Management Control Systems

BASICS OF MANAGEMENT CONTROL SYSTEMS

 Management Control System consist of three words – Management , Control and

System

Management as we all know is a process of planning, organizing, leading and controlling the
resources of an organization in effective and efficient manner. This process has to be carried
out for survival, success and prosperity of the organization for which management is
accountable.

Exercising control ensures actual performances conform to predetermined results. Control

involves measurement of performance, identification of deviations, initiating course
corrective actions to rectify deviations.

System is a group of elements working together in an integrated and coordinated manner in

order to achieve synergy. System is association of parts that are related to each other.
Control is therefore integral part of entire system. The concept of system is very relevant
from MCS point of view as managers are required to convert the disorganized resources of
men machines and money into a useful, effective and productive use with the help of
systems developed in the organization.

 Definition –

It’s a framework / set up by which the manager ensures the control over the actions of his
subordinates as well as control over the whole operations. Management control implies the
measurement of accomplishment against the standards and the correlation of deviations to assure
attainment of objectives according to plans.

It is the process by which managers assures that resources are obtained and used effectively and
efficiently.

It is a systematic effort by business managers to compare performance to predetermined standards,

plans and objectives in order to determine whether the actual performance is in line with standard in
order to take any remedial action if required.

It is a process of evaluating, monitoring and controlling the various sub units of the organization so
that there is effective and efficient allocation of resources.

MCS is the control exercised by management over its managers through proper systems.

 Meaning –

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It’s a System in a prescribed way. They are activities which are of repetitive nature. It’s a function
of implementation of strategies.

It’s a process by which managers influences other members to implement the organization’s
strategies”. There is also a difference between task control / operational control and management
control. Task / operational control are the process of assuring that specified tasks / operations are
carried out effectively and efficiently. Task/operational controls - scientific where as management
control - never be scientific.

 MCS activities –

1. Planning - what the org should do

2. Coordinating the activities of several parts of org.

3. Communicating the information

4. Evaluating the information

5. Deciding about , any rectification needs to be taken

6. Influencing people to change their behavior

7. Reporting to management – should be need based, summarized in nature, highlight the

weaker areas, may need external information, frequency and promptness, accuracy,
comparison and consistency, simplicity and reliability

 MCS - can be made operative through –

1. Periodic reports ( MIS )

2. Occasional reports ( special reports / special audit )

3. Continuous basis ( MCS )

 Characteristics of MCS –

1. Ongoing process

2. Goal orientation

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3. Goal Congruence – it implies integrating personal goal and organizational goals, or at

least minimizing conflict between these two.

4. Universality

5. Financial structuring

6. Central coordinating agency

 MCS has four elements –

1. Detector / Sensor – identifies as to what is actually happening in the entire process to be

controlled

2. An assessor – who determines the significance of what is happening and finds the difference
in actual happening and what it should be

3. Effectors – who alters the behavior if assessor identifies the deviation. This is also known as
feedback

4. Communication network – Transmits the information between detector and assessor

 MCS consists of following steps:

1. Classification of company into responsibility centers

2. Strategic planning

3. Budget preparations and fixing responsibilities

4. Analysis of financial reports

5. Performance reporting and appraisal ( PA)

6. Management compensation linked to PA

7. Real time control by management

 Management exercised Control on –

1. Overall company performance

a. Financial performance , monthly profit and loss statement

b. Company budget performance

c. Progress of capex

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d. Company performance compared to industry

2. Sales and marketing Performance

a. Sales invoice ( actual / forecast )

b. Order booking / backlog

c. Profit margin ( actual / forecast )

d. Sales expenses ( actual / budgeted )

3. Production performance

a. Actual shop floor output v/s planned output

b. Plant utilization capacity

c. Scrap report / wastages normal abnormal

d. Spoilages / defectives

e. Overtime / labour turnover

4. Material / inventory status

a. Actual v/c planned levels of stocks

b. Work In Progress

c. Major purchase orders placed / pending

d. Purchase costs actual / budgeted

e. Rejections during purchases

5. Personnel performance

a. Plant wise / category wise personnel status report

b. New recruits / requisitions

c. Staff turnover / absenteeism / promotions

d. Training / development / learning curve

6. Financial and cost performance

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a. Overall profitability ( ROI / ROA / EVA )

b. Cost over / under runs – Budgetary control

c. Variance analysis

d. Capitalization – over/under

 Prerequisites of MCS

1. Control requires plans

2. Clear cut , well defined organization structure

3. Involvement of top management

4. Employee motivation

5. Effective communication

6. Supporting accounting systems and MIS

 Management control and Operational control

Control is one of the fundamental management functions which follow other functions. By
forcing events to happen, control becomes connected with planning and has some
characteristics of unity, continuity and feasibility.

Control comprises of all methods and measures adopted by all groups to ensure happening
of an event as per plan and in a manner desired by management.

Control can be established at management as well as operational level. Operational control

is more concerned with the activities and thus the focus is on individual performance.

While management control is continuous process of verifying whether actions are being
taken as per plan to ensure desired objectives are being achieved, operation control is
process of assuring that the specific tasks are carried out effectively. So the focus is entirely
on operations / activities / tasks

So management control can be said to function at higher level where as operation control
can be said to function at operating / lower level.

 Griesenger’s Cybernetics Paradigm

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Cybernetics is the word derived from German word Kybernetes which means steersman. It
is defined as how systems regulate themselves. The main concern lies in negative feedback
given by network system. Particular version is developed by Griesenger in 1979. The model
works like -

1. Uses four basic elements – Detector / sensor, Assessor, Effectors and communication
network

2. Draw a diagram of “Cybernetic Paradigm” – Feed back is received from environment

and sensors – perception of feedback( factual premises) – compared with goals ( value
premises ) - If Gap exists – effectors has to play a role – again process of feedback
starts.

3. Every responsibility center operates in an environment – which may be internal or

external.

4. Responsibility center should be responsive to changes in environment or changes in

organizational goals , strategies etc

5. Manager scans the environment formally or informally and obtain the information

6. Manager then analyses the information and forms certain beliefs, these are known as
factual beliefs. Actual information is value beliefs

7. If gap exists in factual and value beliefs, the research process starts to find out reasons
causes behind this.

8. The search is activated to find out alternate course of action – such that it eliminates the
gap.

9. Search process continues till the gap is reduced to minimum.

10. Once gap is eliminated the performance is measured and checked once again

11. Feedback follow up process continues throughout.

System is association of parts that are related to each other. Control system design is the
process of designing parts of the system so that the purpose of the system is attained. MCS
requires interrelated communication structure. This structure enables information
processing. Communication network links different units of an organization. These units
have autonomy in decision making. Because of this heart of cybernetic system is feedback.
Feedback can be positive or negative. Negative feedback will prompt managers to make
behavioral change. Positive feedback indicates that current system is to be persisted with.

