A FORMAL DEFINITION OF RESPONSIBILITY ACCOUNTING

Responsibility accounting involves the creation of responsibility centres. A responsibility centre may be defined as an organization unit for whose performance a manager is held accountable. Responsibility accounting enables accountability for financial results and outcomes to be allocated to individuals throughout the organization. The objective is to measure the result of each responsibility center. It involves accumulating costs and revenues for each responsibility centre so that deviation from performance target (typically the budget) can be attributed to the individual who is accountable for the responsibility centre.

Responsibility accounting is a system under which manager are given decision making with authority and responsibility for each activity occuring within a specific of the company. Under this system Manager is made responsible for the activities of segments. These segments may be called department or divisions.

Responsibility Accounting is defined as :Charles T Horngreen - "Responsibility accounting is a system of accounting that recognizes various responsibility centres throughout the organisation and reflects the plans and actions of each of these centres by assigning particular revenues and cost to the one having the pertinent responsibility. it is also called profitability accounting and activity accounting"

Elements/Features of Responsibility Accounting:

It is a system of accounting.

It apply on various responsibility centres.

It is a tool for controlling the action of the executives

it emphasis on human factor management.

it is based on accounting information.

The process of communication of information follows the principles of organisation.

It is an accounting system which collects and report both planned and actual accounting data in terms of sub units which are recognised as responsibility centres.

Principles of responsibility Accounting:

The basic principles of responsibility accounting are -

Responsibility centres within an organisations are identified.

For each responsibility centre, the extent of responsibility is defined.

Controllable and non-controllable factors and activities at various levels of responsibility is specified and defined broadly.

Performance reports are prepared by the responsible person to provide information to the users team.

Some steps of an effective Responsibility Accounting System:

The organisation structure of the business should be divided into various centres like responsibility centre.

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A sound organisation structure with strictly and well defined authority and responsibility shoudl exist.

Adequate, bearable, acceptable and Accurate budgets with full participation of concerned managers should be developed.

Responsibility accounting should have top management support.

It should be supported understood and assigned by managers.

Merits of Responsibility Accounting:

It introduces the sound system of control.

Every person individually accountable for their work assigned and performed by them.

Everybody knows what is expected o fhim.

It is effective tool of cost control and cost reduction.

it is very useful in applying budgetary control and standard costing.

It help the management to make an effectives delegation of authority and required responsibility as well.

It facilitates the management to set realistic plans and budgets.

Responsibility accounting:- is an underlying concept of accounting performance measurement systems. The basic idea is that large diversified organizations are difficult, if not impossible to manage as a single segment, thus they must be decentralized or separated into manageable parts. These parts, or segments are referred to as responsibility centers that include: 1) revenue centers, 2) cost centers, 3) profit centers and 4) investment centers. This approach allows responsibility to be assigned to the segment managers that have the greatest amount of influence over the key elements to be managed. These elements include revenue for a revenue center (a segment that mainly generates revenue with relatively little costs), costs for a cost center (a segment that generates costs, but no revenue), a measure of profitability for a profit center (a segment that generates both revenue and costs) and return on investment (ROI) for an investment center (a segment such as a division of a company where the manager controls the acquisition and utilization of assets, as well as revenue and costs). 

RESPONSIBILITY ACCOUNTING AND RESPONSIBILITY CENTER

Responsibility accounting is the system for collecting and reporting revenue and cost information by areas of responsibility. It operates on the premise that managers should be held responsible for their performance, the performance of their subordinates, and all activities within their responsibility center. Responsibility accounting, also called profitability accounting and activity accounting, has the following advantages:

It facilitates delegation of decision making. 1.It helps management promote the concept of management by objective. In management by objective, managers agree on a set of goals. The manager`s performance is then evaluated based on his or her attainment of these goals.

 2.It provides a guide to the evaluation of performance and helps to establish standards of performance which are then used for comparison purposes.

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3.It permits effective use of the concept of management by exception, which means that the manager`s attention is concentrated on the important deviations from standards and budgets.

 4.For an effective responsibility accounting system, the following three basic conditions are necessary:

(a) The organization structure must be well defined. Management responsibility and authority must go hand in hand at all levels and must be clearly established and understood.

(b) Standards of performance in revenues, costs, and investments must be properly determined and well defined.

(c) The responsibility accounting reports (or performance reports) should include only items that are controllable by the manager of the responsibility center. Also, they should highlight items calling for managerial attention.

A well-designed responsibility accounting system establishes responsibility centers within the organization. A responsibility center is defined as a unit in the organization which has control over costs, revenues, and/or investment funds. Responsibility centers can be one of the following types:

Cost center. A cost center is the unit within the organization which is responsible only for costs. Examples include production and maintenance departments of a manufacturing company. Variance analysis based on standard costs and flexible budgets would be a typical performance measure of a cost center.

Profit center. A profit center is the unit which is held responsible for the revenues earned and costs incurred in that center. Examples might include a sales office of a publishing company, and appliance department in a retail store, and an auto repair center in a department store. The contribution approach to cost allocation is widely used to measure the performance of a profit center. This topic is covered in Chapter 9 (Control of Profit Centers).

Investment center. An investment center is the unit within the organization which is held responsible for the costs, revenues, and related investments made in that center. The corporate headquarters or division in a large decentralized organization would be an example of an investment center.

responsibility center:-unit in the organization that has control over costs, revenues, or investment funds. For accounting purposes, responsibility centers are classified as cost center, revenue center, profit center, and investment center. A well-designed responsibility accounting system should clearly define responsibility centers in order to collect and report revenue and cost information by areas of responsibility.

1. Cost Center:-A cost center is an organizational sub-unit such as department or division, whose manager is held accountable for the costs incurred in that division. For example, a Power and Airco Department can can be defined as a cost center within the Operation and Maintenance Department in United Telecommunication Company. Manager of a cost center is responsible for controllable costs incurred in the department, but is not responsible for revenue, profit or investment in that center. A cost center is a responsibility center in which inputs, but not outputs are measured in monetary value.

or……….unit within the organization in which the manager is responsible only for costs. A cost center has no control over sales or over the generating of revenue. An example is the production department of a manufacturing company. The performance of a cost center is measured by comparing actual costs with budgeted costs for a specified period of time.

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Non-revenue-producing element of an organization, where costs are separately figured and allocated, and for which someone has formal responsibility. The personnel function is a cost center in that it does not directly produce revenue.

In business, a cost centre or cost center is a division that adds to the cost of an organization, but only indirectly adds to its profit. Typical examples include research and development, marketing andcustomer service.[1] There are some significant advantages to classifying simple, straightforward divisions as cost centres, since cost is easy to measure. However, cost centres create incentives for managers to underfund their units in order to benefit themselves, and this underfunding may result in adverse consequences for the company as a whole (for example, reduced sales because of bad customer service experiences).

Because the cost centre has a negative impact on profit (at least on the surface) it is a likely target for rollbacks and layoffs when budgets are cut. Operational decisions in a cost centre, for example, are typically driven by cost considerations. Investments in new equipment, technology and staff are often difficult to justify to management because indirect profitability is hard to translate to bottom-line figures.

Business metrics are sometimes employed to quantify the benefits of a cost centre and relate costs and benefits to those of the organization as a whole. In a contact centre, for example, metrics such as average handle time, service level and cost per call are used in conjunction with other calculations to justify current or improved funding

2. Revenue Center:-A manager of a revenue center is held accountable for the revenue attributed to the sub-unit. Revenue centers are responsibility centers where managers are accountable only for financial outputs in the form of generating sales revenue. A revenue center's manger may also be held accountable for selling expenses such as sales persons' salaries, commissions, and order receiving costs.

