conduct.
9. Make sure that employees comply with the Conflict of Interest policy and disclose
potential conflicts of interest (e.g., ownership interest in companies doing business or

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 proposing to do business with the organization they are employed in).
10. Make sure that job descriptions exist, clearly state responsibility for internal control,
and correctly translate desired competence levels into requisite knowledge, skills, and
experience; make sure that hiring practices result in hiring qualified individuals.
11. Make sure that the department has an adequate training program for employees.
12. Make sure that employee performance evaluations are conducted periodically.
13. Good performance should be valued highly and recognized in a positive manner.
14. Make sure that appropriate disciplinary action is taken when an employee does not
comply with policies and procedures or behavioral standards.

1.5 Four basic Management control Approaches

Management control has a variety of ways to categorize the various types of control approaches
.The control approaches can be categorized according to two factors (type and focus).The type
factor in itself is divided into formal and informal approaches to control.

a) Formal control systems consist of written rules. They specify explicitly and in detail the
processes, standards, and steps to be followed.
b) Informal Control relies on written expectations regarding performance. For example,
work groups are likely to develop norms for performance and employees who fail to
perform at those levels/norms receive quick and certain feedback that they need to
improve. Even though they are unwritten, informal controls can be powerful source for
regulating performance.

The focus factor refers to whether a control tool is directed at the outcome or the process.

c) Outcome approach focus on result of a business process, such as number of units sold,
amount of market share, or financial outcomes, such as profits.
d) A process approach focuses on how the work is actually performed .A process control
tool centers on the steps involved in a process and the standards that should be followed
in carrying out these steps.

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The control techniques are not necessarily” pure” An organisation may employ multiple control
approaches, some of which may be more formal and others more informal, and some more
focused on process and others on outcomes.

Nonetheless, in most organizations, there is a primary, or dominant, approach to control.

Company executives may use control techniques that focus on both process and outcomes, but
outcome control may clearly be the primary focus while process is only a secondary concern.

Figure 1 Control Approaches

Subjective Market Control
Outcomes Control Financial controls
Focus (1) (2)

Clan Control Operations

Process (3) Management
Bureaucratic control
Balanced scorecard
(4)

Informal Formal

Type

1.6 Objectives of Management Control

Management controls are a heart of budget and policy implementation. Policies and procedures
put in place enable the company to ensure that the following objectives are achieved:

 Makes the company to be on right track by achieving the set goals

 Plans for proper and effective usage of resources
 Enables and supports decision making
 Supports production and output in the firm
 Adherence to external rules and management policies
 Prevention and detection of fraud and errors

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  It helps in the quality of accounting records and timely production of reliable financial
and management information

Fig.2 Element of Control process in a simpler system

Control device 2. Assessor (Comparison with

standards)

1. Detector (Information about 3. Effector (Behavior alteration, if

what is happening needed

Entity being
controlled

Every control system in a company has at least four elements:

1. A detector or sensor which measures what is actually happening in a process being controlled.

2. An assessor; a device that determines the significance of what is happening by making its
comparison to some standards or expectation of what should happen.

3. An effector (often called feedback) is a device that alters behavior if the assessor indicates the
need to do so.

4. A communication network is a device that transmit information between the detector and the
assessor and between the assessor and the effector.

1.7 Boundaries of Management Control

This section explains how management control fits between strategy formulation and task control
in several respects. The strategy formulation is the least systematic of the three, task control is
the most systematic one and management control lies in between.

Strategy formulation focuses on long run, task control focuses on short-run activities, and
management control is in between.

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Strategy formulation uses rough approximation of the future, task control uses current accurate
data. Each activity involves both planning and control, but the emphasis varies with the type of
activity. Planning process is much more important in strategy formulation, the control process is
much more important in task control, and the planning and control are of approximately equal
importance in management control.

Fig.3 Boundaries of Management Control

Strategy formulation (Goals, strategies and policies)

Management control (Implementation of strategies)

Task Control (Efficient and effective performance of

individual tasks).

Management Control Activities

Management control involves a variety of activities which include the following:

1. Planning what the organisation should do

2. Coordinating the activities of several parts of the organisation
3. Communicating information
4. Evaluating the information
5. Deciding what, if any, action should be taken
6. Influencing people to change their behavior

Management control does not necessary require that all actions correspond to a previous
determined plan such as a budget. Such plans are based on circumstances believed to exist at the
time they were formulated. If these circumstances have changed at the time of implementation,
the actions dictated by the plan may no longer be appropriate.

1.8 Prerequisite for Effective management Controls

Management controls are the responsibility of the leadership in the organisation. Establishing
and maintaining a strong and regular controls the top leadership of the organisation needs first of

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all, to be engaged to the effective management of the entity and to the creation and effective use
of mechanisms that will assure its ability to exercise its management responsibilities.

The leadership must also demonstrate personal integrity and professionalism. Only if that
commitment and example are in place will it be possible to establish and maintain an effective
system of controls.

Because of the importance of management controls in assuring the effective control of public
/private funds and the proper use of the budget, the central budget office (Finance) in many
governments plays an active role in strengthening the management controls of the operating
units.

If the leadership of an organisation is determined towards an effective management, the next

requirement is a careful a thorough assessment of the risks facing the organisation and the
identification of useful controls to manage those risks.

In a very complex organisation, this can be difficult task and one for which the leadership of the
entity may wish to seek expert assistance. Internal and external auditors are in this case well
placed to provide the assistance needed. They may be able to identify risks of which the
management was unaware and to suggest control procedures that can reduce the risks. Whatever
assistance is provided, it is very crucial that the leadership of the organization remains involved
throughout the process and especially in the decision related to control arrangements to be put in
place. The controls that are implemented must be ones that the management will use, even when
they create some inconvenience in day-to-day operations, and must be used throughout the
organisation.

1.9 Types of Management Controls

Since Management controls are designed for the particular circumstances of a particular entity,
there is no universal and exhaustive applicable list of controls. However, it is possible to describe
categories of controls and the circumstances in which they might be appropriate.

1. Financial reporting:

All organizations must operate within the limit of the available budgets. Those budgets may be
relatively fixed, as with an appropriation from the legislature, or they may be flexible, as in a

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commercial activity that generates income. In either case, it is essential that management receive
a timely, reliable flow of information about its financial status and that management initiate
prompt corrective action when the accounting data indicate a significant deviation from the
budget. Thus, the financial accounting system is a vital part of any structure of management
controls. To make sure that the accounting system of an entity produces timely and reliable data,
management should require that the system be audited at regular intervals.

2. Performance Monitoring

Organizations exist to accomplish certain activities. Management first responsibility is to assure

that those activities are achieved. To this end, it is essential that management track performance
of the organization against its stated goals. It requires that management describes the goals in
measurable terms (clients served, units of output delivered, etc.) and establish a reliable and
timely reporting system to keep itself informed of progress against the stated goals. Management
should establish its performance expectations with respect to the outputs being measured and
should initiate corrective action if the reported results deviate to far from the expectations.

3. Effective Communication

In modern organizations, managers do recognize that subordinates and front line workers
perform better if they have a clear understanding of the mission and goals of the organisation and
the purpose being served by the activities they are asked to perform. In such an organisation, the
channels of communication are part of the management control system. For example, managers
should communicate their performance expectations to subordinates, who should then define the
expectations for their components of the organisation that are needed to accomplish the overall
goals organisation. It is important that communications flow upward as well as downward.

When management sets clear goals and expectations, workers can often suggest ways of
achieving greater efficiency in attainment of those goals. In addition to assuring that output goals
of the organisation are achieved, however, managers are also responsible for assuring that the
resources available to the organisation are protected against improper use. A variety of
management controls might be used for this purpose.

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4. Physical Controls: Physical control over assets and records helps to protect company’s assets.
This kind of control may include and not limited to electronic or mechanical controls or
computer related controls dealing with access privileges.

5. Accounting Controls: These would include the procedures by which transactions are required
to be recorded in the accounting system.

For example, there might be a requirement that all cash receipts be deposited daily, that whoever
collects the cash might be required to provide written receipts to the payer and to file a copy with
the accounting clerk.

Accounting controls include the internal procedures within the accounting systems that are
intended to detect and report any anomalies. In addition, accounting control would apply to
expenditures Vs the budget or with other authorization process.

6. Process Controls

These are the procedures that are designed to assure that actions are taken only with proper
authorization. For example ,the issuance of a Local Purchase Order or the approval of a contract
especially one above some minimum threshold, might require documentation/supporting
documents from the requesting official, review by a purchasing clerk and approval by
concerned supervisor or the responsible person in the organisation.

Unusually purchases of huge amount might require approval from a higher official. Payments to
contractors might require documentation in the form of original purchase order, a voucher from
the contractor describing the goods and services provided, and a certification or confirmation
from the receiving official that the goods and services were received.

7. Separation of duties

The central feature of this is that, with to “risky” events or transactions, at least two people
should be involved to minimize respect the risk of improper actions. Especially in Finance,
separation of duties is very capital to avoid risk of fraud, corruption and theft.

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1.10 Limitation of Management Control Systems
No system of controls can be an absolute guarantee against the risk of wrongdoing or honest
error. Any system that attempted to reach that goal, especially in a complex organisation, would
impose costs far out of the proportion to the risks and create rigidities for the organisation. Thus
the proper goal of the control system should be to provide “reasonable assurance” that
improprieties will not occur or that if they occur, they will be revealed and will be reported
timely to the concerned authorities. With this in mind, managers should be aware of certain risks
involved in building and maintaining management control systems.

 Design flaw

 Poor Implementation

 Poor response to reported anomalies

 Collusion

 Wrongdoing by top managers

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 1.11 Management Control Systems and Organizational Goals
The first and most basic component in management control system is the organization’s goals.
Top managers set organization-wide goals, performance measures, and targets, which they
generally review annually. These goals provide a long term framework around which an
organization will form its comprehensive plan for positioning itself in the market

Figure 4. MCS & Organizational goals

A. Set goals
and Targets

D. Evaluate,

Reward
Feedback and B. Plan and
Learning Execute

C. Measure, Monitor and Report

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CHAP 2: RESPONSIBILITY CENTERS: REVENUE AND EXPENSE
CENTERS
In this Chapter we review the considerations involved in assigning financial responsibility (In
terms of costs, revenues, profit, and assets) to organisation subunits. It begins with describing the
nature of the responsibility centers in general and the criteria of efficiency and effectiveness that
are relevant in measuring the performance of the managers.

A responsibility center is an organisation unity that is headed by a manager who is responsible

for its activities.

The responsibility centers form a hierarchy. At the lowest level are the centers for sections, work
shifts, and other organisation units. Departments or business units comprising several of these
small units are higher in the hierarchy.

From the standpoint of senior management and the board of directors, the entire organisation is a
responsibility center, though the term is usually referring to units within the organisation.

2.1. Nature of responsibility centers

A responsibility center is there to accomplish one or more purposes. Each organisation as a
whole has goals, and senior management decides on a set of strategies to accomplish these goals.
The objectives of the organization’s various responsibility centers are to participate in the
implementation of these strategies.

Because every organisation is the sum of its responsibility centers, if each responsibility center
meets its objectives, the goals of the organisation will have been achieved.

Responsibility receives inputs, in the form of materials, labor and services. Using working
capital (e.g., inventory, receivables), equipments and other assets, the responsibility center
performs its particular function with the ultimate objective of transforming its inputs into
tangible or intangible outputs.

In a production plant, the outputs are goods whereas in a staff unit such as human resources,
transportation, engineering, accounting and administration, the outputs are services.

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2.2. Efficiency and Effectiveness
The concepts of inputs, outputs and costs will help to explain the meaning of efficiency and
effectiveness, which are the two important criteria by which the performance of a responsibility
center is judged.

Efficiency is the ratio of outputs to inputs, or the amount of output per unit of input..
Responsibility center A is more efficient than Responsibility center B if,

 It uses fewer resources than Responsibility center B but produces the same output

 It uses the same amount of resources but produces a greater output.

Note that the first criterion does not require that output be quantified; it is only necessary to
judge that the outputs of the two units are approximately the same; if so, assuming both centers
are performing their jobs in a satisfactory manner and the respective jobs are of comparable
magnitude, the unit with the lower inputs (i.e., lower costs) is the more efficient. In the second
criterion, however, where the input is the same but the output differs, some quantitative measure
of output is required.

In many responsibility centers, efficiency is measured by making a comparison between actual

costs with some standard of what those costs should have been at the measured output.

In contrast to efficiency, which is determined by relationship between input to output,

effectiveness is determined by the relationship between a responsibility center’s output and its
objectives. The more this output contributes to the objectives, the more effective the unit. Since
both objectives and outputs are difficult to quantify, effectiveness tends to be expressed in
subjective, on analytical terms.

Efficient and effectiveness are not mutually exclusive; every responsibility center ought to be
both efficient and effective.

