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Concept Notes On Enterprise Performance Management PDF
Concept Notes On Enterprise Performance Management PDF
Concept Notes
Contents
Concept Notes
Sl.No. 1. 2. 3. 4. 5. 6. 7. 8. 9. Title Pages
Enterprise Performance Management An Overview ..................... 1-18 Design of Organization Structure and Control Systems ................ 19-38 Strategic Performance Control ....................................................... 39-48 Budgeting Techniques .................................................................... 49-60 Business Performance: Targets, Reporting, and Analysis ............ 61-76 Auditing ........................................................................................... 77-94 Transfer Pricing ............................................................................ 95-106 Business Ethics and Enterprise Performance Management ...... 107-118 Performance Management of Production and Operations (A) ... 119-130
10. Performance Management of Production and Operations (B) ... 131-146 11. Performance Management of Service Organizations ................ 147-158 12. Project Control ............................................................................ 159-178 13. Implementation Issues in Enterprise Performance Management ......................................................... 179-194
Contents
Cases
Sl.No. 1. Title Pages
Jack Welch and Jeffrey Immelt: Continuity and Change in Strategy, Style, and Culture at GE............................................................. 197-220
2. 3. 4. 5. 6. 7. 8. 9.
GCMMFs Cooperative Structure ............................................... 221-237 Whole Foods Markets Unique Work Culture and Practices ...... 238-262 Balanced Scorecard Implementation at Philips.......................... 263-284 Tesco: The Customer Relationship Management Champion .... 285-302 Hollinger International: The Lord Black Saga ............................. 303-318 The Bribery Scandal at Siemens AG ......................................... 319-337 BP: Putting Profits Before Safety? ............................................. 338-362 P&Gs Brand Management System............................................ 363-377
10. Taiichi Ohno and Toyota Production System ............................. 378-396 11. Quality and Safety Practices at LEGO ....................................... 397-412 12. Consumer Driven Six Sigma at Ford .......................................... 413-426 13. The AXA Way: Improving Quality of Services ............................ 427-444 14. Pixars Incredible Culture .......................................................... 445-466 15. Millau Viaduct: Creating an Engineering Marvel. ....................... 467-490 16. CRM Implementation Failure at Cigna Corporation. .................. 491-505 17. Governance and Control at AXA ................................................ 506-525 18. The Fall of Barings Bank ............................................................ 526-537 19. Human Resource Management System Reforms at Matsushita .............................................................................. 538-553
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Concept Note - 1
complying with the law and adhering to ethical principles. Therefore, to ensure that the organization achieves its objectives, management control has to address all its subsystems. Management control thus has four broad objectives effectiveness, efficiency, disclosure, and compliance. Technically, we can limit the scope of enterprise performance management to the first two issues of effectiveness (including learning and innovation) and efficiency. But in reality, these issues go hand in hand with the other two issues of disclosure and compliance for the management to meet the expectations of shareholders as well as other stakeholders. This note will help you understand the following fundamentals of management control: The various approaches to management control systems The different objectives of management control The schemes for classifying management controls The contextual factors influencing management control. The note Design of Organization Structure and Control Systems discusses how the management creates suitable structures in the organization and puts in place certain systems, processes, policies, and practices. The note Strategic Performance Control outlines the boundary-setting nature of vision and mission, and describes the use of a balanced performance measurement system for strategic control and strategic learning. The notes Budgeting Techniques, Business Performance: Targets, Reporting, and Analysis, Auditing, and Transfer Pricing discuss four important techniques that are used for managing the performance of an enterprise. The note Business Ethics and Enterprise Performance Management discusses the interplay between business ethics and enterprise performance management and explains the use of ethical control mechanisms to regulate the ethical behavior of employees. The operating core of organizations is usually concerned with production and operations, services, or projects. The notes Performance Management of Production and Operations (A), Performance Management of Production and Operations (B), Performance Management of Service Organizations, and Project Control discuss enterprise performance management in terms of these core functions. This is followed by a note on Implementation Issues in Enterprise Performance Management that discusses the challenges in operationalizing and maintaining a management control system over the life cycle of an organization. In addition to the above, enterprise performance management is dependent on the control of certain functions. These functions should not be confused with departments: for example, the financial control of the enterprise is not limited to the Finance department. Enterprise performance management tools and techniques with respect to finance, marketing, and information technology functions were discussed in the following concept notes: Financial Insights: Financial Control and Financial Reporting Strategic Marketing: Marketing Control IT for Competitive Advantage: Information Resource Management and IT Governance 2
Step 1: Determining areas to control Before initiating the control process, the major areas that need to be controlled have to be determined. Such decision on control areas should be based on organizational goals and objectives defined during the planning process. Exercising control over critical areas helps a manager manage a large number of subordinates effectively, reduce costs, and improve communication. Step 2: Establishing standards Standards form the foundation for the cybernetic process. They are predetermined benchmarks against which employee performance and related behavior is assessed. Standards may be incorporated into goals or may need to be developed during the control process. Standards are usually expressed numerically and aim at achieving the desired quality and quantity within a specific cost and time boundary. In the context of employee behavior, establishing standards serve two purposes: It helps employees understand what is expected of them and how their work will be evaluated, thus helping them to perform effectively It also helps in identifying job difficulties related to the personal limitations of employees, which may include lack of experience, insufficient training, or any other task-related deficiency. The Management by Objectives (MBO) method encourages a participative approach to standard setting by involving employees in the setting of objectives. Step 3: Measuring performance After establishing standards, a manager needs to determine how to measure the actual performance. Evaluation of actual performance becomes easy if performance standards are clearly established and the means for exactly determining what subordinates are doing are available. There are certain activities which are difficult to measure, and for which it is difficult to establish standards. As a result, most organizations use a combination of quantitative and qualitative performance measures. After selecting the means of measurement, the frequency of measurement should be decided. Managers may need to control data on a periodic or continuous basis. Decision on the frequency of performance measurement depends on the importance of the goal, the nature of deviation from the standards, and the expenses that may be incurred on correcting the deviation. Step 4: Comparing actual performance against standards The performance measured in step 3 is compared with the standards established in step 2. Managers often make comparisons based on the information provided in reports. Computerized information systems give supervisors direct access to realtime, unaltered data and information. Online systems identify real-time problems and situations that require a management-by-exception approach. This approach suggests that managers should be informed about a difficult situation only when data shows a significant deviation from standards and when a situation is difficult to handle. 4
Step 5: Rewarding performance and/or taking corrective action when necessary When an employees performance meets or exceeds the standards, it should be acknowledged. Recognition of good performance helps sustain such performance and encourages further improvement. Specific actions should be taken to correct a negative discrepancy. The cause of deviation should be determined followed by the required action to eliminate or minimize it which may involve redrawing plans. Managers may reassign or clarify the subordinates duties and responsibilities. They may have to train existing employees; remove inefficient ones or recruit new employees. A manager should not only propose corrective action, he/she should also ensure that they are implemented correctly, for the successful rendition of the control process. Step 6: Adjusting standards and measures when necessary The established standards may at times become obsolete and inappropriate and may need to be modified. To ensure that standards and performance measures meet future needs, managers should conduct a periodic review of standards. This review may entail changing organizational objectives, technology, etc. If a manager feels that conforming to a particular standard may consume a lot of resources, it may be given low priority. The control process should ensure that it meets the current organizational needs. Management by Objectives (MBO) is a management control tool that can be viewed as a specific application of the cybernetic process.
in the achievement of goals, reasons for the shortfall, and preventive action required to avoid such difficulties in the future. It also recognizes the areas in which subordinates have performed effectively, and identifies areas in which individuals could improve by acquiring some specialized skills. The goals and plans for the next MBO cycle can also be discussed at this stage. Figure 1: The MBO Process
Adapted from Bartol, Kathryn M. and David C. Martin. Management. Third ed. USA: Irwin McGraw-Hill, 1998, p211.
MBO as a management control tool MBO facilitates the integration of individual, group, and organizational objectives. Its practice impacts various organizational processes and initiatives like performance appraisal, organization development, and long-range planning. As MBO forces the management to clearly state objectives, it leads to the development of effective controls. As it focuses on the result of activities, it helps in evaluation and control and in turn, in better management. A clear set of verifiable goals helps managers determine what should be measured and what action should be taken to correct deviations. MBO helps in identifying objectives for the key result areas; tries to link individual objectives with those of the organization; gives individual targets to all and thus, strengthens the employees commitment to the organizational goals; and facilitates impartial performance appraisal thereby ensuring better performance. Refer to Exhibit I for an overview of how MBO can be used in information technology (IT) projects.
Contd
To use MBO in an IT project and to see that business objectives are met, an IT project should be designed and developed to create the right deliverables at the right time, as without them, it is difficult to measure performance. To measure whether the IT project is meeting the business objectives, it is important to measure the performance of the user using the application. Through this, it has to be checked whether the transaction and the training times are reduced. The user interface should be carefully designed and prototyped as it determines various aspects like: The time taken by the user to perform a transaction The time taken by the user to learn the new user interface Whether wastage has reduced in the users activities Whether the user stopped double handling in his/her activities. Also, the performance of the user of the application should be measured immediately to take timely corrective action so that the project meets the business objectives.
Adapted from Craig Errey, Management by Objectives and IT Projects, November 01, 2006, <http://www.ptg-global.com/papers/strategy/management-by-objectives-and-it-projects.cfm>.
Limitations of MBO Some problems are inherent in the MBO process itself while others are due to shortcomings in the implementation of MBO concepts. Failure of the MBO process may occur due to: Failure among participants to understand the concepts of self-direction and selfcontrol on which the MBO philosophy is built on Inadequacy of guidelines provided to those who are expected to set goals Failure to set verifiable goals against which performance can be measured Failure to revise individual goals as and when the organizational goals change Inadequacy of time, effort, and paperwork and inability to meet the high costs of managerial training required Lack of top managements commitment which should be strong and sustained Misuse of objectives by overzealous managers - arising due to the over-emphasis on measurable objectives Frustration among managers arising out of dependence on one managers efforts to achieve goals on the achievement of goals of others.
external environment, and making innovations that improve business processes and responsiveness to the market conditions. The Committee of Sponsoring Organizations of the Treadway Commission (COSO) broadly classifies the objectives of management control under the following heads Effectiveness and efficiency of business operations Reliability of financial reporting Compliance with applicable regulatory and legal framework.
The time of implementation of controls. Refer to Table 1 for the different classifications according to these three bases.
Description It involves a supervisor reviewing a subordinates plan of action. Control here takes place before an action is carried out so that wrong action may be prevented. This form of control entails making employees responsible for their actions and in essence is applicable after an action has been carried out. To be effective, it is required to set regulations for actions based on acceptability and unacceptability; make employees aware of this code; and have schemes in which commendable performance will be rewarded while non-conformance to regulations for action will lead to penalties.
Action accountability
Results Controls Results controls are focused on the consequences of actions taken rather than on the actions themselves. These controls do not place any restriction on actions, and empower employees to use their discretion in doing what they feel is best for the organization. The outcome or output of action is the focus of control based on which a reward system is put in place. Individual rewards often accompany these controls to motivate individuals to perform well. Results controls can be used at various levels of an organization, and are often used along with action controls. Personnel/Cultural Controls Personnel/cultural controls aim at encouraging employees to monitor themselves and others with whom they work. These controls co-exist with action and results controls or are used in organizations to control aspects in which actions and results controls are not effective or sufficient. These controls are established in a manner that certain culture, values, beliefs, and norms of behavior become intrinsic to the organization as a whole. It is to be ensured that the right people are placed in the right positions, and provided with the right resources. It is also to be ensured that the job is designed keeping in mind the person to whom it is being allotted. Training helps in orienting and familiarizing an employee with the organizations expectations. It also helps in new employees socializing with existing employees. Establishing a reward system which commends group achievement is suitable for personnel/cultural controls, rather than rewards based on individual performance. Group-reward systems enable the focus to shift to a group effort which motivates members of a group to monitor themselves and the others in the group.
and regulations; and formulating explicit systems of rewards, penalties, and approvals to ensure compliance. Policies, standard operating procedures (SOPs), budgetary controls, financial reporting, audit, performance measurement systems, and incentive systems are examples of formal controls. Informal Controls Informal controls are not about any fixed rules and regulations. They are exerted by establishing a corporate culture and value system in which there is an interactive exchange of information which may not be strictly official at all times. For informal controls to develop and be effective, interpersonal relationships among employees at various levels are encouraged so that a feeling of trust pervades the organization and among external agencies dealing with the organization. Informal controls are found in organizations that rate high on innovation and creativity. In a controlled organization, both informal and formal controls co-exist, and the effect of one is not independent of the other. Informal controls complement formal controls and in ways, dilute certain drawbacks of formal controls by encouraging peer interaction, self-initiation, and creativity.
national culture; corporate strategy and organizational diversification; competitive strategy; managerial styles; organizational slack; stakeholder expectations and controls; and organizational life cycle.
Passed on to the employees, the shareholders, and to the government as taxes from Is in the form of monetary benefits so, tangible in nature.
Type of rewards
organizations complex. Large organizations have more influence over the environment in which they operate. The use of mass production techniques in these organizations leads to mitigation of task uncertainty. In these organizations, the presence of many business units or functional departments leads to huge amount of information generation and processing. This helps in developing controls such as rules, documentation of the information, creation of specialized role functions, and a higher degree of decentralization.
Description High on masculinity a higher competitive spirit, independent thinking, assertiveness, etc. The higher the masculinity, the greater will be the tendency among employees to accept higher targets, and greater will be the tendency to expect incentives for individual achievements. In countries with low masculinity, the emphasis is more on better working conditions and team-based incentive programs. High on femininity higher interdependence, inclination toward service, etc.
While designing its MCS, an organization has to consider stakeholders demands and the value it intends to deliver to them. This in turn leads to maintaining a mutually beneficial relationship that is profitable in the long run. Figure 2 shows the different factors to be considered and improved upon for increasing value for the specific stakeholders.
Adapted from Business Ethics and Corporate Governance. ICMR Center for Management Research, 2004 and Walters, David. Performance Planning and Control in Virtual Business Structures. Production Planning & Control. Vol. 16 Issue 2, March 2005, p226-239.
Refer to Exhibit 2 for a description of a leading pharmaceutical companys initiatives to explicitly address stakeholder concerns and formally report its performance on financial, socio-economic, and environmental parameters by adopting a Triple Bottom Line approach.
16
Contd
The reporting activity in Novo had evolved over the years. It began with creating an environmental report which included information on aspects like resource utilization, effluents, and other harmful emissions, etc. Later it adopted the inclusive reporting approach, thus improving business performance and shareholder value. The reports presented to the stakeholders contain both financial and non-financial information. This approach involved aligning activities like setting of targets and devising the key performance indicators by involving both the internal and external stakeholders. Novo adopted the Triple Bottom Line approach of reporting by including socioeconomic information along with environmental and financial information in the report. This triple bottom line approach helped the organization build on its sustainability initiative and was integrated into the business objectives of the organization. Novo began publishing and distributing the sustainability report and the financial report at the same time. This helped the stakeholders gain a better understanding regarding the performance of the organization, and its strategic initiatives.
Adapted from <http://annualreport.novonordisk.com>.
6. Summary
In the management context, Control traditionally refers to the activities of establishing standards of performance, evaluating actual performance against these standards, and implementing corrective actions to accomplish organizational objectives. Management control is broadly concerned with the attainment of goals and implementation of strategies. In a dynamic environment, it helps fulfill the needs of effectiveness, efficiency, and adaptive learning. Management control is a process whereby management and other groups are able to initiate and regulate the conduct of activities so that their results accord with the goals and expectations held by those groups. A management control system is a set of interrelated communication structures that facilitates the processing of information for the purpose of assisting managers in coordinating the parts and attaining the purpose of an organization on a continuous basis. The basic control process based on the cybernetic approach comprises the following steps: determining areas to control, establishing standards, measuring performance, comparing performance against standards, rewarding good performance and/or taking corrective action when necessary, and adjusting standards and measures when necessary. MBO, a concept propounded by Peter F. Drucker, is a specific application of the cybernetic process of management control. In this, goals/objectives (which should be SMART) are set jointly by the supervisor and the subordinate. According to the COSO framework, objectives of management controls may be discussed under three heads effectiveness and efficiency of business operations; reliability of financial reporting; and compliance with the applicable regulatory and legal framework. 17
Management controls have been classified based on the object of control (action controls, results controls, and personnel/cultural controls); the extent of formalization of control (formal controls and informal controls); and the time of implementation of controls (open loop controls and closed loop controls). Closed loop control is further classified into feedforward control and feedback control. Contextual factors which influence the design and use of MCS include: the nature and purpose of the organization, organization structure and size, national culture, corporate strategy and organizational diversification, competitive strategy, managerial styles, organizational slack, stakeholder expectations and controls, and organizational life cycle. The nature and purpose of an organization, that is, whether it is a for-profit or a non-profit organization has a major impact on MCS. The organization structure establishes the formal pattern of job roles and responsibilities that individual employees and groups have to undertake, and the hierarchical structure and reporting relationships. An increase in size of organization necessitates development of controls such as rules, documentation of information, creation of specialized role functions, and a high degree of decentralization. The MCS of any organization is influenced by the national culture of the country in which it operates. Geert Hofstede identified four dimensions along which national cultures vary. The dimensions are: power distance; uncertainty avoidance; individualism/collectivism; and masculinity /femininity. To achieve goal congruence between the organizations goals and those of individual strategic business units, it is necessary that the MCS has a good fit with the corporate strategy. Management controls also differ depending on the type of diversification -related or unrelated. The choice of generic competitive strategy overall cost leadership, differentiation, or focus -- also influences the MCS. Managerial styles (autocratic or democratic, permissive or directive) play an important role in influencing the behavior of the employees in an organization, and thus, the design and implementation of control systems. Organizational slack refers to that capacity in an organization which is in surplus of what is required for normal operations. It may be created voluntarily or involuntarily, and may be considered good or bad for an organization. Stakeholders (investors, employees and managers, suppliers, customers, community, government, etc.) are defined as individuals or groups of people who are impacted by or who impact the activities and operations of the organization. It is necessary for organizations to consider what the stakeholders want while designing their MCS.
18
Concept Note -2
2. Organization Structure
Organization structure refers to the role-responsibility relationships of individuals in an organization along with their pre-defined interaction patterns. It defines the formation of sub-groups within the organization, along with the formal techniques and methods of communication and coordination to be used. It facilitates both vertical (downward and upward communication between different hierarchical levels) and horizontal (between different people at the same hierarchical level) information flow in the organization. From a management control perspective, the organization design should promote communication, cooperation, teamwork, motivation, and performance. It should be best fitted to the organization and its external and internal environments.
Degree of Formalization
20
Dimensions Definition
It refers to the reporting relationships prevalent in the organization and the span of control (number of subordinates who report to a supervisor). Description The hierarchy of authority is flatter In organizations with a wide span of control, (where a large number of people report to a particular manager) than in organizations with a narrow span of control. For effective control, the management needs to determine an optimal span of control for the organization depending on certain factors which include the complexity of the tasks performed by subordinates; the extent and nature of intervention required from the manager; whether tasks being performed by subordinates are identical or varied; and whether tasks being performed are inter-dependent or may be performed independently of each other. Tall structures provide closer supervision and tighter control by supervisors as there are only a few people reporting to a supervisor, while in flat organizations, supervision is less tight as a supervisor has a larger number of subordinates to supervise and the communication channel is simpler. Definition It refers to the level in the hierarchy which has the decisionmaking authority. Description When the decision-making authority lies with the top management, the organization is said to have a high degree of centralization, and when the decision-making authority is distributed among the lower levels of the hierarchy, the organization is said to be decentralized. Decentralization gives the individual business managers the right to take decisions for their respective business units. While a decentralized structure fosters innovation and entrepreneurship, and responsiveness to customer needs, centralization helps in strict adherence to plans. Coordination at the lower levels of the organization may be lower in a centralized organization, resulting in loss of effectiveness, bottlenecks, and lack of responsiveness to market demands. 21
Hierarchy of authority
Degree of Centralization
Dimensions Definition
It refers to the level of formal education of the employees. Description The higher the number of years of formal education and training, the higher the professionalism. Degree of Professionalism In organizations with a high level of professionalism, MCS may be designed in such a way as to provide an environment which encourages accomplishment of objectives. While professional individuals may not require very close supervision of actions and results, they need to be placed in the right jobs to feel sufficiently motivated. Close supervision of actions and results is more useful where the level of professionalism is low. Definition It refers to the distribution of people into different functions and departments. Description Personnel ratios In a specific function, it is calculated as the ratio of the number of people in the function to the total number of people in the organization. They indicate the managements priorities judgments regarding the deployment of people. and
Examples of personnel ratios are administrative ratio, sales force ratio, etc.