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Process begins from the stage of setting the goals. Goals are set through interaction of
subordinates and superiors. System requires that performance is regularly measured on the
basis of performance measurement system. Next logical step is to compute variance. Then
the appropriate corrective action should follow for adverse variance.

TOPIC 2

RESPONSIBILITY CENTERS

 Meaning - Responsibility Centers

For simplicity organization gets divided into various departments and each department is headed by
the departmental head, which is responsible for all functions carried out in that department.
Responsibility accounting is the result of decentralization and delegation of authority and
accountability.

Responsibility center is an organization unit that is headed by a manager who is responsible for all
activities occur in that unit. A decentralized company is therefore a collection of responsibility
centers. For managing director or board of directors, entire company is responsibility center.

Responsibility center is an area of responsibility of a concerned delegated to and controlled by

an individual who is accountable to his higher authority for such responsibility.

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Responsibility center is a segment of a concern over which a manager exercises responsibility and
he in turn is accountable for all activities in that center. Hence in every responsibility center there
must be some identifiable responsibility for cost or revenue

Responsibility centre may be a cost centre, profit centre, investment centre or different combination
of these.

 Responsibility centre can be of following types –

1. Cost Centre

2. Revenue centre

3. Profit Centre

4. Contribution Centre

5. Investment centre

Cost / expenses centre – These are responsibility centers for which inputs or expenses are
measured in terms of monetary terms but the output can not be measured in monetary terms.
There are two types of cost / expenses centre – 1. Engineered costs and 2. Discretionary
costs.

In Engineered cost centers the input costs can be measured with the great degree of
certainty. In production department the cost of input for a desired output can be calculated
and the optimum relationship between the input and output can be established. This means
that one can know the cost of production. Direct costs such as raw material, labour,
components, supplies and utilities are engineered cost. Discretionary costs, on the other
hand are those costs, for which no such engineered estimates are possible. Management
based on their judgment incurs these costs. Under these, costs output cannot be measured in
monetary terms. For example, administrative cost, support units costs, expenses incurred on
R&D, etc.

Cost center is also known as expense center, where only inputs are measured in monetary
terms. Responsibility under this center is restricted only for costs incurred. Output of cost
center is not measured in monetary terms since services rendered by such centers are un
measurable in money terms. Performance of manager under cost center is evaluated by costs
incurred with budgeted costs.

In Revenue centre, outputs are measured in monetary terms, but no formal attempt is made
to relate inputs to outputs. For example, marketing dept - performance is measured in terms
of achievement of target sales. Responsibility of revenue centre is restricted to accumulation

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of revenue only. Main responsibility of revenue center is generating more and more revenue.
Focus therefore is on more and more order booking. These centers do not have authority to
set the selling prices of the products that they sale. Head office decides the prices of the
products.

In Profit centre, performance is measured in terms of profits made. Production and selling
is combined in one unit. Profit means excess of revenue over costs. It is a segment of an
organization in which both cost and revenue are measured in terms of monetary units. In this
center inputs are taken as costs and output are taken as revenue. Manager is held responsible
for both costs and revenues earned. So generally the head of particular SBU is held
responsible for that SBU as a profit center.

Investment centre is a profit centre whose performance is measured by its return on capital
employed. The main object of this centre is to see that maximum return is earned on the
investment made. Investment center is a responsibility level of an organization where the
manager is concerned not only with cost management and revenue generation but also held
responsible for investment in asset used by the center. So manager here holds more authority
and responsibility as compare to that of cost or revenue center. Performance of investment
center is measured in terms of ROI of each center

TOPIC 3

PERFORMANCE EVALUATION TOOLS

Certain measures to evaluate the performances are-

1. ROI ( Return On Investment )

2. ROA ( Return On Assets )

3. MVA ( Market Value Added )

4. EVA ( Economic Value Added )

5. Du pont analysis

 Return On Investment –

ROI provides a suitable measure for assessment of profitability.

Under ROI, there are 3 different concepts of investments – viz. Total assets, capital employed and
shareholders equity.

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One method to calculate ROI is - ROA (Return on Assets) - Here the profitability ratio is calculated
in terms of relationship between net profits and total assets

Formula is ROA = PAT / Total assets

Another method of calculating ROI is ROCE (Return on capital employed)

Formula is ROCE = EBIT / Cap Employed

ROCE = PAT + Interest ( 1-tax rate ) / Capital Employed

Or = PAT / Sales * Sales / Capital employed

 Advantages of ROI

1. It is easy to calculate, and easy to understand

2. It is a comprehensive measure because anything that affects financial statements is

reflected in this ratio.

3. It being a common denominator it can be applied to organizations of any size.

 Limitations of ROI

1. Problem with investment base – There are operational problems regarding the different
practices being followed to measure the investments.

2. Problem with earnings –Problem arises about the allocation of common, corporate expenses
among various divisions, share of research and development expenses etc.

3. Major point of limitation of ROI is that it misguides the top management with divisional
ROI concept. For example, in a company with over all ROI as 12 % there are two divisions
–A and B. Division A is earning profit of 15 % on investment of 100 , Division B is earning
profit of 10% on investment of 100. Division A is having now, an opportunity to invest
another 30 lacs with earning capacity of 14 %. Division B has opportunity to invest 30 lacs
but the earning capacity of 11%. Now here the Division A is likely to reject the investment
proposal of earning 14 % return just because its present earning is 15 % which is more than

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the expected 14%. However this opportunity is desirable from over all company points of
view. Where as Division B is likely to go ahead with the proposal since its expected
earnings are more than what they are earning today. But this opportunity perhaps is not
desirable from over all points of view.

 MVA and EVA

Valuation implies task of estimating the worth or value of an asset, a security or a business

It is the price that an investor or buyer is willing to pay to purchase the specific asset, security or
business. Obviously two different buyers may not have same valuation for an asset as their
perception may vary. Before understanding the concept of MVA, and EVA we need to understand
first the various concepts under the term ‘value’ –

1. Book Value

2. Market Value

3. Intrinsic value

4. Replacement value

5. Salvage value

6. Fair value

Book value as the name indicates, is the value appearing in books of accounts and does not indicate
the sale value

In contrast to book value, market value shows the price at which an asset can be sold in the market.
Obviously market value can be determined in case of tangible asset only. Market value of business
refers to aggregate market value of all equity shares. The market value is applicable to listed
companies only

Intrinsic value of asset is equal to present value of incremental future cash inflows likely to accrue
due to acquisition of asset, discounted at appropriate rate of interest. It represents the maximum
price the buyer would be willing to pay for such an asset

Replacement value is the cost of acquiring the new asset of equal utility and usefulness.

Salvage value represents the realizable value or scrap value on the disposal of asset after expiry of
its normal life

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Fair value is the average of book value, market value and intrinsic value.

