Notes
Program Name- MBA
Course Name- Managerial Control System Sem- IV
Unit Number- 02 Unit Name- Management Control Structure & Process
Topic Name- Management Control Structure & Process
Introduction
• The main focus of responsibility accounting lies on the responsibility centres.
• A responsibility centre is a sub unit of an organization under the control of a manager
who is held responsible for the activities of that centre.
• It is like a small business to achieve the objectives of a large organisation
Content
1. Cost Centre
o A cost or expense centre is a segment of an organisation in which the managers
are held responsible for the cost incurred in that segment but not for revenues.
o According to CIMA, London a cost centre is “a location person or equipment ,
for which costs maybe ascertained and used for purposes of cost control”
o Responsibility in a cost centre is restricted to cost.
o For planning purposes, the budget estimates are cost estimates; for control
purposes, performance evaluation is guided by a cost variance equal to the
difference between the actual and budgeted costs for a given period.
o Cost centre managers have control over some or all of the costs in their segment
of business, but not over revenues.
o In manufacturing organisations, the production and service departments are
classified as cost centre. Also, a marketing department, a sales region or a single
sales representative can be defined as a cost centre.
o Cost centre may vary in size from a small department with a few employees to
an entire manufacturing plant. In addition, cost centres may exist within other
cost centres.
o E.g. accounting department, repairs & maintenance department
2. Revenue Centre
o It is a segment of the organisation which is primarily responsible for generating
sales revenue.
o A revenue centre manager does not possess control over cost, investment in
assets, but usually has control over some of the expense of the marketing
department.
o The revenue centre manager will control the selling price, promotion mix and
product mix
o The performance of a revenue centre is evaluated by comparing the actual
revenue with budgeted revenue, and actual marketing expenses with budgeted
marketing expenses.
o E.g. sales department
3. Profit Centre
o Also called business centre
o It is a segment of an organisation whose manager is responsible for both
revenues and costs.
o In a profit centre, the manager has the responsibility and the authority to make
decisions that affect both costs and revenues (and thus profits) for the
department or division.
o The managers are encouraged to act as if they were running their own separate
business
o The main purpose of a profit centre is to maximise profit by making decisions
relating to production volume, product mix, selling price, marketing strategy.
o Profit centre managers aim at both the production and marketing of a product.
4. Investment Centre
o It is responsible for both profits and investments.
o The investment centre manager has control over revenues, expenses and the
amounts invested in the centre’s assets.
o He also formulates the credit policy which has a direct influence on debt
collection, and the inventory policy which determines the investment in
inventory.
o The manager of an investment centre has more authority and responsibility than
the manager of either a cost centre or a profit centre.
Concept of transfer pricing
Transfer price means a price at which a unit or branch or subsidiary company of an entity located
in one country provides goods or services to a unit or branches or subsidiary company of the
same entity located in other country.
The transfer price includes transactions not only between units, branches or subsidiary company
of an entity but also includes transactions with any associated unit, branches or subsidiary
company of the same entity.
The associated entity, unit, branches, subsidiary companies are those directly or indirectly
controlled by an entity.
In the example above, Chinese unit needs to record the transaction as sell at a transfer price. The
European unit will record the procurement of these goods at a transfer price.
For an entity as whole it is internal transactions. However, an entity needs to develop a policy for
transfer pricing considering the various issues.
Transfer prices affect profitability of different units or subsidiaries but it does not have an impact
on the overall profitability of an entity.
Methods of Transfer Pricing
An entity needs to define the method by which goods or services between multinational units will
be transacted. OECD has suggested Arm’s Length Principle method for taxation purpose as a
transfer price method.
Other ways of arriving at transfer price are:
Transfer Prices decided by Market Rate: This method is similar to the Arm’s Length Principle.
Under this method the price of goods or services supplied are charged as per market rate. It also
resolves various issues related to transfer pricing. If the goods or services are not supplied by a
multinational unit of an entity, the other unit of an entity is forced to procure it from the open
market. Hence, the final price of the product should include the actual cost
decided by the market.
The product or services supplied in inter-units are required to be available in the market of the
similar quality and features. These prices actually evaluate the profitability and viability of units
in real market situation.
However, sometimes it becomes very difficult to identify the similar product or services as
provided by one multinational unit to other. Also market price includes various types of cost, i.e.,
risk of bad debts, marketing cost, etc. which is not required for inter-unit transactions.
Negotiated Prices: The transfer prices are decided as per negotiation between the multinational
units of an entity. Under this method the supplying unit calculates the prices to be charged
considering the total cost and profit margin which needs to be accepted by the purchasing unit.
However, for the supplying unit it is not possible to charge the profit margin because the
negotiated price may also result into providing the products or services at cost or even lower than
that. If these negotiations are taking place independently without interference of an entity then
prices could be decided as per the Arm’s Length Principle.
Transfer Price based on Variable Cost: Under this method price is determined as total of
variable cost required to manufacture goods or required to generate service for a multinational
unit. The multinational unit or branch is established by an entity to manufacture particular types
of goods or to generate particular types of services in a specific location. These units do not
perform any other operations and are established to take the advantage of low cost availability of
raw materials or low cost availability of labours. Hence, the cost which varies by setting up unit
at a specific location should charge price based on these variable cost.