22
Functional Structure The functional structure is characterized by people being grouped based on their expertise and skills (such as the R&D department looks after the research and development function). It is used when the requirement for expertise in a specific field is important. In this structure, the vertical hierarchy is stronger than the horizontal hierarchy. It calls for centralization as the decisions regarding resolution of issues are generally made by the top management. Divisional Structure The divisional structure is also called a product structure; the divisions may be referred to as strategic business units (SBUs). The divisions are formed based on an organizations product range, the specific markets which the organization caters to, or 23
the geographic locations in which it operates. This structure fosters higher adaptability to change due to the small size of each division and also better interaction between the various functions within a division. It is characterized by higher decentralization as the decision-making authority rests with business unit managers rather than the top management. When an organization is divided into small business units, the authority and responsibility of decision making for that unit is placed with unit-level managers. This delegation acts as an inherent motivator for them as they can clearly understand the impact of the choices made and actions taken on the performance of their unit. Matrix Structure The matrix structure tries to integrate the salient features of the functional structure (say, technical specialization) and those of the divisional structure (say, market responsiveness, product innovation, or project delivery). In this structure, an employee reports simultaneously to two different supervisors -- One supervisor representing a functional department and the other representing the division, product, market, geography, or project. This structure is commonly used in project-based organizations and for new product development. It is useful in organizations which have a limited product range and/or when a high degree of interaction is required between the functions. The matrix structure requires a high degree of cooperation and coordination among managers. Horizontal Structure Frank Ostroff proposed the horizontal structure as the structure that prevents the rigidity and departmentalization existing in a vertical system by grouping managers and employees into synergistic teams for problem-solving. Organizations move toward the horizontal structure through business process re-engineering. Here, process stands for an organized group of related tasks and activities that work together to transform inputs into outputs that create value for customers . The owner of a process is responsible for coordinating and controlling the process in its entirety. In a horizontal structure, the emphasis is on teams which direct themselves. Team members are provided with resources, motivation, and the authority to take core decisions. They are also cross-trained so that they can substitute for each other if required. Creativity, flexibility, trust, cooperation, employee empowerment, and a customer-centric approach characterize horizontal structures. In a horizontal structure, the people carrying out activities in a single process have better coordination with others in the same process. Hybrid Structure Hybrid structures are formed as a combination of the functional, divisional, or horizontal structures. They help organizations combine the strengths of different structures while eliminating the weaknesses of each. In an extremely volatile environment, it has become very important for organizations to quickly adapt to changes. This is an important characteristic seen in the hybrid structure, also called the flexible or adaptive organization. Two important characteristics of a hybrid organization are that there is scope for different ways of thinking and a participative style of management. For such organizations, organizational design is decided based on which structure is appropriate in a specific situation and at a particular point in time. Flexible organizations continuously assess and modify their structure so that the employees are best aligned to the strategic changes. 24
There are two types of hybrid structures. The first type combines the functional and divisional structures. When an organization with a functional-divisional matrix structure grows in size, it is generally divided into smaller divisions which have their own functional setup. Refer to Exhibit 1 for a description of the hybrid structure of the AXA Group, a France-based insurance and investment organization. The second type of hybrid structure combines the functional and horizontal structures.
in
adapting
easily
to
Most of the decision-making power is done at the top that leads to delay in the process. Lack of coordination between various departments and a myopic view prevailing among employees regarding organizational objectives lead to restrictions in innovation and creativity. Advantages It is easy to measure the performance of each small unit and to reward commendable performance with more accuracy. Increase in financial incentives and other rewards in the form of promotions, expressed praise, etc. can be directed at individuals and groups who actually deserve them. Increased speed of communication, understanding, analysis, processing and acclimatizing to new information (such as changes in customer preferences, supplier behavior, and change in risk profile due to the changed nature of competition). Such information is first available to the individual divisions/units (closer to the source of the information) rather than the top-level management which is more concerned with broader issues affecting the organization as a whole. Limitations Negative impact of some decisions (made by a business unit manager who is responsible for the performance of only his/her division/unit) on other divisions. A business unit manager may ignore the repercussion of, or may not have sufficient information required to assess the ripple effect of, a decision made for his/her unit, on other units. Advantages Retention of the functional aspect helps retain economies of scale and that of the divisional aspects helps in incorporating customers preferences, thus improving their own profitability. Economical sharing of resources among the various departments so as to achieve the organizations goals and objectives. 26
Divisional structure
Matrix structure
Organization Structure
Advantages and Limitations Presence of dual authority leading communication between managers. to greater
Capability of adapting to changes in the environment through better allocation of resources. Limitations Presence of dual authority leads to a higher chance of conflicts arising and so a lot of time is consumed in conflict resolution. Requirement of strong interpersonal individuals within the structure skills in
Meetings between participants take up a lot of time. Requirement of mutual respect among participants. Advantages Enables the organization to adapt easily to a changing environment, and it ensures that satisfaction and value addition for the customer are the main goals. Employee satisfaction due to shared responsibilities, enhanced authority for decision-making, and a clear understanding of an employers contribution toward organizational goals. Limitations More time taken to identify core processes; it becomes necessary to change the organizational culture, job structure and function, and performance measurement system; and there is the possibility that the employees specialization in specific functions may be hampered. Employees also require a great deal of training in varied areas in order to be effective in a horizontal structure. Advantages Scope for different ways of thinking and a participative style of management. Aids quick decision-making, quick adaptability to market changes, increased spending on R&D. Limitations Difficulty in identifying the environmental changes, deciding on the strategic modifications required for such changes, and the trickle down effect of such decisions.
Horizontal structure
Hybrid structure
3. Responsibility Structure
A responsibility structure is a collection of responsibility centers. Each responsibility center is a function, division, or unit of an organization under a specified authority with a specified responsibility. Performance evaluation of each of these responsibility 27
centers is done based on certain criteria (specific to each type of center) to assess its contribution to the organization as a whole using responsibility accounting. According to the Institute of Cost and Works Accountants of India (ICWAI), responsibility accounting is a system of management accounting under which accountability is determined according to the responsibility allotted to various levels of management. An organizations control system should be able to measure the influence that the activities of each manager have on the organizations performance. In other words, it should be able to pinpoint the contribution of each manager to the achievement of the organizations goals.
The responsibility centers performance can be judged using the effectiveness and efficiency criteria. Responsibilty centers can be classified into -- cost centers, revenue centers, profit centers, and investment centers -- according to the nature of monetary inputs and outputs. Cost Centers Cost centers are held responsible for the costs incurred. According to the cost center manager, either the costs or the level of outputs can be independently controlled, but not both. A cost center can operate in two ways -- either the cost budget is specified and the goal is to maximize the output, or the expected output is specified and the goal is to minimize the cost. In the first case, a certain fixed budget is allocated to the cost center, and it is expected to achieve the best possible result within the allocated budget. In the second case, the goal is to achieve the required level of output at minimum cost; the performance level depends on the cost incurred by that center. Responsibility center managers are expected to maximize the services offered while keeping within the budgeted limits. In the control of cost centers, managers make mistakes by evaluating performance with a view to only minimize costs and may ignore important non-financial indicators of performance such as output quality, safety issues, or ethical and environmental issues. The control system in a cost center should therefore be designed so that it recognizes the role of all factors that have an impact on organizational goals. Cost centers are of two types -- standard cost centers and discretionary expense centers. Standard cost centers are also known as an engineered expense centers; standard cost centers are usually found where a standard cost system is in place or in organizations that have a repetitive task to be performed. The managers aim is to prevent or reduce unfavorable variance between the actual and budgeted costs, while maintaining the quality and quantity of outputs at the desired levels. For a discretionary expense center, it is difficult to measure the outputs in monetary terms against a given level of inputs. Generally, a budget is decided upon for the chosen time period, say, a financial year. Revenue Centers Managers of revenue centers are held responsible for the revenues (outputs) but are not directly responsible for profits. Costs traceable to a revenue center are normally adjusted with the sales revenue to calculate the net revenue of the revenue center. In many organizations, revenue centers are the points of contact closest to existing and potential customers. The main objective of these centers is to maximize net revenues and assume no responsibility for production. Profit Centers Profit centers are responsible for profits. The profit center manager has control over both the input as well as the output, while he/she does not have control over the level of investment. A profit center aims to achieve profit targets by focusing on both cost reduction and revenue maximization. The manager cannot afford to reduce quality to reduce cost as that would lead to reduced sales revenue and profit, and may not optimally utilize the capital employed thereby not being able to maximize profit. 29
Traditional cost centers are now being converted into profit centers. For example, IT departments earlier provided services to other departments (internal customers) free of cost. But now, they are being charged a transfer price. In this scenario, the buying center and the selling center (earlier a cost center) have the option of contracting with an external firm that can provide similar services. Investment Centers Investment centers are responsible for the overall economic performance in terms of the cost incurred, the revenue generated, as well as the associated investment. Performance of investment centers is measured with respect to Return on Investment (ROI) or Return on Capital Employed (ROCE) (profit divided by the capital employed in making that profit), and Economic Value Added (EVA). These centers have a drawback - since the value of capital employed is taken from the balance sheet, the value of ROI or ROCE may depend on the accounting technique followed by the organization. Also, the investment center may postpone new investments like purchasing new equipment, as the ROCE will decrease in the short run, though the organization may benefit from these investments in the long run.
about control alternatives to be used involves an analysis of the structural and contextual factors which influence control systems and also carrying out a cost-benefit analysis. Costs include the consumption of available resources, harmful behavioral side-effects like depletion of trust among managers and employees, and development of negative attitudes among employees on implementation of control. Benefits include the extent to which the variance between desired actions and likely actions is minimized. It is not feasible for a control system to eliminate this variance altogether at a reasonable cost. It should be possible for an organization to avoid sudden upheavals if this variance is minimized to the extent possible. While doing so, benefits derived should be higher than costs incurred on designing and implementing the MCS. After deciding the control alternatives, the organizations policies and practices should be framed and implemented to fit the control alternatives, which in turn will have major implications for the HRM function in the organization. For example, employee selection criteria, performance appraisal practices, and the design of reward systems may vary based on the selected set of control alternatives. Personnel/Cultural Controls Personnel/cultural controls are the primary control alternatives that try to ensure an environment where employees monitor themselves and their peers. It helps in restricting the variance between the desired and the likely outcomes and is able to address most problems that come in way of attaining organizational objectives. This type of control incurs lower monetary costs and usually does not lead to harmful side effects or negative attitudes. Before considering other types of control, an organization must first assess the extent to which these controls may be used. Tight personnel/cultural controls can be used easily in small, single business organizations as there is often a commonality between the desires of individual employees and that of the organization as a whole. Tight control is also possible in large organizations which have a very strong culture acting as a guide. Lack of formal accountability for actions and their results may make employees too sure of themselves and may also lead to a loss of direction and a decrease in effectiveness or efficiency. It is not easy to achieve tight controls only based on personnel/cultural controls as these controls are easily affected by environmental changes. To achieve tight controls, these should be accompanied by actions and/or results controls, depending on the given setting.
The time spent by the managerial staff for pre-action appraisal increases their workload. Discretionary use of this control enables avoidance of operating holdups and reduction in the managerial staff size. It enables productive use of time by the existing staff for revenue-generating activities. Pre-action appraisal controls, to become tight, need to be thorough and should be carried out by competent personnel. Action accountability controls involve rewarding good actions and penalizing unacceptable ones. These controls result in a harmful side effect wherein employees lay more importance on the actions they perform rather than the results which are expected of them. Tight action accountability controls require defining the desired actions; communicating the actions definition to the performer of the action so that it is understood and agreed with; effectively tracking the action; and providing significant rewards or punishment for actions taken. Rewards and punishments, as an integral part of action accountability controls, should be significant to the person being rewarded or punished. Results Controls Results controls are directly focused on the output of actions and do not place limits on actions themselves. These controls are used if the outcome from actions can be assessed quantifiably and in situations where accepted norms for actions cannot be formed or are difficult to enforce. Employees are given the authority to use their discretion that leads to greater dedication among employees toward their role in the organization. The costs involved in results controls are less than those in actions control. The information that needs to be generated for such controls in most cases, already exists as it is also required for strategic planning and financial reporting. Results controls, to be tight, require setting of realistic targets against which performance may be measured. A well-designed reward-punishment (individual or group) system is required which rewards commendable performance and penalizes negative performance. These targets should be in alignment with organizational objectives and should be set in consultation with the concerned employees. Costs of results controls include pecuniary costs relating to performance bonuses. The results achieved are not always related to employees efforts; they may be affected by external factors and beyond the employees skill or motivation level. Targets and reward systems considered inappropriate by employees act as demotivators and lead to negative attitudes. For results controls, to be successfully implemented, it is necessary to ensure that there is correct understanding of the results. Employees tend to maximize only those aspects of their contribution which can be quantifiably measured and ignore the qualitative aspects. So, the result obtained will not be optimal if too much importance is laid on results control. It should be accompanied by actions control and personnel/cultural control to have an MCS which provides a reasonable assurance of achievement of organizational goals.
they may not make any conscious effort to sell the service. Most NPOs believe that the service provider can decide the features of the service without taking inputs and feedback from the intended beneficiaries, unlike a product-based manufacturing business where the customer influences the product design. This belief leads to flaws in the design of service product. NPOs also face problems in service delivery due to lack of proper reward systems, poor communication and relationships between members, or lack of top managements support and encouragement. Due to the fundamental differences between them, it is not sufficient to merely extend controls used in the for-profit organizations to NPOs. Geert Hofstede proposed the criteria clarity of objectives, quantifiability of results, predictability of interfaces, and repetitiveness of activities -- which help in management control of public/NPOs and how different control systems are possible, depending on these criteria. Combinations of the four criteria give rise to different types of controls routine control, expert control, trial and error control, intuitive control, judgmental control, and political control. These controls are described in Table 3. These controls can be used in any type of organization, but, we have restricted their scope to public/non-profit organizations as discussed by Hofstede.
It is institutionalized in the form of standard operating procedures and rule books. Control activities can be performed manually or they can be automated. Expert control Clear objectives, quantifiable results, interfaces, and non-repetitive activities. predictable
Experts are people who have in-depth knowledge about the procedures and processes and hence are capable of exercising control. Trial and error control Clear objectives, quantifiable results unpredictable interfaces, and repetitive activities. Standard operating procedures cannot be devised as they come into play in activities like new product launch. Intuitive control Clear objectives, quantifiable results, unpredictable interfaces, and non-repetitive activities. Commonly seen in project-based non-profit organizations where each new project is unique and each project has to be approved by the top management. 33
Description When the objectives are clear but the results are not quantifiable, it is necessary to see whether other forms of control mechanisms can be put to use. If it is not possible, the control becomes judgmental and is dependent on the hierarchical structure and authority that the management has. If objectives are unclear, the control used is political control. It is dependent on the hierarchical structure, negotiation, availability of resources, and the differences of opinions regarding values and objectives. Generally works at the top level where the objectives get clarified. As the objectives cascade down the system, other forms of control can be incorporated at the lower levels.
Political control
Adapted from Simons, Robert. Control in the Age of Empowerment. Harvard Business Review. Vol. 73 Issue 2, Mar/Apr 1995, p83.
34
35
Contd.
Art as a Team Sport Pixar succeeded in making art a team sport, marked by collaborative action where everybody helped and even rescued the other. Directors looked over each others work and helped each other without imposing their own tone or style. Though there were various star performers in Pixar, the team was considered more important than any individual. The company recognized that movie-making was a collaborative process, and when a project succeeded, it was not due to any one persons contribution alone. Though the star performers got hig her salaries and received larger blocks of options when a film did well, everybody in the team was given a bonus. Analysts also noted that the hallmark of Pixars culture was that technology, creativity, and production were given equal importance and recognition. At Pixar, all the employees were encouraged to be a part of the filmmaking process. This unique atmosphere also helped Pixar retain talent. Preserving the Culture In 2006, the Walt Disney Company (Disney) acquired Pixar; this acquisition raised concerns regarding the future of Pixars unique culture. Some analysts felt that the Disneys bureaucratic style would threaten Pixars culture. However, the management of both Disney and Pixar stressed that Pixars culture would be protected.
Source: Purkayastha, Debapratim and Rajiv Fernando. Case Study - Pixars Incredible Culture. The ICMR Center for Management Research, 2006. <www.icmrindia.org>
They focus on information like technologies, government policies, competitor activities, and customer preferences, which are ever changing This information is vital to all managers at all organizational levels The information and data generated by the interactive control systems has to be discussed at open meetings between all organizational levels Interactive control systems help in healthy discussions about the assumptions of the top management and action plans intended.
7. Summary
Organization structure refers to the role-responsibility relationships of different employees in an organization along with their pre-defined interaction patterns. The structural dimensions of organization design are -- formalization, specialization, hierarchy of authority, centralization, professionalism, and personnel ratios. The various types of organization structures include -- functional, divisional, matrix, horizontal, and hybrid structures. A responsibility structure is a collection of responsibility centers. A responsibility center is a function, division, or unit of an organization under a specified authority with a specified responsibility. In an organizational setting, it is necessary that the performance measurement systems are designed to be fair. Two major aspects to be considered are controllability and goal congruence. Transfer pricing is a tool used in responsibility accounting to assign monetary values to transactions taking place between two or more responsibility centers. According to the nature of monetary inputs and outputs, responsibility centers can be classified into four types -- cost centers (further divided into standard cost centers and discretionary expense centers), revenue centers, profit centers, and investment centers. Designing an optimal MCS involves determining the specific control measures to be used and the degree of tightness or looseness of control required to provide the desired level of certainty of achievement of objectives. An organization may choose any one or a combination of action control, results control, and personnel/cultural control. Decision about control alternatives to be used involves an analysis of the structural and contextual factors which influence control systems and also making a cost-benefit analysis. Management control of non-profit organizations is an area distinguishable from that in for-profit organizations because of the inherent difference with respect to source of funds, features of service, the strategies for selling the service, the mode of delivering the services, reward systems for employees, etc. According to Geert Hofstede, four criteria which determine the nature of management control of non-profit organizations are clarity of objectives, quantifiability of results, predictability of interfaces, and repetitiveness of activities. 37
NPOs can adopt different types of controls routine control, expert control, trial and error control, intuitive control, judgmental control, and political control. Managers must find ways to encourage employees to be creative and to initiate process improvements, but must still retain enough control to ensure that employee creativity benefits the organization. Robert Simons concept of levers of control aims at addressing this issue. The four levers of control are diagnostic control systems, beliefs systems, boundary systems, and interactive control systems.
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Concept Note - 3
Source: <http://licindia.com/mission_vision.htm>.
performance. The degree to which strategies can control the organizations performance depends on the way it differentiates itself from its competitors and the ability of the competitors to respond to its strategies.
The middle management may be interested in a PI that reflects a single variables performance (e.g., machine downtime). However, the top management may be interested in a PI that indicates the collective performance of a number of variables in a single indicator (e.g., plant efficiency). Good PIs are SMART, that is, Specific, Measurable, Attainable (Achievable), Realistic, and have a Time perspective. The frequency of monitoring PIs has shifted from periodic intervals (weekly or monthly) to a continuous or daily basis with the emergence of concepts like TQM and continuous improvement, and improvements in information systems and technology. Key Performance Indicators (KPIs) KPIs deal with aspects which when enhanced would result in radical performance improvements and would lead to a cascading improvement in most of the other PIs. They have an impact on all the key result areas of the organization. Better results from KPIs would result in better organizational performance. The top management uses KPIs as yardsticks or measures to monitor and control the organizations performance. KPIs are identified from the PIs based on the strategic nature of the indicator considering the industry to which the organization belongs. Here, strategic nature refers to the indicators ability to include performance measurement of multiple factors, both internal and external to the organization. Thus, KPIs for organizations will vary from industry to industry. KPIs also vary from organization to organization within an industry depending on the strategic positioning of the organization in terms of customers (and other stakeholders) need fulfillment, that is, what is being satisfied, and how it is being satisfied. A KPI can be identified from a set of PIs based on how it reflects the performance parameters of several CSFs and based on how it reflects in totality the effect of other PIs. Characteristics of Key Performance Indicators KPIs are generally non-financial in nature. For example, in a dine-in restaurant, the occupancy level may be a KPI. These are usually measured at short intervals of time like 24/7, daily, or weekly. Top executives should devise KPIs in such a way that they are understood and effectively utilized by employees at all levels in the organization. Both teams and individuals are held responsible for the KPIs. KPIs have a major effect on most of the critical success factors and they have a positive impact on most of the PIs. Key Result Indicators (KRIs) KRIs emerge from the organizations activities. They indicate whether the approach toward achieving performance is appropriate but do not indicate a means or method to achieve better performance or outcomes. KRIs are indicators of the quality of the results achieved by the organization and are predominantly used for enforcing action accountability (after the action has been completed). These are measures that are useful for the governance aspect of the organization and are generally reported to the top management or the board, and are monitored on a monthly or quarterly basis. Return on capital employed and profitability are examples of key result indicators used by many organizations. 41
Figure 1 describes the relationship between critical success factors and the different performance measures performance indicators, key performance indicators, and key result indicators.
variables that are diverse in nature and also uncertain. A DSS can be used to develop a range of outcome alternatives from very positive to very adverse for each country that is being considered for entry.