A responsibility center which carries out its charge with the lowest possible consumption of
resources, may be efficient, but its output fails to contribute adequately to the attainment of the
organization’s goals, it not effective. A responsibility center is efficient if it does things right, and
it is effective it does right things

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e.g. If a credit department handles the paperwork connected with delinquent accounts at low cost
per unit, it is efficient; but if, at the same time, it is unsuccessful in making collections, it is
ineffective.

2.3. Types of Responsibility Centers

They are four types of responsibility centers, classified according to the nature of the monetary
inputs and/or outputs that are measured for control purposes:

 Revenue Centers;

 Expense Centers;

 Profit Centers;

 Investment Centers

a) Revenue Centers

In a revenue center, output (i.e., revenue) is measured in monetary terms, but no formal attempt
is made to relate input (i.e., expense or cost) to output. Revenue centers are typically
marketing/sales units that do not have authority to set selling prices and are not charged for the
cost of the goods they market. Actual sales or orders booked are measured against budget or
quotas, and the manager is held accountable for the expenses incurred directly within the units,
but the primary measurement is revenue.

Example: In 1999, two companies, Servico and Impac Hotel Group, merged to create
Lodgian,Inc., One of the largest owners and operators of hotels in the USA. Lodgian reorganized
itself into six regions, each with a regional Vice President, a regional Operation Manager, and a
regional Director of sales and Marketing. The sales and marketing functions were constituted as
revenue centers, with the goal to significantly improve market share.

b) Expense Centers

Expense centers are responsibility centers whose inputs are measured in monetary terms, but
whose outputs are not.

[25]
There are two general types of expense centers (engineered and discretionary).These labels relate
to two types of cost which are engineered and discretionary costs. The engineered costs are those
for which the ‘’ right’’ or ‘’ proper’’ amount can be estimated with reasonable reliability.

Discretionary costs also called managed costs are those for which no such engineered estimate is
feasible. In discretionary expense centers, the costs incurred depend on management’s judgment
as to the appropriate amount under the circumstances.

c) Engineered Expense centers

These centers have the following characteristics:

⸗ Their input can be measured in monetary terms

⸗ Their output can be measured in physical terms

⸗ The optimum dollar amount of input needed to produce one unit of output can be
determined.

⸗ They are usually found in manufacturing operations.

Warehousing, distribution within the marketing organisation may also be engineered expense
centers. Accounts receivable, accounts payable and payroll sections in the administrative and
support departments may be engineered expense centers.

In an engineered expense center, output multiplied by the standard cost of each unit produced
measures what the finished product should have cost. The difference between the theoretical and
the actual cost represents the efficiency of the expense center being measured.

d) Discretionary expense centers

It includes administrative and support units (e.g., accounting, legal, industrial relations, public
relations etc.), research and development operations and most marketing activities. The output of
these centers cannot be measured in monetary terms.

The term discretionary does not imply that management’s judgment as to optimum cost is
capricious or haphazard rather it reflects management’s decisions regarding certain policies.
Management’s view as to the proper level of discretionary costs is always subject to
modification, especially when new management takes over.

[26]
In a discretionary expense center, the difference between budget and actual expense is not a
measure of efficiency. Rather, it is simply the difference between the budgeted input and the
actual input, and does not incorporate the value of the output.

2.4 Measurement of Performance

At regular intervals, usually monthly or quarterly, most companies compare actual expenses with
budgeted expenses for all responsibility centers and ongoing projects. These comparisons are
summarized for managers at progressively higher levels to assist the managers of responsibility
centers in planning their expenses and to assure their superiors that those expenses are remaining
at approved levels.

[27]
CHAPTER 3: STRATEGIC PLANNING
This third chapter describes the nature of strategic planning, techniques for analyzing and
deciding on new programs and it also describes techniques that are useful in analyzing ongoing
programs and the final step in this chapter will be to describe the steps to go when making
strategic planning.

3.1. Nature of Strategic planning

Competent managers and other senior officers in different organizations spend considerable time
thinking about the future. The result may be an informal understanding of the future direction the
entity is going to take, or it may be a formal statement of specific plans about how to get there.

Such a formal statement of plans is called a strategic planning (also called long- range planning
and programming).

Strategic planning is the process of deciding on the programs that the organisation will undertake
and on the approximate amount of resources that will be allocated to each program over the next
several years.

3.1.1. Relation to strategy formulation

In this section, a distinction between two management processes is drawn. That is between
strategy formulation and strategic planning.

Strategy formulation is the process of deciding on new strategies, whereas strategic planning is
the process of deciding how to implement the strategies. In the strategy formulation process,
management arrives at the goals of the organisation and creates the main strategies for achieving
those goals. The strategic planning process then takes the goals and strategies as given and
develops programs that will carry out the strategies and achieve the goals efficiently and
effectively.

Example: A decision by an industrial goods manufacturer to diversify into consumer goods is a

strategy formulation, a strategic decision, after which a number of implementation issues have to
be resolved: whether to diversify through acquisition or through organic growth, what product
lines to emphasize, ether to make or to buy, which marketing channels to use.

[28]
In the planning process there are different document and different document produced, the one
that describes how strategic decision is to be implemented is called strategic plan.

In practice, there is a considerable amount of overlap between strategy formulation and strategic
planning. Studies made during the strategic planning process may indicate the desirability of
changing goals or strategies. Conversely, strategy formulation usually includes a preliminary
consideration of the programs that will be adopted as a means of achieving the goals. It is
important to keep a conceptual distinction between strategy formulation and strategic planning;
one reason being that the planning process tends to become institutionalized, putting a damper on
purely creative activities. Strategy formulation should be an activity in which creative,
innovative thinking is strongly encouraged.

Strategic planning is systematic; there is an annual strategic planning process with prescribed
procedures and timetables. Strategy formulation is unsystematic. Strategies are reexamined in
response to perceived opportunities or threats.

In many organizations, goals and strategies are not stated explicitly enough or even
communicated clearly to the managers who need to use them as a framework for their program
decisions. Thus, in a formal strategic planning process it is important that the first step be of
writing descriptions of the organization’s goals and strategies.

3.2. Evolution of strategic planning

Fifty years ago, the strategic planning process in most organizations was unsystematic.
Management thoughts related to long-range planning were not in a coordinated way.

A fewer companies started formal strategic planning system in the late 1950s, but most early
efforts were failures, they were minor adaptations of existing budget preparation systems.

The required data were more detailed than was appropriate; staff people rather than line
management did most of the work; participants spent more time filling in forms than thinking
deeply about alternatives and selecting the best ones. As time went on, management learned their
lessons, and in this process, the objective should be to make difficult choices among alternative
programs, not to extrapolate numbers in budgetary detail; time should go into analysis and

[29]
informal discussion, relatively less on paperwork, the focus should be on the program itself
rather than on the responsibility centers that carried it out.

3.3. Benefits and Limitation of strategic planning

Strategic planning even though important, presents some benefits and limitation. The following
are benefits generated or obtained from good strategic planning:

⸗ Framework for developing the annual budget

⸗ A management development tool

⸗ A mechanism to force management to think strategically to long term

⸗ A means to align managers with the long term strategies of the company

⸗ Facilitates optimal resource allocation decisions in support of key strategic options

Another benefit of strategic plan is that it helps management of each organisation to formulate an
effective operating budget.

3.4 Linkage between Planning and Organizational Control

Systems
Planning and organizational control systems should go hand in hand. An effective control system
alerts managers when something is going wrong and provides them the opportunity to respond.
Once plans are formulated and carried out, an effective control system allows the organization to
compare planned objectives with observed results. If there is a significant discrepancy between
expected and actual results, then managers should take corrective action in order to improve
future plans and modifications to those plans being implemented.

It is very wise to leave open the possibility of abandoning the existing plans and replacing them
with new ones when the control system indicates that there is a high deviation of expected versus
actual results.

[30]
3.5 Framework for Developing the Budget
The budget preparation calls for resource commitments over the coming, it is essential that
management make such resource commitments with a very clear idea of where the organisation
is leading to or heading over the next several coming years. A strategic plan is a major tool that
provides a broader framework.

A company which does not have a strategic planning process considers too many strategic issues
in the budgeting process which to some extent may lead to

⸗ Information overload

⸗ Inadequate consideration of some strategic alternatives

⸗ Negligence of some choices altogether

⸗ A dysfunctional environment that can seriously affect the quality of resource allocation
decisions

3.6 Management development tool

Formal strategic planning is an excellent management education and training tool that provides
managers with a process for thinking about strategies and their implementation. The following
are two different companies where one has a strategic plan and another has not.

[31]
Figure 5.Company with and without a strategic plan
a) A Company without a strategic planning process

Strategic option A

Strategic option B Budgeting

Strategic option C

Strategic option D

b) A Company with a strategic planning process

Strategic option A /01 Strategic option A

Strategic option B \Budgeting

Strategic option C

Strategic option D Strategic option C

3.7. Means of Aligning Managers with Corporate strategies

The debates that are done during planning process, discussions and negotiations clarify corporate
strategies, unify and align managers with such strategies and reveal the implications of corporate
strategies for individual managers.

During the planning process, program decisions are made one at a time and the strategic plan
brings them all together. Preparing the strategic plan may reveal that individual decisions do not
add up to a satisfactory whole, especially in the following cases:

 Planned new investments may require more funds in certain years than the company can
obtain in those years.

 The profit anticipated from individual programs may not add up to satisfactory profit for
the whole organisation.

[32]
Example: In recent years, One of the African prestigious company with a capital spending and
exploration budget of USD 3.6 billion decided to produce manufacturing products to Angola,
Zambia, Rwanda, DRC, Namibia, Egypt. Since these areas were too dispersed and with the level
of risk associated with the different production areas and the amount of resources available,
strategic planning was a necessity for this company in choosing which area to maintain and
sustain its activities.

3.8 Limitations of strategic planning

There a number of pitfalls or limitations to a formal strategic planning and those are the
following:

 There is always a danger that planning can end up becoming a ‘’ form filling’’ or a
bureaucratic exercise.

 Organisation may create a large strategic planning department and delegate the
preparation of the strategic plan to that staff department

 Strategic planning is time consuming and expensive. The most significant expense is the
time devoted to it by senior management and managers at other levels in the company.

3.9 Program structure and content

In most industrial organizations, programs are products or product families, plus research and
development, general and administrative activities, planned acquisitions, or other important
activities that do not fit into existing product lines.

In service organizations, programs tend to correspond to the types of services by the entity while
in multi-unit service organizations, such as a hotel or restaurant, each unit or each geographical
region may be called a program.

The typical strategic plan covers a period of five future years. Each organisation based on its
vision and on its broad orientation develops a five years strategy from which yearly plans are
extracted and developed. Five years is a long enough period to estimate the consequences of
program decisions made currently. The consequences of a decision to develop and market a new
product or acquire a major new capital asset may not fully be felt within a shorter period. It is not
mandatory to have a strategic plan of five years but this seems reasonable. Some organizations

[33]
make very rough plans that go beyond five years and some others prepare plans that cover only
the next three years.

3.10 Organizational relationships

Relationships in organization are very crucial in developing a clear and well tailored strategic
plan. The strategic planning process involves senior management and managers of business
units/departments or divisions or other principal responsibility centers assisted by their
subordinates.

A primary purpose of these relationships is to improve the two ways communication between
corporate and business unit executives by providing a sequence of scheduled activities through
which they can arrive at a mutually agreeable set of objectives and plans.

In some organizations, the controller organisation prepares the strategic plan, in others; there is a
separate planning unit. Strategic planning requires analytical skills and broad outlook that may
not be available in the controller organization. The controller organisation may be skilled
primarily in the detailed analytical techniques that are needed in preparing the budget and
following up its execution or analyzing variances between the actual and budgeted amounts.
Even when there is a separate planning unit, the controller organisation activities should be
limited to disseminating guidelines and assembling proposed numbers. The numbers in the
strategic plan, in the annual budget, and in the accounting system must be consistent with one
another, and the best way of assuring consistency is to assign responsibility for all three to the
same units (staff) and compile it in a single computer model.

3.11 The influence of Top Management to the strategic planning

Strategic planning is a management process, and the way in which it is conducted in a given
organisation is heavily dependent on the style of the Chief Executive officer. Some CEOs prefer
to make decisions without the benefits of a formal planning apparatus, and when a controller of
such organization attempts to introduce a formal system, he/she is likely to be unsuccessful. No
system will function effectively unless the CEO uses or supports it. If other managers perceive
that the system is not a vital part of the management process they will give only a lip service to
it.

[34]
Designers of any system must correctly diagnose the style of senior management and see to it
that the system is appropriate for that style

3.12 Capital Investment Analysis

Most proposals require new significant capital. Techniques for analyzing capital investment
proposals attempt to find either the NPV of the project, that is, the excess of the present value of
the estimated cash inflows over the amount of investment required, or the IRR (internal rate of
return) implicit in the relationship between the inflows and the outflows. These techniques are
only used in about half the situations in which, conceptually, they are applicable.

They are four reasons for not using present value techniques:

 The proposal may be so obviously attractive that a calculation of its present value is
unnecessarily.