 Concept of Value added –

Value added is a basic and important measurement to judge the performance of an enterprise. It
indicates the net value or wealth created by the manufacturer during the specified period.
Investment made in an enterprise comprises the investment by shareholders, debenture holders,
creditors, financial institutions; if such investment does not create wealth (value added) it means
that it is misuse of public funds.

Excess of income (turnover) over the cost of bought out items, services is termed as Gross Value
Added and annual charge of depreciation is deducted from gross value added to arrive at Net Value
Added

Value added is shared by three contributing members – 1) Employees, 2) government 3) Providers

of capital (lenders and shareholders)

Government provides the infrastructure facilities and hence share of value added has also to be
given to government in the form of taxes levies

Part of value added is retained in the business as reserves. (– Ref Book – Financial management by
Ravi Kishor page 209)

 EVA – Economic Value Added – Goal of FM is to maximize the shareholders value /

wealth. Shareholders wealth is measured by Returns they receive on their investment. The
returns are in two parts -1. In the form of dividends and 2. Capital appreciation reflected in
the market of their shares.

The market value - influenced by no of factors, one of the major factors is expectation of
shareholders regarding the return on their investment. For this, various measures like ROCE, ROI,
EPS, NP margin etc have been used to evaluate the performance

EVA is modified version of residual income (RI). Residual income is - net income less imputed
interest charge on capital employed. Therefore, a positive RI indicates that the required ROCE has
been exceeded It indicates clearly whether goal congruence has been achieved. For example, if a
division is earning a net income of 4 lacs on a investment of 20 lacs and company’s required rate of
return is 16 %, then, RI is calculated as-

Net Income 400000

Less imputed interest @ 16 % on 20 lacs 320000

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Residual Income / EVA 80000

That means, division is earning in excess of the required rate since the RI shows the positive value
of 80,000 ( 4 % in excess of 16 % )

Economic value added is the amount in rupees that remains after deducting the implied interest
charge from operating income. Implied interest charge reflects the opportunity cost EVA is
essentially the surplus left after making an appropriate charge for the capital employed.

Shareholders expect a minimum return of say 12% on their investment; they do not begin to make
money until profits rise above that.

Peter drucker has said – what we call profits is usually not at all profit, until a business returns a
profit greater than cost of capital – it operates at loss. Conventional profit accounts for interest
charge on debt but do not have provision at all for cost of equity capital.

If EVA is used as a tool to decide on the basis of which investment decisions are to be made then,
investments which produces a profit that is more than the cost of capital are to be made. Thus
positive EVA project attract investors.

EVA may be calculated in one of the following way-

1. NOPAT – ( WACC * Economic Book value of capital employed)

2. Economic book value of capital employed ( ROI – WACC )

ROI is to be calculated based on NOPAT / Capital Employed

3. [ PAT + Interest ( 1-tax rate ) ] - ( WACC * Economic Book Value of capital employed )

4. PAT – ( cost of equity * equity employed )

There are 3 components of EVA

1. NOPAT

NOPAT = PAT + [INT ( 1-tax rate )] Or = EBIT ( 1- tax rate )

2. Cost of capital - Providers of capital that is shareholders and lenders should be suitably
compensated for investing their capital in the firm, so cost of capital represents WACC in
post tax terms

3. Capital employed

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Excess of returns (ROI) over cost of capital (WACC) is termed as EVA. It measures whether
operating profits are sufficient to cover cost of capital. Company must earn sufficient returns for the
risk taken by its shareholders. Returns have to be more than the cost to justify the risk taken by the
owners. If EVA is negative, firm is destroying shareholders wealth,

Under calculation of EVA, we consider operating profit after taxes. Since WACC takes care of
financial costs of all sources of funds (including debt), it is imperative that Operating profit after
taxes that is NOPAT (and not PAT) is considered for calculating EVA.

While calculating NOPAT, non operating items like dividend, interest on securities invested outside
the business, non operating expenses will not be considered. In calculating WACC, cost of debt is
cost after tax and cost of equity is based on Capital Asset Pricing Method (CAPM)

The required rate of return is equal to risk free rate plus the risk premium. Risk free return is
the return on risk free security. Risk free security is the security which has no risk of default or
which has zero variance or standard deviation. For example government bills, government bonds.

Risk premium is the premium for systematic risk. Systematic risk is measured by Beta. Beta is a
measure of volatility of systematic risk of a security or investment in the portfolio. Beta factor
explains the correlation coefficient between the returns on market portfolio of investment and the
returns on a particular stock or investment.

Beta factor of a market as a whole is 1

Beta equal to 1 indicates that systematic risk is equal to the aggregate market risk. It means a
particular security return fluctuates equal to market returns.

Beta greater than 1 indicates that systematic risk is greater than the aggregate market risk. It means
that particular security returns fluctuates more than market returns.

Beta less than 1 indicates that systematic risk is less than the aggregate market risk. It means that
particular security returns fluctuates lesser than market returns.

Zero beta indicates there is no volatility.

Under CAPM, cost of equity is calculated as under-

Risk free return + risk coefficient (ß)(Expected market return – risk free return)

For example, if risk free return on government bonds is 5.5%. rate of return on market portfolio is
13.5%, beta of that company is 1.1875. then required rate of return or cost of equity will be as
under-

5.5% + 1.1875 ( 13.5% - 5.5%) = 15%

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EVA is always expressed in rupee terms and not in percent.

Calculation of EVA requires 3 figures – 1. NOPAT, 2. TCE, 3. WACC

 Market Value Added ( MVA ) MVA approach measures the change in the market value of
firm’s equity vis-à-vis equity investment, symbolically –

MVA = Market value – Equity investment . MVA approach is applicable to only those firms whose
shares are quoted in market – that is listed securities only, besides the value provided by this
approach may exhibit wide variations due to many reasons.

MVA approach reflects market expectations and is essentially a future oriented and forward looking
approach.

Suppose, XYZ ltd is having equity market value of 3400 crore, assuming equity share capital is
2000 crore and its retained earning is 600 crore. Find MVA

MVA = 3400 - ( 2000+600) = 800 crore.

Another example, XYZ Ltd, has equity market value as 900 crore, It has equity capital and
accumulated losses as 1200 crore and 200 crores. Find MVA

MVA = 900 – ( 1200-200) = - 100 Crore

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BUDGETARY CONTROL AS A CONTROL TOOL

 Budget

A budget is defined as “A quantitative plan of action that aids in co ordination and control
of acquisition and utilization of resources over a given period of time.

It is quantitative expression of management plans. It is a formal expression of policies,

plans, objectives and goals laid down in advance. There is master budget for the enterprise as a
whole, composed of numerous functional budgets like sales, manufacturing budget, admin, finance
budget. The process of preparing budget is known as budgeting.