Underlying Question To satisfy our customers and shareholders, at what business processes must we excel? To achieve our vision, how will we sustain our ability to change and improve?
Adapted from Kaplan, Robert S. and David P. Norton. The Balanced Scorecard Translating Strategy into Action. Boston: Harvard Business School Press, 1996, p9.
Figure 2: Implementing BSC for Strategic Performance Control and Strategic Learning
Vision and Mission
Strategy formulation
Strategy
Communicate and link strategic objectives and measures Corrective actions for strategic performance control Strategic feedback and learning Plan, set targets, and align strategic initiatives
Adapted from Kaplan, Robert S. and David P. Norton. The Balanced Scorecard Translating Strategy into Action. Boston: Harvard Business School Press, 1996, p11.
45
Exhibit 1 describes how Trent, the retail division of the Tata Group, implemented the Balanced Scorecard.
5. Summary
Strategic learning involves anticipating changes and monitoring the variables mentioned continuously and countering them on a proactive basis. In a strategic learning context, management control aims at recognizing change and responding to it effectively. 46
Vision clearly explains what the organization intends to become in the future and reflects its core ideology. The mission statement is based on the vision statement and states the reason for the organizations existence. The vision and mission statements together define the scope of business activities that the organization may undertake, thus controlling resource allocation and utilization. The strategies implemented by the organization directly control its strategic positioning and performance. Critical success factors (CSFs) are the limited number of areas in which satisfactory results will ensure successful competitive performance for the organization. CSFs should receive constant and careful attention from the management. Performance measures can be of three types: performance indicators (PIs), key performance indicators (KPIs), and key result indicators (KRIs). PIs act as control tools by describing what is to be done, by describing where to achieve the desired results or outcomes, and by identifying the specific areas that need control intervention to enhance organizational performance. KPIs deal with aspects which when enhanced would result in radical performance improvements and would lead to a cascading improvement in most of the other PIs. KRIs indicate whether the approach toward achieving performance is appropriate but do not indicate a means or method to achieve better performance or outcomes. Information technology and systems (IT&S) facilitate monitoring/reporting of various performance measures. the continuous
Strategic information systems are information systems applications that serve the top managements needs for strategic performance control. Nature of operations and information intensity, extent of geographical and operational spread, and nature of industry are some of the contexts in which IT&S are of strategic significance. Balanced Scorecard (BSC) helps the organization in strategic performance control and strategic learning. The BSC framework considers four perspectives customer, financial, internal business process, and innovation/learning and growth which are all observed and evaluated in a combined manner. The customer perspective is concerned with attracting, satisfying, and retaining profitable customers/consumers in the chosen target segments. The financial perspective is concerned with increase in revenue, productivity, and profitability; reduction in costs; and better utilization of the organizations assets in monetary terms. The internal business process perspective deals with the processes, decisions, and actions that are internal to the organization that influence customer satisfaction. The innovation/learning and growth perspective helps the organization to manage business in a changing environment by coming out with new products, enhancing and upgrading the existing processes, and enhancing employee capabilities depending on the value systems of the organization. 47
BSC clarifies the organizations vision and strategy, and expresses the expectations of the top management through clearly defined strategic objectives and related performance measures. These strategic objectives and measures are communicated throughout the organization in order to align the objectives of the organization with those of the individuals. The top management continuously monitors the performance to assess whether the planned strategies are being successfully executed and to learn whether there should be a change in the strategy itself.
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Concept Note - 4
Budgeting Techniques
1. Introduction
Budgets are business plans that are stated in quantitative terms and are usually based on estimations. A budget can be defined as a quantitative statement, for a defined period of time, which may include planned revenues, expenses, assets, liabilities, and cash flows. Budgeting refers to the process of designing, implementing, and operating budgets. It provides an action plan for an organization and serves as a control tool. This note will help you understand: The formulation and administration of budgets The human dimension in budgeting The different types of budgets The concept of zero-based budgeting.
Creating a budget department or appointing a budget controller Developing guidelines for budget preparation Developing budget proposals at the department/business unit level Developing the budget for the entire organization Determining the budget period and key budget factors Benchmarking the budget Reviewing and approving the budget Monitoring progress and revising the budget
Creating a Budget Department or Appointing a Budget Controller Large firms generally have a budget department, while small firms may have just an individual budget controller. The budget department/controller is responsible for issuing the guidelines for budget preparation and for ensuring that this information is properly communicated throughout the organization. It is the responsibility of the budget department/controller to analyze and suggest changes to projected budgets in proposals received from the departments/business units. Other responsibilities include co-coordination of budget related work with the departments/business units and periodical revision of budgets. Developing Guidelines for Budget Preparation The budget department/controller in consultation with the lower level managers, prepares the guidelines for budget preparation. These guidelines are then, approved by the top management. Once approved, the budget department or the controller sets a timeframe for the budget preparation process for the entire organization. Developing Budget Proposals at the Department/Business Unit Level The heads of different departments/business units propose their budgets taking into consideration the existing facilities, employees, objectives, etc. Refer to Exhibit 1 for some practical tips on budgeting.
50
Budgeting Techniques
Contd
Establish a flexible budget: It is better that managers have provisions for changing the budgets mid-way if the need arises. That is, if revenues are higher than expected, the expenditure can be revised upward and the organization can go in for additional investments. If the revenues are lower, further control on expenses would be necessary. Keep track of the cash flow: If a manager wants to adhere to the budget expectations, it is necessary to ensure that the revenues more than offset the expenses. Keeping track of income helps ensure that there is sufficient cash flow. Budgets should be verified every month. This will help the manager keep track of the funds and cash flows. Be conservative: It is better for the manager to err on the high side in estimating expenses, and on the low side when estimating revenues. This is a conservative approach to budgeting for expenses and revenues, and provides a greater margin for dealing with the unpredictability of the revenues and costs. Provide a buffer: The manager must be prudent and set aside a part of the income to tide over lean times in the future. This can be used to cover unexpected expenses, and will stand the organization in good stead during difficult times. Use budgets as controls: The manager should ensure that the budgets are flexible enough to accommodate expenses that will benefit the business. The budgets should not be so rigid that they do not enable the manager to take last minute decisions to spend on something that could be a potential revenue earner.
Adapted from Wuorio, Jeff. 8 Ways to Make a Budget Work. <http://www.work911.com/cgibin/planning/jump.cgi?id=6659>.
Developing the Budget for the Entire Organization After the individual heads set the budgets for their respective departments/business units, these departmental budgets are combined to generate a budget for the entire organization. The combined budget should conform to the organizations strategic plan. The budget department or controller has to communicate the final approved budget and the performance measures that will be used for the current year to the respective departments/business units. Determining the Budget Period and Key Budget Factors The budget period is the time for which a budget is set. The period of the budget varies based on the type of industry, the production cycle of the organization, etc. Key budget factors like materials, working capital, labor, plant capacity, and the top management approach should be assessed in order to ensure that the budgets achieve their targets. Benchmarking the Budget A benchmarking exercise helps an organization be up-to-date with the standard budgeting practices followed by other companies in the industry. Benchmarking also helps an organization identify the weaknesses that need to be addressed or the strengths which can be enhanced in its budgeting approach. 51
Reviewing and Approving the Budget The budgets prepared by each department go through a series of reviews by different levels of management. If a budget is found inadequate at any of these levels, it is sent back for rework. Once a budget is found satisfactory at the budget committee level, it is forwarded to the CEO for approval. On being approved by the CEO, the budget is presented to the board of directors. Monitoring Progress and Revising the Budget The budget controller is responsible for checking the progress of the planned activities against the budgets. He/she should communicate the progress to employees and suggest ways to improve financial control. Internal factors (like changes in internal policies and practices regarding market share and/or product mix and production costs) and external factors (like changes in economic activity, labor rates, and raw material prices) can lead to changes in budgets. Budgets need to be revised only when there are discrepancies in them. It is necessary to keep revisions to the minimum as frequent revisions would mean that the budget is inconsistent with organizational objectives.
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Budgeting Techniques
4. Types of Budgets
Table 1 outlines the different types of budgets.
Flexible Budget
The static amount includes both discretionary and committed costs while the flexible part includes engineered costs per X value.
The static part: salaries, depreciation, property taxes, and planned maintenance. The flexible part: direct material, direct labor, and variable overhead. Also, some costs related to sales representatives such as sales commissions and travel. New plant and equipment.
Capital Budget
Decisions regarding potential investments are made using discounted cash flow techniques. A comprehensive plan is developed for all revenues and expenditures.
Committed costs.
Master Budget
Adapted from James R. Martin, Management Accounting: Concepts, Techniques & Controversial Issues, Chapter 9, The Master Budget or Financial Plan, <http://maaw.info/Chapter9.htm>.
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Budgeting Techniques
Steps in the Preparation of a Master Budget The principal steps in the preparation of the master budget are preparation of the operating budget and preparation of the financial budget. The master budget should be subjected to a follow-up to ensure performance in terms of planned goals and objectives. The follow-up process is done by preparing performance analysis statements on a periodic basis, indicating the budgeted versus actual performance. Preparation of operating budget: The preparation of the operating budget entails preparation of: Sales Budget The sales budget starts with the sales planning exercise. This exercise is done to develop projections of the expected sales volume in physical and monetary terms. 55
Production budget Budgeted units of production = (Number of units sold) + (Desired ending finished goods inventory) (Beginning finished goods inventory).
Direct materials budget The direct materials budget constitutes calculation of five different heads: i. Quantity of material needed for production
ii. Quantity of material to be purchased iii. Budgeted cost of material purchases iv. Cost of material used v. Cash payments for direct material purchases
Direct labor budget The direct labor budget involves two calculations: i. Direct labor hours needed for production = Units to be produced x Direct labor hours budgeted per unit
ii. Budgeted direct labor cost = Direct labor hours needed for production x Budgeted rates per hour. Factory overhead budget Factory overhead =
Cost of goods sold budget Cost of goods sold (COGS) involves two calculations: i. Budgeted total manufacturing cost = (Cost of direct material used) + (Cost of direct labor used) + (Total factory overhead costs) ii. Budgeted cost of goods sold = (Budgeted total manufacturing cost) + (Beginning finished goods) (Ending finished goods).
Selling & administrative budget Selling and administrative costs consist of variable and fixed components. The bottom line of the selling and administrative budget is the planned level of expenditures.
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Budgeting Techniques
Budgeted Income statement Preparing the budgeted income statement involves combining the relevant amounts from the sales, cost of goods sold, and selling & administrative expense budgets and then subtracting interest, bad debts, and income taxes to obtain budgeted net income.
Preparation of financial budget: The preparation of the financial budget involves preparation of: Capital budget The capital budget deals with the organizations long-term investments. Cash budget The cash budget is concerned with making estimates of cash inflows, outflows, and the expected surplus or deficit of cash. Cash budgets are developed for shortterm as well as long-term projections. Budgeted balance sheet The budgeted balance sheet projects each balance sheet item in accordance with the business plan. The balance sheet indicates the financial status as envisaged at the end of the budget year. It also projects the sources and uses of financial resources. Benefits of Master Budgets Some of the benefits of master budgets are: It guides performance: A master budget helps the employees track how each of their business unit objectives when achieved contribute to the objectives of the organization. It integrates and organizes: The master budget, a compilation of budgets from different departments, helps in better integration of all organizational functions. It is used as the base for acquiring and using the resources that are needed to achieve the objectives of the organization. It effects continuous improvement: The planning activity in the master budget helps organizations to look for alternative ways in which they can enhance value to customers and also minimize costs thus, helping in continuous improvement.
5. Zero-based Budgeting
Zero-based budgeting (ZBB) was put in to use formally by Peter Phyrr at Texas Instruments, a world leader in digital signal processing and analog technologies based in the US, in 1969. Unlike the traditional budgeting process which is a yearly process and uses the budget of the previous year as a starting point to devise the current years budget; in ZBB, the base is taken as zero and the budget is devised as for a new venture. In ZBB, the responsibility centers are called decision units. The processes and activities involved in each decision unit are called decision packages. 57
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Budgeting Techniques
6. Summary
A budget can be defined as a quantitative statement, for a defined period of time, which may include planned revenues, expenses, assets, liabilities, and cash flows. Budgeting refers to the process of designing, implementing, and operating budgets. It provides an action plan for an organization and serves as a control tool. Budget formulation consists of a series of activities: creating a budget department or appointing a budget controller, developing guidelines for budget preparation, developing budget proposals at the department/ business unit level, developing the budget for the entire organization, determining the budget period and key budget factors, benchmarking the budget, reviewing and approving the budget, monitoring progress, and revising the budget. The budgeting process is referred to as participative budgeting when it is a combination of both top-down and bottom-up approaches. Rolling budgets/forecasts are developed at regular intervals, say after every three months, and forecast performance for a specified time period, say the next twelve to eighteen months. As these forecasts are developed at regular intervals, they are frequently updated with the latest changes that occur in the environment. The attainability of budget goals has a significant impact on the behavior of the employees. Budgetary slack may help in improving creativity, resolving goal conflicts, and retaining people but may also represent managerial inefficiency and self-interest. The relation between national culture and budgeting may be examined using Geert Hofstedes dimensions of culture: power distance, uncertainty avoidance, masculinity/femininity, and individualism/collectivism. Budgeting is an internal process and hence, lack of cultural similarities will pose a problem in the budget being communicated across subsidiaries of an organization. This problem becomes more pronounced in the case of multinational corporations. The budgeting process in an organization tends to lead to unethical behavior on the part of employees, if linked to compensation. The different types of budgets used by organizations are appropriation budget, flexible budget, capital budget, and the master budget. The master budget forms the basis of control systems in organizations. The principal steps in the preparation of the master budget are preparation of the operating budget and preparation of the financial budget. The operating budget consists of the following budgets: sales, production, direct materials, direct labor, factory overhead, ending inventory, cost of goods sold, selling & administrative, and income statement. The financial budget comprises the capital budget, the cash budget, and the budgeted balance sheet.
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In zero-based budgeting (ZBB), the base is taken as zero and the budget is devised as if it is for a new venture. The ZBB process involves the following steps: decision unit identification; decision package development; evaluation and grading of decision packages; and resource allocation. Some of the limitations of ZBB are that it provides for creation of budgetary slack; it involves a lot of documentation and hence is a slow process; and it is expensive to implement.
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Concept Note - 5
Budgets and quotas are examples of year-to-date reporting, though they can also be used for period-to-period reporting. A budget refers to the amount of revenue or expense that should be realized over a specified period, say, yearly. This amount is broken down into monthly figures. Quotas relate to production volume or number of transactions for that period. Usually, the top management tries to ensure that the annual expenditure is within the budget than the monthly/weekly expenditure. Year-to-date reporting gives an idea of the activity level within a particular period. Monitoring the activity level will enable managers to track resource utilization and plan for future resource requirements. The actual activity undertaken can be compared with the targeted activity on a periodic basis. This can be represented in a graphical format. Year-to-date graphs alert the management to situations where past performance rates were too fast or too slow, so that it can adjust future activity so that the yearly targets are met. Period-to-Period Reporting In period-to-period reporting, performance is tracked and targets are set on a monthly or weekly or seasonal basis. There are four common types of targets in period-toperiod reporting depending on the behavior of the performance parameters. These are flat line, step, seasonal, and growth curve. Table 1 gives the various types of targets and their features.
between the top management and the organizational culture may be in the form of three different kinds of strategic business profiles rigid/efficient profile, flexible/inefficient profile, and flexible/cost conscious profile. Refer to Table 2 for a description of each of these profiles.
Flexible/inefficient profile
service than its competitors can charge a premium price, and thereby earn higher margins. Emphasis on quality helps enhance market share as customers today are more aware and give importance to quality. Quality management also helps in providing a competitive advantage and improve the organizations performance.
4. performance Reports
The information required to evaluate the actual performance against the planned performance should be collected, collated, analyzed, and documented as a performance report which can be easily understood. Some reports are meant for internal use for decision making, for employees performance evaluation, etc., while some reports like the corporate annual report are meant for external users.
Turnover
Year 2000 2001 2002 2003 2004 2005 2006 2007 2008 ABC Limited 12,000 15,000 9,000 9,500 10,500 11,000 12,000 12,500 13,000 XYZ Limited 11,000 12,000 11,000 10,500 12,000 13,000 13,500 14,000 16,000
The given data can be represented in the form of a column chart which will help in easy comprehension and interpretation.
Turnover of ABC Limited and XYZ Limited 18000 16000 14000 Turnover (Rs. in Million) 12000 10000 8000 6000 4000 2000 0 2000 2001 2002 2003 2004 Years 2005 2006 2007 2008
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Contd
Balance Sheet Profit and Loss Account Cash Flow Statement Schedules to the Accounts Report of the Auditors Balance Sheet Abstract Guide to Subsidiaries/ Joint Ventures/ Associates Consolidated Financial Statements Statement regarding Subsidiary Companies Ten Years at a Glance Financial Highlights Business Updates o o o o ITC Infotech Technico Agarbattis Safety Matches
Source: <http://www.itcportal.com/itc-annual-reports-2008/report&accounts.htm>
5. Performance
The performance of any business depends on both internal and external factors. In a competitive business environment, it is necessary to evaluate performance based on multiple performance dimensions that will reflect the changes in the business environment as well as the achievement of targets set by the organization. Refer to Table 3 for an analysis of the performance dimensions that may be used by organizations.
Customers
Analysis Evaluating internal business processes helps in ascertaining whether efficiency of the actual usage of resources in business processes is at par with the planned efficiency parameters or not. Evaluation of growth dimensions helps compare actual training, technology adoption, and employee productivity with industry standards and the organizations own plans. Corrective actions are taken if there are any variances.
Growth dimensions
The difference between actual and planned financial performance could be due to revenue variance or expenditure variance or both. Revenue variance can be due to sales volume variance, sales mix variance, sales quantity variance, market share variance, and market size variance. Expenditure variance can be classified into fixed cost variance and variable cost variance. Refer to Figure 1 for the various types of financial performance variance. Figure 1: Types of Financial Performance Variance
Revenue variance can be calculated either through the value method or through the profit method. In the value method, the sales value is used for calculating the components of the revenue variance. In the profit method, they are calculated in terms of the margin. The profit method is recommended for the purpose of management control. We have used the following terms in our discussion on calculating the various components of revenue variance using the profit method: When we refer to the sales of one product, we will use the terms Planned sales and Actual sales. When we refer to the total sales of the set of products of an organization, we will use the terms Total planned sales and Total actual sales. When we refer to the market size with respect to one product, we will use the terms Estimated market size and Actual market size. When we refer to the total market size of the set of products of an organization, we will use the terms Total estimated market size and Total actual market size. When we refer to the organizations market share for its set of products, we will use the terms Planned market share and Actual market share. When we refer to the selling price per unit of a product, we will use the terms Standard selling price per unit and Actual selling price per unit. When we refer to the budgeted value of margin per unit of a product, we will use the term Standard margin per unit. When we refer to the budgeted value of average margin per unit for the set of products of an organization, we will use the term Standard average margin per unit.