 The estimates involved in the proposal are so uncertain that making present value
calculations is believed to be not worth the effort one can’t draw a reliable conclusion
from unreliable data. This situation is common when the results are heavily dependent on
estimates of sales volume of new products for which no good market data exist.

 The rational for the proposal is something other than increased profitability. The present
value approach assumes that the objective function is to increase profits, but many
proposed investments are oriented towards increasing or improving the morale of
employees, the company’s image or safety

 There are no feasible alternative to adoption. Environmental laws may require investment
in a new program.

3.13 Activity-Based Costing

Developments of computerization and automation in factories have led to significant changes in
systems for collecting and using cost information.

Few years ago, most companies allocated overhead costs to products by means of a plant wide
overhead rate based on direct labor hours or dollars.

[35]
Today, an increasing number of companies collect costs for material-related costs (e.g.,
transportation, storage) separately from other manufacturing costs; and they collect
manufacturing costs for individual departments, individual machines, or individual “cells”,
which consist of groups of machines that perform a series of related operations on a product.

In all the above cost centers, direct labor costs may be combined with other costs, giving
conversion cost, that is, the labor and factory overhead cost of converting raw material and parts
into finished products.

The basis of allocation, or cost driver, for each of the cost centers reflects the cause of cost
incurrence. That is, the element which explains why the amount of cost incurred in the cost
center, why activity varies.

Example: - In procurement, the cost driver may be the number of orders placed.

Most large companies in economically developed countries have substantially improved their
costing systems in recent years, mostly by implementing activity – based costing (ABC).
Activity based costing assigns costs first to an organization’s activities and then to the products
based on each product’s use of activities.

Activity is defined as any discrete task that an organisation undertakes to make or deliver a
product/service (e.g., placing a Local purchase order). Activity-based costing relies on the
concept that products consume activities and activities consume resources.

ABC helps managers to identify cost-reduction opportunities. It also provides more detailed and
clear information about activities being implemented and easy the work of managers in deciding
how to reconfigure production processes to reduce costs, how to reprice products to be
competitive at the market. If managers of a company want competitive products, they must
know;

 the activities that go into making the goods or providing services;

 the cost of those activities;

To reduce a product’s costs, managers will likely have to change the activities consumed by the
product. Rarely will be a manager’s announcement that everyone is to reduce costs by a certain

[36]
percentage/level prove sufficient effect such a cost decrease. More likely, significant cost
reduction requires managers, production and marketing people, accountants, engineers, and
others to thoroughly examine the activities that a products consumes to identify how to rework
those activities to make the product more efficient.

When discussing activity-based costing, one should remember the following points:

 Different allocation methods result in different estimates of a product’s costs;

 ABC provides more detailed measures of costs than do plant wide and departmental
allocation methods;

 ABC can help marketing people select and price products by providing more accurate
product numbers;

 ABC also benefits production because it provides better information about how much
each activity costs. In fact, it helps identify cost drivers (that is, the activities that cause
costs) that managers did not previously recognize.

 ABC provides more information about product costs but requires more recordkeeping.
Managers must decide whether the benefits of improved decisions justify the additional
cost of activity-based costing compared to departmental or plant-wide allocation.

 Installing ABC requires teamwork among accounting, production, marketing,

management and others.

The ABC concept is not particularly subtle or counterintuitive. In fact, it is very much in line
with common sense. But in earlier days, factories tended to produce fewer different products,
cost was labor dominated (high labor cost relative to overhead), and products tendered to differ
less in the amount of support services they consumed. Thus, the activity basis for overhead
allocation was not likely to result in product costs much different from a simple volume-driven
basis tied to labor cost.

Today, labor cost in many companies is not only dramatically less important. It is also viewed
less and less as a cost to be varied when the production volume varies.

Indirect cost is now the dominant part of cost in many companies. In the prototypical “flexible
factory”, raw material is the only production volume – dependent t cost and the only cost directly
relatable to individual products. The advocates or supporters of ABC maintain that a meaningful

[37]
assessment of full cost today must involve assigning overhead in proportion to the activities that
generate it in the long run.

3.13.1 Use of ABC information

ABC, when used as part of the strategic planning process, may provide useful insights. For
example, it may show that complex products with many separate parts have higher design and
production costs than simpler products, that products with low volume have higher unit costs
than high-volume products. Products with many set ups or engineering change orders have
higher unit costs than other products.

Information on the magnitude of these differences may lead to changes in policies relating to full
line versus focused product line, product pricing, make - or - buy decisions, product, mix
decisions, adding or deleting products, elimination of non value added activities and to an
emphasis on better factory layouts and simplicity in product design.

3.14 Strategic planning process

In a company that operates on calendar year basis, the strategic planning process starts in the
spring and is completed in the fall, just prior to the preparation of the annual budget. The process
involves the following steps:

 Reviewing and updating the strategic plan from last year

 Deciding on assumptions and guidelines

 First iteration of the new strategic plan

 Analysis

 Second iteration of the new strategic plan

 Review and approval

[38]
3.15 Action Plan
a) Strategic Action Plans
In doing strategic Action plans, top executives are normally responsible for developing strategic
action plans. At times divisional managers and the board of directors are also involved.

Strategic action plans are based on overall organizational features, resources, and the
environment. They establish long-term, corporate wide actions designed to accomplish the
company’s mission and major objectives. An important emphasis at this level is linking the
action plans of different organizational functions and units so that they reinforce the strategies
adopted by the entire organization.

To be effective, a strategic action plan should meet the following criteria:

1. Proactivity: It is a degree to which the strategic action plan takes a long term view of the
future and actively moves the company forward in the desired direction.

2. Congruency: Is the extent to which the strategic action plan fits with organizational
characteristics and the external environment.

3. Synergy: Is the integration of the efforts of various organizational subunits to better

accomplish corporate wide business objectives.

b) Tactical Action Plans

Tactical action plans are developed at division or department level. They specify the activities
that must be performed, when they must be completed, and the resources a division or
department will need to complete the portions of the strategic action plan under its purview.

The primary criterion of effectiveness for tactical action plans is the extent to which they
contribute to the achievement of the company’s strategic objectives. In general, tactical actions
cover a period of one to two years.

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 C) Operation Action Plans
Line Managers and Employees directly responsible for individual tasks or activities are the ones
who create operational action plans. These plans tend to be narrowly focused on resources,
methods, timelines, and quality control issues for a particular kind of operation. In general, the
timeframe for operational action plans is shorter than for tactical action plans.

The figure below illustrates a typical operation. Inputs such as human, financial, raw material
and other related resources are transformed through assembly, chemical treatment, combination
with other elements into outcomes like products and services.

Figure6. Operation Action Plan

Control

Outcome
Inputs
Transformation
s

Feedback Loop

The control component includes information about the required characteristics of inputs and
outputs and how inputs must be modified to produce outputs/outcome. It ensures that the
quantity and quality of inputs and outputs fall within certain parameters and that costs remain
within the stipulated budget. Feedback is returned from output to transformation and input so
that continuing improvement may be achieved by using resources more efficiently.

If properly conducted, operational planning offers several benefits to organizations, including:

[40]
- The opportunity to use feedback for continued incremental learning

- The ability to visualize alternative types of operations-that is, alternative ways to use
resources to create a product or service

- The ability to predict the effects of modifications in operations on the efficiency of

operations.

- The ability to evaluate the effectiveness of operations

[41]
CHAPITER 4: BUDGET PREPARATION FOR PLANNING AND
CONTROL
This chapter focuses on management control of operations in the current year. It describes the
process of budget preparation that takes place before the financial begins. Here we will discuss
about and describe the purposes of a budget and distinguishing a budget from a strategic plan and
from a forecast. The discussion will move to the several types of budgets and some of the details
given in a typical operating budget, thirdly we will see the steps in preparing an operating
budget. Finally, there will be a discussion of behavioral implications of the budget preparation
process.

4.1 Budgets and the Organization

Most people associate the word budget primarily with limitations on spending. For example,
most of governments often approve a spending budget and then maintain expenditures within the
limits prescribed by the budget.

The same case happens in most business organizations where budget is given wrong
consideration. In all these, the main functions of the budget are for planning, performance
evaluation and communication.

Budgets provide a very comprehensive financial overview of planned company operations

throughout a well determined period. Budget highlights potential problems and opportunities
early allowing managers to take steps to avoid the problems or use the opportunities wisely.

In many organizations, budgets also are used by Managers as benchmark for performance
evaluation in a sense that budgets help to measure expected or desired performance against
actual performance.

Finally, budgets provide an important two-way communication channel. Budgets convey

strategies and expectations downward from the upper-levels of the organisation and
communicate capabilities and opportunities upward from the lower-levels of the organization.

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4.2 Nature of a Budget
Budgets are an important tool for effective short-term planning and control in organizations.

An operating budget usually covers one year and tries to indicate clearly the revenues and
expenses planned for the year.

Operating budget presents the following characteristics:

 A budget estimates of the potential profit of the business unit.

 It is stated in monetary terms, although the monetary amounts may be backed up by non
monetary amounts (e.g., units produced or sold).

 It generally covers a period of one year. In businesses that are strongly influenced by
seasonal factors, there may be two budgets per year (for example, apparel companies
typically have a fall budget and a spring budget).

 It is a management commitment; managers agree to accept responsibility for attaining the

budgeted objectives.

 The budget proposal is reviewed and approved by an authority higher than the budgetee
(e.g., budget prepared by BO.DAF reviewed by PS of the Institution-MINECOFIN-
CABINET and approved by the PARLIAMENT) before it starts to be implemented.

 Once approval is granted, the budget can be changed only under specified conditions.

 Periodically, actual financial performance is compared to budget and variances are

analyzed and explained.

The process of preparing a budget should be distinguished from a strategic planning and
forecasting.

4.3 Relation between Budget and Strategic planning

Strategic planning as earlier defined is the process of deciding on the nature and size of the
several programs that are to be undertaken in implementing an organization’s strategies.

Both strategic planning and budget preparation involve planning, but the types of planning
activities are different in the two processes. The budgeting process focuses on a single year,
whereas strategic planning focuses on activities that extend over a period of several years.

[43]
Strategic planning precedes budgeting and provides the framework within which the annual
budget is developed.

A budget is, in a sense, a one year slice of the organization’s strategic plan, although for some
reasons the budgeting process involves more than simply carving out a slice.

Another important difference between strategic plan and a budget is that the former is essentially
structured by product lines or other programs, while the latter is structured by responsibility
centers. This rearrangement of the program so it corresponds to the responsibility centers
charged with executing it, is necessary, because the budget will be used to influence a manager’s
performance before the fact and appraise performance after the fact.

The big relation between planning and budgeting relies also on the fact that the most important
planning, evaluation and communication benefits depend on an effective budgeting process that
engages employees throughout all levels of the organization.

4.4 Contrast with Forecasting

A budget differs in several respects from a forecast.

A budget is a management plan, with implicit assumption that positive steps will be taken by the
budgetee (the manager who prepares the budget) to make actual events correspond to the plan.

A forecast is merely a prediction of what will most likely happen, carrying no implication that
the forecaster will attempt to so shape events that the forecast will be realized.

The forecast has the following characteristics:

 A forecast may or may not be stated in monetary terms.

 It can be for any time period.

 The forecaster does not accept responsibility for meeting the forecasted results.

 Forecasts are not usually approved by higher authority.

 A forecast is updated as soon as new information indicates there is a change in

conditions.

 Variances from forecast are not analyzed formally of periodically.

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An example of forecast is one that is made by the treasurer’s office to help in cash planning.
Such a forecast includes estimates of revenues, expenses, and other items that affect cash flows.
The treasurer, however, has no responsibility for making the actual sales, expenses, or other
items conform to the forecast. The cash forecast is not cleared with top management; it may
change weekly or even daily, without approval from higher authority; and usually the variances
between actual and forecast are not systematically analyzed.

From management’s point of view, a financial forecast is exclusively a planning tool, whereas a
budget is both a planning tool and a control tool. All budgets include elements of forecasting, in
that budgetees cannot be held responsible for certain events that affect their ability to meet
budgeted objectives. If however, a budgetee can change a so-called budget each quarter without
formal approval, such a document is essentially a forecast, rather than a true budget. It cannot be
used for evaluation and control because, by the end of the year, actual results will always equal
the revised budget.

4.5 Use of a Budget

The preparation of an operating budget has four principal purposes which follow:

 To fine-tune the strategic plan;

 To help coordinate the activities of the several parts of the organisation;

 To assign responsibility to managers, to authorize the amounts they are permitted to

spend, and to inform them of the performance that is expected of them;

 To obtain a commitment that is a basis for evaluating a manager’s actual performance.

a) Fine-Tuning the Strategic Plan

As earlier said, the budget helps to fine-tune the strategic plan, which is a broad and long term
plan of a well established organisation. The following are the characteristics of strategic plan:

⸗ It is prepared early in the year;

⸗ It is developed on the basis of the best information available at the time of preparation;

⸗ Its preparation involves relatively few managers and it is stated in fairly broad terms.