Transfer Price based on Standard Cost: Under the Standard Cost method an entity itself
determines the transfer price for every location and also sets the transfer price based on this
standard cost for various international transactions. This standard cost may be calculated on the
basis of historical cost if the unit is running for a number of years at a particular location.
Otherwise, an entity will gather the standard cost of similar type of products or services at
a specific location and will accept it as a Standard Cost. Standard Cost is useful for an entity as a
whole as the various cost components for price calculations are determined even before
transacting the same.
This method does not provide any type of motivation to the leaders of the unit to evaluate and
present their performance. The actual cost may differ significantly in various economic situation
of a specific location.
Transfer Price based on Actual Cost: The unit may calculate all the cost required to
manufacture goods or to generate services and the total cost will be charged as transfer price.
Under this method the fixed cost involved in the operations will also get considered. This method
also reflects the efficiency or inefficiency of the multinational unit or branch as the cost may get
compared with the market rate of similar product. If the total cost of manufacturing goods or
generating services is less than that of market price it will add contribution in the profit of an
entity. As a result, the performance of the branch or unit is also evaluated on the basis of cost
savings in the market price.
However, accumulation of total cost has its own demerits. It depends upon the absorption rate for
various costs which may not be acceptable for the unit to which goods or services are supplied.
Also it does not provide additional incentives to a branch in the form of profit.
Profit plus Method: To avoid the demerits of transfer price on actual cost basis, an entity can
adopt profit plus method, commonly known as cost plus pricing. Under this method, a prescribed
percentage of profit margin is added in the total cost of manufacturing goods or generating
services. An entity can decide the rate of margin for various multinational locations. This also
helps in deciding the final selling price of the product and percentage of profit involved in it. The
transfer price calculated by this method can be compared with market
price of similar product to evaluate the unit performance.
Budgetary Control
Management functions include Planning, Directing, Coordinating and Controlling. Budget is one
of the techniques of planning and controlling.
Budget is a step of establishing a plan, which is a very first step in the process of controlling.
a) Budget:
The chartered Institute of Management Accountants (CIMA) UK has defined budget as “A plan
quantified in monetary terms prepared and approved prior to a defined period of time, usually
showing planned income to be generated and/or, expenditure to be incurred during the period and
the capital to be employed to attain a given objective.”
According to Brown and Howard, “A budget is a pre-determined statement of management policy
during a given period which provides a standard for comparison with the results actually
achieved.”
b) Characteristics of Budget:
From the above definitions, the following points are understood:
1. A budget is a planning and controlling activity.
2. A budget is expressed in quantitative terms.
3. A budget is prepared for definite future period.
4. A budget aims at framing plans and policies for achieving
predetermined goals and objectives.
Budgets are classified as follows.
c) Budgetary Control
Budgetary control is a controlling process, which involves certain steps.
(These steps are similar to those we have seen in the process of control.)
1. Establishment of Budget for each function/ department
2. Measurement of actual performance
3. Comparison of Budget v/s Actual performance
4. Deriving the variances, which may be positive or negative
5. Finding out the causes of variances
6. Taking corrective actions, if required
d) Advantages of Budgetary Control
1. Budgetary control helps in effective and efficient planning.
2. Budgetary control facilitates effective coordination among various departments.
3. It helps in maximising profit through careful planning and controlling.
4. It provides standard for comparison and finding out the variances.
5. Budgetary control gives a definite objective, which gives direction to the management and
employees about where they have to reach.
6. A budgetary control helps in assigning duties and responsibilities.
7. It reduces wastage by providing proper objectives.
8. A budget gives motivation to attain given goals.
e) Principles of Effective Budgetary Control
The principle means the guidelines. Here are some of them, which help in making budgets more
meaningful or effective.
1. For the preparation of an effective budget, participation of all employees concerned is
necessary.
2. An effective budget cannot be prepared without the strong support from top management.
3. Reasonable goals setting is a very important activity, as unreasonable goals lead to confusion
and waste of time and costs.
4. A good budget should be flexible in control.
5. A budget should always be prepared in time.
f) Limitations of budgetary control:
1. Budget is prepared based on past records, which may lead to establishment of outdated
standards.
2. Budget once prepared cannot be changed. Thus, it’s a rigid activity.
3. Budget is a result of Quality of Information; wrong information leads to wrong budget.
4. Opposition from staff, as it is a time consuming activity.
5. Preparation of budget needs expert knowledge. Hence, it is an expensive activity.
Summary
• Responsibility centers defines the person or department responsible for certain business
activity
• Transfer price is a price between two or more units or subsidiaries of an entity located in
various country locations.
• Transfer price affects individual unit’s profitability but does not affect the overall
profitability of an entity.
Self assessment questions
1. Define responsibility accounting with examples
2. Elaborate types of responsibility centers
3. What is transfer price? Discuss the various issues related to transfer pricing.
4. Explain the various methods of arriving at transfer prices.
5. Write a note on budgeting