Sales Volume Variance (Profit Method) Sales volume variance is the product of standard margin per unit and the difference between actual sales and planned sales. That is, Sales Volume Variance =
(Standard Margin Per Unit Standard Average Margin Per Unit ) = (Actual Sales Actual Sales at Standard Sales Mix )
Sales Quantity Variance Sales quantity variance is the product of the standard average margin per unit and the difference between actual total sales and the planned total sales for a period. That is, Sales Quantity Variance = = [Standard Average Margin Per Unit (Actual Total Sales - Planned Total Sales )] 69
Sales Price Variance Sales price variance refers to the change in revenue caused by a difference between the actual selling price of the units sold during a period as compared to the standard selling price. It is defined as the difference between the product of the actual sales volume and the standard selling price per unit and the actual sales revenue. That is, Sales Price Variance = = [Actual Sales Revenue - (Actual Sales Volume Standard Selling Price Per Unit ) ] Market Share Variance Market share variance is a comparison of actual market share achieved to the organizations planned market share. It is the product of standard average margin per unit, total actual market size, and difference between total actual market share percentage and total planned market share percentage. That is, Market Share Variance =
(Standard Average Margin Per Unit ) (TotalActua l MarketSize ) = (Total Actual Market Share% - Total Planned Market Share% )
Market Size Variance Market size variance is a comparison between total actual market size and the total estimated market size. It is the product of standard average margin per unit, total planned market share percentage, and the difference between total actual market size and total estimated market size. That is, Market Size Variance =
(Standard Average Margin Per Unit ) (Total Planned Market Share% ) = (Total Actual Market Size Total Estimated Market Size )
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Contd
Calculate the following: i. Total sales volume variance ii. Total sales mix variance iii. Sales quantity variance iv. Total sales price variance v. Market share variance vi. Market size variance Solution: i. Total Sales Volume Variance
SalesVolumeVariance= (StandardMarginPer Unit) (ActualSales PlannedSales)
Sales Volume Variance (Alpha) = Rs. 7 (3,500 3,000) = Rs. 3,500 Sales Volume Variance (Beta) = Rs. 3 (4,500 5,500) = Rs. 3,000 (-) Sales Volume Variance (Gamma) = Rs. 5 (2,300 3,500) = Rs. 6,000 (-) Total Sales Volume Variance = Rs. 3,500 Rs. 3,000 Rs. 6,000 = Rs. 5,500 (-). The negative total sales volume variance of Rs. 5,500 indicates the opportunity to earn a margin of Rs. 5,500 foregone by the organization. ii. Sales Mix Variance Sales Mix Variance =
(Standard Margin Per Unit Standard Average Margin Per Unit ) (Actual Sales Actual Sales at Standard Sales Mix )
Actual Sales at Standard Sales Mix (Alpha) = 3,000 Actual Sales at Standard Sales Mix (Beta) = 5,500
= 2,575 units
71
Therefore, Sales Mix Variance (Alpha) = Rs. (7 4.58) (3,500 2,575) = Rs. 2.42 925 = Rs. 2,238.5. Sales Mix Variance (Beta) = Rs. (3 4.58) (4,500 4,721) = Rs. 1.58(-) 221(-) = Rs. 349.18. Sales Mix Variance (Gamma) = Rs. (5 4.58) (2,300 3,004) = Re. 0.42 704 (-) = Rs. 295.68 (-). Total Sales Mix Variance = Rs. 2,238.5 + Rs. 349.18 Rs. 295.68 = Rs. 2,292. The positive total sales mix variance of Rs. 2,292 indicates that the organization had gained the potential to earn an additional margin of Rs. 2,292. Sales of Alpha were greater than planned while sales of Beta and Gamma were less than planned. Since, standard margin per unit of Alpha (7) was much higher than the standard average margin per unit (Rs. 4.58), AML benefited from the positive variance in its performance. Standard margin per unit of Gamma (5) was also higher than the standard average margin per unit (Rs. 4.58) but this did not benefit AML much as it also had a negative variance in sales. Since Betas standard margin per unit (Rs.3) was less than the standard average margin per unit (Rs. 4.58), lower actual sales of Sandal when compared to the planned sales benefited the organization. iii. Sales quantity variance Sales Quantity Variance =
[Standard Average Margin Per Unit (Actual Total Sales - Planned Total Sales)]
Sales quantity variance = Rs. 4.58 (10,300 12,000) = Rs. 7,786 (-) The negative sales quantity variance of Rs. 7,786 indicates that the opportunity to earn a margin of Rs. 7,786 was lost by the organization due to the fact that overall, fewer units of Alpha, Beta, and Gamma were actually sold when compared to the planned number of units to be sold. iv. Sales price variance Sales Price Variance =
[Actual Sales Revenue - (Actual SalesVolume Standard SellingPrice Per Unit) ]
Alpha:
Actual Selling Price of Actual Sales Volume = 3,500 Rs. 10 = Rs. 35,000 Standard Selling Price of Actual Sales Volume = 3,500 Rs. 12 = Rs. 42,000 Sales Price Variance = Rs. 35,000 Rs. 42,000 = Rs. 7,000 (-). 72
Beta:
Actual Selling Price of Actual Sales Volume = 4,500 Rs. 8 = Rs. 36,000 Standard Selling Price of Actual Sales Volume = 4,500 Rs. 7 = Rs. 31,500 Sales Price Variance = Rs. 36,000 Rs. 31,500 = Rs. 4,500.
Gamma:
Actual Selling Price of Actual Sales Volume = 2,300 Rs. 9 = Rs. 20,700 Standard Selling Price of Actual Sales Volume = 2,300 Rs. 10 = Rs. 23,000 Sales Price Variance = Rs. 20,700 Rs. 23,000 = Rs. 2,300 (-). Total Sales Price Variance = Rs. 7,000(-) + Rs. 4,500 + Rs. 2,300(-) = Rs. 4,800 (-). The negative sales price variance of Rs. 4,800 indicates that the organization has lost revenue of Rs. 4,800 due to a variance in the standard and the actual sales price. v.
Market share variance
100
100
Market Share Variance = Rs. 4.58 19,000 (54.21% 61.54%) = Rs. 6,378.57 (-). Negative market share variance of Rs. 6,378.57 represents the margin lost since the organization was unable to achieve its planned market share. vi. Market size variance Market Size Variance =
(Standard Average Margin Per Unit ) (Total Planned Market Share% ) (Total Actual Market Size Total Estimated Market Size ) = Rs. 4.58 61.54% (19,000 19,500) = Rs. 1,409.27 (-). The negative market size variance of Rs. 1,409.27 indicates the margin foregone by the organization due to reduction of the market size.
and non-operational causes. Operational causes can be further divided into controllable causes and uncontrollable causes.
Operational causes: Operational causes occur due to operational activities like purchases. Uncontrollable operational causes are not directly under management control. For example, in operational activities involving human beings, a small degree of involuntary variations creep in from time to time, as human performance cannot be absolutely consistent over a period of time. Such variances are uncontrollable.
Controllable operational causes are those which are under the managements control. For example, implementing a new method of operation may lead to improved performance due to favorable efficiency and volume variances. In contrast, if there is a machine failure, it would lead to unfavorable efficiency and volume variances.
Non-operational causes: Non-operational causes relate to problems in the usage of the costing system. Variance could be misreported due to a system malfunction caused by wrong data entry, programming defects in the information system, etc. For example, when the cost of materials is recorded wrongly, it would lead to cost variance for materials. If its value is recorded as less than the correct or budgeted value, then it would lead to favorable variance, and if the value is recorded as higher than the actual value then the variance would be negative. In both cases, it would provide a wrong picture to the management.
Inappropriate estimates, budgets, or standards can lead to the reporting of variances (even if operational performance is satisfactory). For example, if project budgeting does not factor in any provisions for contingencies, then most probably the actual cost of the project would exceed the budgeted cost wrongly reflecting an unfavorable variance. Moreover, standards may become obsolete over a period of time if not reviewed and revised regularly, it will lead to wrong reporting of variance.
Types of Cost Variance
Cost variance can be of two types: fixed cost variance and variable cost variance.
Fixed cost variance: This is the difference between the planned or budgeted fixed cost for a period and the actual fixed cost. Expenses incurred on electricity, rent, administration, etc., can be categorized under fixed costs. These costs remain fixed for a particular time frame, and do not depend on quantity of production or sales. Variable cost variance: This is the difference between the actual variable cost and the planned or budgeted variable cost for a period. Variable costs are those which vary directly with quantity of production. Expenses for raw materials and labor are some of the variable costs. For calculation of variable cost variance, the budgeted variable cost should be adjusted with the actual quantity of production.
Variance (Rs)
Items
3,000
3,000
9,000,000
3,500
10,500,000 33,000,000
3,000 10,000
30,000,000 11,000
From the tables given here, we can see that if the actual expense (fixed or variable) is less than the budgeted expense (fixed or variable), it leads to a favorable (positive) variance; if the actual expense (fixed or variable) is more than the budgeted expense (fixed or variable), it leads to unfavorable (negative) variance.
6. Summary
Based on certain plans regarding their business outcomes, organizations set targets for financial and non-financial performance. Actual performance can be tracked with respect to targets with the help of either year-to-date reporting or period-to-period reporting. For period-to-period reporting, targets can be divided into four types flat line target, step target, seasonal target, and growth curve target depending on the patterns they follow. Business performance depends on a number of external and internal factors. External factors are beyond the control of the organization whereas the internal factors can be controlled by the management. 75
Favorable/ Unfavorable
To evaluate and analyze actual performance with respect to planned performance, the actual performance should be recorded and documented properly in the form of performance reports. The corporate annual report is a mandatory reporting requirement for organizations. An organizations performance can be evaluated along various dimensions financial measures, customer satisfaction and behavior toward organization and competitors, internal business processes, and growth. The difference between actual and planned financial performance can take place due to cost or expenditure variance, revenue variance, or both. Revenue variance has two components sales price variance and sales volume variance. Sales volume variance can be divided into sales mix variance and sales quantity variance. Sales quantity variance can be further sub-divided into market share variance and market size variance. Expenditure variance can be classified into fixed cost variance and variable cost variance. Cost variance or expenditure variance can arise due to a number of factors, which can be divided into two categories operational causes and non-operational causes.
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Concept Note - 6
Auditing
1. Introduction
Audit is the activity of examination and verification of records and other evidence by an individual or a body of persons so as to confirm whether these records and evidence present a true and fair picture of whatever they are supposed to reflect. Audits are most commonly used in the accounting and finance function. Audit ensures that an enterprises activities and their effect on different events and transactions are correctly accounted this is not only for achieving the control objective of reliability of financial reporting but also for the prudent and effective management of the enterprise. This note will help you understand: The different categories of audits The concept of financial statement audit The concepts of internal audit, fraud auditing, and forensic auditing The concept of management audit The concepts of social audit and environmental audit The process of auditing The benefits and limitations of auditing.
2. Categories of Audits
According to the Institute of Chartered Accountants of India, auditing is a systematic and independent examination of data, statements, records, operations, and performances (financial or otherwise) of an enterprise for a stated purpose. In any auditing situation, the auditor perceives and recognizes the propositions before him for examination, collects evidence, evaluates the same, and on this basis, formulates his judgment which is communicated through his audit report. Audits may be categorized based on their: Emphasis (on financial data and/or non-financial data) Primary audience (that is, for external reporting or for internal use) Primary purpose (compliance, certification, communication, and/or control) Scope (limited to the organization, or also concerned with the impact of/on the environment)
Internal audit
Fraud auditing and forensic accounting Operational audit Information systems audit
Management audit
Social audit
Environmental audit
78
Auditing
Inherent risk (I.R.): Inherent risk is the risk of a material misstatement assuming that there are no related internal control structure policies or procedures. Control risk (C.R.): As per Information Systems Audit and Control Association (ISACA), Control risk is the risk that a material misstatement could occur in an assertion for an account balance or class of transactions, and would not be prevented or detected on a timely basis by the internal control policies and procedures. Detection risk (D.R.): As per ISACA, Detection risk is the risk that the auditors substantive procedures will not detect an error which could be material, individually or in combination with other errors.
A.R = I .R C.R D.R
True and Fair Concept The concept of true and fair in the audit report deals with the opinion of the auditor as to whether the state of affairs and their results as confirmed by the auditor during the audit process are truly and fairly represented in the financial statements being audited. For a financial statement to be assessed as a true and fair representation of an organizations state of affairs, the auditors expect: Consistency in adhering to accounting principles Correct valuation of assets in accordance with the relevant accounting principles Separate disclosure of exceptional items that are material to the organizations financial health; etc.
Auditing
The modern role of internal audit may be explained by a definition by the Institute of Internal Auditors, which describes internal audit as, an independent appraisal function established within an organization to examine and evaluate its activities as a service to the organization. The objective of internal auditing is to assist members of the organization in the effective discharge of their responsibilities. To this end, internal audit furnishes them with analyses, appraisals, recommendations, counsel, and information concerning the activities reviewed. As per ICAI, Internal audit is an independent management function, which involves a continuous and critical appraisal of the functioning of an entity with a view to suggest improvements thereto and add value to and strengthen the overall governance mechanism of the entity, including the entitys strategic risk management and internal control system. Need for Internal Auditing The need for an internal audit is determined by the increasing size and complexity of organizational operations. In order to avoid discrepancies from creeping into their systems, processes, and operations, such organizations appoint teams of specialists called internal auditors to monitor, track, and report such discrepancies, or inefficiencies of personnel in the concerned departments. Usually an in-house internal audit team undertakes the internal audit. Organizations also hire the services of different external auditing and consulting firms for the internal audit process. There are many auditing organizations that provide internal auditing services to other organizations. For example, PricewaterhouseCoopers has a standard framework in place which it alters and modifies based on the internal audit requirements of its clients. Refer to Exhibit I for the framework that PricewaterhouseCoopers uses for providing internal audit services to its clients.
81
Contd
PwC customized its internal audit service in such a way that it took into consideration the organization and the industry in which it competed, the organizations priorities regarding risk management, etc. The internal audit was structured to include all these factors and their effect on the business. For example, one of the industry verticals targeted by PwCs internal audit services was the pharmaceutical and healthcare sector. For this sector, risks included clinical outsourcing, treasury management risk, regulatory compliance with the Food & Drug Administration (FDA), field sales operations, R&D grants, privacy and data protection, pricing compliance, sample management, ethics and business conduct, strategic alliances, e-business risk, intellectual asset management, managed-care reimbursement, and security and control risks. Adapted from <http://www.pwc.com/extweb/industry.nsf/docid/2A2A81CA456BAC6480257221005E 85FF/ $file/internal_audit.pdf> and <http://www.pwchk.com/home/eng/fs_im_manage_risk.html>.
ii. Concealment which involves the steps taken by the perpetrators to hide the fraud from others iii. Conversion which involves selling or converting stolen assets into cash and then spending the cash. According to the Institute of Internal Auditors (US), the deterrence, detection, investigation, and reporting of fraud is the responsibility of the internal auditor. Frauds can be investigated or detected by Certified Fraud Examiners (CFEs) who are trained to detect, investigate, and deter fraud. CFEs are professionals who are knowledgeable in four major areas fraud investigation; legal standards regarding evidence of fraud; patterns of fraudulent financial transactions; and knowledge of the criminal behavior associated with fraudulent activities. The fraud auditor looks for potential loopholes in the system and does a deeper analysis of certain financial transactions by taking into consideration the underlying behavioral aspects. Bologna et al defined forensic accounting as the application of financial skills and an investigative mentality to unresolved issues, conducted within the context of rules of evidence. As a discipline, it encompasses financial expertise, fraud knowledge, and a strong knowledge and understanding of business reality and the working of the legal system. Its development has been primarily achieved through on-the-job training as well as experience with investigating officers and legal counsel. 82
Auditing
5. Management Audit
A management audit appraises an organizations position and helps it determine where it (the organization) is, where it is heading with its current plans and programs, whether it is meeting its objectives, and whether any revision of plans is required to enable it to achieve its predefined goals and objectives.
83
Functional management audit: A functional management audit measures the difference between the actual performance of an organization and its objectives, with emphasis on a particular function. Efficiency audit: The objectives of an efficiency audit are to establish how an organization is operating with regard to economy and efficiency, and whether it has a system in place to gather information on these aspects. These audits are conducted to ensure that resources are utilized in such a way that they generate the best returns. Propriety audit: Propriety audits are conducted to examine the effects of the managements decisions and actions on society and the general public.
Allocation of Personnel Personnel placed in the audit unit should have: Competence and required subject knowledge, experience, and professional ability A good understanding of audit processes and thorough knowledge of the fundamentals of organization and management Knowledge of the principles and effective methods of control and requirements for scientific appraisal A sound background in accounting and knowledge of other relevant disciplines. Ability to deal successfully with human relations issues Ability to objectively appraise others actions without generating undue suspicion.
Drawing up Training Programs for Staff A continuous training program is necessary to achieve quality in performing audit assignments. An effective training program enables the staff to assume additional responsibilities in the organization. It acts as an incentive for drawing capable people into the department and retaining them. 84
Auditing
Deciding the Audit Time and Frequency Management audits should be conducted often enough to provide protection against emerging problems. The time required to complete a management audit varies, depending on: The extent and nature of the assignment The number of auditors assigned to the work Whether more specialists in a particular field are required.
A social audit is a systematic attempt to identify, analyze, measure, evaluate, and monitor the effect of an organizations operations on society, according to Blake, Frederick, and Myers. Social audits assess adherence to the specified norms, which may pertain to the governments standards of social performance, standards established by the organization, or norms set by outside agencies. The aim of conducting a social audit is to influence the policies, objectives, and actions of the concerned organization to improve its social performance. There are various approaches used to conduct a social audit, which are: Inventory approach: This approach involves a simple listing and short descriptions of programs which the organization has developed to deal with social problems. Program management approach: This approach is a more systematic effort to measure the costs, the benefits, and the achievements of the organization. Cost-benefit approach: This approach attempts to list all social costs and benefits incurred by an organization in terms of money.
85
Social indicator approach: This approach pertains to utilizing social criteria (e.g., suitable housing, good health, job opportunities) to clarify community needs and then evaluating corporate activities in light of these community indicators.
Depending on the audit scope and coverage, Fredrick, Myers, and Blake have identified six types of social audits. These are described in Table 2. Table 2: Types of Social Audits Type Social balance sheet and income statement Social performance audit Scope This kind of audit requires quantification of social costs and income. It is conducted to reduce social costs in terms of money. This audit is conducted to assess the performance of companies with respect to some area of social or public concern. It can assume the form of a research-based appraisal that is conducted to find out the extent of pollution caused by cement and steel industries. This type of audit is conducted to evaluate an organizations social performance in terms of social indicators that signify public interest. It evaluates the contribution of the organization to the well-being of the local community. This kind of audit is conducted to ascertain how corporate actions affect employees or the general public in different ways. Depending on the findings of the audit, the policies or actions of the organization are modified. This type of audit is conducted by authorized government agencies to study an organizations performance in areas of social concern. Such audits could relate to environmental protection, etc. This audit is limited to specific processes and programs of an organization that may have social implications. It aims to appraise a program which has already been initiated by the organization.
86
Auditing
Organizations undertake environmental audits for many reasons. They are: To enhance safety For environment management To minimize costs For securing a financier or a buyer To improve the image of the organization
There are two types of environmental audits -- environmental compliance audit and environmental management audit. Environmental Compliance Audit An environmental compliance audit is generally conducted to gauge the position of the organization against these compliance parameters on the day of the audit. The issues that arise at the time of environmental compliance auditing should be prioritized in such a way that the issue that may cause the most harm to the environment is documented and addressed first. It is performed to check - Conformance with the occupational health and safety requirements Conformance with the emission standards and license requirements of the local, state, and national governments.
An environmental compliance audit usually involves two main activities: Obtaining some physical proof of non-conformity Checking records and documents.
Environmental Management Audit An environmental management audit is conducted to evaluate whether the organizations management has the resources to reach the level of compliance required and to maintain the level of compliance. The issues to be considered while conducting an environmental management audit are - Who is in charge of the environmental program? Who is responsible for the environmental issues? Who are the staff and how well are they trained? How well will a crisis be handled? How is the relationship of the organizational actors with the regulatory bodies? Refer to Exhibit II for the environmental audit initiatives at Kansai Nerolac Paints Ltd.
87
Auditing
to conduct the audit. If the control risks are assessed to be high, the detection risk should be reduced by the extensive use of substantive procedures such as verification of documents, transactions, and account balances. The auditors perform tests of controls to check whether the internal controls are functioning appropriately and effectively. The broad categories of audit procedures are: Verification: It is aimed at ascertaining the accuracy, reliability, and validity of assets, records, statements, conformance to rules and regulations, etc. and assessing the effectiveness of internal controls. Table 3 shows the various procedures involved in verification.
Checking the mathematical calculations that have been performed earlier Matching two independent sets of records and to show mathematically, with supporting documentation, the differences (if any) between the two records. Obtaining information from an independent source so as to verify the existing information. Verification of recorded transactions or amounts by examining supporting documents. The purpose is to verify correctness, that is, whether recorded transactions represent actual transactions. Here the direction of testing is from the recorded item to supporting documentation. Tracing procedures begin with the original documents and are followed through the processing cycles into summary accounting records. The purpose of tracing is to verify completeness, that is, whether all actual transactions have been recorded. Here the direction of testing is from supporting documentation to the recorded item.
Confirm Vouch
Trace
90
Auditing
Observation: It deals with watching the behavior of people or the performance of a certain activity or process. This is a technique of collecting primary data. Inquiry: Oral or written inquiries can be performed using interviews or questionnaires. The auditor has to take care that the questions are appropriately framed keeping in mind the position and expertise of the person being interviewed, and the answers are documented and confirmed. Analysis: Auditors perform analysis of documented data to calculate financial ratios, discover trends, identify exceptions, compare the current actuals with historical data or benchmarks, etc. The intelligent use of computers increases the efficiency and effectiveness of the analytical procedures.
Indirect resistance to audit recommendations is subtle and more difficult to identify. Indirect resistance can be resolved by making the people who are resisting write down their concerns and having open talks with them. 91
8.1 Benefits
Auditing identifies opportunities for improvement of operational processes. It identifies outdated organizational strategies. Auditing increases the managements ability to address concerns. It enhances teamwork and commitment to change. It acts as a reality check.