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The budget which is completed just prior to the beginning of the budget year, provides an
opportunity to use the latest available information and is based on the judgment of managers at
all levels throughout the organisation.

The ‘’ first cut’’ at the budget preparation provides an opportunity to make decisions that will
improve performance before a commitment is made to a specific way of operating during the
year.

b) Coordination

In each organisation, every responsible center manager participates and must contribute actively
to the preparation of a budget. Then, when the staff in the organisation assembles the pieces into
an overall plan, inconsistencies may show up. The most common is the possibility that the plans
of the production organisation are not consistent with the planned sales volume, in total or in
certain product lines. Within the production organization, plans for shipment of finished products
may be inconsistent with the plans of plants or departments within plants to provide components
for these products. Another example is that, line organizations may be assuming higher level of
service from support organizations than those organizations plan to provide. During the budget
preparation process, these inconsistencies are identified are resolved.

c) Assigning Responsibility

The approved budget should make clear what each manager is responsible for. The budget also
authorizes responsibility center managers to spend specified amounts of money for certain
designated purposes without seeking the approval of higher authority.

Example: Authorization to overspend to a certain % limit without asking approval to the higher
authority. (For public and for private institution).

d) Basis for Performance Evaluation

The budget represents a commitment by the budgetee to his or her superior. It is therefore a
benchmark against which actual performance can be judged. The commitment is subject to
change if the assumptions on which it is based change, but the budget nevertheless is an
excellent starting point for performance appraisal. The budget assigns responsibility to each
responsibility center in the organisation. At the top level, the budget summary assigns

[46]
 responsibility to individual profit centers. Within profit centers, the budget assigns responsibility
to functional areas (such as marketing).Within functional areas, the budget assigns responsibility
to individual responsibility centers (such as regional sales offices in the marketing organization).

Exemples. Nicolas G.Hayek,the CEO of SMH(makers of swatch and Omega watches), has been
credited with both a dramatic turn-around of SMH as well as the revitalization of the Swiss
watch industry itself. Nicolas Hayek uses the budgets as part of his broader set of tools in this
revitalization process. Hayek has remarked:”We are big believers in decentralization. This
company has 211 profit centers. We set tough, demanding budgets for them. I personally
participate in detailed budget reviews for our major profit centers. Then we track performance
closely. We get monthly sales figures for all profit centers on the sixth day of the following
month. We get profit and loss statements about 10 or 15 days later. The moment anything looks
strange, we react very quickly, very decisively and very directly.

4.6 Content of an operating Budget

The content of an operating budget is summarized in the following exhibit.
SRATEGIC PLAN OPERATING BUDGET CAPITAL BUDGET

Revenue and Expenses for each major For organisation as a whole and for Each major capital project listed
each business unit
program separately
Classified by responsibility centers
Not necessarily by responsibility
centers Typically includes:

 Revenues
Not as much detail as operating budget
 Production cost and cost
of sales
More expenses are available  Marketing expense
 Logistics
For several years expenses(sometimes)
 General & Administrative
Total reconciles to operating  R&D
 Income taxes(sometimes)
budget  Net Income

Expenses may be:

 Flexible
 Discretionary
 Committed

For one year divided into months or Total project expenditures by quarter
quarters

Total reconciles to strategic

plan(unless revised)

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4.7 Operating Budget Categories
In a relatively small organisation, especially the one that has no business units, the whole budget
may fit on one page. In larger organizations, there is a summary page and other pages that
contain details for individual business units, plus R&D, General and administrative expenses.
The revenue item is listed first, because it is the first item on an income statement and also
because the amount of budgeted revenue influences the amount of many of the other items.

a) Revenue Budgets

A revenue budget consists of unit sales projection multiplied by expected selling prices. Of all
the elements of a profit budget, the revenue budget is the most critical, but it is also the element
that is subject to the greatest uncertainty. The degree of uncertainty differs among companies,
and within the same company the degree of uncertainty is different at different times.

Companies with large backlogs or companies whose sales volume are constrained by production
capacity will have more certainty in sales projections than companies whose sales volume are
subject to the uncertainties of the market place. The revenue budget usually is based on forecasts
of some conditions for which the sales manager cannot be held responsible. For example, the
state of the economy must be anticipated in preparing a revenue budget, but the marketing
manager obviously has no control over it. Nevertheless, effective advertising, good service, good
quality, and well trained sales people influence the sales volume, and the marketing manager
does control these factors.

b) Budgeted Production Cost and Cost of Sales

Although different text books indicate that direct material cost and direct labor cost are
developed from the product volumes contained in the sales budget, this often is not feasible in
practice because these details depend on the actual mix of products that are to be manufactured.
Instead, the standard material and labor costs of the planned volume level of a standard mix of
products are shown in the budget production managers make plans for obtaining quantities of
material and labor, and they may prepare procurement budgets for long –lead-time items. They
also develop production schedules to ensure that resources needed to produce the budgeted
quantities will be available.

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The budgeted cost developed by the production managers may not be for the same quantities of
products as those shown in the sales budget. The difference represents additions to or
subtractions from finished goods inventory.

The cost of sales reported in the summary budget is the standard cost of products budgeted to be
sold. Similarly, the budgeted cost of sales in wholesale and retail establishments is not
necessarily the cost of the goods that will be purchased in the budget year. Control over the
amounts that may be purchased is obtained by detailed “open to buy” authorizations made during
the year, rather than by the amounts shown in the budget. As is the case with manufacturing
companies, the difference between purchases and sales represents additions to or decreases
in inventory.

c) Marketing Expenses

Marketing expenses are expenses incurred to obtain sales or to increase sales on certain products.
A considerable fraction of the amounts included in the budget may have been committed before
the year begins.

If the budget contemplates a selling organisation of a specified number of sales offices with
specified personnel, then plans for opening or closing offices and for hiring and training new
personnel (or for laying off personnel) must be well underway before the year begins.
Advertising must be prepared months in advance of its release, and contracts with media also are
placed months in advance. The marketing expense budget is illustrated in the following table:

Model of Marketing Expense Budget

Quarter

Q1 Q2 Q3 Q4 Year

Planned sales in Units 2,000 6,000 6,000 2,000 16,000

Variable marketing expense per unit x$0.05 x$0.05 x$0.05 x$0.05 x$0.05

Total Variable Expenses $100 $300 $300 $100 $800

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Fixed Marketing Expense

Salaries $10 $10 $10 $10 $40

Advertizing $10 $10 $10 $10 $40

Depreciation $5 $5 $5 $5 $20

Travel $3 $3 $3 $3 $12

Total fixed expenses $28 $28 $28 $28 $112

Total marketing expenses $128 $328 $328 $128 $912

d) Logistics Expenses

They are usually reported separately from order getting expenses. They include order entry,
warehousing and order picking, transportation to customer, and collection of accounts
receivables. Conceptually, these expenses have more like production costs than marketing costs;
that is, many of them are engineered costs. Nevertheless, many companies include them in the
marketing budget, because they tend to be the responsibility of the marketing organisation.

e) General and Administrative Expenses

These are expenses of staff units, comprising staff at headquarters and at business units. Overall,
they are discretionary expenses, although some components (such as bookkeeping costs in the
accounting department) are engineered expenses. In the budget preparation, much attention is
given to these categories because they are discretionary; the appropriate amount to authorize is
subject to much debate.

The Administrative expense budget consists of estimated expenditures for the overall
organization and operation of the company. Most administrative expenses are fixed with respect
to sales. They include salaries, depreciation on the headquarters building and equipment, legal
and auditing fees and so on. The administrative expense budget is shown in the following table.

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The General and Administrative budget for the Year ended 31, 2010

In thousand($)

Q1 Q2 Q3 Q4 Total(year)

Salaries 25 25 25 25 100

Severance Pay/Term. Benefits 10 10 10 10 40

Insurance 15 - - - 15

Depreciation 10 10 10 10 40

Travel 3 3 3 3 12

Total General and Adm.Budget 63 48 48 48 207

f) Research and Development Expenses

The R&D budget uses either of two approaches, or a combination of them. In one approach, total
amount is the focus. This may be the current level of spending, adjusted for inflation; or it may
be a larger amount in the belief that more can be spent in good times, if the company expects an
increase in sales revenue or if there is a good chance of developing a significantly new product
or process.

The alternative approach is aggregating the planned spending on each approved project, plus an
allowance for work that is likely to be undertaken even though it is not currently identified.
Many companies decide to spend a specific percentage of sales revenue on R&D, but this
percentage is based on a long-run average, that is, R&D spending is not geared to short run
changes in sales volume. To permit R&D spending to reflect the short run could have
undesirable effects on the R&D organisation; hiring and organizing researchers is a difficult task,
and, if spending fluctuates in the short run, inefficiencies are likely.

[51]
Although the bottom line is income after taxes, some companies do not take income taxes into
account in preparing the budgets for business units. This is because tax policies are determined at
corporate headquarters.

Example on R&D. T& B company has a research and development group which is undergoing a
research on product line of washing soap. The expenditures by this group are estimated for the
coming year and presented in following R&D expense budget. This budget is illustrated by
quarter.

R&D Expense Budget for the Year ended 31, 2010

In thousand ($)

Q1 Q2 Q3 Q4 Total(year)

Salaries 25 25 25 25 100

Design & product development 15 15 15 15 60

Total 40 40 40 40 160

4.8 Financial Budget

What are the other budgets?

Although we focused on operating budget, the complete budget also consists of:

 Capital budget: Capital budget states the approved capital projects, plus a lump sum
amount, for small projects that do not require high-level approval. It is usually prepared
separately from the operating budget and by different people.

The following are the techniques for capital budgeting where Net Present Value and Internal
Rate of Return have been calculated using the following exercise.

Bannett Company is a medium sized fabricator that is currently contemplating two projects.
Project A requires an initial investment of $42,000, project B an initial investment of $ 45,000.
The relevant operating cash flows for the two projects are presented in the following tables.

[52]
PAY BACK PERIOD

• The payback method simply measures how long (in years and/or months) it takes to
recover the initial investment.

• The maximum acceptable payback period is determined by management.

• If the payback period is less than the maximum acceptable payback period, accept the
project.

• If the payback period is greater than the maximum acceptable payback period, reject
the project.

Example: Seema Mehdi is considering investing $ 20,000 in a 5% interest in a rental property.

Her good friend and real estate agent, Akbar Ahmed,put the deal together, and he conservatively
estimates that Seema should receive between $ 4,000 and $ 6,000 per year in cash from her 5%
in the property. The deal is structured in a way that forces all investors to maintain their
investment the property for at least 10 years. Seema expects to remain in the 25% in tax bracket
for quite a while. In order to be acceptable, Seema requires the investment to pay itself back in
terms of after –tax cash flows in less than 7 years.

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The computation of the payback period on this deal begins with computation of the range of
annual after-tax cash flow:

After tax cash flow = (1-tax rate) x Pre-tax cash flow

= (1- 0.25) x $ 4,000 = $ 3,000

= (1 – 0.25) x $ 6,000 = $ 4,500

The After – tax cash flow ranges from $ 3,000 to $ 4,500. Dividing the $ 20,000 initial
investment by each of the estimated after- tax cash flows, we get the payback period:

Payback period = Initial investment  After-tax cash flow

= $ 20,000  $ 3,000 = 6.67 years

= $ 20,000  $ 4,500 = 4.44 years

Because Seema’s proposed rental property investment will pay itself back between 4.44 and 6.67
years, which is a range below her minimum payback of 7 years, the investment is acceptable.

PROS AND CONS OF PAYBACK PERIODS

• The payback method is widely used by large firms to evaluate small projects and by
small firms to evaluate most projects.

• It is simple, intuitive, and considers cash flows rather than accounting profits.

• It also gives implicit consideration to the timing of cash flows and is widely used as a
supplement to other methods such as Net Present Value and Internal Rate of Return

• One major weakness of the payback method is that the appropriate payback period is a
subjectively determined number.

• It also fails to consider the principle of wealth maximization because it is not based on
discounted cash flows and thus provides no indication as to whether a project adds to
firm value.

• Thus, payback fails to fully consider the time value of money.

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[55]
 NET PRESENT VALUE (NPV)

Decision Criteria

► If NPV > 0, accept the project

► If NPV < 0, reject the project
► If NPV = 0, technically indifferent

Using the Bennett Company data from Table above, assume the firm has a 10%
cost of capital. Based on the given cash flows and cost of capital (required
return), the NPV can be calculated as shown in Figure …..
Net Present Value (NPV): Net Present Value is found by subtracting the present value of the
after-tax outflows from the present value of the after-tax inflows.

Net Present Value (NPV): Net Present Value is found by subtracting the present value of the
after-tax outflows from the present value of the after-tax inflows.

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 Decision Criteria

 If IRR > k, accept the project

 If IRR < k, reject the project
 If IRR = k, technically indifferent

INTERNAL RATE OF RETURN

The Internal Rate of Return (IRR) is the discount rate that will equate the present value of the
outflows with the present value of
the inflows.