 Budgetary Control:-

There has also to be execution of budgets. Comparison between budget figures and actual
performance should be made.

Budgetary control is one of technique of managerial control. Budgetary control is

establishment of budget relating to responsibilities and continuous comparison of actual with
budgetary results

Budgetary control involves three steps:

1. Preparation of budgets
2. Continuous comparison
3. Revision of plans in the light of changed circumstances.

 Advantages of budgetary control:-

1. Budgets are an effective means of controlling the activities of an enterprise. Budget

provides targets to measure the performance and take necessary remedial action.

2. Budgetary control co ordinates various activities.

3. It saves executive time and attention by emphasizing the exception principle. The
executives need to concentrate their attention on off budgeted performance only.

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4. It helps to fix responsibility once the budget is drawn with the consent of the man in
charge of particular activity, it becomes his responsibility to see that actual are in
conformity with the budget.

5. Reduction of wasteful expenditure is possible.

6. Actions are likely to be based on study and careful consideration.

7. Budget provides data for preparing quotations and filling tenders. They provide data
for fixing overhead recovery rates.

8. Cost variance will reveal the weakness that exists.

9. Sound management principles, delegation and responsibility are recognized.

10. Budget enables a concern to stabilize production.

 Budgeting as a control:-

Budgeting which is an expression of management expectation and plans, also serves as an

important device for control.

1. Budgeted plans - implemented,

2. progress achieved - periodically assessed,

3. deviations - have to be analyzed,

4. corrective action has to be taken in time,

5. Follow-up actions have to be taken for remaining period.

Budgets keeps- constant check, acts as a watchdog

Budgeting as a control mechanism, helps in regulating and reducing costs and expenses.
Any variance - is corrected in time to avoid further losses. Business activities are examined.
Weaknesses as revealed by budgetary deviations are removed, necessary changes are swiftly made.

Planning and control are closely related. Planning provides scope and frame of reference for
control where there is no planning; there will be no effective control.

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Budgeting helps planning and control -

Budgeting - as a comprehensive, formal financial representation of managerial plans. 1.

Comprehensive because, activities directed towards maximize profits, are covered by management
plans and consequently by budgeting. 2. formal in the sense that budgeting is done as a regular and
systematic exercise

It makes management - think well in advance , pinpoints manger’s responsibility for

planning which is likely to suffer because due to day to day work pressures,

Budgeting as a controlling mechanism helps in regulating and reducing costs and expenses.
Weaknesses as revealed by budgetary deviations are removed. Necessary changes are swiftly made.
Resources are most efficiently used.

 Master Budget –

Large business organization - has too many departments, activities and units. Separate
budgets prepared for each such activity, by the respective department managers. The activity or
department - is known as budget centre and budgets are called functional budgets. All separate
budgets need to be coordinated. Master budget is prepared to achieve this co ordination.

Master budget is ‘budget’ of the budget. It is prepared by the top management or budget
committee.

Master budget can be broken into:

1. Functional or operating budgeting

2. Financial budgets.

In short master budget is a summary of functional budget

 Zero base Budget –

In conventional budgeting current years budgets are worked out based on past figures plus some
percentage to cover inflation. There is no relation between expenses made and results obtained.
There is no control over inputs given to obtain output. Zero Based Budgeting (ZBB) overcomes this
limitations by starting the budget with zero figure. It starts with the presumption that next year
budget will be zero and then demand for every rupee needs to be justified in front of budget
committee. So money spending vis-à-vis its effect has to be justified under ZBB.

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ZBB introduced by- Peter Pyhrr , a staff control manager at Texas Corporation in US. He
developed this technique -during 1969-70. ZBB gets recognition after President Jimmy Carter
strongly supported the use of ZBB

ZBB differs from conventional system of budgeting - that it starts from scratch or zero and not on
the basis of historical figures. Every process or expenditure has to be justified by the responsible
manager to include the same in the budget. He has to give reasons to state what would happen if the
same expenditure is not incurred during the budget period.

ZBB provides a choice among different alternatives so that most economical activity can be
selected based on its importance and priority.

Procedure for ZBB –

1. Identifying decision units that is responsibility centers

2. Analysis of decision units in terms of decision package. Decision package contains the
following –

a. Description of activity

b. Goals of function or activity

c. Specific measures of performance

d. Benefits to be derived from activity

e. Consequences of its non funding – justifying how non funding will result into
financial or non financial loss to a company

f. Projected cost of package

g. Alternative ways of performing that activity

3. Evaluating decision package and ranking of the same

4. Preparing detail operating budget

 Identification of Key factor -

Starting point - is identification of key factor / limiting factor / principal budget factor. Key factor
may not be the same for all years; it may change from year to year. Management must give the

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reasonable time to decide about the key factor and also the remedial measure to overcome this
factor in due course of time. Examples of principal budget factors are –

a. Material – availability , restrictions by govt

b. Labour – shortage of skilled / qualified labour

c. Plant and machinery – capacity to produce, lack of space , bottlenecks in key process,
insufficient funds to procure

d. Sales – low demand , poor advertisement

e. Finance – long term , short term

f. Time

g. Research work

 Budgeting with reference to engineered and discretionary costs –

Budgets for expenses are of two types – 1. Engineered costs or expenses and 2. Discretionary costs
or expenses.

In Engineered cost centers the input costs can be measured with the great degree of
certainty. In production department the cost of input for a desired output can be calculated
and the optimum relationship between the input and output can be established. This means
that one can know the cost of production. Direct costs such as raw material, labour,
components, supplies and utilities are engineered cost. Discretionary costs, on the other hand
are those costs, for which no such engineered estimates are possible. Management based on
their judgment incurs these costs. Under these, costs output cannot be measured in monetary
terms. For example, administrative cost, support units costs, expenses incurred on R&D, etc.

Points of difference between Engineered cost v/s Discretionary cost

1. Engineered costs - Amount can be estimated with reasonable accuracy and reliability.
For example, direct labour, material, components, utilities etc. Magnitude of expense can
be estimated.

Discretionary costs - No estimate is possible, amount depends on management’s

judgment. Costs tend to vary with the volumes from one year to another. But they do not
vary with short term fluctuations in volume within given year.

2. Engineered cost centre - budgetary control is exercised by setting standard and

reporting actual costs against these standards.

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Discretionary cost centre – Purpose is to allow the manager to control cost by

participating in planning.

3. Engineered cost centre - financial performance report helps higher management to

evaluate the efficiency of the manager.

Discretionary cost centre - financial performance report is used to ensure -

commitments will not exceed without superior’s knowledge.

4. Engineered cost centre - financial control is exercised through an operating expense

budget

Discretionary cost centre - financial control is exercised at the planning stage before
amounts are incurred.