8.2 Limitations
The quality of the audit will only be as good as the quality of the audit tool. A financial statement audit does not comment on the soundness of the management or on the safety of its practices. Nor does it assess the risk of losses if there is any change in the business environment. Though management auditing can highlight the changes that are important for the organization, it cannot be used for resource allocation or to decide which of the changes should be undertaken first. While an audit can bring out the weaknesses in the system and identify opportunities for improvement, it would not be beneficial unless there is a strong commitment to improve or strengthen the process being studied. In organizations which use audits to manage suppliers performance, audits may prompt the suppliers to resort to unethical means, especially in the matter of adherence to labor standards, if they fear that their contracts may be terminated.
9. Summary
Auditing is a systematic and independent examination of data, statements, records, operations, and performances (financial or otherwise) of an enterprise for a stated purpose. In any auditing situation, the auditor perceives and recognizes the propositions before him for examination, collects evidence, evaluates the same, and on this basis formulates his judgment which is communicated through his audit report. Audits may be categorized based on their emphasis; primary audience; primary purpose; and scope.
92
Auditing
The different categories of audits are: financial statement audit, internal audit, fraud auditing and forensic accounting, operational audit, information systems audit, management audit, social audit, and environmental audit. Financial statement audits are conducted: to examine the correctness of financial statements; to establish whether they present a true and fair picture of the organizations financial position at a given time; and to check compliance with regulations like the Generally Accepted Accounting Principles (GAAP). Objective assessment of the financial statements requires significant inspection and evaluation of the organizations statements of accounts which involves application of certain key concepts: audit materiality, audit evidence, audit risk, and the concept of true and fair. According to the modern approach, internal audit is an independent management function which furnishes organizations with analyses, appraisals, recommendations, counsel, and information concerning the activities reviewed. Frauds can be investigated or detected by Certified Fraud Examiners (CFEs) who are trained to detect, investigate, and deter fraud. Forensic accounting encompasses financial expertise, fraud knowledge, and a strong knowledge and understanding of business reality and the working of the legal system. It involves the application of financial skills and an investigative mentality to unresolved issues, conducted within the context of rules of evidence. A management audit appraises an organizations position and helps it determine where it (the organization) is, where it is heading with its current plans and programs, whether it is meeting its objectives, and whether any revision of plans is required to enable it to achieve its predefined goals and objectives. Management audits can be classified into complete management audit, compliance management audit, program management audit, functional management audit, efficiency audit, and propriety audit. A social audit is a systematic attempt to identify, analyze, measure, evaluate, and monitor the effect of an organizations operations on society. Social audits assess adherence to the specified norms, which may pertain to the governments standards of social performance, standards established by the organization, or norms set by outside agencies. There are various approaches used to conduct a social audit, which are: inventory approach; program management approach; cost-benefit approach; and social indicator approach. Depending on the audit scope and coverage, Fredrick, Myers, and Blake have identified six types of social audits. Environmental audits are used to evaluate the organization on various parameters which include: conformance to the occupational health and safety requirements; conformance to the emission standards and license requirements of the local, state, and national governments; and generation, storage, and disposal of hazardous wastes. There are two types of environmental audits -- environmental compliance audit environmental management audit. 93
The auditing process consists of the following steps: staffing the audit team, creating an audit project plan, laying the groundwork and conducting the audit, analyzing audit results, sharing audit results, writing audit reports, dealing with resistance to audit recommendations, and building an ongoing audit program. The benefits of auditing are that it identifies opportunities for improvement; acts as a reality check; identifies outdated strategies; measures performance improvements; strengthens managements ability to address concerns; enhances teamwork; and changes employee mindsets and increases acceptance to change. The quality of the audit will only be as good as the quality of the audit tool. While an audit can bring out the weaknesses in the system and identify opportunities for improvement, it would not be beneficial unless there is a strong commitment to improve or strengthen the process being studied.
94
Concept Note - 7
Transfer Pricing
1. Introduction
Decentralization is one of the approaches large organizations use to attain operational effectiveness. The main challenges in decentralization lie in designing responsibility structures and framing suitable policies and methods to determine the responsibility centers performance. Transfer pricing helps in the smooth functioning of responsibility structures in such organizations. When there is a transfer of goods or services from one business unit to another, the concept of transfer pricing comes into play. Transfer price is a major determinant of the revenue and profits of a responsibility center that sells a product or service to an internal customer. For the responsibility center buying the product or service, transfer price is the major determinant of expenses incurred. So, the transfer price is an important factor for both the selling and the buying unit. This note will help you understand: The concept of transfer pricing The various factors influencing transfer pricing The different methods used for calculating the transfer prices The administration of transfer prices The Indian perspective of transfer pricing.
Goal Congruence While designing the transfer pricing mechanism, the interests of individual profit centers should not supersede those of the organization as a whole. The divisional manager, in maximizing his/her divisions profits should not indulge in decision making that fails to optimize the organizations performance. Performance Appraisal Transfer pricing should aid in reliable and objective assessment of the profit centers activities. Transfer prices should provide relevant information to guide decision making, assess the divisional managers performance, and also assess the value added by profit centers toward the organization as a whole. Divisional Autonomy The transfer pricing policy should aim at providing optimum divisional autonomy, thereby allowing the benefits of decentralization to be retained. Each divisional manager should be free to satisfy the requirements of his/her profit center from internal or external sources. There should be no interference in the process by which the buying center manager rationally strives to minimize costs and the selling center manager strives to maximize revenues. Practically, it is a difficult task to simultaneously meet all these objectives. For multinationals, internal transfer pricing can determine where profits are to be declared and taxes paid. In case of transactions with sister concerns (legal entities) that supply intermediary products, it should considered that different countries have different tax and exchange rates. The transfer pricing policy should ideally enable multinational corporations to minimize tax liability.
Transfer Pricing
Reduce the Impact of Taxes and Tariffs Multinational corporations reduce their total tax liability by maximizing profits in countries where corporate taxes are low. This will result in reduction in the tax liability of the organization as a whole. Multinational corporations can also reduce the impact of tariffs on imports while purchasing products from the overseas business units of the organization. This will lead to low tariffs for the importing business unit, as most duties are levied on the value of the goods imported. Movement of Funds between Countries A multinational corporation may prefer to invest its funds in one country rather than another. Transfer pricing provides an indirect way of shifting funds into or out of a particular country. Refer to Exhibit I and Exhibit II for transfer pricing disputes in India and the US respectively.
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GSK decided to settle the issue to avoid future fund outflow toward legal proceedings. On September 11, 2006, GSK announced that it was settling the dispute by paying $3.1 billion to the IRS. According to Mark W. Everson, I.R.S. commissioner, The settlement of this case is an important development and sends a strong message of our resolve to continue to deal with this issue.
Adapted from <http://www.cfo.com/article.cfm/3012017?f=related>; and other sources.
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Transfer Pricing
Proper investment: The transfer pricing department should be well funded and should coordinate well with other departments in the same organization, the transfer pricing departments of other business units, as well as with the top management. Another important aspect is compliance with the transfer pricing jurisdiction and to maintain documentation of transfer pricing in order to deal satisfactorily with any legal issues that may arise. In reality, it is not possible to fulfill all these conditions due to the internal policies of the organization and certain external factors. These constraints, both external and internal, have been given below.
Transfer Pricing
This is because the cost of new equipment will be included in the margin, and would be able to reap higher profits. Organizations need to also decide on the treatment of fixed costs and research and development costs. The cost-based pricing method is generally accepted by the tax and customs authorities of a country as it provides some indication that the transfer price approximates an items real cost. This approach is, however, not as transparent as it may appear as it can be easily manipulated to alter the magnitude of the transfer price.
Enterprise Performance Management organizations account. These charges are later eliminated while drawing up consolidated financial statements. This method is used when there are frequent conflicts between the buying and selling units, which cannot be resolved by any method. The disadvantages of this method are it is difficult to maintain a separate account each time a transfer of goods is made; and it motivates the managers to concentrate only on internal transfers (where they are assured of a good mark-up) at the expense of outside sales. Table 1 provides a summary of the different methods of transfer pricing.
3 4
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Transfer Pricing
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Organizations can form either a formal or informal system of arbitration to administer the transfer price mechanism and solve conflicts. In a formal system, both parties submit a written case to the arbitrator, who reviews it and decides on the price. In an informal system, most of the presentations are oral. Conflicts resolution techniques like forcing, smoothing, bargaining, and problem solving can be used by the management. Forcing and smoothing help in conflict avoidance, whereas bargaining and problem solving indicates conflict resolution.
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Transfer Pricing
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Under Section 92E, the documentation has to be available with the assessee by the specified date and has to be retained for a period of eight years. During the course of any proceedings under the Act, the Commissioner may require any person who has undertaken an international transaction to furnish the information and documents specified under the rule within a period of thirty days from the date of receipt of the notice issued in this regard, and this period may be extended by a further period not exceeding thirty days. Moreover, Section 92E provides that every person who has entered into an international transaction during a previous year shall obtain a report from an accountant and furnish this report on or before the specified date in the prescribed form and manner.
Adapted from <http://incometaxindia.gov.in/transferpricing.asp>.
7. Summary
Transfer price is the internal price charged when one business unit in the organization transfers goods or services to another business unit in the same organization. The main objective of transfer pricing is the proper distribution of revenue between responsibility centers. A transfer pricing policy should meet the three broad objectives of goal congruence, performance appraisal, and divisional autonomy. In international business, the additional objectives of transfer pricing are: managing exchange rate fluctuations, handling competitive pressures, reducing the impact of taxes and tariffs, and providing ease of movement of funds between countries. The conditions necessary for the development of a proper transfer pricing mechanism are: role definition, external advisers, competent managers, equity, information on prevailing market prices, and proper investment. Constraints to the implementation of a transfer pricing mechanism may be classified as external (limited markets; surplus or shortage of industry capacity) and internal constraints. The different methods for calculating transfer prices are: market-based pricing method (comparable uncontrolled price method), cost-based pricing method (cost plus method), negotiated pricing method, and resale pricing method. Vertically integrated organizations can use some alternative methods for transfer price calculation: two-step pricing method, profit sharing or profit split method, and two sets of prices method. The administration of transfer pricing involves close monitoring of the implementation process, because any errors in the process, whether intentional or unintentional, are viewed as grave offenses in the eyes of law and can be detrimental to the organization.
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Implementing a transfer pricing mechanism involves: articulation and communication of the transfer pricing strategy; documentation of the process and of inter-company agreements; involvement of a multidisciplinary team; negotiations between heads of various units; and arbitration and conflict resolution in case conflicts arise. Organizations can misuse transfer pricing to minimize their tax liabilities, as well as to project a wrong image about their financial health, and thus mislead the stakeholders. The Government of India has introduced full-fledged transfer-pricing regulations with effect from April 1, 2001 to reduce tax avoidance by organizations operating in India.
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Concept Note - 8
Ethical Decision Ideology Ethical decision ideology is concerned with how different individuals apply their ethical philosophies for decision making when faced with ethical dilemmas. Ethical decision ideologies can be classified based on two dimensions: idealism and relativism. Idealism refers to the belief that behaving ethically ensures positive results. Relativism refers to the belief that moral values depend on circumstances. There are four classifications of ethical decision ideologies based on these two dimensions: Absolutist: It refers to a person who scores high on idealism and low on relativism. Exceptionist: It refers to a person with a low score on both idealism and relativism. Situationist: It refers to a person who scores high both on idealism and relativism. Subjectivist: It refers to a person who scores low on idealism and high on relativism. Figure 1 depicts the matrix of ethical decision ideologies. Figure 1: Ethical Decision Ideologies Matrix Relativism Low Low Idealism High Absolutist Situationist
Adapted from Stead, Edward W.; Dan L. Worrell and Jean Garner Stead An Integrative Model for Understanding and Managing Ethical Behavior in Business Organizations. Journal of Business Ethics. Vol. 9 Issue 3, Mar1990, p233-242.
High Subjectivist
Exceptionist
Culture and Structure The culture of an organization includes the prevailing values, belief systems, and norms. The hierarchy of authority decides the level of autonomy or freedom (both the number and types of decisions taken and the extent of empowerment that the employees have) that the employee enjoys. This is an important factor that contributes to ethical behavior. Ethical decision making can be encouraged by allowing the employees, whose activities ethically affect the organization, to choose activities which are ethical. Unethical behavior can be curbed by delegating decision-making rights to employees who are skilled enough and aware of the characteristics and outcomes of the decisions that are made. Performance Measurement Systems Performance measurement systems are used to assess the performance of employees against predetermined standards or targets. Systems which are too stringent may trigger unethical behavior. A performance measurement system should be designed to identify unethical behavior and to communicate to the employees that the management would not approve of unethical behavior. Employees empowered to make ethical decisions should be well informed about the consequences of unethical behavior. Performance measurement systems should be so designed that they do not require employees to resort to unethical means to achieve expected performance levels. Also, it should reward ethical behavior. Reward Systems The reward systems in an organization, which may be both monetary and nonmonetary, should incorporate clauses which enforce ethical behavior. Reward systems should be integrated with the performance measurement systems, and should reflect the extent of decision-making authority given to employees. Position-Related Factors Position-related factors that influence ethical behavior include peer pressure, expectations of the top management regarding achievement of objectives, presence or absence of a code of conduct, superior-subordinate relationships, and the extent of resource availability. Positions that have a central role would entail employees to face more situations where ethical dilemmas arise. Organizational factors also affect the decision history through the reward systems. Employees will tend to behave ethically if that behavior is rewarded. Employee will refrain from unethical behavior if he/she gets punished for that behavior.
Social Factors
Giving the right information to customers regarding the products being sold or new product being launched is one of the major ethical considerations that companies must keep in mind. Being ethical serves as a competitive advantage for organizations, as it builds a good reputation and image.
Adapted from Stead, Edward; Dan L. Worrell and Jean Garner Stead An Integrative Model for Understanding and Managing Ethical Behavior in Business Organizations. Journal of Business Ethics. Vol. 9 Issue 3, Mar 1990, p233-242.
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An example of ethical dilemma in the sales function may be given pertaining to the pharmaceutical organization where every salesperson has a monthly sales target. Generally, for target achievement, salespersons meet wholesalers and the retailers, take orders, and supply them with the necessary products. At the end of the month, if targets have not been met, some salespersons resort to promising additional discounts or special gifts for orders from distributors and chemists, so as to achieve their targets.
Qualitative measures used for performance appraisal leading to biased evaluations wherein undeserving candidates are rewarded instead of deserving candidates Misuse of authority by management. Refer to Exhibit I for some ethical scandals at a multinational corporation.
Integrating the reward systems of the organization with the accomplishment of objectives and in turn encouraging the employees to perform: To help the employees integrate their personal goals with organizational goals. The different mechanisms used by organizations to regulate ethical behavior are: Code of Ethics, Ethics Committee, ethics training for employees, corporate governance focused on ethics, system of whistleblowing, and reward systems based on ethics.
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For the proper conformity between ethics and corporate governance, it is necessary that the behavior of the top management and all employees is monitored to check for compliance with the ethical code at all levels as well as with the mission statement and functional strategies of the organization.
3.11 Whistleblowing
Whistleblowing is the act whereby an employee of an organization informs the higher authorities or public about the unethical practices taking place in the organization. Whistleblowers have helped organizations in tracking and curbing unethical practices, which would otherwise have damaged the reputation of the organization and also caused harm to the well-being of other employees. Albeit the benefits, whistleblowing as a control mechanism, is not an easily accepted approach in many organizations. In some organizations, whistleblowers reports may be overlooked by the concerned people, and the unethical practices in the organization may continue. Often, whistleblowers are perceived as a threat to the top managements authority and this may lead to the whistleblower being reprimanded for his/her act. Refer to Exhibit III to understand the ethical responsibilities of the employees of Infosys Technologies Limited, as laid down by its Code of Business Conduct and Ethics.
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or reasonable grounds for dismissal of the person engaging in such conduct, OR conduct which is otherwise in violation of any law or the Companys policies, you should promptly contact any of the following, in accordance with the companys whistleblower policy: Corporate Counsel; Your Immediate Supervisor You may also report your concerns anonymously by e-mailing the Companys email id for this purpose at whistleblower@infosys.com or by sending an anonymous letter to the Corporate Counsel. If you have reason to believe that both of those individuals are involved in these matters, you should report those facts to the Audit Committee of the Companys Board of Directors. For more details, you should read the Companys whistleblower policy. Violations of law, this Code of Business Conduct and Ethics or other Company policies or procedures by Company employees can lead to disciplinary action up to and including termination. In all cases, if you are unsure about the appropriateness of an event or action, please seek assistance in interpreting the requirements of these practices by contacting the Human Resource Department or Legal Department.
Source: Code of Business Conduct and Ethics. Infosys Technologies Limited. <http://www.infosys.com/ investor/corp_gov/CodeofConduct.pdf>.
4. Summary
Ensuring ethical behavior among employees requires an in-depth understanding of the many factors which contribute to their decisions to behave ethically or otherwise. Organizations attempt to ensure that their employees behave ethically, using control systems. The ethical behavior of an employee depends on factors such as the individuals ethical philosophy, that is, utilitarianism, individual rights, or justice; ethical decision ideology, that is, absolutist, exceptionist, situationist, or subjectivist; other individual factors, organizational/position-related factors, and external environmental factors. In the context of management control, ethical issues can arise in any department or function of an organization. On the financial front, the ethical issues may arise due to creation of budgetary slack and managing earnings. 117
Ethical issues in the sales function arise when the salespeople are under pressure from the higher authorities to achieve targets in order to earn incentives or recognition. In the operations function, ethical issues may arise in terms of productivity and quality or on the safety front. In human resource management, lack of job security and increased risk of unemployment, excessive scrutiny and control over employees, and discrimination are some issues that are important in terms of their ethical implications. To regulate ethical conduct, organizations have in place different mechanisms like Code of Ethics, Ethics Committee, ethics training for employees, corporate governance focused on ethics, system of whistleblowing, and reward systems based on ethics.
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Concept Note - 9
3. Production Controls
Production controls in manufacturing organizations are dependent on two broad variables the nature of the production process (process production or discrete production) and the degree of mechanization (high or low) involved in the production process. In process (continuous) production (e.g., petroleum refining and petrochemicals industry, pharmaceutical industry, the food and beverages industry), the plant supervisor controls the settings of various machines in accordance with the production plan of the day. Control is exercised to a large extent through visual inspection and less through manual intervention. In discrete (assembly line) production (e.g., car manufacturing, television manufacturing, and computer manufacturing) a variety of components are combined to make the final product. Production controls in such organizations focus on the following issues: Producing the finished components as per design specifications and the predetermined time standards laid down Synchronizing the production processes of all the components and ensuring the right balance of production capacity of different production chains of the various components
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Ensuring the right production capacity within a component production process Ensuring that the work layout is appropriately designed and there is a smooth flow of materials on the shop floor. Specifying the quantum of materials to be stacked on the production floor of both the inputs and the outputs Specifying the number of persons who can be present on the shop floor, the uniform or dress which the employees have to wear, and the safety precautions which have to be followed Defining the wastage and spoilage norms, and benchmarking the actual wastage and spoilage against these norms Defining the quality norms which are to be met at each stage of production process and strictly adhered to, to consistently deliver a high quality product.
In a manual production process, say a printing press, each activity has to be closely controlled to ensure uniform quality of the finished product, and to minimize wastage and spoilage. If the production process is highly mechanized and uses advanced techniques like robotics and Computer Numeric Control (CNC) machines where there is a high degree of precision and low scope of error commitment, the control element is built into the production activity itself to a large extent.
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Description Material costs also affect productivity as they may add up to 30% to 40% of the overall costs, or even more. Material Productivity =
= Goods and/or Services Produced (Output) Quantity of Material Used (Input)
Specific ratios are developed that gauge productivity in terms of change in combined inputs. These inputs can include raw materials and labor hours used in the production of a particular output. Multifactor Productivity =
= Goods and/or Services Produced (Output) Quantity of Raw Material Used + Labor Hours Used (Input)
Many organizations measure productivity in terms of partial productivity (single factor or multifactor) as it is difficult to measure total productivity due to the difficulty in identifying/understanding the particular input variable(s) (among many variables) that has led to lower productivity. The problem with total productivity is that all the variables (inputs and outputs) must be expressed in the same units. Total Productivity =
= Goods and/or Services Produced (Output)
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4. Operations Controls
In the business context, an operation is a set of activities carried out to achieve a specific purpose. For instance, purchase operations comprise activities like identification of vendors, comparing vendors, placing orders with vendors, and scheduling and monitoring deliveries from the vendors. Purchase operations ensure timely supply of various materials (raw material or packaging material) required to carry out business, and aims at procuring the materials at optimal costs and quality. Operations of a manufacturing organization can be classified as internal and external operations. Internal operations are executed within the organizational boundaries and have limited or no external linkages. The control elements to such operations are largely defined by the organization and thus can be easily controlled. Internal operations include production operations taking place in the organization, inventory and warehouse operations, and the quality assurance mechanism implemented with respect to the production process and the finished product. However, there may be significant dependencies on external entities. For example, the sales departments inputs on the product mix desired for a future period is an important consideration for production planning, inventory planning, and purchase planning. The marketing and sales, and purchase operations have an external focus as they deal with customers and vendors, respectively, who are external to the organization. They also deal with thirdparty service providers (transporters) to achieve the goals. Quality controls and inventory controls are two important control areas in internal operations, while purchasing controls and warehousing controls are two important control areas in external operations.