Or……..unit within an organization that is responsible for generating revenues. A revenue center is a profit center since for all practical purposes there is no revenue center that does not incur some costs during the course of generating revenues. A favorable variance occurs when actual revenue exceeds expected revenue.

3. Profit Center:-Profits are the excess of revenue over the total expenses. Therefore, the manager of a profit center is held accountable for the revenues, costs, and profits of the center. A profit center is a responsibility center in which inputs are measured in terms of expenses and outputs are measured in terms of revenues.

Or………responsibility unit that measures the performance of a division, product line, geographic area, or other measurable unit. Divisional profit figures are best obtained by subtracting from revenue only the costs the division manager can control (direct division costs) and eliminating allocated costs common to all divisions (e.g., an allocated share of company image advertising that benefits all divisions but is not controlled by division managers). Profit is a very often used method to evaluate a division's financial success as well as the performance of its manager. In determining divisional profit, a transfer price may have to be derived. The divisional profit center allows for decentralization. as each division is treated as a separate business entity with responsibility for making its own profit.

A profit center is a section of a company treated as a separate business. Thus profits or losses for a profit center are calculated separately

A profit center manager is held accountable for both revenues, and costs (expenses), and therefore, profits. What this means in terms of managerial responsibilities is that the manager has to drive the sales revenue generating activities which leads to cash inflows and at the same time control the cost (cash outflows) causing activities. This makes the profit center management more challenging than cost center management. Profit center

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management is equivalent to running an independent business because a profit center business unit or department is treated as a distinct entity enabling revenues and expenses to be determined and its profitability to be measured.

Business organizations may be organized in terms of profit centers where the profit center's revenues and expenses are held separate from the main company's in order to determine their profitability. Usually different profit centers are separated for accounting purposes so that the management can follow how much profit each center makes and compare their relative efficiency and profit. Examples of typical profit centers are a store, a sales organization and a consulting organization whose profitability can be measured.

Peter Drucker originally coined the term profit center around 1945. He later recanted, calling it "One of the biggest mistakes I have made." He later asserted that there are only cost centers within a business, and “The only profit center is a customer whose cheque hasn’t bounced.”

4. Investment Center:-The manger of investment center is held accountable for the division's profit and the invested capital used by the center to generate its profits. Investment centers consider not only costs and revenues but also the assets used in the division. Performance of an investment center are measured in terms of assets turnover and return on the capital employed.

Or………responsibility center within an organization that has control over revenue, cost, and investment funds. It is a profit center whose performance is evaluated on the basis of the return earned on invested capital. The corporate headquarters or division in a large decentralized organization would be an example of an investment center. Return On Investment (ROI) andResidual Income (RI) are two key performance measures of an investment center.

Or……An investment center is a classification used for business units within an enterprise. The essential element of an investment center is that it is treated as a unit which is measured against its use of capital, as opposed to a cost or profit center, which are measured against raw costs or profits.

The advantage of this form of measurement is that it tends to be more encompassing, since it accounts for all uses of capital. It is susceptible to manipulation by managers with a short term focus, or by manipulating the hurdle rate used to evaluate divisions.

In business, a revenue centre or revenue center is a division that gains revenue from product sales or service provided.[1] The manager in revenue centre is accountable for revenue only.

What Does Investment Center Mean?A business unit that can utilize capital to directly contribute to a company's profitability. Companies evaluate the performance of an investment center according to the revenues it brings in through investments in capital assets compared to the overall expenses. An investment center is sometimes called an investment division.

RESPONSIBILITY REPORTING SYSTEM:-Involves preparation of a report for each level of responsibility in the company's organization chart.

Begins with the lowest level of responsibility and moves upward to higher levels.

Permits management by exception at each level of responsibility.

Also permits comparative evaluations.

Plant manager can rank the department manager’s effectiveness in controlling manufacturing costs.

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Comparative ranking provides incentive for a manager to control costs.

Definition and Explanation of Decentralization

A decentralized organization is one in which decision making is not confined to a few top executives but rather is throughout the organization, with managers at various levels making key operating decisions relating to their sphere of responsibility. Decentralization is a matter of degree, since all organizations are decentralized to some extent out of necessity. At one extreme, a strongly decentralized organization is one in which even the lowest-level managers and employees are empowered to make decisions. At the other extreme, in a stronglydecentralized organization, lower-level managers have little freedom to make decisions. Although most organizations fall somewhere between these two extremes, there is a pronounced trend toward more and more decentralization.

Advantages/Benefits of Decentralization:

Decentralization has many advantages/benefits, including:

Top management is relieved of much day-to-day problem solving and is left free to concentrate on strategy, on higher level decision making, and coordinating activities.

Decentralization provides lower level managers with vital experience in making decisions. Without such experience, they would be ill-prepared to make decisions when they are promoted into higher level positions.

Added responsibility and decision making authority often result in increased job satisfaction. Responsibility and the authority, that goes with it makes the job more interesting and provides greater incentives for people to put out their best efforts.

Lower level managers generally have more detailed and up to date information about local conditions than top managers. Therefore the decisions of lower level management are often based on better information.

It is difficult to evaluate a manager's performance if the manager is not given much latitude in what he or she can do.

Disadvantages of Decentralization:

Decentralization has four major disadvantages:

Lower level managers may make decisions without fully understanding the "big picture." While top level managers typically have less detailed information about local operations than the lower level managers, they usually have more information about the company as a whole and should have a better understanding of the company's strategy.

In a truly decentralized organization, there may be a lack of coordination among autonomous managers. This problem can be reduced by clearly defining the company's strategy and communicating it effectively throughout the organization.

Lower-level managers may have objectives that are different from the objectives of the entire organization. For example, some managers may be more interested in increasing the sizes of their departments than in increasing the profits of the company. To some degree, this problem can be overcome by designing performance evaluation system that motivate managers to make decisions that are in the best interests of the organization.

In a strongly decentralized organization, it may be more difficult to effectively spread innovative ideas. Someone in one part of the organization may have a traffic idea that would benefit other parts of the organizations, but without strong central direction the idea may not be shared with, and adopted by other parts of the organization.

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Definition and Explanation of Segment:

A segment is a part or activity of an organization about which managers would like cost, revenue or profit data. Examples of segments include divisions of a company, sales territories, individual stores, service centers, manufacturing plants, marketing departments, individual customers and product lines.

Effective decentralization requires segment reporting. In addition to the companywide income statement, reports are needed for individual segments of the organizations. These segmented income statements are useful in analyzing the profitability of segments and measuring the performance of segment managers.

Decentralized companies typically categorize their business segments into cost centers, profitcenters, and investment centers--depending on the responsibility of the segment managers of the segment.

Cost center:A cost center is a business segment whose manager has control over costs but not over revenue or investment funds. Service departments such as accounting, finance, general administration, legal, personnel and so on, are usually considered to be cost centers. In addition, manufacturing facilities are often considered to be cost centers. The managers of cost centers are usually expected to minimize the costs while providing the level of services or the amount of products demanded by the other parts of the organization. For example, the manager of a production facility would be evaluated at least in part by comparing actual costs to how much costs should have been for the actual number of good units produced during the period. Standard costing and variance analysis page deals this evaluation of the performance of cost centers in detail.