The IRR is the project’s intrinsic rate of return

The Internal Rate of Return (IRR) is the discount rate that will equate the present value of the
outflows with the present value of the inflows.

• The IRR is the project’s intrinsic rate of return.

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Which approach of the two (NPV & IRR) is better?
On a purely theoretical basis, NPV is the better approach because:

⸗ NPV assumes that intermediate cash flows are reinvested at the cost of capital whereas
IRR assumes they are reinvested at the IRR,

⸗ Certain mathematical properties may cause a project with non-conventional cash flows to
have zero or more than one real IRR.

Despite its theoretical superiority, however, financial managers prefer to use the IRR because of
the preference for rates of return.

 Budgeted balance sheet

The following is the Budgeted Balance sheet as of the end of Oct-Dec 20x1( in $)

Assets October November December

Currents Assets

 Cash 8,000 8,000 8,000

 Accounts receivable 56,000 68,000 72,000

 Inventory 15,300 16,200 9,000

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Total Current Assets 79,300 92,200 89,000

► Plant, less accumulated depreciation 217,750 215,750 213,750

Total Assets 297,050 307,950 302,750

Liabilities and Equities

Liabilities

 Accounts payable 22,350 25,950 23,400

 Notes payable 17,900 15,379 5,383

Total liabilities 40,250 41,329 28,783

Stockholders’ equity

 Capital stock 180,000 180,000 180,000

 Retained earnings 76,800 86,621 93,967

Total Equities 256,800 266,621 273,967

Total liabilities and Equities 297,050 307,950 302,750

It shows the balance sheet implication of decisions included in the operating budget and the
capital budget.

 Budgeted cash flow statement

The budgeted cash flow statement shows how much of the cash needs during the year will be
supplied by the retained earnings and how much, if any, must be obtained by borrowing or from
other outside sources.

4.9 Budget Preparation Process

Budget department performs the following functions:

 Publishes the procedures and forms for the preparation of the budget

 Coordinates and publishes each year the basic corporate wide assumptions that are to be
the basis for the budgets(e.g., assumptions about the economy)

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  Makes sure that information is properly communicated between interrelated organisation
units(e.g., sales and production)

 Provides assistance to budgetees in the preparation of their budgets.

 Analyzes proposed budgets and makes recommendations, first to the budgetee and
subsequently to senior management.

 Administers the work of making budget revisions during the year

 Coordinates the work of budget departments in lower echelons (e.g., business unit budget
departments).

 Analyzes reported performance against budget, interprets the result, and prepares
summary reports for senior management.

Today, with the development of technology, computer and especially the internet, the above
functions can be performed more accurately, with fewer copying and arithmetic errors and much
more quickly without breaking the need for decisions and interactions between individuals.

4.10 Budget Committee

The budget committee in big organisation/company consists of members of senior management
such as;

 The Chief Executive Officer(CEO)

 Chief Operating Officer (COO)

 Chief Finance Officer (CFO)

In some companies, the CEO decides without a committee. The budget committee performs a
vital role in reviewing, adjusting and approving each of the budgets.

In a large, diversified company, the budget committee might meet only with the senior operating
executives to review the budgets for a business unit or group of business units. In some other
companies, however each business manager meets with the budget committee and presents the
budget proposals.

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4.11 Producing Budget Guidelines
Either or not there is a strategic plan in a company, the first step to go in budget preparation
process is to develop guidelines that governs the preparation of the budget and these guidelines
are distributed to managers.

The guidelines are those that are implicit in the strategic plan modified by development that has
occurred since its approval, especially the performance of the company for the year to date and
its current outlook. All responsibility centers must follow some of these guidelines, such as
assumed inflation in general and inflation for specific items like wages; corporate policies on
how many persons can be promoted; compensation at each wage and salary level, including
employee benefits. There may also be developed guidelines that are specific to certain
responsibility centers.

All these budget guidelines are developed by staff and approved by senior management; staff
also develops a timetable for the steps in the budget preparation process and then disseminates
this material throughout the company.

4.11.1 What is the Initial Budget Proposal?

Using the guidelines, head of responsibility centers, assisted by their staffs develop a budget
request. Due to that most of the responsibility centers will start the budget year with the same
facilities, personnel, and other resources that they have currently, this budget is based on the
existing levels which are then modified in accordance with the new guidelines.Change from the
current level of performance can be classified as;

 Changes in external forces

 Changes in internal policies and practice

a) Changes in External Forces

 Changes in the general level of economic activity as it affects the volume of sales (e.g.,
expected growth in the demand for a product line).

 Expected changes in the price of purchased materials and services

 Expected changes in Labor rates

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  Expected changes in the cost of discretionary activities (e.g., marketing, R&D and
administration).

 Changes in selling prices.

b) Changes in Internal Policies and Practices

Changes in internal policies include but not limited to the following:

 Changes in production costs, reflecting new equipment and methods

 Changes in discretionary costs, based on anticipated changes in workload

 Changes in market share and product mix

Some companies require that specific changes from the current level of spending be classified by
such causes as the above. Although this involves extra work, it provides a useful tool for
analyzing the validity of proposed changes.

4.12 Budget Review and approval

The proposed budgets go up through successive levels in the organisation before they reach the
final stage. When they reach the top of a business unit, analysts put the pieces together and
examine the total. At this stage the first slacks (the difference between the budget amount and
the best estimate) are examined.

In his/her analysis, the analyst try to see the consistency, for example, he/she sees if the
production budget is consistent with the planned sales volume, Are service and support centers
planning for the services that are being requested of them? In part, the examination asks whether
the budget will produce a satisfactory profit. If not, it is often sent back for reworking. The same
exercise (analysis) takes place at corporate headquarters.

The final approval is recommended by the budget committee to the CEO, and then after the CEO
will submit the approved budget to the board of directors for ratification some days before the
beginning of the budget year.

4.13 Budget Revision

One of the principal considerations in budget administration the procedure for revising a budget
after it has been approved. This process also follows a series of guidelines. If the budget

[62]
assumptions turn out to be so unrealistic that the comparisons of actual figures against the budget
are meaningless, in that case budget revisions may be desirable.

There exist two general types of budget revisions:

► Procedures that provide for a systematic(quarterly) updating of the budgets

► Procedures that allow revisions under special circumstances

If budget revisions are limited only to unusual circumstances, such revisions should be
adequately reviewed. In general, permission to make revisions should be difficult to obtain.
Budget revisions should be limited to those circumstances in which the approved budget is so
unrealistic that it no longer provides a useful control device.

In summary, budget revisions must be justified on the basis of significantly changed conditions
from those existing when the original budget was approved and in many institutions, these
revisions happen once a year (at the end of the 1st semester).

An important consideration is that managers should be required to adhere to plans that

subsequent events prove to be suboptimum. This can be a serious problem in budgeting because
of the time required for budget preparation and review. Budgets must provide for actions that are
planned months ahead of the time they take place.

It is important that management actions be based on the latest information available.

Consequently managers should act according to the most recent information and performance
should continuously be measured against original budget, but explanations for reasonable
variances are acceptable.

4.14 Contingency Budgets

Some companies prepare contingency budgets that identify management actions to be taken if
there is a significant decrease in sales volume from what was anticipated at the time of
developing the budget (e.g., actions to be taken based on a decrease of 20% from the best
estimate of sales volume).The contingency budget provides a way of quickly adjusting to
changed conditions if the situation arises. If sales volume declines by 20%, business unit

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managers can determine for themselves, according to the predetermined contingency budget,
actions to be taken.

4.15 Participation in Budgetary process

This part shows staff who participate in the budgetary process. In reality, a budget process is
either ‘’top down ‘’or’’ bottom up’’.

With top down budgeting, senior management sets the budget for the lower levels.

With bottom up budgeting, lower-level managers participate in setting the budget amounts. The
top down approach rarely works, however it leads to a lack of commitment on the part of
budgetees which endangers the plan’s success.

Bottom up budgeting is mostly likely to generate commitment to meeting the budgeted

objectives; however; unless carefully controlled, it may result in amounts that are too easy and
that may not match the company’s overall objectives.

An effective budget preparation process blends the two approaches. Budgetees prepare the first
draft of the budget for their area of responsibility, which is ‘’ bottom up’’ but they do so within
guidelines established at higher levels, which is ‘’ top down’’. Senior managers review and
critique these proposed budgets. A hardheaded approval process helps to ensure that budgetees
do not play games with the budgeting system.

The review process should be perceived as being fair, if the superior changes the budgeted
amounts, he/she should be able to convince the budgetee that such a change is reasonable.

The budget participation/inclusion (a process in which the budgetee is both involved in and has
influence over the setting of budget amounts) has positive effects on managerial motivation for
two reasons:

1. There is likely to be greater acceptance of budget goals if they are perceived as being
under manager’s personal control, rather than being imposed externally. This
participation leads to higher personal commitment to achieve the goals.

2. Participative budgeting results in effective information exchanges. The approved budget

amounts benefit from the expertise and personal knowledge of the budgetees who are

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 closest to the product/market environment. Furthermore, the budgetees have a clear
understanding of their jobs through interactions with superiors during the review and
approval phase.

4.16 Potential problems in Implementing Budgets

The benefits of budgeting described previously are limited, in some cases they are severe
problems associated to the budgets. They are three main problems that handicap the successful
implementation of budgets.
1. Low levels of participation in the budget process and lack of acceptance of
responsibility for the final budget. The advantages of budgeting are fully realized only
when employees throughout the organization participate in the budget process and take
responsibility for the final budget. The attitude of top management will heavily influence
lower-level worker’s and management attitudes toward budgets. If top management does
not use budgets effectively in controlling operations and adapting to change, others in the
organization may come to view budgeting as irrelevant.

2. Incentive to lie and cheat in the budget process. Effective budgets provide targets for
managers and motivate them to achieve the organization’s objectives. However misuse of
budgets can lead to undesirable incentives. Not only such incentives lead managers to
make poor decisions, they undercut attempts to maintain high ethical standards within the
organization (This occurs when the information that goes into the budget is wrong).
3. Difficulties in business organisation to obtain sales forecasts.

[65]
 CHAP 5: DECENTRALISATION, RESPONSIBILITY,
ACCOUNTABILITY AND PERFORMANCE EVALUATION
As a firm grows, duties are divided and spheres of responsibility are created that eventually
become centers of responsibility. Closely allied to the subject of responsibility is decision
making authority.

Most companies tend to be decentralized in decision making authority. Issues related to

decentralization include performance evaluation and management compensation.

5.1 Responsibility
In general, a company is organized along the lines responsibility. The traditional organizational
chart, with the pyramid shape, illustrates the lines of responsibility flowing from the CEO
through the vice presidents to middle and lower level managers. As organizations increase in
size, these lines of responsibility become longer and more numerous.

A strong link exists between the structure of an organisation and its responsibility accounting
system. Ideally, the responsibility accounting system mirrors and supports the structure of an
organisation.

Responsibility is a duty to perform assigned tasks. All employees are expected to accept these
responsibilities as a condition of employment .Ideally a manager’s responsibility is matched with
the appropriate amount of authority so that the manager is in ‘’ control’’ of the task. The
manager may delegate, or transfer responsibility to a subordinate or team, but the manager is still
in control because the subordinate or team is subject to his/her authority.

Managers delegate decision –making authority for some tasks in order to give themselves more
time to focus on the most important tasks and decisions.

Sometimes managers are given responsibility without equal levels of authority. This situation is
common in organizations in which managers must work with managers of other units or with
customers outside of the organisation.

For example, the vice president of Global learning solutions at Lucent Technologies, a
manufacturing company of telecommunication equipment is responsible for disseminating
employee development courses to various business units throughout the large corporation. This
executive does not have the authority to control weither or how business-unit managers use the
training services with their own employees. Instead, the executive must’’market’’ the training
courses to various business units in order to effectively fulfill the responsibility of the position.

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The Manager may delegate responsibility to subordinates but he or she remains accountable for
the actions of subordinates. Managers hold the ultimate responsibility for tasks they delegate.

5.2 Accountability
Accountability means that a manager or other employee with authority and responsibility must
be able to justify results to a manager at a higher level in the organization hierarchy. One way
managers are held accountable for the performance of their units is in periodic performance
appraisals.

For example; a management by Objective (MBO) can be used to compare planned goals with
achieved results and this leads to that employees are rewarded based on the fact that they have
exceeded expected results.

5.2.1 Authority (what‘s Authority)?

There are two distinct types of authority:

 Line authority
 Staff Authority

The line authority entitles a manager to directly control the work of subordinates by hiring,
discharging, evaluating and rewarding them.

The line authority is based on superior-subordinate authority relationships that start at the top of
the organisation hierarchy and extend to the lowest level. This provides what is called the Chain
of Command. Line managers hold positions that contribute directly to the strategic goals of the
organization. For example, the line managers in a manufacturing company include the
production managers and sales managers who contribute directly to the bottom line.

The Staff Authority includes giving advice, making recommendations, and offering counsel to
line managers and other members of the organization.