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Quality control is also exercised over activities that are outside the production domain. It ensures that products satisfy the customer expectations and that the services offered by the organization are able to resolve problems quickly and properly. Total Quality Management, a management philosophy, aims to build and inculcate the quality element in the work ethic of the business itself, and does not view quality as a separate organizational function.
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Transportation
Quality Assurance
Transportation
Vendors
Materials
Stores
Materials
Consumers
Purchases
Purchase Request
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Transportation plays a key role in logistics control and management. Through transportation, goods are moved from one place to the other in the supply chain. The various issues involved are timing, routing, promptness, and scheduling of the tasks involved. Timing is important as any delay or errors in delivery would lead to financial losses to the organization, and erosion of the brand image or corporate reputation. Routing and scheduling are concerned with the way to be taken and the plan to be followed, respectively, in the transportation of the goods. These should be framed such that the goods are delivered at the required places in the planned sequence. SCM aims at complete synchronization of every supply chain cycle with the customers final demands. It also aims at controlling and monitoring the vendors supply chains. The current global business environment is characterized by increased distances and longer lead times between the placing of orders and receipt of goods; more complicated transportation routes and distribution patterns; large number of participants in the supply chain; increase in the number of trading partners; difficulty in responding to the consumer demand in a timely fashion; increase in impact of weather or natural disasters on the plans; increase in communication problems; more demanding customers; decreasing product life cycles and time for research and development; increase in the variety of products demanded; and the need for effective coordination among supply chain partners. By focusing on the supply chain element, an organization can control its response to all these challenges, and directly control and influence its speed to market, reduce costs, and fulfill customer needs more effectively than its competitors. Refer to Exhibit II for a brief overview of Pfizers supply chain activities.
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Cycle time
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Supply Chain Metric Supply chain cycle time Defects Per Million Opportunities (DPMO)
Description Refers to the total time that would be taken to satisfy a customer order if all inventory levels were zero Calculated by adding up the longest lead times in each stage of the cycle. DPMO (total number of defects per one million opportunities) is a measure of process performance used in Six Sigma calculations. DPMO =
Total number of defects Number of units Number of opportunit ies per unit
1,000,000
7. Summary
For a manufacturing organization, the conversion of inputs to outputs is viewed as the production activity; and operations cover the processes involved in procuring the inputs and ensuring the optimal supply of finished goods to the customers or consumers in order to satisfy their needs. Production operations include the various activities executed during the production process. Operations management and control covers both production and non-production operations. Production and operations, when combined and synchronized, would be classified as supply chain management (SCM).
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The production controls which are established in a manufacturing organization are dependent on the nature of the production process (process (continuous) production or discrete (assembly line) production) and the degree of mechanization (high or low) involved in the production process. Productivity is used as a control tool to ensure that all the resources are utilized judiciously and efficiently. Productivity can be measured in relation to a single factor such as labor or material (single factor productivity), a combination of some factors (multifactor productivity), or all the factors taken together (total productivity). A variety of reports are made use of to ensure effective production control like production efficiency report, production planning report, daily production report, downtime analysis report, and shift handover report. In the context of a business, an operation is a set of activities carried out to achieve a specific purpose. The various operations of a manufacturing organization can be classified as internal and external operations. Quality controls and inventory controls are two important control areas in internal operations. Purchasing controls and warehousing controls are two important control areas in external operations. Operations starting from procurement of inputs to distribution of finished goods are grouped together and are collectively referred to as SCM. The chain dealing with the post-production activities is referred to as the downstream chain and involves controlling the outbound logistics. The chain dealing with purchases and inventory upto production is referred to as the upstream chain and involves controlling the inbound logistics. The performance of the supply chain can be evaluated with the help of metrics like inventory turns or inventory turnover, projected inventory turns, cycle time, customer order promised cycle time, customer order actual cycle time, cash to cash cycle time, supply chain cycle time, and defects per million opportunities (DPMO). Information systems play a crucial role in production and operations management. Information systems of the present day integrate the entire supply chain. The present day automated operations information systems plan, execute, and reliably track the logistics of stock movement from the warehouse to the branches or the customer locations.
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Concept Note - 10
In the case of buying an item from external sources, there are no fixed costs associated. The total cost of buying is the product of price per unit (P) and the number of units demanded (Q), i.e., Total Cost buy = P Q On the contrary, if the item is made in-house, some fixed cost (F) on equipment and facilities installation is incurred. Also, variable production cost which is equal to variable cost per unit (V) times the number of units demanded (Q) is incurred. The total cost of making will be: Total Cost make = (VQ) + F At the break-even point, the total cost of buying is equal to the total cost incurred on making the item in-house. Let us assume that the break-even point is reached at Q1 units. P Q1 = (VQ1) + F Q1 = F/ (P-V) If the annual demand for the product is less than Q1, the total cost of purchasing the product from an external vendor will be less than the total cost of making it in-house. If demand is greater than Q1, the total cost of making the product in-house will be less than the cost of purchasing it from an external vendor. Apart from the cost of the product, organizations consider many other factors before making a make-or-buy decision -- availability of raw materials in the long run and the ability to monitor and control quality are some such factors. Many organizations maintain both make and buy capabilities to ensure prompt delivery of materials. Organizations may opt for in-house production to have control over all the value chain activities, to put excess plant capacity to productive use, or to ensure that confidentiality of product design is maintained. Organizations may opt for outsourcing of a material to take advantage of the expertise of suppliers, to avoid infrastructure expenditure when the volume of material required cannot justify in-house production, or to maintain a multiple source policy.
ii. Deducting the target profit margin from the target price to determine the target cost. iii. Estimating the actual cost of the product iv. Finding ways to reduce the actual cost to meet the target cost -- in case of estimated cost exceeding the target cost. Target costing is primarily a customer-focused method. Through market research, an organization tries to estimate the value which customers may attach to the product (based on features and attributes) vis--vis competing products. The planned return on investment determines the target profit margin from the product. The target cost is calculated by deducting the target profit margin from the target price of the product. It is then compared with the predicted actual cost of production. If the predicted actual cost is more than the target cost, then efforts are made to reduce costs wherever possible to match the two costs. A team is constituted with personnel from design, marketing, finance, production, and purchasing departments to arrive at a target cost of production, at a predetermined level of functionality and quality. It is ensured that preferences and recommendations of all functional areas are represented equitably in this process. The target cost is arrived at by adding only those product features that will be valued by customers. The product cost should be monitored during the development stage to ensure that the product is developed within the target cost. The advantage of target costing is that it is done during the planning and design stage of the product life cycle and as a result can have a significant impact in determining the committed costs. The target cost process is iterative where several design alternatives are analyzed. Such products or product designs should not be taken to production if the cost of designing the product exceeds the target cost. Products should be designed in such a way that the costs of producing them are equal to or less than the target costs, no compromises having been made on their functionality.
customers perceive as adding to the usefulness of the product or service purchased by them. A non-value added activity provides scope for cost reduction, without reducing the products value as perceived by the customer. Although it is difficult to clearly distinguish between value adding and non-value adding activities, organizations should try to ensure that customers do not pay for non-value adding activities. They should identify ways and means of reducing costs incurred on such activities either by totally eliminating them or by improving their performance efficiency. Kaplan and Cooper have suggested that organizations classify their activities based on a five-point scale to overcome the limitations of the value adding and non-value adding classification. According to them, an activity can be highly efficient with very low (below 5%) scope for improvement; moderately efficient with little (5-15%) scope for improvement; efficient on an average scale with potential (15-25%) scope for improvement; inefficient with a significant (25-50%) scope for improvement; and highly inefficient with (50-100%) considerable scope for improvement.
incurred in preventing waste production that may harm the environment), environmental appraisal costs (costs incurred to ensure that the organizations activities confirm to the environmental regulatory laws imposed by the government), environmental internal failure costs (costs incurred on waste elimination which has not been released into the environment), and environmental external failure costs (costs incurred on waste elimination that has been discharged into the external environment) are reported.
Progressive and proactive organizations create new industry benchmarks by reengineering their business processes and so, gain a competitive edge through superior performance.
3.3 Kaizen
Kaizen is a term used for making improvements in processes through small increments rather than through large-scale innovations. Japanese organizations follow Kaizen to improve productivity, and to reduce/control costs. Kaizen costing is applied during the production stage, and aims at reducing costs by focusing on improving the manufacturing process. Employees are given the power to improve processes, and are encouraged to identify ways to reduce costs, as they are closely associated with the production process and the customers.
TQM Emphasis on a multi-skilled workforce that can be used for different kinds of jobs. Process-oriented approach. Advocates a flat organization with networking among the functions.
Traditional Management Belief in division of labor and separation of manual work from mental work. Result-oriented approach. Proposes a hierarchical and vertical organization structure.
3.5 Benchmarking
Benchmarking involves comparing the organizations practices with the best international practices. It helps to find the best way to perform operations that would lead to superior organizational performance. By comparing its own operations with that of industry leaders, the organization can control the limitations and eliminate weaknesses in its operations. Benchmarking can be classified as competitive and generic. Competitive benchmarking focuses on the products and manufacturing processes of the organizations competitors. This is done to exercise control over product performance with regard to competitors products, and to enhance manufacturing capability and eliminate wasteful processes. Generic benchmarking evaluates the organizations processes with those of other organizations, which are considered to be the best in those processes, irrespective of the nature of the industry. Industries which share some characteristics can also be identified and selected best practices can be adopted from those industries. Steps Involved in Benchmarking The steps involved in benchmarking are: Determining the functions to be benchmarked. The functions that need to be benchmarked are those which have a significant impact on business performance. Identifying the critical success factors of the functions to be benchmarked. Typical critical success factors are quality and delivery. Identifying the best-in-class organizations. Measuring their performance and comparing them with the organizations performance that is to implement benchmarking. Taking suitable actions to meet or exceed the performance of the best-in-class organization. Refer to Exhibit I for the pioneering benchmarking initiatives at Xerox Corporation.
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goal is always to achieve superiority in quality, product reliability, and cost. However, it found this type of benchmarking inadequate as competing copier companies were not adopting the very best practices in many business processes. The company then adopted generic benchmarking, which involved a study of the best practices followed by a variety of companies regardless of the industry they belonged to. Xerox benchmarked its warehousing and inventory management system against that of L.L. Bean (Bean), a mail-order supplier of sporting goods and outdoor clothing. Bean had developed a computer program that made order filling very efficient. The program arranged orders in a specific sequence that allowed stock pickers to travel the shortest possible distance to collect goods at the warehouse. This considerably reduced the inconvenience of filling an individual order that involved gathering relatively fewer goods from the warehouse. The increased speed and accuracy of order filling achieved by Bean attracted Xerox. The company was convinced it could achieve similar benefits by developing and implementing such a program. Similarly, Xerox zeroed in on various other best practice companies to benchmark its other processes. These included American Express (for billing and collection), Cummins Engines and Ford (for factory floor layout), Florida Power and Light (for quality improvement), Honda (for supplier development), Toyota (for quality management), Hewlett-Packard (for research and product development), Saturn (a division of General Motors) and Fuji Xerox (for manufacturing operations), and DuPont (for manufacturing safety). The first major payoff of Xeroxs focus on benchmarking and customer satisfaction was the increase in the number of satisfied customers. Highly satisfied customers for its copier/duplicator and printing systems increased by 38 percent and 39 percent respectively. Customer satisfaction with Xeroxs sales processes improved by 40 percent, service processes by 18 percent, and administrative processes by 21 percent. The financial performance of the company also improved considerably through the mid- and late 1980s. Overall, customer satisfaction was rated at more than 90 percent in 1991. During the 1990s, Xerox, along with companies such as Ford, AT&T, Motorola, and IBM, created the International Benchmarking Clearinghouse (IBC) to promote benchmarking and to guide companies across the world in benchmarking efforts.
Source: Radhika, Neela A. and A. Mukund. Case Study Xerox: The Benchmarking Story. The ICMR Center for Management Research, 2002. <www.icmrindia.org>.
3.6 Benchtrending
Benchtrending helps in controlling and directing an organizations response to the volatility of market forces and the industry dynamics in which it operates. It involves reviewing the existing situation and anticipating changes in the market, and consumer preference variables and evaluating their impact, to control the degree of performance gap that might emerge due to better responsiveness of competitors to the market forces. Benchtrending can be broadly classified into strategic benchtrending and process benchtrending. 138
Strategic benchtrending controls the growth direction of the business unit and sets long-term goals and objectives. It involves defining the market by size, customer preference, competition, etc., and assessing future industry trends and technological shifts. Current and potential competitors are identified and then the organizations current and projected performance is compared with that of competitors. Necessary actions are then taken to bridge the performance gap with the best-in-class organizations. Process benchtrending is used to control the performance of a specific function or process of the organization. It involves understanding the requirements of the process to be benchtrended and the process flow. Processes adopted by present and potential competitors have to be studied and compared, and necessary action taken to eliminate the process gap.
Interaction of managers with employees to motivate them and to get a better understanding of the processes, and to look for ways to make the employees jobs easier. Establishment of accountability and discipline so that employees know what is expected of them, and the consequence of not doing what is expected. Taking care of and personally thanking employees for their efforts and contribution. This will strengthen the bonding between employees and the organization. Proper communication with employees about business performance, changes in the business, and the direction the organization is taking to ensure smoother transition to the lean mode. Provision of an environment in which employees are allowed to express their ideas and then work to implement them. Creation of a set of goals (with respect to the organizations financial performance and customer satisfaction), which should be easy to understand and achievable and to which everyone can relate. Hiring of a leader with experience, as transition to lean is fundamentally different and complex compared to the traditional management processes.
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The results of the implementation of Six Sigma at GE were phenomenal. GE achieved 11 percent increase in revenues, 13 percent increase in earnings, 9.2 percent increase in working capital turns, and 17 percent increase in the operating margin during the first two years of implementation.
Adapted from Six Sigma and Quality Revolution at GE, <http://www.1000ventures.com/business_ guide/cs_quality_six-sigma_ge.html>.
Refer to Table 2 for a description of DMAIC which is an important methodology for Six Sigma implementation, especially for enhancing the quality of the existing processes of an organization.
C= Control
4. Operational Audit
Operational auditing is a technique for appraising the effectiveness of a unit or function on a regular and systematic basis against corporate and industry standards. It is done to identify areas for improvement and to assure the management that its aims are being carried out. Operational audit plays a vital role in appraising the management about an operations efficiency, effectiveness, and profitability. Such an audit is performed on a continuous basis by internal auditors or consultants specializing in various areas such as engineering, survey, designing, and accounting. 141
The audit report has to disclose the effect and status of the existing operation vis--vis the overall objectives. Operational audit is a future-oriented, systematic, and independent evaluation of the organizations activities. The primary sources of evidence for this audit are the operational policies and achievements related to organizational activities, though financial data may be used. The differences between management audit and operational audit are given in Table 3, and those between financial audit and operational audit in Table 4.
Operational audit verifies the operations of control and procedures, and fulfillment of plans in conformity with the prescribed policies.
Operational audits may be directed toward many non-financial areas such as personnel and engineering. Operational audits are conducted by internal auditors or consultants. The timing of operational audit depends on the discretion of the management.
of
Follow-up
A special assignment operational audit deals with process, quality, safety, risk, environment control techniques, etc. While these audits are generally initiated at the request of the management for varied purposes, they can also be undertaken on a regular basis.
5. Safety Audit
To manage risks effectively, safety should be treated as any other business area. Authority and resources should be given to people who will manage risks and be liable if anything untoward happens. Safety performances should be evaluated against set targets to find out the scope for improvements in future. Safety audit is the study of an organizations operations and assets. It discovers existing and potential hazards, and the actions needed to render these hazards harmless. Organizations should do periodic safety audits to improve their safety programs. The areas to be assessed in a safety program are: Accident, disease, illness, or injuries of employees arising due to occupation Safety issues of organization-owned automobiles Safety issues related to the physical plant of the organization -- includes fire prevention and machinery condition, and condition of the plant building Safety issues related to business functions occurring away from the organization premises Safety issues related to the product, if the organization is a manufacturer. The focus of safety audits varies widely from organization to organization, depending on the nature of their operations, nature of the products, management focus, etc. There is no standard safety audit procedure; it needs to be customized for various organization types. Certain points to be kept in mind when conducting safety audits are: Whether safety is among the top priorities for the top management Whether the line managers and supervisors make safety a priority Whether managers have the authority to make safety a priority Whether the organization measures the safety performances and publicizes the results Whether the work-site and work practices are reviewed Whether the investigation process, as to finding answers to questions like who is charged with fact-finding after accidents and whether the organization takes lessons from the investigations to avoid future mishaps, is effective.
6. Summary
Strategic cost management ensures cost reduction in addition to enhancement of the various processes of the organization.
144
Make-or-buy analysis, life cycle costing, target costing, activity-based costing, cost management across the value chain, and environmental cost management are some techniques used to manage and/or reduce costs of production and operations. The make-or-buy analysis helps managers to determine whether it is more economical to produce the item in-house or purchase it from external vendors. Life cycle costing analyzes the costs incurred on a product throughout its life cycle. Target costing concentrates on managing costs during the planning and design stage of a product. Activity-based costing is a method of allocating costs to each and every activity of the organization and determining the cost driver for every major activity. Value chain analysis involves evaluating the various activities in the value chain, improving their efficiency, and identifying the scope for cost reduction. An environmental cost report generated through environment cost management states the costs incurred by the organization with regard to its environmental development and sustainability initiatives. Value Engineering, Business Process Reengineering, Kaizen, Total Quality Management, Benchmarking, Benchtrending, Just-in-Time, Lean Manufacturing, and Six Sigma are some techniques that can be used to enhance organizational performance. Value engineering is the process of analyzing the factors that influence the cost of the product so that the necessary quality standards and functionalities can be obtained in order to arrive at the target cost. Business process reengineering (BPR) is a management technique through which an organization can improve its operational effectiveness, efficiency, and profitability through a fundamental and radical redesign of business processes. Kaizen is an approach to productivity improvement that is applied during the production stage. It aims at cost reduction by keeping its focus on improving the manufacturing process. TQM is an integrated effort to gain a competitive advantage by continuously improving every aspect of the organization. Benchmarking involves comparing the practices of the organization with best management practices from across the globe. Benchmarking can be broadly classified into two types competitive and generic. Benchtrending helps in controlling and directing the organizations response to the volatility of the market forces and the dynamics of the industry in which it operates. Benchtrending can be broadly classified into strategic and process benchtrending. Just-in-Time or JIT is a technique which helps in controlling the inventory costs on both the fronts of procurement costs as well as holding costs. Lean manufacturing is a business strategy focused on the elimination of process waste. Six Sigma is a rigorous technique used to manage process variations that cause defects and to work systematically to manage those variations in order to eliminate the defects. 145
Operational auditing is a technique for appraising the effectiveness of a unit or function on a regular and systematic basis against corporate and industry standards. Operational audits can be broadly classified into three categories functional audits, organizational audits, and special assignment audits. A safety audit is the study of an organizations operations and assets that aims at identifying existing and potential hazards, and the actions needed to render these hazards harmless. It is important for organizations to periodically assess the soundness of their safety systems.
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Concept Note - 11
2. Characteristics of Services
Service organizations differ from manufacturing organizations with regard to certain attributes, which are:
2.1 Intangibility
Unlike products, services cannot be counted, measured, or felt. It is difficult to explain to the customer what a specific feature in the service will give to the customer. As services are intangible, the perceptions of customers regarding the service may differ at any given point in time. Each customer will have a different experience from the same service. Due to this intangibility factor, evaluating the quality of service poses a major problem for service organizations.
2.2 Heterogeneity
Heterogeneity of services means different people rate the characteristics of services differently. It is easy to assess the quality of a product as it is tangible and also because there are specific characteristics associated with each product. But in the case of services, there are different characteristics and different people may rate these characteristics differently. The services provided involve human interactions (between the service personnel and customer), it is not possible to ensure that all customers receive or perceive the same level of quality every time. Heterogeneity has an effect on three areas service encounter, productivity, and service quality. Management control of service organizations has to grapple with all these implications of heterogeneity of services.