Profit center:A profit center is any business segment whose manager has control over both cost and revenue. Like a cost center, a profit center generally does not have control over investment funds. Profit center managers are often evaluated by comparing actual profit to targeted or budgeted profit. Segmented income statements should be used to evaluate the performance of profit center managers.

Investment center:An investment center is any segment of an organization whose manager has control over cost, revenue and investments in operating assets. Investment centers are usually evaluated usingreturn on investment or residual income measures.

Responsibility Center:Responsibility center is broadly defined as any part of an organization whose manager has control over cost, revenue, or investment funds. Cost centers, profit centers and investment centers are all known as responsibility centers.

DIVISIONAL PERFORMANCE MEASUREMENT

A.Objective: The objective is to develop performance measurement systems for divisions that are significant investment centers in large organizations. Such systems should: (1) provide information for economic decisions, (2) facilitate the control of division operations, (3) motivate managers to achieve high levels of divisional performance so as to further the objectives of the entire organization, and (4) serve as a basis for evaluating the performance of divisional managers.

B.The nature of divisionalization:-As a special case of decentralization, divisionalization represents the concept of delegated profit and, to some extent, investment responsibility.

Divisions usually perform many of the basic business functions themselves – planning, production, accounting, marketing, and some financing activities.

Definitions: A segment of a business is recognized as a division when it exercises responsibility for both producing (or purchasing) and marketing products or services. Normally a division has some control over both sources of supply and the customers served.

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A segment is recognized as an administered center when it is a captive customer of other units within the same economic entity. A division has more of an independent business unit than an administered center.

Reasons for divisionalization:-

Work sharing is one very simple reason for delegating decision-making authority. As firms become larger, and serve more diverse markets, the decision-making process can become bogged down and out-of-touch if it is center in a few individuals. Committees are utilized in order to coordinate information and to improve decisions in place of individual executives. Divisionalized operations make use of specialized skills such as knowledge about a particular product, a particular type of customer, a market or a geographic area. The idea is to better utilize specialized knowledge by letting the managers with the specialized knowledge make more decisions.

Greater manager motivation is believed to result when the creative talents of responsible individuals can develop in a climate of individual responsibility, authority and dignity made possible by the decentralization of decision-making authority.

Divisional operations provide a good training ground for top management positions because a division manager has the opportunity to make a variety of decisions which would not be possible in either functional areas or in positions of limited responsibility.

Since much of managerial activity is directed toward the problem of generating income, the establishment of profit centers in the form of divisions makes it possible to evaluate managers on their ability to generate income from operations.

The chain of command shortened in divisionalized operations since most decisions are made at the division level or below. Therefore, a divisionalized company should be more responsive to market changes and to production developments than a centralized company.

Much of the information used in the management of a company is developed at lower levels in the organization. Therefore, decentralization has the effect of moving decision points closer to the sources of information for those decisions.

Conditions necessary for divisionalization to succeed

Each division should be sufficiently independent of other divisions with respect to both production activities and marketing activities to make its separate profit responsibility a meaningful reality.

In order for the company to prosper as an economic entity, a certain amount of cooperation and interdependence among the divisions is necessary to achieve corporate goals. The objective is to fully exploit opportunities for operating, investment, and product-line synergies.

Relations between divisions must be regulated so that no division, by seeking its own profit, can reduce that of the corporation.

The corporate administration must maintain some self-restraint in issuing directives to division managers to ensure division managers are making decisions and not just administering decisions made at a higher level.

Problems associated with divisionalization

Divisionalized administrative systems are more expensive to operate, so that the benefits must outweigh the added costs.

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It requires more administrative talent to operate a firm. Sufficient talent may not be available at any one point in time.

The top management skills needed to run a divisionalized firm are different than the skills needed to run a centralized firm, so top management personalities must be consistent with the organizational structure adopted.

Division of Authority Between Staff Departments and Divisions

Staff functions at the division level have two bosses in a sense, the divisional general manager and the corresponding staff group at central office. It is customary to require division staffs to at least consult with central staff experts.

Purchasing – Master contracts may be made by central purchasing and most information collected centrally. This does not preclude specific terms being set at the local level, taking advantage of specialized knowledge and needs.

Marketing – Pricing decisions are made centrally in many divisionalized firms and at the division level in other firms. Likewise, advertising may essentially be under the control of a central staff, which obtains budget approval from the DGM, or the division may have responsibility for divisional advertising.

Economic forecasting – General forecasting is almost always done at the corporate level but divisions in specialized market will normally survey their own markets and these surveys used at various levels of planning to supplement corporate forecasts.

Research – Fundamental research is usually carried out in a central research facility under contract with division or at corporate expense. Applied research is more likely to be carried out at the divisional level or in one portion of a central facility.

Employee Relations – Union recognition policy, pension plans, vacation policy, employee insurance programs and executive development are usually administered at the central office. Routine training is usually done at the division level. Labor negotiations depend on the unions involved and the extent to which various divisions employ members of a common union, etc.

Public relations – Primarily a centralized function.

Legal services – Almost always centralized with perhaps a legal staff member in residence at each major division.

Financial Services – Treasury functions are usually centralized, especially cash management. The handling of billing and accounts receivable varies, but actual money collection is usually centralized.

Insurance – is usually purchased centrally to achieve more favorable costs. Typically, coverage is standardized.

Controllership – functions are often split between the central office and the division. The centralization of computing and the information needs of management often result in a centrally specified account structure and reporting system.

Typical constraints on divisions

Product price and (approximate) mix decisions may be made by or require approval by central management.

Interdivision transfers within the company may inhibit the product mix decisions of one or more division managers.

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Centralized financing decisions influence if not determine the overall levels of divisional investment.

Centralized approval of capital expenditures influences the rate of growth and composition of divisional investment.

Corporate R & D budgets determine research directions and influence product innovation.

Corporate advertising and promotion programs influence product demand levels.

Types of performance evaluation

Economic (Activity) Evaluation is concerned with the measurement of the economic productivity of a division relative to both other divisions and other forms of investment. Economic performance evaluation should help managers make investment-divestment decision.

Operations evaluation is concerned with the day-to-day monitoring of operations vis-à-vis competitors and planned results. This score-keeping and attention-directing information is of primary interest to the responsible divisional managers.

Managerial evaluation is concerned with the measurement of the performance of individuals as managers of divisions. This score keeping information is of primary interest in the periodic planning and performance review cycle which influences the systems of rewards.

Dimensions of Economic Performance

Return per dollar invested relative to the time invested in terms of purchasing power (price-level adjusted cash) flows.

Timing of the returns on investment.

Risk of the returns on investment.

Economic Decision Criteria

The generally accepted approach is to maximize the net present value of future purchasing power flows at a level of risk, which depends upon the investor’s utility function.

Operationally, risk and return are measured separately or the certainty-equivalent purchasing power flows are discounted at the cost of capital to determine a net present value.

Divisional Performance Measures

Primary approaches to divisional performance measures.

Return on investment (ROA).

a. Definition: Return on investment is income from operations or some other measure of return dividend by: (1) total operating assets, (2) total operating assets less current liabilities, or (3) net operating assets.

(1) ROA (total assets) = Return x Sales

Sales Total assets

(2) ROA (net assets) = Return x Sales x Total assets

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Sales Total assets Net assets

Strengths:

The amount of return (earnings) is related to the investment base required to generate that return. Thus, the emphasis is on the rational allocation of scarce capital resources.