Topic 6

Capital Budgeting as a tool for Management Performance

“Budgets” are essentially meant for:

 Allocation of scarce resources and

 Control and monitoring of expenses
The two major finance budgets that a business enterprise usually prepares are:

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 Revenue budget – prepared on an annual basis with monthly break-up. Purpose is to control
revenue expenses related to different activities in an organization. If there is a monthly break-up
of expenses, the review is also done on a monthly basis.
 Capital budget – prepared on an annual basis with once in a year review process. This budget is
more meant for capital expenses. External finance and shareholders’ capital are warranted only
for major capital expenditure like expansion, diversification, modernization etc. There is a
difference between capital expenditure on routine items like say copier machine, furniture and
fixtures, EPABX (telephone exchange) etc. which do not give any return unlike industrial
projects. Industrial projects require a lot of funds and in turn, give positive cash flows (net cash
flows being positive – difference between cash outflows and cash inflows)

Different kinds of capital budgets –

There could be different kinds of capital budgets in an organization like:

1. Budgets for projects that involve huge capital outlays (cash outflows) but also bring in
substantial net cash inflows

2. Budgets for replacement of assets that bring in improved operating efficiency resulting in cost
reduction that is indirectly cash inflow – this is different from the first one in requirement of
funds also.
3. Budgets for routine items that are fairly regular and involve only capital expenditure from
internal accruals.
Parameters for all the above three would be different for planning, resource mobilization, resource
allocation, monitoring and control.

1. Budgets for projects require in-depth and detailed planning like project report including report
on marketing feasibility, technical feasibility, technological feasibility, financial feasibility etc.
Resource mobilization will be partly from equity of promoters and major portion will be in the
form of debts like project loans, debentures etc. There will be a separate committee constituted
in professionally run organizations called, “project committee” that takes the responsibility for
the entire project. The committee is associated with the project right from the conception of the
project till its completion and commercial production. One of the major functions of the
committee is “project review, monitoring and control”. Lenders go in depth into the risks
associated with the projects and have a detailed appraisal before sanctioning the loans etc. The
repayment of the external loans is spread over a fairly long period.
2. Budgets for replacement may or may not be supported by external assistance. If the requirement
is substantial due to a number of machines being replaced, although in a phased manner,
external assistance may be called for in the form of loans; otherwise the resources could be
“internal accruals”.

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3. Budgets for routine items have to be met only from internal accruals. There will be constant
demand from various departments within the organization for funds and budgetary process is
very much indicated here. Not much of planning is required and resources are available
internally.

Choosing capital projects – Conventional and Discounted Cash Flow techniques

A project owner wants return from the project higher than the cost of debt (borrowing) and the cost
of equity (his own contribution). He also wants the recovery of capital within a period that he is
comfortable with. This period is known as “pay back period”.

The finance manager proceeds to prepare the project cash flows based on certain assumptions that
are central to the working of the project. Some of the assumptions that a finance manager should
consider are:

 The cost of the project and means of financing them

 The cost of all inputs like materials, power etc. and the selling prices of outputs
 The weighted average cost of capital
 The rates of depreciation on the fixed assets
 The requirement of working capital for the project
 The installed capacity (in terms of 100% production) of the plant
 The capacity utilization in terms of % of the installed capacity
 The cost of imported materials, components if any and the foreign exchange fluctuation if any
etc.

Methods of financial evaluation of the project:-

The methods take into account the following considerations from the project owners’ and project
lenders’ points of view:

1. Whether the project is earning a return that is higher then its cost of capital?
2. Whether the project’s earnings recover the capital investment in the desired period called
“payback period”?
3. Whether the objective of the project in creating assets is achieved through “wealth
maximization”

Broad classification of the methods of financial evaluation of projects –

1. Conventional Method

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2. DCF ( Discounted cash flow )

Conventional methods – these methods do not consider the time value of money.

Payback period
This is defined as the period in which the original capital investment is recovered.

In case there is more than one project with the same amount of investment to choose from, based on
payback period method, the project having less payback period will be chosen.

Example,
We invest in a project Rs. 300 lacs. The projected cash flows at the end of three years are as under:

Year 1 = Rs. 150 lacs

Year 2 = Rs. 100 lacs

Year 3 = Rs. 75 lacs

Total = Rs. 325 lacs.

At the end of two years, the capital recovery is Rs. 250 lacs. Remaining amount to the recovered =
Rs. 50 lacs. We will have to find out in how many months, this stands recovered in the third year.
This is based on the assumption that the cash flows occur uniformly in the project.

(50/75) x 12 months = 8 months

Thus payback period for this project is = 2 years + 8 months = 2.67 years

Without this calculation, on the first reading of the figures of cash flows it can be seen that the
payback period lies between the second and the third year of the project.

Merits:

 Easy to calculate
 Gives an idea of capital recovery
Demerits:

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1. Does not consider the time value of money or timing of the cash flows. For example if Rs. 100
lacs were to be the cash flows at year 1 and year 3, both are considered to be equal.
2. Reliability as an evaluation method is very limited as the cash flows after the pay back period
are ignored.

The shortcoming in this method can be overcome by discounting the future cash flows at a suitable
rate of discount and then determine the payback period. This is called “adjusted” or “discounted”
payback method.
Modern methods or “Discounted Cash flow Techniques” are:
1. Net Present Value ( NPV )
2. Internal Rate of Return ( IRR )
3. Profitability Index ( PI )
Net Present value method
Merits:

1. Takes into consideration the project cash flows for the entire economic life of the project.
2. Applies time value of money – timing of the cash flows is the basis of evaluation.
3. Net present value truly represents the addition to the wealth of the shareholders.
4. Reliable as a method of evaluation of alternative projects.

Demerits:

1. It is not an easy exercise to estimate the discounting rate

2. In real life situations, alternative investment projects with the same amount of capital
investment are non-existent practically

Internal Rate of Return method (IRR)

Internal Rate of Return for an investment proposal is the discount rate that equates the present value
of the expected net cash flows (CFs) with the initial cash outflow.

This means that the Net present value in the case of IRR = “zero” or Present value of project cash
flows = original investment at the beginning of the project.

How do you get IRR by calculation?

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IRR is obtained by “trial and error” method. Suppose we are given a set of cash flows, both outflow
at the beginning and inflows over a period of time in future. We start with some rate as the
discounting rate and start determining the NPV till we get NPV= zero. In case the rate lies between
two rates, we fix the range and mention that the IRR lies in this range. By employing the method of
interpolation we find that the IRR =

Merits:

1. It tells us the rate at which the project should get a return taking into consideration the risks
associated with the project
2. It takes into consideration the time value of money and hence reliable as a tool for evaluation of
projects
3. It is very useful to a lender who is always interested in NPV = zero at a given rate and in a given
period.
Demerits:

1. It takes a long time to calculate

2. Based on this comparison cannot be made between projects of unequal size. A smaller project
could get selected because of higher IRR as against a project in which wealth maximization is
very good (NPV being very high) only because it’s IRR is less than the previous one.
3. Multiple IRRs (more than one IRR) will be the outcome in case there is a negative sign in the
project cash flows in the future. This means that should it happen that in one-year project cash
inflow is negative (cash outflows being more than cash inflows) it will give rise to more than
one IRR.