Staff authority is based on expertise and is not related directly to achieving the strategic goals of
the organization. The staff managers help line managers achieving bottom line results but they
contribute indirectly to the outcomes. For example, the accounting, legal, human resource
management staffs of a manufacturing firm provide specialized advice on cost control, federal
regulations, and staffing requirements to line managers.

The key to knowing whether a position has line or staff status is the organization’s strategic
objectives. In an accounting firm or in an auditing firm, the accountants/auditors have line
authority since their work directly contributes to the bottom line, whereas accountants in a
manufacturing firm are used in an advisory capacity and thus are classified as having staff
authority.

[67]
Figure.7 Authority

An organization chart summarizes the line of authority in an organization. In the above

organization chart, authority flows in a vertical downward direction, starting with the President,
who has authority over two vice presidents, who in turn are assigned to supervise one or several
department heads. The department heads manage supervisors, who have authority over the
operatives.

Each box represents a position in the organization occupied by one person. Each horizontal level
of boxes represents a level of authority in the organisation

5.2.2 Span of Control

A critical feature of the vertical structure of an organization is the number of subordinates who
report to a manager. This is called” Span of Control”. It determines the number of managers and
number of levels of management in an organization.

A manager with a small span of control supervises a small number of subordinates (about five or
six on average) and can closely monitor the work of each subordinate on a regular basis. Small
spans of control are usually associated with many levels of management, which gives rise to a
tall vertical organization structure.

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A tall vertical structure may have too many levels of management separating front-line
employees from top executives. It may cause the organization to perform inefficiently because
the company is not being responsive to the needs of customers.

When a top executive is required to go through numerous intermediaries to learn what is

happening at the operational level of the business, information often gets distorted and poor
decisions result.

Larger spans of control (ranging from 10 to 20 or more subordinates) mean more responsibility
is pushed to lower levels. A manager with a large span of control may not be able to directly
monitor the behavior of all subordinates. However, using management information systems,
which provide systematic feedback on employee performance, and work teams, in which
monitoring activities are performed by peers on the team, managers can effectively supervise
many subordinates.

Large spans of control result in fewer management levels. Executives at well-managed

companies take pride in having fewer levels separating top management from first-level
operative employees who deal with customers or produce the product. A large span of control
works best when there are routine tasks, highly trained subordinates, competent managers,
similar jobs with comparable performance measures and subordinates who prefer autonomy.

5.3 Centralization and Decentralization

Figure.8 Decentralization & Decentralization

Minimum constraints

Minimum Freedom

CENTRALIZATION

Minimum Constraints

Maximum Freedom

DECENTRALIZATION

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5.3.1 Centralization
It is the location of decision authority at the top of the organisation hierarchy. Centralization and
decentralization are related to the degree of concentration of decision authority at various levels
of the organization. Centralized companies can coordinate activities in a consistent way across
diverse units or departments of an organization.

Ex; in old time, recruitment of all civil servants was done at the ministry level

5.3.2 Decentralization
With decentralization decision – making authority is pushed to lower levels in the organization.
Decentralization is often more effective in rapidly changing environments where it is necessary
to be responsive to changing customer needs and tastes.

Decentralized decision-making authority spurs innovation and risk taking by allowing

individuals to control resources and engage in experimentation without having to obtain the
approval of higher authority.

In recent years, decentralized decision authority has become relatively common in organizations.
Decentralization permits greater utilization of the talents and abilities of managers and teams of
employees and makes it possible to be more responsive to the needs of customers.

For example: By maintaining a highly decentralized structure,3M corporation has become one
of the world’s most innovative companies with more than 60,000 diverse products such as
Scotch Tape, Post-it Notes, Video recording Tape, Computer storage diskettes,etc. One of the
keys to the high rate of innovation at 3M is its 40 autonomous product divisions and other
business units that are purposely kept small.

There is a trade-off between centralization and decentralization. Centralization allows

management to coordinate the various parts of the organisation in a consistent manner.
Decentralization provides greater flexibility to respond to change.

5.4 Performance Evaluation

5.4.1 Performance Appraisal: One of the keys to both individual and organisation
success is providing quality feedback about individual performance.

Performance appraisals have three important objectives:

 They open two - way communication channels. In this, Supervisors may convey to
employees what is expected of them and employees have an opportunity to tell
supervisors what is on their minds.

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  They provide constructive feedback to employees. With this objective, positive steps may
be taken to capitalize on strengths and reduce weaknesses. Performance appraisal is an
integral part of the career development process.

 Performance appraisal helps the manager decide who should be paid more based on
individual contributions.

The numerous techniques that measure performance can be classified by the type (relative or
absolute) of judgment required. They can also be classified by the focus of the measure (trait,
behavior, or outcome).

5.4.1.1 Judgment approaches to performance appraisal.

Performance appraisal may use relative judgment or absolute judgment approaches.

a) Relative Judgment: Employees are compared to one another. Supervisors may be asked
to rank subordinates from best to worst ,or they may be asked to create to create a forced
contribution by classifying a given percentage of employees into various groups, such as
exceptional, standard, room for improvement, and not adequate.

The advantage of relative judgment approach is that it requires supervisors to make difficult
choice. Supervisors who want their subordinates to like them typically prefer to rate most as
excellent which may not be valid.

The disadvantage of relative judgment is that the performance distributions may vary among
units, the performance of a person at the top in one unit may rank at the bottom of another
and the system can also force managers to make unrealistic performance distinctions which
create dissatisfaction in the workforce. The relative judgment may also reduce cooperation
among workers, which will have a negative impact on the performance of the entire unit.

b) Absolute Judgment

It helps to evaluate the performance of employees against performance standards and not in
comparison to other employees.

There are several advantages to this approach which are the following:

 The evaluation data are comparable from one unit to another;

 Employees are more likely to cooperate with one another since individual ratings that are
high are not a threat to the other workers;
 From development perspective, the supervisor can provide more constructive feedback
since the evaluation is centered on job requirements.

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  Absolute judgment is easier to defend legally than relative judgment
 The firm/organisation can show or prove that each employee’s evaluation is based on
performance dimensions that measure success on the job.

5.4.2 Compensation
The three key objectives of any compensation system should be attract high quality workers from
the labor market, retain the best employees the company already has, and motivate employees to
work harder and to help the company achieve its strategic goals.

An employee’s total compensation package is made up of three components.

The first is base compensation, or the fixed amount of money the employee expects to receive in
a weekly or monthly paycheck or as an hourly wage. The second is pay incentives, or the
compensation that rewards employees for high performance.

Incentives may be based on employees’ own contributions or the performance of the team,
business unit, and entire company. They are generally paid out as a percentage of base
compensation. Pay incentives are often referred to as variable pay because the amount is
contingent on or varies according to changes in performance.

The third component of total compensation is benefits, or indirect compensation. This accounts
almost 40% of the typical total compensation package. Benefits include health insurance,
pension plans, unemployment insurance, vacations and sick leave.

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Figure.9 Compensation

Compensation is a major cost for most firms. Labor costs may be as high as 60% in some
manufacturing environments and even higher in service organizations. For instance personnel
costs reach 80% of the total budget of the US Postal service. This means that how well
compensation dollars are allocated is likely to have a significant effect on firm’s performance.
The design of compensation system should fit with the firm’s strategic objectives, the firm’s
unique characteristics and the company’s environment. The best compensation practices or the
reward system in any growing company should help implement the firm’s strategy and in that
case the compensation will be called’’ Strategic compensation”.

5.4.3 Managing Team Compensation

Team management requires vigilant management. Teams do not always perform effectively,
possibly because of a lack of team spirit, a disruptive team member, or a lack of commitment to
team goals. Factors that need to be taken into account in managing effective team performance
are the stages of team development, the roles of team members and leaders, and team member
behaviors.

Before a team get started, planning and organizing must take place so that all members
understand their roles and how they contribute to achieving team objectives. There are five
stages of team development:

 Forming: When team members meet for the first time to get acquainted and discuss
expectations between group members and at this stage basic ground rules are established.

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  Storming: Team members voice differences about team goals and procedures. Difference
may involve goal priorities, the allocation of team resources, selection of team leader, etc.
 Norming: Conflict resolution and agreement over team goals and values emerge in the
norming stage. Team members finally understand their roles and establish closer
relationship, intensifying the cohesion and interdependence of members.
 Performing: It characterized by a focus on the performance of the tasks delegated to the
team. Team members collaborate to capture synergies between individuals with
complementary skills.
 Adjourning: Teams that are designed to disband reach adjourning stage in which the team
has completed its work. Team members feel satisfaction about the completion of the
team’s goals, but they are also anxious about possible new assignments and about
separating from friends they made while on the team.

These stages occur in sequence, although they may occur rapidly when a team is under strong
time pressure.

5.4.4 Team Performance problem

Several problems within teams make it difficult to succeed. Trust and cooperation are absent or
weak in manufacturing teams and in this case the performance suffers a lot. There are three most
challenging problems in team performance:

 Free riders: These are those individuals who find it rational to withhold effort and
provide minimum input to the team in exchange for a full share of the rewards. It takes
place mainly when individuals can hide behind the collective effort of the team and get
lost in the crowd. With this, some individuals will ask various questions like” Why
should I work hard when free riders profit at my expense?’’.
 The nonconforming high performer: This includes disciplining the offending party
through peer group pressure and giving the individuals strongly worded critical feedback
during a performance evaluation
 The lack of rewards for teamwork: A problem that is common to many organizations
that utilize teams is that few if any rewards for teams that meet or exceed performance

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 goals. These same organizations provide merit pay and other rewards for individual
performance.

Teamwork must be rewarded to strengthen and sustain team effort. Rewards can be monetary
(such as a team bonus) or nonmonetary (such as recognition).

5.4.5 Organization wide Reward Systems

Another approach to compensation and to coordinating activities of people from different
departments is to provide a reward based on organization profits.

Profits sharing plans pay a share of the company’s profits to the employees in the form of a
bonus. Profit sharing creates a “We are in this together” mentality, which nurtures collaboration
between departments.

As a result of profit sharing for example at Hewlett-Packard, new technologies developed in one
division can be shared with other divisions and fashioned into new products.

Profit sharing can also be used to encourage cooperation between people at different levels of the
hierarchy.

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CHAP 6: MEASURING AND CONTROLING ASSETS EMPLOYED
In some business units, the focus is on profit as measured by difference between revenues and
expenses. In other business units, profit is compared with the assets employed in earning it.

In this chapter we will fist discuss each of the principle types of assets that may be employed in
an investment center. When all these assets are summed up, they are called” Investment base”.
Next will be a discussion on the two methods of relating profit to the investment base which are:

1. The percentage Return on Investment (ROI)

2. Economic Value Added (EVA)

We will describe the advantages and qualifications of using each to measure performance.
Finally, we will pass through the different problem of measuring the economic value of an
investment center, as compared to evaluating the manager in charge of the investment center.
Today, some authors use the term of residual income instead of economic value added and these
two concepts are effectively the same.

6.1 Purpose of Measuring Assets Employed

The purposes of measuring assets employed are analogous to the purpose mentioned for profit
centers. The purposes are summarized in the following sentences:

- To provide information that is useful in making sound decisions about assets employed
and to motivate managers to make these sound decisions that are in the best interests of
the company.
- To measure performance of business unit as an economic entity.

With the alternative treatment of assets and the comparison of ROI and EVA, the two ways of
relating profit to assets employed we are first of all interested in how well the alternatives serve
these two purposes of providing information for sound decision –making and measuring business
unit economic performance.

Focusing on profits without considering or including the assets employed to generate those
profits is an inadequate basis for control.

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Except in certain rare types of service organizations, in which the amount of capital is
insignificant, an important and primary objective of a profit-oriented company is to earn a
satisfactory return on the capital that the company uses.

Example: A profit of RWF 100 million in a company that has RWF 10 billion of capital does
not represent a good performance as a profit of RWF 100 million in a company that has only
RWF 5 billion of capital, assuming both companies have similar risk profile.

Unless the amount of assets employed is well recorded and taken into account, it is difficult for
senior management to compare the profit performance of one business unit with that of other
units or to similar outside companies. Comparing absolute differences in profits is not
meaningful if business units use different amounts of resources. The more resources used, the
greater the profits should be. This kind of comparison helps to judge how well business unit
managers are performing and to decide how to allocate resources.

6.2 Performance Objectives

Business unit managers have two performance objectives which follow:

- They should generate adequate profits from the resources at their disposal.
- They should invest in additional resources only when the investment will produce an
adequate return.( Conversely, they should disinvest if the expected annual profits of any
resources, discounted at the company’s required earnings rate, are less than the cash that
could be realized from its sale).