ROA normalizes the size effect since it is a ration. This, we can compare entities of different sizes.

As a percentage-return measure, ROA is comparable to cost-of-capital and market rate of return measures.

Changes in ROA will lead to changes in EPS. Thus, achieving ROA objectives consistent with a firm’s cost of capital will lead to the achievement of desirable levels of total earnings, EPS and corporate ROA.

Weaknesses:

There is no incentive for a division to expand to the point where the marginal return on investment equals the cost of capital.

ROA can be improved by selling low-return but acceptable projects.

As an accounting measure, ROA has all of the defects of such measures.

Residual Income (RI)

Definition: Residual income is net operating income or net after-tax earnings plus interest (net of the tax effect) less the desired rate of return on investment multiplied by the amount of investment

Strengths:

The amount of return (earnings) is related to both the investment base required to generate that return and the required rate of return on investment (cost of capital). Thus, the emphasis is on the rational allocation of scarce capital resources.

Residual income focuses on the magnitude of income earned in excess of the cost of capital. Some writers believe managers are primarily interested in magnitudes, not rates of return.

RI is more early consistent with the net present value method of selecting capital investments, the preferred method in theory and practice.

RI converts the interest computation to a periodic flow measure which quickly translates into it effect on residual income. Thus, it is easy to translate a change in the cost of capital into its effect on residual income, a flow measure.

The method by which RI is calculated lend itself to the use of different required rates of return for activities with different risk levels.

Changes in RI will lead to changes in EPS. Thus, achieving RI objectives will lead to the achievement of desirable levels of total earnings and EPS at the corporate level.

Weakness:

As an accounting measure, RI has all of the defects of such measures.

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Profit Margins (PM)

Definition: Profit margin is some measure of return, usually net operating earnings after tax, divided by sales revenue.

Strengths:

Profit margins are sensitive to changes in revenues and expenses, which both require careful planning and control on a continuing basis.

Changes in profit margins are the primary determinant in changes in ROA.

Weaknesses:

Focusing on profit margins ignores the capital required to generate those margins, which may result in a misallocation of product-market resources.

As an accounting measure, PM has all of the defects of such measures of revenue and expense.

Investment Intensity (Asset Turnover)

Definition: Investment intensity is a ratio measure of the relationship between sales revenue and the dollar investment in assets required to generate those sales.

Strengths:

Asset utilization is conceptually an important component of ROA management.

Asset utilization is a familiar concept.

Weaknesses:

Asset utilization is a means to an end, not an end in itself.

Asset utilization does not seem to vary much over time. That is, changes in asset utilization are not a major factor in changes in ROA based on empirical studies of changes in ROA.

Limitations of Accounting Measures of Performance

Due to timing differences between cash flows and income flows, performance is being measured on a basis that may be inconsistent with the investment criteria in use by management and by investors in the firm. Accounting Measures of Performance

Accounting measures are relatively insensitive to the time-value-of money except that portion reflected by the explicit interest cost.

Accounting measures are relatively insensitive to sudden shifts in risk level although various measures of risk tend to be correlated over time.

Changing price levels can “cover-up” poor sales and earnings growth and make comparisons more difficult.

Unrealized changes in resource prices are extremely important in some situations but are reported on a limited, ad hoc basis.

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Depreciation patterns tend to overstate the trend in ROA and RI especially if they are calculated on net investment. The annuity method of computing depreciation is an exception.

Depreciation alternatives and other allocation problems tend to make comparability difficult.

For short and intermediate periods, accounting measures of corporate performance may provide inconsistent signals. The most troublesome inconsistency is between ROA and EPS.

Divestments

Stock-for-stock mergers

Investment timing

There are a number of different measures of investment that may be used to compute ROA and RI

Traceable assets – All assets specifically identifiable with the investment center, regardless of their location.

Controllable investment – All assets controllable by division management, less any current liabilities within its jurisdiction.

Total assets – All assets of the investment center including a share of centrally administered assets.

Net investment – The division’s share of total assets less non-interest bearing current liabilities.

Stockholders’ equity – The owner’s prorate share of the investment in divisional assets.

Asset (investment) measurement problems include:

Centrally administered assets.

Changing resource prices can “cover-up” marginal investments.

Defining the investment base to properly include relevant assets and liabilities (lease, intangible assets, software, etc.)

Return on Investment (ROI) for Measuring Managerial Performance:

In a truly decentralized company, segment managers are given a great deal of autonomy. Profit and investment centers are virtually independent businesses, with their managers having about the same control over decisions as if they were in fact running their own independent firms. With this autonomy, fierce competition often develops among managers, with each striving to make his or her segment the "best" in the company. Competition between investment centers is particularly keen for investment funds.  How do managers in corporate headquarters go about deciding who gets new investment funds as they become available and how do these managers decide whichinvestment centers are most profitability using the funds that have already been entrusted to their care?  One of the most important ways of making these judgments is to measure the rate of return that investment managers are able to generate on their assets. This rate of return is called the return on investment (ROI)

Definition of Return on Investment (ROI):

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The return on investment (ROI) is defined as net operating income divided by average operating assets.

ROI Formula / Equation:

[ROI = Net operating income / Average operating assets]

Net operating income and operating assets defined:

Net operating income rather than net income is used in the ROI formula. Net operating incomeis income before interest and taxes and is sometimes referred to as "earnings before interest and tax (EBIT)" Net operating income is used in the formula because the base (i.e.., denominator) consists of operating assets. Thus, to be consistent we use net operating income in the numerator. Operating assets include cash, accounts receivable, inventory, plant and equipment, and all other assets held for productive use in the organization. Examples of  assets that would not be included in operating assets category would include land held for future use, an investment in another company, or a building rented to someone else. These are also called non operating assets.

The operating assets used in the formula is typically computed as the average of the operating assets between the beginning and the end of the year.

Plant and Equipment: Net Book Value or Gross Cost?

Determining the dollar amount of plant and equipment that should be included in the operating assets base is a major issue in ROI computations.

Example:

Assume that a company reports the following amounts for plant and equipment on its balancesheet:

Plant and equipment $3,000,000

Less accumulated depreciation 900,000

 

Net book value $2,100,000

 

What dollar amount of plan and equipment should company include in its operating assets in computing ROI?

One widely used approach is to include only the plant and equipment's net book value. That is the plant's original costless accumulated depreciation ($2,100,000 in the example above). A second approach is to ignore depreciation and include the plant's entire gross cost in the operating assets base ($3,000,000 in the example above). Both of these approaches are used in actual practice, even though they will obviously yield very different figures for operating assets and therefore for RIO computations.

Methods of Controlling and Improving  the Rate of Return on Investment (ROI):

Return on investment is normally used to judge the managerial performance in an investment center.

Managers therefore try to control and improve the ROI of their investment center. Here we shall discuss the methods of improving rate of return on investment.

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 The following formula is usually used for computing return on investment.

Return on investment (ROI) = Net operating income / Average operating income

This formula is also discussed at rate of return for measuring managerial performance page. We can modify this formula slightly by introducing sales as follows:

ROI = (Net operating income / Sales) × (Sales / Average operating assets)

These two equations are equivalent because the sales terms cancel out in the second equation. The first term on the right hand side of the equation is margin, which is defined as follows:

Margin = Net operating income / Sales

Margin is a measure of management's ability to control operating expenses in relation to sales. The lower the operating expenses per dollar of sales, the higher the margin earned.