Profitability Index (PI)

The profitability index or benefit-cost ratio of a project is the ratio of present value of future net
cash flows to the initial cash outflow. It can be expressed as

Weighted average cost of capital (WACC)

For discounting cash flow techniques we require cash flows to be discounted at cut off rate that is
generally weighted average cost of capital. This rate depends on capital structure that is how the
capital is made up of.

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TRANSFER PRICING

 Objectives and need –

Transfer of goods and services - can be made with / without profit. Transfer price is a price
related to goods or services transferred from one process to another or from one dept to
another. Transfer price is a matter of policy.

Need arises from the departmentation. When the enterprise is divided into various
departments, it is essential to decide about the transfer price. Transfer pricing may be used -
to ensure goal congruence between different autonomous divisions. Finally transfer pricing
has to be decided considering the overall profitability of company.

Objectives

1. To provide each business segment - relevant information to determine optimum trade off
between costs and revenues

2. It should induce the goal congruence - division and also company profits

3. Help to measure economic performance

4. System should be simple to operate

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Transfer price typically include the profit element because an independent company
normally would not transfer the goods and services to another independent unit at cost or
less.

The fundamental principle - transfer price should be similar to price that would be charged if
the product were sold to outside customer.

Under TP, two decisions must be made periodically.

1. make or buy decision

2. transfer price decision

 How to arrive at competitive transfer price –

1. If prices are published they are treated as benchmark

2. If production profit centre (PC)can sell it to outside market, TP can be decided

3. If buying PC can buy it from outside source, TP can be decided.

4. If excess capacity is available it has to be utilized

5. In case of shortages in market, selling centre may well get better prices by selling it in open
market

6. If market price be ascertained or can be approximated, use it

 Methods of transfer pricing

1. Market based transfer price

2. Cost based transfer price

3. Two step pricing

4. Dual transfer pricing

5. Profit sharing

Market based – Market based prices are best choice. Both selling and buying divisions can sell or
buy as much as they want. Managers are indifferent

- Usual practice to give discounts on market price since there is no cost of marketing when the
transfers are internal.

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Cost based transfer price – Under following situations cost based transfer price is used:

1. When there is no market price for the product such as semi finished, specialized products
etc.

2. When there is difficulty in determining the market price.

Cost based price is either at cost or cost plus mark up profits. Under cost based there are following
versions-

1. Standard or actual cost based

2. Variable cost based

3. Variable cost plus pricing

4. Total cost plus pricing

Two step pricing

Two step pricing - include two components – 1. Charge for standard variable cost of production and
2. Periodic charge which is equal to fixed costs associated with the facilities reserved for buying
unit. One or both of these two charges include profit element. Example –

Business unit x – has expected monthly sales to Business unit Y - 5000 units.Its variable cost is Rs.
5 and monthly fixed costs are Rs.20,000. The investment made by Business unit X for the facilities
are Rs. 12 lacs on which 10% return is expected.

Under two step pricing method transfer price would be decided as under –

Charge 1 towards variable cost – that is Rs.5 per unit

So Business Unit Y will pay Rs.5 * 5000 = 25000 plus

Charge 2 towards fixed cost and profit calculated as –

Fixed cost @ Rs. 4 * 5000 = 20,000

Profit at 10% on 12,00,000 for one month = 10,000

Total = 30,000

Charge 1 + charge 2 = 25000 + 30000 = 55,000

This is the same amount it would pay to Business unit X if the transfer price were Rs.11 (5 v.c + 4
f.c + 2 profits)

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If the transfer in another month were only 4000 units then, as per two steps pricing Business unit Y
has to pay as under –

Charge 1) Rs. 5 (variable cost) * 4000 = 20000

Charge 2) Fixed cost plus profit element = 30000

Total 50000,

This amount is higher as compared with Rs. 44000, ( Rs.11 * 4000 = 44000 ), this is because it has
not utilized full capacity of 5000 units of Business unit X

 Dual transfer pricing

Transfers are recorded by the selling units at market price, while the purchaser records the
purchases at cost based transfer price. Since there are two different prices, the reconciliation
account is must.

Dual – a) Enhance the cooperation between divisions, b) prevent conflicts , c) encourage

transferring division to maximize the income, d) provide the cost effective product for purchasing
division.

Dual pricing gives motivation to selling division as goods are transferred at market price, which
would otherwise can be sold. The buying division will continue to buy at cost unless the outside
price is less than the variable cost of selling division.

 Profit sharing –

In case the two step pricing system is not feasible, profit sharing system might be used to ensure
congruence between business units.

This system operates as under –

1. The product is transferred to marketing unit at variable cost

2. After the product gets sold , business units share the contribution earned which is the selling
price less variable manufacturing and marketing cost

This system - is appropriate when the demand - is not constant but - fluctuating.

However there may be arguments over the sharing of contributions by business units and senior
management may have to intervene frequently. Another difficulty is, since the contribution can not
be allocated until the sales are effected, the manufacturing unit has to wait till the goods are sold
and profits are earned.

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Questions on the topic –

1. Why transfer pricing is required? What are different methods to calculate transfer prices?
2. Short notes –
a. Market based and cost based transfer price
b. Transfer pricing

Cases in Transfer Pricing

TOPIC 8

INTRODUCTION TO AUDIT FUNCTIONS

Audit –

Meaning and definition –derived from Latin word – “audire “which means to “hear / Listen “.
Initially auditor used to hear the accounts of accountant.

Prof Dicksee defines auditing as “ an examination of accounting records undertaken with a view to
establishing whether they correctly and completely reflects the transactions to which they purport to
relate.

It is intelligent and critical verification of books of accounts by an expert ( auditor ) who has no
connection with the writing of these set of books of accounts.”

To safeguard the interest of shareholders, audit by the independent , competent agency has become
essential and hence audit has been made compulsory for all companies under companies act.

Main object - is to determine accuracy and reliability. The emphasis is clearly on verification of
accounting data with a view to report on reliability, testing of reliability, competency and adequacy
of evidence

Auditor collects, tests, weighs the evidence to obtain support of his audit findings. U/S 227 auditor
has to confirm in their report about – whether in his opinion the accounts represents true and fair
view of the business concern.

Audit can be statutory or non statutory – Statutory audit is the audit compulsory under any
particular statute or act.