EXHIB.. Business Unit Financial Statements

I. Balance Sheet($000s)

Current Assets
Cash……………………………………………………………………… 50
Receivables………………………………………………………... 150
Inventory………………………………………………………….. 200
Total Current Assets 400
Fixed Assets
Cost………………………………………………….. 600

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Depreciation…………………………………… -300
Book Value……………………………………………………….. 300
Total Assets…………………………………………………….. 700

Current Liabilities
Accounts payable…………………………………………….. 90
Other current…………………………………………………… 110
Total current liabilities…………………………………….. 200
Corporate Equity………………………………………………. 500
Total Equities………………………………………………. 700

II. Income Statement($000s)

Revenue…………………………………………………………………………… 1000

Expenses,except depreciation……………………………………… 850

Depreciation………………………………………………………... 50

Expenses ,including depreciation……………………………………………….. 900

Income before taxes…………………………………………………………….. 100

Capital charge(500*10%)…………………………………………………………. 50

Economic Value Added(EVA)……………………………………………………. 50

Return on Investment(ROI) = 100 ÷ 500 = 20%

The above exhibit is a simplified set of business unit financial statement that will be used
throughout the analysis. In the interest of simplicity, income taxes have been omitted from this
exhibit and generally will be omitted from discussion in this part. Income taxes will also change
magnitudes in the calculations but will not change the conclusions.

The exhibit shows the two ways of relating profits to assets employed through return on
investment and economic value added.

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Return on Investment (ROI): Is a ratio where the numerator is income, as reported on the
income statement and the denominator is the asset employed. In the exhibit above, the
denominator is taken as the corporation’s equity in the business unit. This amount corresponds to
the sum of noncurrent liabilities plus shareholder’s equity in the balance sheet of a separate
company. It is mathematically equivalent to total assets less current liabilities, and to noncurrent
assets plus working capital.

A favorite objective of top management is to achieve its profit targets. Companies often evaluate
segment managers in decentralized units based on their segment’s profitability. The trouble is
that profitability does not mean the same thing to all people. Is it income? If so, is it income
before taxes? Is it an absolute amount? A percentage? If a percentage, is it a percentage of
revenue or of investment? This is to show that great consideration is given to strengths and
weaknesses of several commonly used profitability measures.

Often, managers stress net operating income and ignore the investment associated with
generating that income. Suppose Nike has two divisions, X and Z. To say that Division X, with
an operating income of $ 200,000 has better performance than division Y with an operating
income of $ 150,000 ignores an important aspect of profitability.

A better test of profitability is the rate of return on investment (ROI) which is the income ( or
profit) divided by the investment required to obtain that income or profit. Given the same risks,
for any given amount of resources required, the investor wants the maximum income. If division
X requires an investment of $ 500,000 and division Y requires only $ 250, 000, division Y has
the higher ROI as it is computed here below:

Income
ROI =
Investment

$200,000
ROI division X =  40%
$500,000

$150,000
ROI division Y =  60%
$250,000

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Every dollar invested in division Y generates income of $ 0,60 compared to the $ 0,40 generated
by the 1$ invested in division X. In all ROI calculations, we should measure invested capital as
an average for the period under review. Because income is a flow of resources over a period of
time and we should be able to measure the average investment that generates that flow over the
same period. This average may be simply the average of the beginning and ending balances or it
may be a more complicated average that weights changes in investments through the months.

Like in above case, division X had $ 450,000 of investment at the beginning of the year and
gradually increased it to $ 550,000 by the end of the year. The investment to use when
calculating ROI will be ($ 450,000  $550,000)  2  $500,000

ROI facilitates the comparison of a unit’s performance with that of other segments within the
company or with similar units outside the company. Because, unlike the income itself, ROI does
not depend on the size of the various segments. It is a return per unit invested, regardless of the
size of investment.

ROI is the product to two items which are:

- Return on sales (income divided by revenue)

- Capital turnover(revenue divided by invested capital)

Income revenue
  Return on sales  capital turnover
revenue investedcapital

Managing ROI is essentially a process of managing return on sales and capital turnover and an
improvement in either of these rates without changing the other will improve the ROI.

Although use of ROI causes managers to consider both income and investment in their decisions,
using ROI may cause managers, especially those in profitable units to reject profitable
investment opportunities. Due to this, development of alternative performance measures that
focus more on economic profit were made.

Economic profit or Economic Value Added (EVA): Is a dollar amount, rather than a ratio. It is
found by subtracting a capital charge from the net operating profit. This capital charge is

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found by multiplying the amount of assets employed by a rate, which is 10% in the example
given above.

One goal of performance measure is to motivate managers to make appropriate decisions that
increase the value of the company. Most of the managers accept that value increasing metrics
include both profit and investment.ROI is only one such measure focusing on income as a
percentage of investment.

Economic profit also called residual income is defined as after-tax operating income less a
capital charge.

The capital charge is the company’s cost of capital multiplied by the amount of investment,
where the cost of capital is what the firm must pay to acquire more capital.

The economic profit tells you how much a company’s after-tax operating income exceeds what it
is paying for capital.

Example1 on Economic profit. Consider Nike’s division A. Suppose its after-tax operating
income is $ 200, 000, the average invested capital in the division for the year is $ 500,000,and
the company’s after-tax cost of capital is 8%.The residual income is calculated as follows:

- Divisional after – tax operating income $ 200,000

- Minus capital charge on average invested capital( 0,08 0,08  $500,000 = $40,000
- Equals Economic profit(or residual income) $ 160,000

There several different ways to calculate economic profit, depending on how company chooses
to define the terms used. One popular variant coined and marketed by the consulting firm (stern
Stewart & Co.) is the economic value added.

Example2 : AT&T used the EVA measure to evaluate business unit managers. For instance, the
long-Distance group consisted of 40 business units which sold different services such as
telemarketing and public telephone calls. All the capital costs, from switching equipment to new
product development, were allocated to these 40 business units. Each business unit manager was
expected to generate operating earnings that substantially exceeded the cost of capital.

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The cost of invested capital (%) is the cost of long term liabilities and stockholders’ equity
weighed by their relative size for the company or division. Stern Stewart makes specific
adjustments to financial reporting measures of after-tax operating income and invested capital.

Economic profit and EVA have received much attention in recent years as scores of companies
are adopting them as financial performance metrics. AT&T, Coca – Cola,CSX,FMC and Quaker
Oats claim that using EVA motivated managers to make decisions that increased shareholder
value.

All the above companies are successful because they do better job than many of their
competitors at allocating, managing, and redeploying scarce capital resources such as fixed
assets, etc.

6.3 Relation between ROI and Economic Profit

Why do some companies prefer economic profit (or EVA) to ROI? We will illustrate how ROI
performance metric can motivate poor investment decision and how profit has no such effect. If
we take again the example of NIKE division and give it a net operating income of $ 900,000 and
average invested capital of $ 10,000,000. An ROI performance metric will show the following;

Divisional net operating income after taxes $ 900,000

Average invested capital $ 10,000,000

Return on Investment ( 10900 , 000

, 000, 000 ) 9%

With ROI, the basic message is, go forth and maximize your rate of return (a high
percentage).Thus, if a company measures performance using only ROI, managers of divisions
currently earning 20% may be reluctant to invest in projects that earn 15% because doing so
would reduce their average ROI.

However,top management may want division manager to accept projects that earn 15% due to
the following reason:

Suppose the company’s cost of capital is 8%.Investing in projects earning 15% will increase
the company profitability because it we consider that for every $ 100 of investment, the

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 company gets $ 15 in operating income and pays $ 8 for the capital, a net gain of $ 15 - $ 8 =
$ 7.

When a company uses economic profit as a performance metric, managers tend to invest in any
project earning more than the cost of capital, because such investment will increase the
division’s economic profit. That is, the economic profit approach fosters goal congruence and
managerial effort.

The basic message from Economic profit approach is, go forth and maximize economic profit
which is an absolute dollar amount.

Example: Consider two other Nike divisions, Division X with operating income of $ 200,000
and Division Y with operating income of $ 50,000.Both divisions have average invested capital
of $ 1 million. Suppose a project is proposed that either Division X or Y could undertake. The
project will earn 15% annually after taxes on a $ 500,000 investment, or $ 75,000 a year.

Solution

Without Project With Project

Division X Division Y Division X Division Y
Net operating income $ 200,000 $ 50,000 $ 275,000 $ 125,000
Invested Capital $ 1000,000 $1000,000 $1500,000 $1500,000
ROI ( net operating income / invested capital) 20% 5% 18.3% 8.3%
Capital charge( 8% x invested capital) $ 80,000 $80,000 $120,000 $ 120,000
Economic Profit(net operating income-capital $120,000 $ ( 30,000) $155,000 $ 5,000
charge)
The cost of capital for the project is 8% as indicated in the above exhibit. Suppose you are a
manager of division X. If top management of Nike bases your evaluation on ROI, would you
invest in the project? if think “NO” because it would decrease your ROI from 20% to 18.3%. But
if you were in division Y would you invest? Here it “YES” because ROI increase from 5% to
8.3%.In general, in companies using ROI as a profitability metric, the least profitable divisions
have more incentive to invest in new projects than do the most profitable divisions.

And when top management evaluates performance using economic profit. The project would be
equally attractive to either division. Economic profit increases by $ 35,000 for each division,

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from $ 120,000 to $ 155,000 for X and from negative $ 30,000 to $ 5,000 for Y. Both divisions
have the same incentive to invest in the project, and the incentive depends on only the
profitability of the other activities of the division.

In general, use of EVA will promote goal congruence and lead to better decisions than using ROI
even though most companies still use ROI.

6.4 Measuring Assets Employed

In deciding what investment base to use to evaluate investment center managers, senior
management at headquarters ask two questions.

- The first one is to know what practices will induce business unit managers to use their
assets most efficiently and to acquire the proper amount and kind of new assets?
Presumably, when their profits are related to assets employed, business unit managers
will try to improve their performance as measured in this way. Senior management wants
the actions that they take toward this end to be in the best interest of the whole operation.
- The second is to know what practices best measure the performance of the unit as an
economic entity.

6.3.1 Cash
Most companies control cash centrally due to that central control allows the use of smaller cash
balance than would be the case if each business unit held the cash balances it needed to whether
the unevenness of its cash inflows and outflows.

Business unit cash balances may well be only “float” between daily receipts and daily
disbursements. Consequently, the actual cash balances at a business unit level tend to be much
smaller than would be required if the business unit were an independent company.

Many companies therefore use a formula to calculate the cash to be included in the investment
base. For example, General Motors in the USA was reported to use 4.5% of annual sales; Dupont
was reported to use two months’ costs of sales minus depreciation.

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6.3.2 Receivables
Business unit managers can influence the level of receivables directly or indirectly by;

- Their ability to generate sales

- Establishing credit terms
- Approving individual credit accounts and credit limits
- Their vigor in collecting overdue amounts

In the interest of simplicity, receivables often are included at the actual end of period balances,
although the average of intraperiod balances is conceptually a better measure of the amount that
should be related to profits.

Whether to include accounts receivables at selling prices or at cost of goods sold is debatable.
One could argue that business unit’s real investment in account receivables is only the cost of
goods sold and that a satisfactory return on this investment is probably enough.

On the other hand, it is possible to argue that the business unit could reinvest the money
collected from account receivables, and therefore, accounts receivable should be included at
selling prices. From the two positions or point of views above, the usual practice is to take the
simpler alternative, which is to include receivables at the book amount, which is the selling price
less an allowance for bad debts.If the business unit does not control credits and collections,
receivables may be calculated on a formula basis and this formula should be consistent with the
normal payment period.

Example: 30 days’ sales where payment normally is made 30 days after the shipment of goods.

6.3.3 Inventories
Inventories ordinarily are treated in a manner similar to receivables that is, they are often
recorded at end of period amounts even though intraperiod averages would be preferable
conceptually. If the company uses LIFO for financial accounting purposes, a different valuation
method usually is used for business unit profit reporting because LIFO inventory balances tend
to be unrealistically low in periods of inflation.

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CHAP 7: BALANCED SCORE CARD

7.1 Definition
The Balance score card (BSC) is a performance measurement and reporting system that strikes a
balance between financial and nonfinancial measures, links performance to rewards, and gives
explicit recognition to the diversity of organizational goals ( Charles T.Hongren;Gary L.Sundem,introduction to
management accounting,14th ed,p401).

Balanced score card ties performance measurement directly to organizational goals and
objectives. Different big companies such as Microsoft use BSC to focus management’s attention
on key performance indicators-measures that drive an organization to achieve its goals. About
50% of the 1000 largest US firms use balanced score card

The Balanced Scorecard (BSC) is a strategic performance management framework that allows
organizations to manage and measure the delivery of their strategy. The concept was initially
introduced by Robert Kaplan and David Norton in a Harvard Business Review Article in 1992
and has since then been voted one of the most influential business ideas of the past 75 years.

The Balanced Scorecard is a strategic performance management framework that has been
designed to help an organisation monitor its performance and manage the execution of its
strategy. In a recent world-wide study on management tool usage, the Balanced Scorecard was
found to be the sixth most widely used management tool across the globe which also had one of
the highest overall satisfaction ratings. In its simplest form the Balanced Scorecard breaks
performance monitoring into four interconnected perspectives: Financial, Customer, Internal
Processes and Learning & Growth.