The second term on the right hand side of the equation is turnover, which is defined as follows:

Turnover = Sales / Average operating assets

Turnover is a measure of the sales that are generated for each dollar invested in operating assets.

The following alternative form of the ROI formula, which we will use here, combines margin and turnover.

ROI = Margin × Turnover

Both the formulas give same answer. However margin and turnover formulation provides some additional insights. Some managers tend to focus too much on margin and ignore turnover. To some degree the margin can be a valuable indicator of a manager's responsibility. Standing alone, however, it overlooks one very crucial area of manager's responsibility--the investment in operating assets. Excessive funds tied up in operating assets, which depresses turnover, can be just as much of a drag on profitability as excessive operating expenses, which depresses margin. One of the advantages of return on investment (ROI) as a performance measure is that it forces the manager to control the investment in operating assets as well as to control expenses and the margin.

When return on investment (ROI) becomes a very crucial to judge the performance of investment centers managers, managers need to improve ROI of their centers. An investment center manager can improve ROI in basically three ways.

To illustrate how an investment center manager can improve ROI by making the use of three methods mentioned above consider the following example:

Example:

The following data represents the results of an investment center of the operations of a company for the most recent month. 

Net operating incomeSalesAverage operating assets

$10,000100,00050,000

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The rate of return generated by the company for this investment center is as follows:

ROI               =             Margin             ×           Turnover

(Net operating income / Sales) × (Sales / Average operating assets)

($10,000 / $100,000) × ($100,000 / $50,000)

10%  × 2= 20%

As we stated above that manager can increase sales, reduce expenses, or reduce the operating assets to improve the ROI figure.

Residual Income-Another Method to Measure Managerial Performance:

Residual income is the net operating income that an investment center earns above the minimum required return on its operating assets. Residual income is another approach to measuring aninvestment center's performance. Economic Value Added (EVA) is an adoption of residual incomethat has recently been adopted by many companies. Under EVA, companies often modify their accounting principles in various ways. For example funds used for research and development are often treated as investment rather than as expenses under EVA. These complications are best dealt with in more advanced courses. Here we will focus on the basics and will not draw any distinction between residual income and EVA.

When residual income or EVA is used to measure managerial performance, the objective is to maximize the total amount of residual income or EVA, not to maximize return on investment (ROI).

Example:

For the purpose of illustrating consider the following data for an investment center of a company. 

Basic Data for Performance Evaluation

Average operating assetsNet operating incomeMinimum required rate of return

$100,000$20,00015%

The company has long had a policy of of evaluating investment center managers based on ROI, but it is considering a switch to residual income. The controller of the company, who is in favor of the change to residual income, has provided the following table that shows how the the performance of the division would be evaluated under each of the two methods:

 Alternative Performance Measures       

ROI Residual income

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Average operating assets (a)

Net operating income (b)ROI, (b) ÷ (a)Minimum required return (15%  $100,000)

Residual income

$100,000=======$20,00020% 

$100,000=======$20,000

15,000----------$5,000=======

The reasoning underlying the residual income calculation is straight forward. The company is able to earn a rate of return of at 15% on its investments. Since the company has invested $100,000 in the division in the form of operating assets, The company should be able to earn at least $15,000 (15% × $100,000) on this investment. Since the division's net operating income is $20,000, the residual income above and beyond the minimum required return is $5,000. If residual income is adopted as the performance measure to replace ROI, the manager of the division would be evaluated based on the growth in residual income from year to year.

Comparison of return on investment (ROI) and residual income:

One of the primary reasons why controllers of companies would like to switch from ROI to residual income has to do with how managers view new investment under the two performance measurement schemes. The residual income approach encourages managers to make investments that are profitable for the entire company but that would be rejected by managers who are evaluated by ROI formula.

To illustrate consider the data mentioned above and further suppose that the manager of thedivision is considering purchasing a machine. The machine would cost $25,000 and is expected to generate additional operating income of $4,500 a year. From the stand point of the company, this would be a good investment since it promises a rate of return of 18% [($4,500 / $25,000) ×100], which is in excess of the company's minimum required rate of return of 15%. If the manager of the division is evaluated based on residual income, she would be in favor of the investment in the machine as shown below. 

Performance evaluated using residual income

  Present New Project Overall

Average operating assets

Net operating incomeMinimum required return

Residual income

$100,000=======$20,00015,000-----------$5,000========

$25,000=======$4,5003,750-----------$750========

$125,000========$24,50018750-----------$5,750=======

Since the project would increase the residual income of the division, the manager would want to invest in the new machine.

Now suppose that the manager of the division is evaluated based on the return on investment (ROI) method. The effect of the machine on the division's ROI is computed as below:

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Performance evaluated using residual income

  Present New project Overall

Average operating assets (a)Net operating income (b)ROI, (b) ÷ (a)

$100,000$20,00020%

$25,000$4,50018%

$125,000$24,50019.6%

The new project reduces the ROI from 20% to 19.6%. This happens because the 18% rate of return on the new machine, while above the company's15% minimum rate of return, is below thedivision's present ROI of 20%. Therefore the new machine would drag the division's ROI down even though it would be a good investment from the standpoint of the company as a whole. If the manager of the division is evaluated based on ROI, she would be reluctant to even propose such an investment.

Basically, a manager who is evaluated based on ROI will reject any project whose rate of return is below the division's current ROI even if the rate of return on the project is above the minimumrate of return for the entire company. In contrast, any project whose rate of return is above the minimum required rate of return of the company will result in an increase in residual income. Since it is in the best interest of the company as a whole to accept any project whose rate of return is above the minimum rate of return, managers who are evaluated on residual income will tend to make better decisions concerning investment projects than manager who are evaluated based on ROI.

As a matter of historical note, the ROI approach to financial control was originally pioneered by Du Pont for its decentralized operations, and today in many companies that use some form of return-on-investment measurement it is often referred to as the “Du Pont system.” Nothing in this article, however, should be construed as criticism of the Du Pont company.

I have used the original form of the Du Pont system as the basis for my article because: (a) it was the first major comprehensive decentralized financial control system developed in the United States; (b) almost every major decentralized company today uses some adaptation of it; and (c) the system itself is extremely well documented. At the time Du Pont first developed its return-on-investment control system, it was far superior to anything else then in existence. Over the years, however, flaws have been discovered in the system. Moreover, changes in accounting techniques have created problems that did not exist when the system was first developed. Finally, return on investment is only one of Du Pont’s control mechanisms; yet many companies have adopted the ROI system while ignoring the other elements of control that have made this approach effective at Du Pont. All of the conclusions presented herein, therefore, will apply to systems that measure profit performance in terms of “return on investment.”

The Du Pont System:-William T. Jerome has described Du Pont’s decentralized financial control system in this way:“As practiced by Du Pont executives, return on investment has become a symbol for the company’s system of management control. As such, return on investment is a way of approaching the problem of top-level control rather than a magic formula for solving these problems.”1

Distinctive elements

The chief characteristic of such a management control system is the measurement of financial performance in terms of return on investment. This is a fraction, the numerator of which is the accounted profit earned by the division, while the denominator is the investment assigned to the division. The investment consists of two parts: fixed assets and working capital (inventories, receivables, and cash). The fixed assets are included in the investment base at gross book value (original cost); inventories and receivables are included in the investment base at their actual accounting balances; and cash is an allocated amount (since cash is controlled centrally) that is

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equal to one-and-a-half times the department’s forecasted average monthly cost of sales less the depreciation taken by the department.