 Objectives of audit –

Objectives can be broadly divided into two categories –

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1. Primary

2. Secondary

Primary objective - whether statement of accounts represents true and fair view, this means that
auditing - does not only restricted to arithmetical accuracy but also aims at fairness

Secondary objectives can be further divided into following-

a. Detection and prevention of errors

b. Detection and prevention of frauds

 Financial audit

Statutory audit. Statutory because it is made mandatory by the companies act 1956 u/s 224

Object – 1). whether balance sheet and profit and loss account exhibits true and fair view of state of
affairs of the company, and whether it is drawn up as per the requirement of company’s act 1956 ,
2) Detection of fraud

Statutory auditor is reporting to shareholders and is appointed by shareholders in annual general

meeting.

 Objectives of financial audit –

1. To assess whether there is compliance as to accounting procedure

2. Prevention of fraud , waste , detection of error

3. Plugging the loopholes in the financial management

4. Verify the documentation is in conformity with internal control system

5. Compliance with the companies ( auditors report ) order 2003

 Rights of financial / statutory auditor –

1. Right to access books of accounts at all times. Cost records maintained u/s 209 is also
included in the term “ books “

2. Section 227 has given full rights to auditor to ask for any type of assistance and information
from any officer / responsible person of the company in order to support to performance of
his duties

3. Right to attend the general meeting

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4. Right to visit branch office

5. Right to seek opinion of expert

6. Right to receive the remuneration

 Duties of statutory auditors –

1. To make a report to shareholders

2. To make adequate disclosures in report – disclosures about a) true and fair view of business,
b) report on Compliance Audit Report Order – C (AR) O 2003, he has to report on all
matters specified in the order. C) he has to report in thick type about the observations and
comments which have any adverse effect on functioning of company, d) report on specific
enquiry

3. Duty to give reasons for qualification if any

4. Duty to sign the audit report

5. Duty to comply with standard auditing practices (SAP’s) SAP’s lay down the principles
governing an audit. If for any reason the auditor has not been able to perform audit in
accordance with SAP’s, his report should draw special attention on this matter.

 Cost Audit

In 1965 companies act 1956 was amended to incorporate statutory maintenance of cost records and
then cost audit become possible under section 233 B of companies act.

As per Institute Of Cost And Works Accountants Of India (ICWAI) it is an audit of efficiency of
minute detail of expenditure while the work is in process and not postmortem of records.

CIMA, London defines cost audit as verification of correctness of cost accounts and its adherence to
accounting plans.

ICWAI defines cost audit more specifically to give emphasis on ongoing process of audit and not
just a postmortem of records.

Basic objective is to ensure that in respect of companies engaged in manufacturing, production,

processing and mining activities proper records relating to utilization of material labour are
available which would make efficiency audit possible.

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Section 233 B of companies act - the central Government, by an order direct that an audit of the
cost records kept by the company u/s 209 (1) (d) shall be conducted by cost accountant within the
meaning of cost and works accountants act 1959.

This is in addition to the audit conducted by the auditor under section 224. Subsection 2 of section
233 B prescribes that the cost auditor shall be appointed by Board of Directors (and not
shareholders) with the previous approval of central government.

Cost auditor shall have same powers and duties as that of auditor u/s 227.

Cost auditor does not submit his report to shareholders, but to central government (with a copy to
company)

Central government can direct to company to circulate the part of the report to its members along
with the notice of annual general meeting.

Cost audit report rules (amended from time to time) prescribe the rules regarding cost audit report
and its contents.

Cost audit report is to be sent - within 180 days

Company has to furnish all details within 135 days

Cost audit presupposes the existence of cost accounting records. Government has through section
209 of companies act 1956 powers to make it compulsory in case of specified companies to
maintain cost records.

In exercising these powers the government has prescribed rules regarding maintenance of cost
records separately for many industries like – sugar, cement , tyres and tubes , automobile batteries ,
caustic soda, electric lamps , air conditioners , electric motors , electric fans , vanaspati , bulk
drugs , jute goods , paper , rayon , cotton textiles , motor vehicles etc.

 Definition –

CIMA , London - it as “ it is verification of correctness of cost accounts and of the adherence to cost
accounting plan “.

According to ICWA of India - “ it is system of audit introduced by Government of India for the
review , examination and appraisal of the cost accounting records and added information required to
be maintained by specified industries “

 Cost auditor reports on –

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1. Matters which appear to him to be clearly wrong in principle or unjustifiable.

2. Cases where company’s funds have been used in negligent manner

3. Factors which could have been controlled but has not been controlled leading to increase in
cost of production

4. Contracts and agreements between company and other parties

5. Adequacy of budgetary control system

6. Suggestions and improvement in performance if any

Copies of cost statements in prescribed format should be attached to cost audit report.

Cost audit report rules have specified various points in which the cost auditor should make his
observations and give his conclusions.

Cost auditor must report on the adequacy of cost records and confirm in writing that they (cost
records) give a true and fair view of cost of production, cost of sales and margin on the product.

Cost accounting uses same basic principles of accounting - But varies in its approach and emphasis.

It gives more emphasis on factory organization, engineering process, knowledge of workings of

factories. Costing aims at making the organizations more efficient and economical by providing the
information about cost effective solutions, productivity analysis.

 Cost audit Vis-à-vis Financial audit

1. Financial audit is compulsory for all companies; where as cost audit is not compulsory for
all but only some specified companies.

2. Financial audit covers all records including cost records, where as cost audit is restricted to
cost records only

3. Financial audit is conducted by practicing chartered accountant, where as cost audit by

practicing cost accountant

4. Financial auditor is appointed by shareholders in its AGM, where as cost auditor is

appointed by board of directors with previous approval of central govt.

5. Financial audit is supposed to submit report to shareholders, where as cost auditor is

required to submit his report to CG with a copy to company

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6. Financial results are published in news papers, where as cost audit results are not published
in media

 Internal audit

It is in addition to statutory audit. When companies grow beyond its limits, it is advisable to
appoint internal auditors. It is an independent appraisal of activity within an organization for
review of financial accounting and other business practices as protective arms of management.

It is - continuous critical review of financial and operating activities by a staff of auditors

functioning as full time salaried employees of an organization.

Recently a new name called operational audit or management audit is being used for internal
audit. By operations it means transactions of business, since internal audit covers all transactions
of business, it is termed as operation audit. Internal audit is integral part of whole internal
control system.

 objectives of internal audit are –

1. To verify accuracy and reliability of accounting data

2. To ensure that company incurs liabilities in respect of valid and legitimate activities.

3. To prevent and detect frauds etc.

4. To analyze existing system of internal control

5. To detect and correct inefficient operations and weak points, recommend changes if
required.

6. Safeguarding assets, utilization and accounting.

 Principles of audit :

1. Integrity, objectivity and independence

2. Confidentiality

3. Skill and competence

4. Documentation

5. Planning

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6. Evidence

7. System and internal control

8. Conclusion and reporting

 Management audit

 The term management audit, operational audit and the modern concept of internal audit
often convey more or less same meaning. There is no clear cut demarcation between
these terms, and these can be used interchangeably.