2.3 Inseparability
Irrespective of whether a service is provided by a person or by a machine, the production and consumption of the service cannot be separated from the source that provides it. Services involve the customer in the production process and they generally first get sold, then produced, and then consumed. Thus, inseparability is an integral attribute of services and it has a major bearing on service delivery. The production of the service requires the customer to communicate with the producer to get the desired output.
2.4 Perishability
Services cannot be stored. They are consumed as soon as they are produced. This describes the perishability characteristic of services. In the hotel industry, the metric associated with the perishability characteristic is the occupancy rate the percentage of rooms that are occupied at a given point of time.
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Capacity management and service quality determine how effective the service will be. The interaction between capacity management, service quality, and productivity is the basis on which service operations are planned and controlled. Capacity Management Strategies Organizations use different strategies for capacity management. They are: Customer development: Service organizations try to gain the loyalty of the customers through loyalty programs or by allowing customers to try out the services before purchasing them. Bundling: Two or more services are marketed together and the customer is given a discount. Differentiation: In this technique, some of the capacity is kept idle at normal times in order to be able to handle exceptional situations. Queueing theory is a mathematical model widely used in capacity management. This enables mathematical analysis of several related processes, including arriving at the (back of the) queue, waiting in the queue (essentially a storage process), and being served by the server(s) at the front of the queue.
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Contd
Yield management considers three factors to decide the prices: the route of travel, that is, from the origin to the destination; the attributes whether the flight is a non-stop flight, whether the money is refundable, whether the ticket is booked in advance, etc.; and deciding on a pricing slab for the number of seats for each fare class. Yield management helps in increasing profits by applying the peak load pricing policy, categorizing customers based on their price consciousness, and by applying seat inventory control to handle the fluctuations in demand. Yield management systems are used by airlines to predict the demand for each fare class for a specific flight. This can be achieved by collecting data on the booking and cancellation trends on similar flights for a period of 12 to 18 months. This trend analysis together with the fares for different classes helps in effectively segregating the available seats into different fare classes for a similar flight on a later date. Implementing yield management systems helps the airlines increase their revenue by three to eight percent. One airline that has benefited from the implementation of the yield management system is Air India, which has been able to price its tickets very effectively. Issues in yield management: The major issues that airlines face are the differences in demand, overbooking, elasticities of demand, and information systems. Differences in demand arise on the basis of the available fares. Airlines have to find out what rates are preferred by most of the customers. This helps them in gauging how many seats could be sold at a higher rate so as to increase profitability, rather than selling them at a lower price. Overbooking is a concept where the airlines book more number of passengers than the number of seats; this is done as a buffer against cancellation of tickets by customers. The next issue is elasticity of demand, that is, the effect of increasing prices on the customers buying decision and also on the competitors has to be checked. Another issue is that of proper information systems in that the data collected should be accurate.
Adapted from Indias Airlines find that Fast Growth has its Ups and Downs. Knowledge@Wharton. January 25, 2007, <http://knowledge.wharton.upenn.edu/india/article.cfm?articleid=4151>; and A Strategy for Intelligence. <http://www.networkmagazineindia.com/200307/cover2.shtml>.
Control through Yield Management Some models used in yield management, according to Kimes are: Mathematical programming models Economics based models Threshold curve Expert systems The more commonly used models are economics based models and threshold curve. Taking the example of the airline industry, economics based model and threshold curve can be described as follows: 151
Economics based models: A typical scenario in the airline industry is selling the flight tickets at premium or at concession rates. Generally, the demand for concession rate tickets comes much before the demand for premium rate tickets. This trend makes it necessary for organizations to decide on a ceiling on the number of seats that can be sold at a concession rate. Setting a high ceiling may result in the loss of premium customers and a low ceiling may result in idle inventory. To resolve this issue, airline industry players make use of a marginal revenue model, which is based on economics. Threshold curve: The threshold curve is constructed using past data available on seat bookings. A trend of bookings made in the past is collected and threshold curves are constructed keeping in mind the historical aggregate demand patterns. Once these curves have been constructed, the present booking trends are plotted against the forecast. Figure 1 shows the threshold curves plotted for estimating the demand for airline seats.
Adapted from Kimes, Sheryl E. Yield Management: A Tool for Capacity-Constrained Service Firms. Journal of Operations Management, Volume 8, Issue 4, October 1989, Pages 348-363.
Determinants of Service Quality A. Parasuraman, Valarie A. Zeithaml, and Leonard L. Berry have given a classification of certain factors that customers rely on to judge service quality. Table 1 summarizes these service quality determinants.
Adapted from Parasuraman A.; Valarie A. Zeithaml; and Leonard l. Berry. A Conceptual Model of Service Quality and its Implications for Further Research. Journal of Marketing. Vol. 49, Fall 1985, p41-50.
The major factors on which service quality depends are the service delivery process and the people who deliver the service. To control and improve service quality, it is necessary that the top management of service organizations designs the service quality standards keeping in mind the expectations of customers from that service. Once the service standards are set, it is the responsibility of the management to train the employees and equip them with the necessary knowledge, skills, and behavioral traits. The management of the organization should ensure that the employees understand what is expected of them, and are aware of the objectives, strategies, values, vision, and quality standards of the organization. The service organization should ensure that there is adequate publicity about the service and that the right message and information is communicated to customers. 153
The organization should ensure that it delivers whatever it has promised. It is very important for the organization to keep track of whether the customers feel that the service that they receive is as per their expectations. This is achieved by asking the customers to give suggestions and/or feedback regarding the service. Evaluating Service Quality Two important ways in which service quality can be evaluated are: By conducting a service quality audit: J.M. Juran defines service quality audit as an independent evaluation of service quality to determine its fitness for use and conformance to specification. By collecting customer feedback: A customer feedback system is used to gather information regarding customer satisfaction levels. These systems help the organization understand whether the customers are satisfied or dissatisfied in their transactions with the organization and also the satisfaction levels regarding each service that they have experienced. Six Sigma for Service Quality Six Sigma helps in increasing the effectiveness and efficiency of services by minimizing the defects, errors, and flaws in their processes. The Six Sigma strategy helps organizations to attain the desired levels of service performance (on an average) and to reduce the variability in the process. In the services setting, Six Sigma aims at understanding how defects arise and at developing improvements in the processes to minimize these defects. This ultimately results in increased customer satisfaction. P.D. Hinduja Hospital in the healthcare industry and Bank of America in the banking industry are some examples of service organizations that have implemented Six Sigma. Refer to Exhibit III for a discussion on the Six Sigma initiative of Bank of America.
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expectations from its services. Six Sigma was applied to enhance the usage of the computerized and electronic channels such as ATMs, telephone banking, and online banking by the customers. The basic idea was to reach the customers in a variety of ways. As a business approach, Six Sigma was applied to every aspect of BoAs operations and to the entire value chain of the company. Importance was given to the way the business was being done. An integrated business planning process was implemented that proved very effective for the company. Six Sigma helped BoA in analyzing business processes, identifying problems within them, increasing efficiency, and reducing the errors arising during the course of providing the services. Six Sigma was also used as a leadership philosophy to lead the entire organization toward the predetermined goals. BoA recruited senior Six Sigma professionals from General Electric, Honeywell1, and Motorola2 to help it to adapt to a culture of quality. Quality training was imparted by these professionals to the employees. Process engineering teams were set up to select the top business priorities that define customer delight/experience.
Adapted from Pushpanjali Mikkilineni and Sanjib Dutta. Case Study Six Sigma: A Tool to Increase Customer Satisfaction at Bank of America. The ICMR Center for Management Research, 2005. <www.icmrindia.org>.
Through Six Sigma, an organization can benefit both on the human resource and the operational fronts: On the human resource front: o o achievement of better cross-functional teamwork improvement in job satisfaction and in the morale of employees due to greater understanding of problem-solving methods. improvement in the quality of decisions as the decisions are based on facts rather than assumptions. fast service delivery due to minimization of steps which do not add value to the process minimization of costs incurred due to late delivery, complaints, etc. enhanced consistency of results due to reduced process variability.
Honeywell is a multinational conglomerate that produces a variety of consumer products, engineering services, and aerospace systems. It caters to private consumers and corporations. Source: <http://en.wikipedia.org/wiki/Honeywell> Motorola is a multinational communications company based in Illinois, Chicago. Source: <http://en.wikipedia.org/wiki/Motorola>
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Absence of a service person when a machine needs to be repaired Delay in the service delivery Faulty administration of service The service recovery process is one of the most significant processes in a service industry as it is during this process that customers are more focused on the way the organization treats them. The person who handles the service recovery process plays an important role in improving customer satisfaction. Service Failure and Customer Switching Customer switching (defection) occurs when an existing customer defects and becomes the customer of a competitor. Customer switching results in market share erosion and reduced profits. The absence of effective and timely service recovery is one of the important reasons for customer switching. As the cost of acquiring new customers is much higher than the cost of retaining existing customers, service organizations search for various alternatives to reduce the rate of customer switching. Keaveney identified eight different reasons relating to service failure on the part of service organizations that cause customers to switch to other service providers. Five of these reasons can be addressed by service recovery. They are: Core service failures Service encounter failures Price failures Inconvenience Employee response to service failures. The other three reasons are: attraction by competitors, ethical problems, and involuntary switching; these reasons cannot be addressed by service recovery.
Product focus / process focus Level of customization Back office focus/ front office focus Duration of customer contact Level of discretion
**
Relative throughput time Throughput time measured for a service transaction as compared to others in the industry.
Adapted from Schmenner, Roger W. Service Businesses and Productivity. Decision Sciences. Summer2004, Vol. 35 Issue 3, p333-347 and Olorunniwo, Festus and Maxwell K. Hsu. A Typology Analysis of Service Quality, Customer Satisfaction and Behavioral Intentions in Mass Services. Managing Service Quality. Volume: 16 Issue: 2; 2006.
lower responsiveness due to lower degree of variations. This issue can be handled by training the workforce in the required skills. Proper monitoring of customer feedback should be carried out to increase customer retention and customer loyalty. Service shops are characterized by a high degree of variation and lower relative throughput time. The issue in controlling the service shops generally focuses on reducing the variations through standardizing the services and trying to spread the overhead costs over a greater number of service units without compromising on the throughput time.
6. Summary
Service organizations differ from manufacturing organizations with regard to: intangibility, heterogeneity, inseparability, and perishability. A service blueprint is a map or a diagrammatic representation of the service delivery process, the associated tangible evidence, and the employees involved in the service delivery process. Service blueprinting is the process of designing the service blueprint. Capacity management deals with managing the demand and supply of services to the customers. It is an important aspect in managing service organizations as other factors like service quality and productivity are closely associated with it. Yield management, also known as revenue management, is a method which can help an organization sell the right inventory unit to the right type of customer, at the right time, and for the right price. Quality in service organizations primarily depends upon how a customer perceives what he/she gets and whether it meets his/her expectations. The three main components of service quality are physical facilities and processes, peoples actions, and professional opinion, which form the three Ps of service quality. Service recovery is a set of activities that an organization undertakes to rectify issues faced during delivery of the service. There are six dimensions that can be used to understand the differences between various types of service organizations -- equipment focus / people focus; product focus / process focus; level of customization; back office focus / front office focus; duration of customer contact; and level of discretion. Services are broadly classified into four categories -- service factory, service shop, mass services, and professional services -- based on the degree of variation and the relative throughput time. The dimension degree of variation has its implications for managing service quality; while the throughput time dimension is associated with the productivity aspect of the services. To simultaneously increase both productivity and service quality, managers may try to reduce both the relative throughput time and the degree of variation. 158
Concept Note - 12
Project Control
1. Introduction
A project can defined as a temporary endeavor undertaken, to create a unique product or service or a unique set of coordinated activities, with definite starting and finishing points, undertaken by an individual or organization to meet specific objectives within defined schedule, cost, and performance parameters. Project planning and execution are the basic business activities for project-based organizations. Manufacturing or service organizations take up projects to fulfill specific needs. Project-based organizations and other organizations can succeed in their businesses if they have the ability to identify viable projects and execute them successfully. This note will help you understand: The significance of project control in the successful execution of projects The use of project overview statement as the basis for control How to use project plan as the primary control mechanism The importance of organizing for project control How to control the execution of a project The concepts associated with overall change control The process of project auditing How to conserve and utilize resources in projects.
Technical/managerial competence, troubleshooting capabilities, and flexibility of the project personnel Project control systems, including (but not limited to) progress review, information systems, communication, and coordination mechanisms.
Refer to Exhibit I for details of the commercial failure of the Concorde project and Exhibit II for details of the implementation failure of a software project.
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Project Control
Contd
Too many things at the same time Apart from implementing ERP at the wrong time, Hershey made another mistake. It went for a simultaneous implementation of other enterprise applications like CRM. While the company was busy solving problems in its businesses, ERP and other applications were not fully implemented. When the regular business problems were solved and changes made in the business processes to go with the applications, the applications failed to function properly as the implementation was incomplete and as there was gap in the implementation process.
Adapted from Analyzing ERP Failures in Hershey, <http://www.erpwire.com/erparticles/failure-story-in-erp-process.htm>.
Project managers exercise control over the project team and others who are involved in various project functions. The purposes of project control are to plan and organize the project in order to achieve the effectiveness and efficiency objectives; to execute the project so that its performance is close to the plan; to suitably revise the project plan (when required); and to conserve and ensure proper utilization of resources (physical assets, finances, or human resources). Project control systems are required to have a check on the progress of the project in terms of time, cost, and quality of output. The cybernetic process in project control involves planning of control, assessing performance, and taking corrective actions; and plays a vital role in the overall project life cycle. Planning of control involves deciding on how, when, and what to monitor and control. Assessment involves evaluation of actual performance and comparison with planned performance. The task of taking corrective actions focuses on analyzing the reasons for the difference between actual and planned performance and applying corrective measures. Successful completion of a project depends on the ways in which problems are identified and immediately controlled or corrected. The control activity is required to keep a check on time, cost, and quality of output. It should not be viewed as a coercive tool, but should be thought of more as an activity that guides the project team toward goal-directed behavior.
successful project completion; the anticipated risks and hindrances that may have a significant impact on the projects progress and completion; and the assumptions involved. Project control requires that the concerned project stakeholders should agree on the project scope. After the agreement, the project overview statement provides the basis for effective project control during the later stages of project execution, and guides the project managers decision-making during project execution. However, it may not provide the level of detail required by the project team members. The project team can develop a detailed project definition statement that can be used as a standard reference by all the project team members. This statement will be aligned to the project overview statement so that it guides the project team members in the right direction during the project execution.
Project Control
members are answerable to the project manager and the departmental managers. This may lead to conflict between the project and functional managers as they have to share the same set of workers for their individual responsibilities. Each manager should try to prioritize his/her jobs and responsibilities to minimize such conflicts. Figure 1 depicts the typical reporting relationships in an organization dealing with construction projects. Figure 1: Typical Matrix Organization Structure
Adapted from Milosevic, Dragan Z. Organizing Project Control Systems. International Journal of Project Management. Vol. 5 Issue 2, May 1987, p76-79.
ii. Control tasks of the project control process are depicted on the left hand side of the chart. They are grouped according to the project stages to enhance clarity. iii. Symbols are used to show the relationship between units and control tasks. This can be done through relationship: category-task (RCT).
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Five types of RCTs are used to define roles in project control. Perform Task/RCT (PT/RCT) means the unit performs the control task. Approves Task Performance/RCT (ATP/RCT) means the unit is supervising the unit performing the control task and has to approve that particular task. General Supervision/RCT (GS/RCT) means the unit is supervising a unit performing ATP/RCT. Its role is to formulate the policy framework for the functioning of ATP/RCT and PT/RCT. The last two types of RCTs are Has to Be Consulted/RCT (HBC/RCT), where the HBC/RCT unit must be consulted by another unit which is performing some control task for inputs, and Has to Be Informed/RCT (HBI/RCT), where the HBI/RCT unit must be informed about certain things by another unit performing some control task.
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Project Control
Features Conducted to check whether the design of the product/service being produced is of the desired performance quality. Conducted to determine whether the processes are going on as planned and whether any improvements are possible. Objectives to preserve the project processes performances that are going on well, and to improve the processes that are below standard. Used for suggesting improvements (even if there is nothing wrong).
Process review
Cost Control Budgeting plays a vital role in project control. The budget should be planned as accurately as possible keeping in mind unforeseen events that may occur due to external factors. Contingency plans (as part of the budgeting process) along with cash flow management help in cost control. Contingency planning: Some amount is set aside in the budget to cover unplanned events. Contingency, however, is not meant to cover activities that involve project scope changes. Preparing a contingency rundown chart (plotting balance in the contingency fund against project period) may ensure that the contingency usage pattern does not deviate significantly from the plan. If the actual contingency rundown curve is above the planned contingency rundown curve, it is a good sign for the project as it means that the actual balance in the contingency fund is more than the planned balance. If the actual contingency usage curve is going below the planned contingency usage curve, the project is using contingencies at a faster rate than planned and may exhaust all contingencies before the project is completed. Therefore, the curve alerts the management to discrepancies in project execution. Cash flow management: The cash flow should be managed during the project. The project team should try to complete the project considering budget constraints. It should always have information about the amount of cash that has been used up and the balance left out for the particular period or particular activity. A cash flow tracking chart helps compare the actual expenditure with the original planned cash flow (Y axis) over the project duration (X axis), and also shows forecasted cash flow, thus estimating the projects final cost. Corrective actions can be taken if there is a considerable difference between actual and planned cash flow.
Project Control
the project duration will be extended or the project will be completed within the stipulated time by using more manpower.
2.
3.
4.
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5.
Calculating EV by multiplying the percentage completion of an activity with the budgeted cost. In other words, EV is the budgeted cost of work performed (BCWP). Calculating the performance metrics as follows: Schedule Variance (SV) = EV BCWS = BCWP BCWS Cost Variance (CV) = EV Actual Cost of Work Performed (ACWP) = BCWP ACWP Schedule Performance Index (SPI) =
6.
Illustration 1:
Given below are the details pertaining to a project at KL Constructions.
Particulars Rs. Million
Budgeted Cost of Work Performed Budgeted Cost of Work Scheduled Actual Cost of Work Performed Based on the given details, calculate the following metrics.
14 12 15
Schedule variance Cost variance Schedule performance index Cost performance index
Solution
Given that, Budgeted Cost of Work Performed (BCWP) = Rs. 14 million Budgeted Cost of Work Scheduled (BCWS) = Rs. 12 million Actual Cost of Work Performed (ACWP) = Rs. 15 million Schedule Variance (SV) = EV BCWS = BCWP BCWS = Rs. 14 million Rs. 12 million = Rs. 2 million Cost Variance (CV) = EV ACWP = BCWP ACWP = Rs. 14 million Rs. 15 million = Rs. 1 million (-)
Contd
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Project Control
Contd
Trouble reports
Emphasis is on the problems that have occurred or are anticipated. Critical problems are identified and highlighted. These reports should essentially be sent to the appropriate manager in time so that corrective actions can be taken at the earliest. 169
Reports
Description
Information is usually transmitted face-to-face or through the telephone. If the report contains important information, the oral communication is followed by a written document to provide a record. Immediate action is taken based on the seriousness of the problem. They compare the actual schedule and costs with the planned schedule and costs for the work done. These reports also contain similar comparisons for overhead activities that are not directly related to the work. Variances associated with costs, schedule delays, and similar factors are identified and measured quantitatively. Emphasis is on the amount of work already done and the amount of work to be carried out. Accurate reports of project costs must be prepared in case of a cost-reimbursement contract since it is the basis for later payments. These reports are not necessary if the project is a fixed-price contract. Maintenance of these reports provides a clear picture of the ways in which financial resources are utilized.
Progress reports
Financial reports
The reports are based on actual time compared to the scheduled time or actual cost compared to the budgeted cost. While interpreting the former, the top management raises the question whether more than estimated time was spent. But the analysis of the latter is somewhat different. If the proposed quality is maintained, the actual costs are compared with the budgeted cost. If the actual costs are less than the budgeted costs, quality might have suffered. So, the top management has to study all the reports individually.
Project Control
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Contd
Scope Change Description: Describe the change in sufficient detail so that others can understand the scope change request. Business Benefit: Why is the request being made? What is the benefit from a business perspective? Implications of Not Making the Change: Describe the consequences if the change is not made. Impact Analysis to the Project: Describe how the change would be incorporated into the project, as well as the impact on the project in terms of cost, effort, and duration. Alternatives: If there are any alternatives, note them here, along with their impact on cost, effort, and duration. Final Resolution: Briefly describe how the scope change was resolved. Approval from Sponsor for Final Resolution: Signifies that the Project Sponsor agrees to the resolution, including any budget, effort, and/or duration implications.
Adapted from <http://www.tenstep.com>.