A second important characteristic of this control system is the wide degree of latitude allowed the industrial departments in meeting their ROI goals. “The job of the operating department is thus to make a projected return on investment, not to live within a budget”.2 In other words, there is little concern as to how the individual manager meets his ROI objective as long as he does. For example, he may increase his return on investment in the short run by reducing costs, by increasing sales volume or prices, or by reducing his investment base. Under this system, the important consideration is the impact on the ROI.

A third characteristic is that performance is evaluated quarterly by comparing actual return on investment with the ROI objective and by analyzing the difference. Individual analyses are made on the basis of charts, of which the “formula chart” shown in Exhibit I is probably the best known.

Mr. Dearden is Professor of Business Administration at the Harvard Business School, and a familiar figure to regular HBR readers. He is the author of many articles and books on management control and planning.

CENTRALIZED VS. DECENTRALIZED DECISION-MAKING:  Sometimes by plan, and sometimes simply as a result of top managements' leadership style, organizations will tend to gravitate to either a centralized or a decentralized style of management.  With a centralized style, the top leaders make and direct most important decisions.  Lower-level personnel execute these directives but are generally powerless to independently make policy decisions.  A centralized organization is benefited by strong coordination of purpose and methods, but it has some glaring deficiencies.  Among these are the stifling of lower-level managerial talent, suppression of innovation, and reduced employee morale.

Many contemporary business successes have occurred in highly decentralized organizations.  Top management concentrates on strategy, and leaves the day-to-day operation and decision-making tasks to lower-level personnel.  This facilitates rapid "front-line" response to customer issues and provides for identifying and training emerging managers.  It can also improve morale by providing each employee with a clear sense of importance that is often lacking in a highly centralized environment.  Decentralization can prove a fertile ground for cultivating new and improved products and business processes.

RESPONSIBILITY CENTERS:  A decentralized environment results in highly dispersed decision making.  As a result, it is imperative to monitor and judge the effectiveness of each manager.  This is easier said than done.  Not all units are capable of being evaluated on the same basis.  Some units do not generate any revenue; they only incur costs in support of some necessary function.  Other units that deliver goods and services have the potential to be assessed on the basis of profit generation.

As a generalization, the part of an organization under the control of a manager is termed a "responsibility center."  To aid performance evaluation it is first necessary to consider the specific character of each responsibility center.  Some responsibility centers are cost centers and others are profit centers.  On a broader scale, some are considered to be investment centers.  The logical method of assessment will differ based on the core nature of the responsibility center.

COST CENTER:  Obviously most business units incur costs, so this alone does not define a cost center.  A cost center is perhaps better defined by what is lacking; the absence of revenue, or at least the absence of control over revenue generation. 

Human resources, accounting, legal, and other administrative departments are expensive to support and do not directly contribute to revenue generation.  Cost centers are also present on the factory floor.  Maintenance and engineering fall into this category.  Many businesses also consider the actual

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manufacturing process to be a cost center even though a saleable product is produced (the sales "responsibility" is shouldered by other units). 

It stands to reason that assessments of cost control are key in evaluating the performance of cost centers.  This chapter will show how standard costs and variance analysis can be used to pinpoint areas where performance is above or below expectation.  Cost control should not be confused with cost minimization.  It is easy to reduce costs to the point of destroying enterprise effectiveness.  The goal is to control costs while maintaining enterprise effectiveness.

Nonfinancial metrics are also useful in monitoring cost centers: documents processed, error rates, customer satisfaction surveys, and other similar measures can be used.  The concept of a balanced scorecard is discussed later in this chapter, and it can be very relevant to evaluating the performance of a cost center.

PROFIT CENTER:  Some business units have control over both costs and revenues and are therefore evaluated on their profit outcomes.  For such profit centers, "cost overruns" are expected if they are coupled with commensurate gains in revenue and profitability.

A restaurant chain may evaluate each store as a separate profit center.  The store manager is responsible for the store's revenues and expenses.  A store with more revenue would obviously generate more food costs; an assessment of food cost alone would be foolhardy without giving consideration to the store's revenues.  

INVESTMENT CENTER:  At higher levels within an organization, unit managers will be held accountable not only for cost control and profit outcomes, but also for the amount of investment capital that is deployed to achieve those outcomes.  In other words, the manager is responsible for adopting strategies that generate solid returns on the capital they are entrusted to deploy.  Evaluation models for investment centers become more complex and diverse.  They usually revolve around various calculated rates of returns.

One popular method was pioneered by E. I. du Pont de Nemours and Company.  It is commonly known as the DuPont return on investment (ROI) model, and is pictured at right.  This model consists of a margin subcomponent (Operating Income/Sales) and a turnover subcomponent (Sales/Average Assets).  These two subcomponents can be multiplied to arrive at the ROI.  Thus, ROI = (Operating Income/Sales) X (Sales/Average Assets).  A bit of algebra reveals that ROI  reduces to a much simpler formula: Operating Income/Average Assets.

But, a prudent manager who is to be evaluated under the ROI model will quickly realize that the subcomponents are important.  Notice that ROI can be increased by any of the following actions:  increasing sales, reducing expenses, and/or decreasing the deployed assets.  The DuPont approach encourages managers to focus on increasing sales, while controlling costs and being mindful of the amount invested in productive assets.  A disadvantage of the ROI approach is that some "profitable" opportunities may be passed by managers because they fear potential dilution of existing successful endeavors.  The consulting firm of Stern, Stewart & Co. has trademarked and popularized the Economic Value Added model as an alternative comprehensive evaluative tool for assessing investment returns.  Presumably, it compensates for the deficiencies of simpler models.  Advanced managerial accounting courses typically devote considerable coverage to the various approaches to evaluating investment centers.

AFFIXING RESPONSIBILITY:  Lower-level managers may only be responsible/accountable for a small subset of business activities.  As one moves up the organizational chart, mid and upper-level managers assume ever greater degrees of responsibility.  The reporting system should mimic the expanded scope, and develop information which reveals the performance for all units within the control of a particular manager.   At successively higher steps, individual performance reports are combined to reveal the success or failure of all activities beneath a particular manager.  This can result in one manager being held accountable for a combination of cost, profit, and investment centers.  A keen manager must be familiar with the specific

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The Chief Executive Officer reports to the owners, and the owners are primarily interested in their return on investment.  Three vice presidents report to the CEO:

The VP of operations is responsible for the overall investment in operations, which is driven heavily by the combined profits of each store.  The VP of Operations oversees procurement, store management, and catering management.

The Procurement Manager oversees purchasing of food and dishware.

The Procurement activities are evaluated as cost centers, relying on budgets and standard costs to control activities.

The Store and Catering managers oversee supervisors from each location.The Store and Catering Managers are responsible for producing profits, and are evaluated accordingly.

The VP of Finance is viewed and evaluated as a cost center.

The VP of Real Estate is responsible for site acquisition and construction.  Although the activities are largely viewed in the context of a cost center, there is an expected rate of return for each new real estate investment.  Therefore, the VP of Real Estate is evaluated for cost control and return on investments.