 In an audit assignment, it is difficult to say which portion is internal audit, which is

operational audit and which portion relate to management audit.

 Some authors attempt to distinguish between operational audit and management audit.
According to them, operational audit is confined to various activities and operations in
functional areas, where as management audit deals with management process as a whole.

 As the name indicates, it is an audit to examine, review and appraise the various policies
and actions of the management. It is comprehensive and critical review of all aspects of
management. It attempts to evaluate performance of management – from top to bottom.
So naturally, to evaluate performance of top executives like CEO, CFO one should be
much competent enough to evaluate their performance and decisions.

Definition -

CIMA defines management audit as an objective and independent appraisal of the effectiveness
of managers and effectiveness of the corporate structure in achievement of company’s
objectives and policies.

Kohler defined it as “an appraisal by a public accountant or other professional person of

management performance relating to adherence to governing policy, profit capability, adequacy
of operating controls, operating procedures, relationship with employees and customers.

According to Churchill and Cyert, “management audit is performed with the objective of
examining the efficiency of information control system, management procedures towards
achievement of objectives”

Aim is to identify existing and potential management weaknesses within an organization and to
recommend the ways to rectify these weaknesses.

There are 3 different schools of thoughts for defining the management audit.

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One school of thought gives the emphasis on auditing of management accounts. Just as financial
audit is audit of financial accounts, management audit is audit of management accounts.

Second school of thought looks it as a review function and it conclude that management audit
should review the management performance. It means it is directed towards review of
performance of top most level – CEO and Board of directors, their decision making etc. But
however the required person to take this review has to be basically of that mettle since lesser
person will not be acceptable as appraiser.

Third school of thought puts management audit in between the first two approaches. It
concentrates its attention on the fact that the management involves different functions like
purchasing, sales, production etc. It called these functions as operations. Therefore it refers
management audit as operational audit.

To keep aside the controversies over the issue, one can simply define management audit as -

Comprehensive and constructive examination of an organization structure of company,

institution or branch of government, and its plans and objectives, its methods of controls, means
of operation and its use of human and physical facilities.

Basic tools to conduct management audit can be broadly stated as under –

a. Questionnaire

b. Flow charts

c. Controls and other charts

d. Interviews

e. Statement analysis

Steps / procedure to conduct management audit

1. Identification of objective of the organization – objectives is the ends towards which all
activities are directed. Objectives should be clearly defined.

2. Overall objectives are then split up into different targets and goals through establishment of
plans , policies , programs , procedures

3. Review of organization structure , whether it can effectively achieve the objectives , specify
responsibility centre

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4. Performance of functional areas and responsibility centers is to be examined. It should be

compared with the targets and objectives. For this it should be first expressed in quantitative
terms.

5. On the basis of examination, realistic course of action is to be suggested... course of action

should always be such that it will motivate the staff

Objectives of management audit can be summarized as under –

1. To ensure optimum utilization of resources employed , including money material, men,

methods

2. To suggest improvement in the methods of operations.

3. To highlight deficiencies if any in objectives , policies , procedures, and programs

4. Highlight weak links in organization structure and in internal control system

5. To help management by providing health indicators, help to prevent sickness, help to

suggest means of how to come out of sickness

6. Anticipate problems and suggest remedies

Scope of management audit

Scope if management audit is endless. There is no clear cut demarcation about where it should stop.
Scope depends from company to company, and there is no limitation. Every organization has to
define the scope of its own management audit Scope of management audit extends to cover almost
all areas, functions of an organization viz. Personnel, administration, Purchase, marketing, finance
etc. Accordingly scope includes the following-

1. Suitability , practicability of the organization, with its desired objectives

2. Effective utilization of resources of the organization

3. Rate of return – whether poor, moderate or above average

4. Relationship of business with the stakeholders

5. Employee relationship

6. Aims and effectiveness at all levels of management – junior , middle ,top level

7. Financial policies and control relating to production, sales and distribution etc.

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Organization is accountable not only to its owners but socially to outsiders – creditors, government,
taxation authorities, and consumers at large. So management audit covers all these areas as well.

Difference between financial audit and management audit

Financial audit is statutory requirement for most of the business or public organization. Financial
audit has a major short coming. It is procedural and rule oriented. It cannot be used as management
tool. It is only a post mortem. Information there in comes too late and is too little to take
management decisions.

Major points of distinction between financial audit and management audit are as under –

1. Expectation – Financial audit is expected to deliver report which is specific and under
statutory guidelines

Whereas management audit report is not a standard and can cover much wide area

2. Attitude – Financial audit acts like a watch dog, where as management audit act as a friend,
philosopher

3. Agency –Financial audit is given to specialized persons like chartered accountants, where as
management audit is given to any specialized, management consultants

4. Force – Financial audit is compulsory, where as management audit is not compulsory but
voluntary

5. Area covered – Financial audit covers mainly accounting part, which is more specific and
defines in statute, where as management audit can cover any area which is in the interest of
management, which can be much wider than financial audit

6. Period – Financial audit is for one financial year which is fixed in period-past one year 1 st
April to 31st march, where as for management audit, there is no specific period – it can be
past or future also

7. Procedure – Financial audit – highly structured, where as in management audit it is flexible

8. Reporting level – Financial audit report is meant for shareholders specifically, where as
management audit report can be made to management , owners, anybody for that matter

Procedure for management audit –

Management audit procedure should be tailored to the specific needs of each situation examined.
General approach in management audit can be outlined as under –

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1. Select an area of operation of management. Make preliminary survey of the activity under
audit to obtain necessary background information.

2. Establish what should be the objective, standard or target; whether the actual results meet
the standards, if not why, whether target is too difficult.

3. Study the basic charter or assignment of responsibility of the activity under audit to ascertain
authorized purposes, related authorities of the activity and any applicable restrictions or
limitations.

4. Study the steps taken for planning, operations, execution and implementation.

5. Review pertinent part of the system of management control by studying the policies
established. On the basis of such review, specific matters may be identified as problem areas
or weaknesses needing further probing.

6. Testing the effectiveness of specific operating and administrative procedures and practices
followed. Whether policy of the organization comply with its basic charter or grant of
authority.

7. Carry out detail investigations, collect evidences - Unlike financial audit there may not be
fixed items of evidences to be checked by management auditor. He has to rely more on his
experience. Evidences come from the discussions with people concerned, surveys and
reviews.

8. Report on the findings of audit work – whether the system of procedures and management
controls is designed to carry out those policies and result in activities being conducted as
desired by management.

9. Making recommendations for improvement

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