Like most good ideas, the concept of the Balanced Scorecard fairly simple. Kaplan and Norton
identified four generic perspectives that cover the main strategic focus areas of a company. The
idea was to use this model as a template for defining objectives and measures in each of the
following perspectives.

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7.2 Balanced Scorecard Perspectives
The balanced score card has four perspectives which follow:

1. The Financial Perspective covers the financial objectives of an organisation and allows
managers to track financial success and shareholder value. The Financial perspective
establishes the long and short term financial performance objectives expected from the
organization’s strategy and simultaneously describes the economic consequences of
actions taken in the other three perspectives. This implies that the objectives and
measures of the other perspectives should be chosen so that they cause or bring about the
desired financial outcomes. The financial perspective has generally three strategic
themes:
 Revenue growth
 Cost reduction
 Asset Utilization
These themes serve as the building blocks for the development of specific operational
objectives and measures. Of course, the three themes are constrained by the need for
managers to manage the risk.
a) Revenue Growth
Increasing revenues can be achieved in a variety of ways, and the potential strategic
objectives reflect these possibilities. Among these possibilities are the following
objectives:
 Increasing the number of new products
 Create new applications for existing products
 Develop new customers and markets
 Adopt a new pricing strategy
Once operational objectives are known, performance measures can be designed. Possible
measures for the preceding list of objectives(in the order given) are percentage of revenue
from new products, percentage of revenue from new applications, percentage of revenue
from new customers and market segments and profitability by product or customer.

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 b) Cost reduction
Reducing the cost per unit of product, per customer, or per distribution channel are
examples of cost reduction objectives. The appropriate measures are obvious: the
cost per unit of the particular cost object and Trends in these measures will tell
whether or not the costs are being reduced.
c) Asset Utilization
Improving asset utilization is the core objective and financial measures such as ROI
and EVA can be helpful in this.
d) Risk Management
Managing the risk associated with the adopted strategy is another critical strategic theme.
The one that is common to the three strategic financial themes which are: Diversification
of customer types, product lines, and suppliers are common means of lowering risk.
Sourcing materials from only one supplier may lower costs but it may also jeopardize the
firm’s throughput if something happens to the supplier ( e.g., a labor strike).Similarly,
revenues may be increased by relying on one very large customer but what happens if the
customer decides to buy elsewhere? Thus, any strategic initiative must be balanced with
careful consideration of the risk involved.

Summary of Objectives and Measures: Financial Perspective

Objectives Measures
 Revenue Growth

Increase the number of new products Percentage of revenues from new products
Create new applications Percentage of revenues from new applications
Develop new customers and markets Percentage of revenues from new sources
Adopt a new pricing strategy Product and customer profitability
 Cost Reduction

Reduce unit product cost Unit product cost

Reduce unit costumer cost Unit costumer cost
Reduce distribution channel cost Cost per distribution channel
 Asset Utilization

Improve asset utilization cost Return on Investment

Economic value added

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 2. The Customer Perspective covers the customer objectives such as customer satisfaction,
market share goals as well as product and service attributes. The customer perspective
defines the customer and market segments in which the business unit will compete and
describes the way that value is created for customer.
The customer perspective is the source of revenue component for the financial objectives.
Failure to deliver the right kinds of products and services to the targeted customers means
revenue will not be generated.

3. The Internal Process Perspective covers internal operational goals and outlines the key
processes necessary to deliver the customer objectives.

4. The Learning and Growth Perspective covers the intangible drivers of future success
such as human capital, organizational capital and information capital including skills,
training, organizational culture, leadership, systems and databases.

Figure.10 Balanced Scorecard perspectives

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7.3 Strategic Alignment
Creating a strategy is one issue and implementing it is another. The balanced scorecard to be
successful implemented, the entire organization must be committed to its achievement.

The balanced scorecard main role is to bring about organizational change. For this change to take
place, employees must be fully informed about the strategy, they must share ownership for the
objectives, measures, targets and initiatives, incentives must be structured to support the strategy,
and resources must be allocated to support the strategy.

a) Communicating the strategy

The Scorecard objectives and measures, once developed, become the means for articulating and
communicating the strategy of an organization to its employees and managers. The objectives
and measures also serve the purpose of aligning individual objectives and actions with
organizational objectives and initiatives. Videos, newsletters, brochures, and the company’s
computer network are examples of media that can be used to inform employees of the strategy,
objectives and measures associated with the Balanced Scorecard. How much specific detail to
communicate is certainly a relevant question.

Communicating too much detail may create a potential problem with competitors. The Balanced
Scorecard is a very explicit representation of the company’s targeted markets and the means
required for obtaining gains in these markets. This can be very sensitive information, the more
employees who are aware of it, the more likely it may end up in the hands of competitors. Yet, it
is important that employees have a sufficient understanding of what is happening so that they
will accept and agree to the strategic efforts of the organization.

Articulation of the Balanced Scorecard should be clear enough that individuals can see the
linkage between what they do and the organization‘s long term objectives. Seeing this linkage
increases the likelihood that personal goals and actions are congruent with organizational goals.

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 b) Targets and Incentives

Once objectives and measures have been clearly defined and communicated, performance
expectations must be established.

Performance expectations are communicated by setting targeted values for the measures
associated with each objective. Managers are held accountable for the assigned responsibility by
comparing the actual values of the measures with the targeted values.

Finally, compensation is linked to achievement of the scorecard objectives. It is vital that the
reward system be tied to all the scorecard objectives and not to traditional financial measures.
The example below provides information of targets using the objectives and measures. The
relative importance management has assigned to each perspective and objective is revealed by
weights expressed as percentages. Targets are set for both the long-term and the short-term (a 3-5
year horizon and a 1-year horizon) and should be backed up with initiatives that can be
undertaken to achieve them. For example, is it really possible to increase share prices by 50%
over a 3-year span? And how much increase will be targeted for the coming year? The increase
is dependent on increasing revenues by 30% and decreasing costs by 20%.These Changes are, in
turn, dependent on other events in other perspectives. Can cycle time be reduced to two days(say,
from a current level of five days)?

Targets and Weighting Scheme Illustrated

Perspectives Objectives Measures Targets

Financial (25%) Increase shareholder value (25%) Share price 50% increase

Increase profits (25%) Profits 100%

Increase revenue (25%) Revenues 30% increase

Decrease process costs (25%) Costs 20% decrease

Customer (25%) Increase market share (20%) Market share 25%

Increase customer retention (30%) Repeat orders 70%

Improve delivery reliability (50%) On-time 100%

percentage

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Internal Process (25%) Improve cycle time (60%) Cycle time 2days

Redesign process (40%) Yes or No Yes

Learning&Growth (25%) Improve employee skills (100%) Hours of training 30hours per
employee

How to structure incentive compensation with multiple dimensions is a challenging task.

Typically, weights that reflect the relative importance of the perspectives are used to determine
the percentage of the bonus pool that will be assigned to each perspective

Thus, from the above exhibit, we see that for example each perspective would be assigned 25
percent of the total bonus pool. But within each category, there are usually multiple objectives
and multiple measures. For example, within the customer category, there are three performance
measures. How much of the 25 percent bonus pool should be assigned to each measure? Again,
weights that reflect the relative importance of each objective within its category are used to make
this determination. The example in the above table reveals that management has decided to
assign 50 percent of the customer category bonus to the On-time delivery objective, 30 percent to
the customer retention objective and 20 percent to the market share objective.

Distributing potential bonus money to the various perspectives and measures is one thing, but
payment of incentive compensation is dependent on performance. The actual values of the
measures are compared to the targeted values for a given time period. Compensation is then paid,
based on the percentage of achievement of each objective. However, there is one major
qualification for the Balanced Scorecard framework. To ensure that proper (balanced) attention
is given to all measures, no incentive compensation is paid unless each strategic measure exceeds
a pre-specified minimum threshold value. Firms adopting the Balance Scorecard seem to realize
the necessity of connecting their reward system to the objectives and measures of the new
performance management system.

c) Resource Allocation

Achieving strategic targets such as those envisioned in the above exhibit requires that resources
be allocated to the corresponding strategic initiatives. This requires two major changes. The first,
an organization must decide how much of strategic targets will be achieved for the coming year.

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Second, the operational budgetary process must be structured to provide the resources necessary
for achievement of these short-time advances along the strategic path. If these changes are not
considered, then it will not be easy that the strategy becomes actionable.

7. 4 from Measurement Dashboards to Strategy Maps

When it was first introduced the Balanced Scorecard perspectives were presented in a four-box
model (see Figure above). Early adopters created Balanced Scorecards that were primarily used
as improved performance measurement systems and many organizations produced management
dashboards to provide a more comprehensive at a glance view of key performance indicators in
these four perspectives.

However, this four box model has now been superseded by a Strategy Map (see Figure below for
the generic template), which is at the heart of modern Balanced Scorecards. A Strategy Map
places the four perspectives in relation to each other to show that the objectives support each
other.

Figure 11 Strategy Maps

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A Strategy Map highlights that delivering the right performance in the one perspective (e.g.
financial success) can only be achieved by delivering the objectives in the other perspectives
(e.g. delivering what customers want). You basically create a map of interlinked objectives. For
example:

⸗ The objectives in the Learning and Growth Perspective (e.g. developing the right
competencies) underpin the objectives in the Internal Process Perspective (e.g. delivering
high quality business processes).
⸗ The objectives in the Internal Process Perspective (e.g. delivering high quality business
processes) underpin the objectives in the Customer Perspectives (e.g. gaining market
share and repeat business).
⸗ Delivering the customer objectives should then lead to the achievement of the financial
objectives in the Financial Perspective.

Strategy maps therefore outline what an organizations wants to accomplish (financial and
customer objectives) and how it plans to accomplish it (internal process and learning and growth
objectives). This cause-and-effect logic is one of the most important elements of best-practice
Balanced Scorecards. It allows companies to create a truly integrated set of strategic objectives
on a single page. For a large number of real-world best practice examples please visit our case-
study section. The danger with the initial four-box model was that companies can easily create a
number of objectives and measures for each perspective without ever linking them. This can lead
to silo activities as well as a strategy that is not cohesive or integrated.

7.5 How many companies use the Balanced Scorecard?

More than half of major companies in the US, Europe and Asia are using Balanced Scorecard
approaches. The official figures vary slightly but the Gartner Group suggests that over 50% of
large US firms have adopted the BSC. A recent global study by Bain & Co finds that the
Balanced Scorecard is one of the top-ten most widely used management tools around the world.
The widest use of the BSC approach has traditionally been in the US, the UK and Northern
Europe, but there is very strong growth in Balanced Scorecard adoption in South America, the
Middle East and Asia.

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7.6 What are the Key Benefits and advantages of using Balanced
Scorecards?
Research has shown that organizations that use a Balanced Scorecard approach tend to
outperform organizations without a formal approach to strategic performance management. The
key benefits of using a BSC include:

1. Better Strategic Planning – The Balanced Scorecard provides a powerful framework for
building and communicating strategy. The business model is visualized in a Strategy Map
which forces managers to think about cause-and-effect relationships. The process of
creating a Strategy Map ensures that consensus is reached over a set of interrelated
strategic objectives. It means that performance outcomes as well as key enablers or
drivers of future performance (such as the intangibles) are identified to create a complete
picture of the strategy.
2. Improved Strategy Communication & Execution – The fact that the strategy with all
its interrelated objectives is mapped on one piece of paper allows companies to easily
communicate strategy internally and externally. We have known for a long time that a
picture is worth a thousand words. This ‘plan on a page’ facilities the understanding of
the strategy and helps to engage staff and external stakeholders in the delivery and review
of strategy. In the end it is impossible to execute a strategy that is not understood by
everybody.
3. Better Management Information – The Balanced Scorecard approach forces
organizations to design key performance indicators for their various strategic objectives.
This ensures that companies are measuring what actually matters. Research shows that
companies with a BSC approach tend to report higher quality management information
and gain increasing benefits from the way this information is used to guide management
and decision making. Another advantage at this level is that line managers can see the
relationship between non financial measures, which often more directly measure the
results of their own actions, and the financial measures that relate to organizational goals.
4. Improved Performance Reporting – companies using a Balanced Scorecard approach
tend to produce better performance reports than organizations without such a structured
approach to performance management. Increasing needs and requirements for

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 transparency can be met if companies create meaningful management reports and
dashboards to communicate performance both internally and externally.
5. Better Strategic Alignment – organizations with a Balanced Scorecard are able to better
align their organisation with the strategic objectives. In order to execute a plan well,
organizations need to ensure that all business and support units are working towards the
same goals. Cascading the Balanced Scorecard into those units will help to achieve that
and link strategy to operations.
6. Better Organizational Alignment – well implemented Balanced Scorecards also help to
align organizational processes such as budgeting, risk management and analytics with the
strategic priorities. This will help to create a truly strategy focused organisation.

These are compelling benefits; however, they won’t be realized if the Balanced Scorecard is
implemented half-heartedly or if too many short cuts are taken during the implementation. For a
more in-depth discussion of the main pitfalls please read the API white paper ‘What is a
Balanced Scorecard’.

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