Corporate Policy

Usually, a documented set of broad guidelines, formulated after an analysis of all internal and external factors that can affect a firm's objectives, operations, and plans. Formulated by the firm's board of directors, corporate policy lays down the firm's response to known and knowable situations and circumstances. It also determines the formulation and implementation of strategy, and directs and restricts the plans, decisions, and actions of the firm's officers in achievement of its objectives.

CONCEPT AND MEANING OF CORPORATE POLICY

Corporate policy is the guide post to decision making. It helps in the managerial thinking process and thus leads to the efficient and effective attainment of the objectives of any organization.Corporate policy has been defined as “Management’s expressed or implied intent to govern action in the pursuit of the company’s objectives.” Corporate policy clarifies the intention of management in dealing with the various problems faced. It gives the managers a transparent guideline to take their decisions by being on the safe side. Corporate policy helps the manager in identification of the solutions to the problem. It provides the framework in which he has to take the decisions. The distinct views regarding policies can be categorized into the following three broad groups:

i) The first category holds the opinion that policy and strategy are synonymous.Corporate policy has been defined by William Glueck as “Management policy is long range planning. For all practical purposes, management policy, long range planning and strategic management mean the same thing.” However, this view is quite controversial as strategy and corporate policy do not mean the same thing.Strategy includes awareness of the mission, purpose and objectives. It has been defined as, “the determination of basic long term goals and objectives of an enterprise, and the allocation of resources necessary to carry out these goals”,while policies are statements or a commonly accepted understandings of decision making and are thought oriented guidelines. Therefore, strategy and corporatepolicy cannot be used interchangeably as there isaclearlineofdifferentiationbetween the two terms.

ii) The second group of experts view corporate policy as the process of implementing strategy. In the words of Frank I. Paine and William Naumes,“Policies guide and channel the implementation of strategy and prescribe how processes within the organization will function and be administered. Thus the term policy refers to organization procedures, practices and structures, concerned with

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implementing and executing strategy.”Supporting this view, Robert Mudric has defined corporate policy as “A policy establishes guidelines and limits for discretionary action by individuals responsible for implementing the overall plan.”

The view represents corporate policy to be

! Restrictive

! Laying stress only on the tactical side and ignoring the strategic dimension.

iii) The third view considers corporate policy to be decisions regarding the future of an organization.In this view, Robert J. Mockler defines corporate policy as, “Strategic guidelines for action. They spell out what can and what cannot be done in all areas of a company’s operation.”According to the policy manual of General Electric Company, “Policy is definition of common purpose for organization components of the company for benefit of those responsible for implementation, exercise discretion and good judgment in appraising and deciding among alternative courses of action.”The views of different management scholars differ because of following reasons:

! There is no clear differentiation of policy from other elements of planning.

! There are different policies made at different levels of management for directing executives.

! Corporate policy encompasses and relates to the entire process of planning.

Thus, corporate policy focusses on the guidelines used for decision making and putting them into actions. It consists of principles along with rules of action that provides for successful achievement of corporate objectives.

FEATURES OF CORPORATE POLICY

After understanding the concept of corporate policy, following features can be identified:

! General Statement of Principles: Policies are general statement of principles followed by corporate for the attainment of organizational objectives. These principles provide a guide to action for the executives at different levels.

! Long Term Perspective: Corporate policies have a long life and are formulated with a long term perspective. They provide stability to the organization.

! Achievement of Objectives: Corporate policy is aimed at the fulfillment of organizational objectives. They provide a framework for action and thus help the executives to work towards the set goals.

! Qualitative, Conditional & General Statements: Corporate policy statements are qualitative in nature. They are conditional and defined in general manner.These statements use words as to maintain, to follow, to provide etc. They can be specific at times but most of the times, a corporate policy tends to be general.

! Guide for Repetitive Operations: Corporate policies are formulated to act as a guide for repetitive day to day operations. They are best as a guide for the activities that occur frequently or repeatedly.

! Hierarchy: Corporate policies have an hierarchy i.e. for each set of objectives at each level of management there is a set of policies. The top management determines the basic overall policy, then the divisional and / or departmental policies are determined by the middle level management and lower level policies are more specific and have a shorter time horizon than policies at higher levels.

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! Decision Making Process: Corporate policy is a decision making process. In formulating corporate policy one has to make choices and the choice is influenced by the interests and attitudes of managers engaged in making the policies.

! Mutual Application: Corporate policies are meant for mutual application by subordinates. They are made for some specific situation and have to be applied by the members of the organization.

! Unified Structure: Corporate policies tend to provide predetermined issues and thus avoid repeated analysis. They provide a unified structure to other types of plans and help mangers in delegating authority and having control over the activities.

! Positive Declaration: Corporate policy is a positive declaration and a command to its followers. It acts as a motivator for the people following it and thus they work towards the attainment of the objectives efficiently and effectively. The corporate policy lays down the values which dominate organization’s actions.

DETERMINANTS OF CORPORATE POLICY

The corporate policy of an organization is influenced by various interrelated and interacting factors. These factors can be classified as internal and external factors. The determinants which are internal to the firm/organization and which influence the decisions directly are known as the internal factors. External factors include all those factors which act from outside the firm and influence the organization externally. We discuss these determinants one by one below:

Internal Determinants:-The determinants include the corporate mission, corporate objectives, corporate resources and the management values which are all internal to the organization and play a very important role in the formulation of corporate policy.

i) Corporate Policy:-The policy maker has to understand the corporate mission, so that the policy is in tune with it. Corporate mission provides the company with the meaning for which it exists and operates. Because policy provides guidelines for managerial action, it has to be made in a manner that it accomplishes the corporate mission.

ii) Corporate Objectives:-Another internal determinant of corporate policy are the corporate objectives. All organizations frame organizational objectives and work towards their achievement. Policy makers must take into account the economic, financial and other objectives of the company.

iii) The Resources:-The organization has to carry out its activities keeping in mind the resources it has. The corporate policy has to identify the various resources available and then only can it be made sound. The size of plants, capital structure, liquidity position, personnel skills and expertise, competitive position, nature of product etc. all elp in the formulation of corporate policy.

iv) Management Values:-Corporate policy reflects the values imbibed in the organization. The personal values of the managers forming corporate policy influences its formulation.Management values differ from organization to organization. It is an important determinant of corporate policy.

External Determinants:-These include the forces external to the firm. The external determinants of corporate policy are industry structure, economic environment and political environment.

i) Industry Structure:-The formulation of corporate policy is influenced by the industry in which the firm exists. The structure of industry comprises of size of firms, the entry barriers, number of competitors etc. The corporate policy is formulated keeping in mind competitors, strategies, policies etc.

ii) Economic Environment:-Economic environment comprises of the demand, supply, price trends, the national income, availability of inputs, the various institutions etc. It includes all these factors

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which influence the policies of the firm. Therefore, it becomes one of the most important determinants of corporate policy.

iii) Political Environment:-The firm has to carry out its activities in accordance with the government regulations and policies. If these are not complied with the firm would not be able to meet its objectives in an efficient manner. The various policies like monetary policy, fiscal policy, credit policy influence the corporate policy of the firm

iv) Social Environment:-The firm affects various sections of the society. The various sections in turn influence the activities of the firm. The social beliefs of the managers influence policies. The religious, cultural and ethnic dimensions have to be dealt with while formulating policies of an organization.

v) Technology:-Every now and then, new technologies are entering the market. An organization has to change with the changes in the environment. It has to remain up to date with respect to technology it uses. Thus technology also plays an important role in formulation of corporate policy.