A scope change control system defines the procedures by which the project scope can be changed such as paper work, tracking systems, and levels of approval necessary for authorizing the changes. Performance techniques like variance analysis, trend analysis, and earned value analysis help in assessing the magnitude of the variations that occur. The scope changes made to the already approved plans (technical plans, financial plans, etc.) are updated, and then all project stakeholders are informed of the changes. The causes of variances and the corrective actions taken are documented for future reference.
Project Control
Examine the changes that are requested by the project stakeholders, and determine the impact of these on the projects cost, schedule, and performance Explore alternate changes that could yield the same or a better output Accept or reject the proposed changes, communicate the changes to the parties involved, and incorporate the changes properly as per the plan Develop monthly reports detailing all the changes and their impact on the project.
Following guidelines are useful in designing an effective change control system. All project agreements should include a detailed report on how requests for a change in the plan, budget, schedule, or output of a project should be introduced and processed. A change order should be prepared which should include a description of the changes that are agreed upon, along with corresponding changes in the plan, budget, schedule, and output. An approval letter must be obtained, both from the clients agent and senior managements representative, on the changes to be implemented. The project manager should be consulted before finalizing the change order. But, his/her approval is not mandatory. Once the change order is approved, a master plan of the project should be made reflecting the changes and the change order becomes a part of the master plan.
An effective change management process contains two documents a requisition for change in a project and a project impact statement.
Requisition for change in a project: Every change requested by the client should be documented in the form of a simple memo or in the format prescribed by the project team. This will help the team evaluate the impact of the change on the project and to determine whether the change can be incorporated. Project impact statement: This is prepared after a requisition for change is made. It identifies various alternative actions along with the pros and cons of each. The client then chooses the best alternative. Following are the possible responses to a requisition for a change accommodating the change within the allocated resources and time schedule of the project; accommodating the change with an extension in the delivery schedule of the project; accommodating the change with additional resources and/or extension in delivery schedule; or implementing the change in a phased manner by way of prioritizing the output needed.
8. Project Auditing
Project auditing can be defined as the process of detailed inspection by the management of a project, its methodology, techniques, procedures, documents, properties, budgets, expenses, and level of completion. A project audit is a key step in the process of closing a project. It can be carried over for the whole project or for a part of it. The project auditors basic responsibility is to convey facts and while doing so must acknowledge the presence of the various kinds of biases of the people in the project. He/she should be aware of the limitations and should seek external help when certain audit aspects of the project are beyond his/her area of expertise. The gathered 173
information should be kept confidential till the official release of the audit report. He/she should not allow any political or technical pressures to influence the audit report.
General audit
Brief review of the project, carried out within a limited time period and with only a few resources. Usually touches on all the six dimensions of the auditing report, that is, the present status of the project, the future status, the status of the crucial tasks, assessing the risk, information relating to other projects, and the project limitations. Conducted as a follow-up to the general audit, and when an unacceptable level of risk has been discovered by the general audit. Depth depends on the seriousness of the issues and their impact on the project objectives. More serious the issue, greater will be the audit depth. Conducted when a detailed audit fails to evaluate the projects technical aspects satisfactorily because of the auditors lack of technical knowledge. The project auditor then employs a technically qualified individual to conduct the audit based on certain guidelines. If such individuals are not employees of the organization, they should be asked to sign a non-disclosure document to ensure confidentiality. It is generally conducted in a detailed manner.
Detailed audit
Technical audit
Project Control
adherence to schedule and budget is given more importance. Auditing at the end of the project life cycle is a value addition to the organization than to the project. During this stage, management concerns like disposing of equipment and reallocating personnel become key issues. Post project evaluation could be necessary for the following reasons: it is specified by the client in the agreement and is required legally; it constitutes a major part of the project report and is also the key information source for giving feedback to the parent organization; and it accounts for all the project assets and expenses as a part of project closure.
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Quality: The significance of quality as an evaluation factor depends on the nature of the project. Quality refers to all the features and characteristics of a product or service which bear on its ability to satisfy a stated or implied need. These needs, in terms of projects, are pre-specified characteristics. If detailed quality specifications are attached to a project, this part of the project status report should contain a detailed review of the quality control procedures, along with the latest results of the quality tests conducted. Future project status: This includes the project evaluators conclusions, the projects progress, and makes suggestions about the pending tasks. Audit report does not rewrite the existing project proposals, but provides guidance to future projects. Critical management issues: This section should address all the important issues that should be continuously monitored by the top management; should explain the link between the critical issues and the project objectives; and should briefly describe the time, cost, and performance trade-off. This helps the management to make decisions in future projects. Risk analysis: This section describes all the major risks involved in the project; discusses the impact of these risks on the projects time, cost, and performance. The report can recommend an alternative course of action for minimizing risks. Limitations and assumptions: This section can be included in the introduction or can be placed toward the end of the report. While the audit reports accuracy and timeliness depends on the project auditor, the top management is responsible for the interpretation and actions taken based on the information given in the report. Therefore, it is important to state the limitations of the audit reports validity.
Project Control
exercized through a series of analyses and audits. Project audits help in assessing the projects exact financial health, the projects output, the suitability of the technical approach, the accurateness of the project plan, and the practices being followed in the project.
10. Summary
The main purposes of project control are -- to plan and organize the project in order to achieve the objectives of effectiveness and efficiency; to execute the project so that its performance is as close as possible to the planned schedule, budget, and specifications; and to suitably revise the project plan, when required. The project overview statement describes what the goal of the project is and how it will be achieved. The approved project overview statement provides the basis for effective project control, and guides the project managers decision-making for planning, organizing, and executing the project. Project plan development includes schedule development, resource planning, cost estimation of each resource, and cost budgeting of activities. Preparation of the overall project plan also involves: establishing the quality standards and identifying the ways of ensuring quality assurance; planning for staff acquisition; identifying the roles, responsibilities, and reporting relationships among the project team members; determining the communication needs of different stakeholders and ways of addressing them; risk identification and evaluation; etc. Project-driven organizations usually adopt the matrix organization structure that combines the advantages of the pure functional organization structure and the product organization structure. In the project execution stage, the project manager should review the projects progress in a timely and phased manner in order to take corrective actions, if required. Project execution can be controlled using methods and tools like project review, cost monitoring and control, schedule control, Earned Value analysis, progress measurement, productivity measurement, and progress reporting. The projects course can deviate from the plan due to external or internal factors. These changes should be kept in view to control the projects cost. Change control systems, configuration management, and scope creep are three key concepts associated with overall change control.
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Overall change control also includes scope change control, schedule change control, and cost change control. A formal change control system can minimize the risks associated with change. Project audit involves detailed inspection of the management of a project, its methodology, techniques, procedures, documents, properties, budgets, expenses, and level of completion. Some of the important considerations in project auditing are the depth of the project audit, timing of the project audit, and the content and format of the project audit report. The project manager should at the same time, become a conservationist; and should conserve and properly utilize the organizations physical assets, its financial resources, and its human resources.
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Concept Note - 13
Description Functional/activity managers review of operational performance, reconciliation of records, etc. Include control activities to ensure that information regarding transactions is correct, complete, and authorized. Examples: Policy manuals, organograms, standard operating procedures, evidence of ongoing use of control systems. Dividing the duties (such as making a demand draft and checking/authorizing it in a bank) in the organization among employees to minimize errors intentional or unintentional. Include physical security of assets and periodic verification of the physical existence of assets as per the records. Data analysis to identify trends, deviations, etc., so that corrective action may be taken, if required. For coordination, problem solving, strategic planning and performance review, innovation, etc.
Documentation
Segregation of duties
Physical controls
Adapted from Internal Control Integrated Framework. Committee of Sponsoring Organizations of the Treadway Commission (COSO). 1994, <http://www.coso.org/publications/executive_summary_integrated_ framework.htm>; and Rittenberg, Larry E.; Frank Martens; and Charles E. Landes. Internal Control Guidance. Journal of Accountancy. Vol. 203 Issue 3, March 2007, p46-50.
Meetings Patrick Lencioni identified four types of meetings that will serve different purposes -the daily check-in, the weekly tactical, the monthly strategic, and the quarterly off-site review. According to him, conducting these meetings will help enhance decision making and reduce the time taken in the decision-making process. Table 2 gives the various types of meetings and their features. Table 2: Types of Meetings and their Features Type of Meeting Daily check-in Features Duration: 5-10 minutes Employees stand and discuss the tasks and activities they will handle that day. Clarifies the priorities to be set and how they have to be tackled. Reduces the time spent on scheduling daily activities. Held at a fixed place and time; should not be cancelled due to low attendance. Discussion should be restricted to the daily priorities of the activities.
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Features Duration: 45-90 minutes Conducted to discuss problems that need to be handled immediately; should avoid discussion of long-term decisions. Comprises three parts o Lightning round: Deals with everyone trying to bring out 2-3 of their most important priorities for the week Progress review: The team tries to compare the progress of activities with the specific critical metrics that have been decided by the organization. Real time agenda: The agenda of the tactical meeting is decided depending on the outcomes of the lightning round and the progress review.
Duration: Monthly 2 to 3 hours Conducted regularly to discuss key strategic issues that arise during the weekly tactical meetings. Key aspects (only 2 to 3) that may affect the business are discussed. Ad hoc strategic meetings should be called for to sort out exceptional strategic issues that require to be addressed urgently. The meetings agenda should be decided beforehand through thorough research and preparation on the topics to be discussed. Duration: Quarterly 1 to 2 days; conducted in a location away from office. Focus of this discussion is about the issues regarding long-term strategies, employees, teams, the industry, and the competitors. Less number of presentations and outside speakers. Avoid tourism spots as they may lead to distractions.
2.2 Communication
Information systems will not be effective without proper communication between the various management levels. Communication helps in passing on the information, work coordination, assigning of responsibilities, etc. Two types of communications take place in any organization internal communication and external communication. Internal Communication Meetings act as mechanisms of internal communication. Consistency/inconsistency of managements behavior with its formal communications (oral/written) is an important component of internal communication to employees. Employee orientation and
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socialization helps in spreading the organizations culture, and shared values to new and existing employees. Internal communication includes Informing the employees about the importance and functioning of the control systems, and the role each employee has to play within the control system Making the employees aware of problems that may arise and the ways to handle them Letting employees know how their activities affect the jobs of other employees Having both regular and exception reporting systems in place which will help employees report important business related information to the higher levels in the hierarchy Collecting and processing employee feedback and ideas related to business functions, products, continuous process improvement, etc. Ensuring proper, two-way communication between the management and the board of directors.
External Communication External communication includes communication with the suppliers, customers, external auditors, regulators, etc. Through such communication, customers can provide feedback about the quality of products and services, and external auditors and regulators can provide information about the effectiveness of the internal controls of the organization. Most business processes, these days, are being outsourced, to organizations located worldwide. Managers, who cannot be present at all the outsourced locations, face problems in controlling aspects like time and costs of the business. These issues can be solved by using various software and communication technologies. Refer to Exhibit I to understand the role of communications in an outsourcing relationship.
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Contd
Communication is carried out on a daily and regular basis through phone, e-mail, etc. Companies also conduct monthly or quarterly face-to-face meetings that deal with issues, problems, and progress of the project.
Adapted from Stacey L. Bell, Your Top 10 Outsourcing Problems Solved, October, 2006, <http://www.mpo-mag.com/articles/2006/10/your-top-10-outsourcing-problemssolved>.
Chief financial officer and Controller Management o Responsible for: o Devising budgets and other plans for the entire organization Monitoring performance on all fronts operational, financial, and compliance.
Departmental managers and managers for specific activities Number of hierarchical levels determine the degree of responsibility that each departmental or lower level manager has in implementing control policies and procedures Responsible for: o o o o Monitoring the effectiveness of controls in their specific departments and for specific activities Devising the departmental and functional controls. Finding discrepancies and other issues Communicating problems to the higher levels of management that will significantly affect the achievement of organizational objectives.
Board of Directors
The board members should have proper knowledge about the organizations operations and activities. Board members form different committees, which help them in the proper discharge of duties. They should be able to spend the time and effort needed to fulfill their responsibilities toward the organization. Responsible for: o o Governance, and supervising and directing the management of the organization Selecting the key members of the top management
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Internal Entity o o o
Functions Guiding the organization in making certain critical decisions regarding objectives and strategies Implementing appropriate controls by providing proper supervision Regularly communicating with all the important internal and external entities involved in the control process.
Internal Auditors
They should be in a position to contact the board whenever necessary, and also have the power and authority to suggest improvements when required. They should be appointed in such a way that there is no conflict of interest or bias involved regarding any of the functions or operations that they are auditing. Responsible for: o Evaluating the controls and suggesting improvements in them o Assessing whether the financial and operating information is reliable and the methods used for obtaining information are appropriate o Assessing whether the control systems conform to the set standards and regulations o Protecting the assets and ensuring proper utilization of resources o Assessing the operations to check whether the outcomes of the operations are matching with the set objectives of the organization. Each employee, within his/her role and responsibility, contributes to the control process. They need to accept accountability for reporting discrepancies, operational issues, non-conformance to the code of ethics, etc., to their supervisors or designated authorities. They should avoid resorting to unethical activities due to any coercion from their supervisors and should also be given the assurance that they will not be punished if they report such coercion.
Employees
In an interview, N R Narayana Murthy, the non executive chairman and chief mentor of Infosys Technologies Ltd., said, A great leader is one who is not only good in creating a vision, creating the big picture, but also ensuring that he goes into the nittygritty, into the details of making sure that the vision is actually translated into reality through excellence of execution. In other words, great leaders have great vision, great imagination, great ideas, but they also implement those ideas through hard work, commitment and flawless execution. In doing so, they motivate thousands of people.1
1
Source: The Renaissance Man, The Times of India, October 14, 2009. 185
External Auditors
Financial Analysts
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External Entity
Functions They provide information that helps organizations know how their performance is rated; the environmental risks that they may be subject to; and newer strategies that they may adopt to improve performance. This in turn helps it in improving the internal control process.
4. Challenges in Implementation
Control systems can be effective if they are designed and implemented appropriately. For technical control subsystems, a good control system design can reduce implementation problems to a great extent. For control components concerned with behavioral aspects, implementation problems often occur even if the design of the control system is good. Consistency of execution is important for the successful administration of MCS. The issues faced in implementation can be of two types: hindrances to the management control process, and dysfunctional consequences of implementing the management control system.
Delays in providing reasonably correct data required for management control Differences in the planning horizons of different functions can affect the control systems performance as it involves the combined efforts of the managers from various departments. Difficulty in assessing the total costs incurred in implementing the control system. Management override, that is, the illegitimate use of management authority to show that the organizations performance is better than it actually is or to bypass procedures and policies for personal gain. The issues of conflict of interest between the manager and the organization and the difficulty of monitoring can be explained in terms of the agency theory. Refer to Exhibit II for a description of agency theory.
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Contd
Difficulty in monitoring When the principal is not able to monitor the activities of the agent properly, he/she may not be in a position to compensate the agent appropriately. A condition called information asymmetry results when the principal does not have complete information about the agents contribution to the organizational outcomes. When there is a lack of monitoring, information on whether the activities are beneficial to the principal is available only to the agent. That is, the agent has more information regarding the activities than the principal and this information is called private information. This conflict of interest and private information leads to a moral hazard, that is, the agent attempts to misrepresent information to the principal.
Compiled from various sources.
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Lagging indicators of performance such as accounting profits or return on investment (ROI) may mislead the management in the short term, and may not be very useful for proactive management control. When different functions or divisions in the business are interdependent, optimization of performance of an individual function or division may not result in an optimal performance of the entire organization. If the control system holds managers responsible for achieving targets which are not in their control but are subject to significant influence of the environment, it reduces the credibility of the top management and the control system. Compared to good performance, bad performance of an employee or a team gets reported to the higher authority, usually faster. This kind of a feedback mechanism is biased against employees and may risk his/her future career prospects.
Direction phase
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Phase
Features It puts in place control systems for accounting, budgets, inventory management, etc. Departments are typically viewed as revenue centers or cost centers. Standard operating procedures and formal reward systems are devised and implemented. Communication becomes formal as introduced in the hierarchy. more levels are
Decision-making authority lies with the senior management team. As the organization grows, it becomes difficult to manage and control it due to the presence of many hierarchical levels and functional departments. This leads to dissatisfaction and frustration among the lower level managers and employees as they are not allowed to apply their expertise and take business decisions on their own. A decentralized structure is implemented, wherein the lower level managers are given the authority to take decisions and the responsibility for business growth. Direct communication between the top-management and the lower levels decreases and takes place via occasional site visits, circulars, etc. The top management also restricts its decision-making responsibility to strategically important decisions. The organization tries to increase motivation levels by introducing the concept of profit centers and by giving incentives. Greater autonomy and higher incentives motivate managers to perform well. Internal control and reporting systems help monitor the activities of lower level managers. Issues arise when the managers fail to comply with the plans and budgets of the organization, and choose to use their own discretion in decision making. The top management perceives a loss of control and tries to restore the centralized structure, which is actually difficult to do. Rather, the management needs to implement suitable coordination mechanisms to align the behavior of line managers toward organizational objectives. It involves an extensive use of formal monitoring and control systems, which are created and implemented by the top management. The functional or geographical organization structure is changed to form a divisional or product based structure. 191
Coordination phase
Phase
Features Planning processes become more formalized and are thoroughly evaluated. The staff functions are strengthened to closely monitor the activities and outcomes of line managers. Decisions regarding investments are thoroughly evaluated by headquarters. Divisions are considered to be investment centers and resource allocation is done considering the return that each center generates on the investment made. Strategically important activities and decisions are centralized while day-to-day operating decisions are decentralized. Incentive systems are revamped to emphasize organizational performance rather than mere individual performance. Coordination mechanisms help in improving resource allocation between the different units. Managers are expected to take decisions that comply with the rules and processes of the organization, which could lead to the problem of goal displacement. Managers and employees tend to resent the increased number of rules and regulations that have to be followed. Conflicts often occur between the members of line and staff functions. Presence of a large number of standard procedures to be followed hampers the innovativeness of employees. Competitive position of the organization may be weakened due to rigid internal processes. Increased levels of collaboration between the line and staff functions Emphasis on social controls and self-discipline rather than formal control mechanisms Organizations may further change their structure from a divisional structure to a matrix structure. Focus on creating interdisciplinary teams that comprise members from both line and staff functions Employees are trained to work in cross-functional teams and manage conflicts constructively. Integrated information systems are put in place to enhance day-to-day decision making. Incentive systems are modified to reward team efforts rather than individual accomplishments. The overall atmosphere of collaboration fosters innovation.
6. Summary
Management control systems may not always be effective, either in terms of design or in terms of implementation. Management control systems merely increase the probability of achievement of organizational objectives of effectiveness, efficiency, accuracy of financial reporting, and compliance. Management controls should be integrated or in-built into the organizations activities. These will influence the organizations capability to achieve its objectives and also help in improving the quality of its business operations. According to the COSO framework, management control has five components -control environment, risk assessment, control activities, information and communication, and monitoring the control system. Control activities refer to the policies and procedures used in an organization to provide a reasonable assurance that the directions and instructions given by the management are followed appropriately. These activities differ depending on the 193
business environment, organizational objectives, complexity in business operations, the people involved in the implementation of these activities, and organizational structure and culture. Conducting meetings helps in improving decision making and in reducing the time taken for the decision-making process. The daily check-in, the weekly tactical, the monthly strategic, and the quarterly off-site review are the four different types of meetings. Communication is not only required to pass on the information but is also necessary for coordination of work, assigning responsibilities, etc. Internal communication and external communication takes place in any organization. Management controls are designed in such a way that the control activities involved are monitored on a continuous basis or separately. This helps the organization by offering feedback on whether the control components are effective or ineffective. The most important factor while implementing control systems is that the organizations should have proper processes in place to identify, communicate, follow up, and rectify discrepancies (if any) in the set plans and objectives. Management control is implemented by a number of people both internal and external to the organization. The entities internal to the organization are the management, the board of directors, the internal auditors, and most of the employees; the entities external to the organization include external auditors, regulatory bodies, customers, suppliers, and financial analysts. The issues faced in implementation can be those which hinder the management control process or dysfunctional consequences of implementing the MCS. Some issues that hinder the management control process are: lack of proper organizational structure, management style, well-defined hierarchy, etc.; lack of proper person-job and person-reward fit; deficiencies in training and developing employees; collusion between the controlled person and the controlling person; illegitimate use of management authority; and lack of proper communication. The implementation and administration of MCS can lead to consequences that are counterproductive to the achievement of organizational objectives. Some dysfunctional consequences of management control systems are excessive quantification and attempt to measure all possible measures, presence of standard operating procedures curbing innovation, and data manipulation. Organizations usually go through five phases of development and growth the creativity phase, the direction phase, the decentralization phase, the coordination phase, and the collaboration phase in their life cycle. The control requirements change depending on which stage of its life cycle the organization is in. In addition to organizational growth, decline, or turnaround, change can also take place when an existing control system used by an organization is modified or a new control system is implemented.
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