SCOPE OF CORPORATE POLICY

Corporate policies are statements of guidelines for corporate thinking and action. They lay down the approach before the management to deal with the challenges in the environment. They cover the following broad areas that affect the decisions of the organization.

i) Corporate policy consists of a variety of subject that affect various interest groups in the organization and outside it.

ii) Corporate policy is concerned with the various functional areas like production,human resources, marketing and finance.

iii) We can understand corporate policy areas in two broad categories: Major and minor policies. The overall objectives, procedures and control are covered in major policies. These policies are concerned with each and every aspect of the organization, its structure, its financial status, its production stature, its human resources and all those issues which require attention like mergers, research, expansion, etc. Basically, the top management is involved in the framing of such major policies. Further, the operations and activities are also carried out by executives so that the organizational objectives are met.The minor policies are concerned with each segment of the organization with emphasis on details and procedures. These policies are part of the major policies.The operational control can be made possible only if the minor policies are implemented efficiently. The minor policies are concerned with the day to day operations and are decided at the departmental levels. The minor policies may cover relations with dealers, discount rates, terms of credit etc. Thus, corporate policies cover wide range of subjects ranging from operational level policies to the top level policies.

CLASSIFICATION OF CORPORATE POLICY

Corporate policies have been classified on the basis of various criteria. Over the years,the number of bases have changed and developed.Basically there are three main types of policies:

! Basic Policies ! General Policies ! Departmental Policies

Different authors have given different kinds of classifications. Some have classified policies on the basis of functional areas, while some have classified them on the basis of levels. Alfred and Beatty have classified policies as:

! Top Management Policies ! Upper Middle Management Policies

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! Middle Management Policies ! Foremen Policies

! Operating Force Policies ! Sales Policies

! Production Policies ! Research Policies

! Financial Policies ! Costing Policies

! Accounting Policies ! Marketing Policies

! Promotion Policies ! Product Policies

I) Classification on the Basis of Scope:-On the basis of scope of an organization, policies are classified as Basic Policies,General Policies and Departmental or Specific Policies.

! Basic Policies:- These are framed by the top management and spell out the basic approach of a company to its activities and its environment.

! General Policies:- These are framed by the middle level management and are more specific. They apply to large segments of the organization.

! Specific Policies:- These are framed by the foremen and supervisors and are very specific in nature. They are applicable to routine activities.

II) Classification on the Basis of Expression:-On the basis of expression, corporate policies can either be expressed or implied.

! Expressed Policies:- The policies which are expressed in clear words either orally or in writing are the expressed policies. These are most suitable for small organizations.

! Implied Policies:- The Policies which are understood by the employees, code of conduct or behavior and are not expressed orally or through written statements are known as implied policies. They flow from philosophy, values and traditions of the organization.

III) Classification on the Basis of Level:-Different policies are framed at different levels of management. These include:

! Top Management Policies:-These are framed by the top management and it is only responsible for them. The policies are derived from top management planning and top management sees that they are put into effect and judges the results.

! Middle Level Management Policies:-These are laid down by the middle levelmanagers and deal with the organizational activities e.g. selection of executives, employee training, deciding processes, methods, techniques etc.

! Lower Level Management Policies:- Those people who have direct control over the working force comprise the lower level management. These people set up policies with respect to the accomplishment of tasks of sub divisions of the organizations.

IV) Classification on the Basis of Origin:-On the basis of origin, policies are classified as original policies, appealed policies, imposed policies and derivatives policies.

Original Policies:- These policies are formed from the company objectives. These are formed by the top management and the top management is responsible for guiding and directing them and the subordinates are responsible in the attainment of organization objectives.

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Appealed Policies:- These are also called “suggested policies” because they are made by taking into account the suggestions of subordinates or people who implement these policies.

Imposed Policies:- External forces sometimes force the company to accept certain policies forcibly. These policies are called imposed policies. The external forces could include government rules and suggestions, arguments with trade unions etc.

Derivative Policies:- These policies are operational in nature and are derived from company’s major policies. They are made as guidelines to perform day to day operations.

V) Classification on the Basis of Functional Areas:-In an organization, various functional areas are seen. The policies are classified according to functional areas i.e. production policies, marketing and sales policies, financial policies and personnel policies.

Production Policies:- These policies are concerned with product to be produced, type of technology, equipment, selection of plant layout, location and size, manufacturing cost, inventory control, quality control, etc.

Marketing & Sales Policies:- The policies which relate to policies in market analysis, business law, salesmanship, advertising are concerned with total process of marketing mix and product mix. These include decisions with respect to customers, channels of distribution, dealers, sales control, promotions, etc.

Financial Policies:- The success of business depends upon these policies. These consist of policies with respect to capital structure, methods of raising funds, the utilization of funds, credit policy, dividend decisions, profit policy, costing and accounting policy, etc.

Personnel Policies:- Employees are very important for the organization and the personnel policies are concerned with issues like recruitment, selection, training and development, promotions and transfer, wages and incentives, etc.

VI) Classification of Policies on the Basis of Nature of Management:-The main functions of an organization comprise of planning, organizing, actuating and controlling. The policies may therefore be classified as planning policies, organizing policy, actuating policy, and controlling policy.

Planning Policies:- These policies are concerned with the determination of ways to attain the objectives of the organization. Such policies decide corporate objectives, alternative courses of action, comparison of alternatives, establishment of budgets,schedules, procedures, etc.

Organizing Policies:- These policies are concerned with allocation of activities to members of the group so that through their collective efforts, objectives could be achieved. These are those policies which provide for issues like organization structure, authority, responsibility, delegation, centralization and various relationships.

Actuating Policies:- The actuating policies include providing leadership, integrating tasks, communication and organization climate. These policies are concerned with organizing the employees of the organization.

Controlling Policies:- Controlling is the process by which the performance is compared with the set objectives. These policies provide for establishment of standards, pointing out deviations, ascertaining causes for deviation and taking corrective actions.

IMPORTANCE OF CORPORATE POLICY

For effective management, the solving of day to day problems is not enough. What is required is the proper assessment of all kinds of activities and operations taking place in the organization. After the

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assessment, they are to be defined in clear cut way, so that objectives could be met. For definition of the business activities and their efficient implementation, the selection and application of policies is required. Without a guiding light, it would become very difficult for the business to go on and policies act as guide and facilitate the manager to direct all the activities towards the same goal.

! Policies are needed to carry out the business activities in a smooth manner.

! They provide clear cut courses for attainment of business objectives.

! If a proper explicit policy has been formulated, many of the details could be conveniently handled by the subordinates and management would not unnecessarily waste its time and energy in doing them.

! Policies provide a guide and framework for decision making.

! Policies encourage delegation of the power of decision making.

! Good policies provide a direction in which all management activities are focused.

! Policies provide stability to the action of the members of the firm.

! Policies deter the subordinates to rethink on the day to day issues and thus avoid repetitive analysis of issues.

! Policies facilitate evaluation of performance by acting as a standard.41

! They enhance employees Corporate Policy’ enthusiasm and loyalty for the organization.

! They help in solving the problems for optimum utilization of scarce resources.

! The sound policies help in building good public image of the business.

! Polices provide the firm with clear objectives with which the managers can decide about the future course of action.

! They act as tool for coordination and control.

Thus, corporate policy is very important for an organization and helps in the overall development and growth. A sound policy provides satisfaction to the employees in terms of working conditions, culture, authority, responsibility and relationships.

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